SMARTFINANCIAL INC. (SMBK) FY 2022 MD&A

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

Selected Financial Data

Set forth below is certain selected financial data related to the Company’s operations for 2022, 2021 and 2020: (dollars in thousands, except per share data)

1Capital Ratios are for SmartFinancial, Inc.

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Business Overview

The following is a discussion of our financial condition and results of our operations for the years ended December 31, 2022, 2021 and 2020. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from our consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that we believe are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth in the “Forward-Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. We assume no obligation to update any of these forward-looking statements.

We are a bank holding company that was incorporated on September 19, 1983 under the laws of the State of Tennessee, and operate primarily through our wholly-owned bank subsidiary, SmartBank. As of December 31, 2022 the Bank provides a comprehensive suite of commercial and consumer banking services to clients through 41 full-service bank branches and one loan production office in the Florida Panhandle.

While we offer a wide range of commercial banking services, we focus on making loans secured primarily by commercial real estate and other types of secured and unsecured commercial loans to small and medium-sized businesses in a number of industries, as well as loans and leases to individuals for a variety of purposes. Our principal sources of funds for loans and leases and investing in securities are deposits and, to a lesser extent, borrowings. We offer a broad range of deposit products, including checking (“NOW”), savings, money market accounts and certificates of deposit. We actively pursue business relationships by utilizing the business contacts of our senior management, other bank officers and our directors, thereby capitalizing on our knowledge of our local market areas.

In addition to our banking services, we offer insurance products through Rains Insurance Agency, Inc. and loans and leases for heavy equipment through Fountain Equipment Finance, LLC., both are subsidiaries of the Bank.  The Bank also contracts with RJFS, a registered broker-dealer and investment adviser, to offer and sell various securities and other financial products to the public through associates who are employed by both the Bank and RJFS. RJFS is a subsidiary of Raymond James Financial, Inc.

Executive Summary

The following is a summary of the Company’s financial highlights and significant events during 2022:

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Analysis of Results of Operations

2022 compared to 2021

Net income was $43.0 million, or $2.55 per diluted common share in 2022, compared to $34.8 million, or $2.22 per diluted common share in 2021. The tax equivalent net interest margin for 2022 was 3.20% compared to 3.24% for 2021. Noninterest income to average assets was 0.59% for 2022, decreasing from 0.62% for 2021. Noninterest expense to average assets decreased to 2.27% in 2022, down from 2.38% in 2021. Income tax expense was $11.9 million in 2022 with an effective tax rate of 21.7%, compared to $9.5 million in 2021 with an effective tax rate of 21.5%.

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2021 compared to 2020

Net income was $34.8 million, or $2.22 per diluted common share in 2021, compared to $24.3 million, or $1.62 per diluted common share in 2020. The tax equivalent net interest margin for 2021 was 3.24% compared to 3.61% for 2020. Noninterest income to average assets was 0.62% for 2021, increasing from 0.50% for 2020. Noninterest expense to average assets decreased to 2.38% in 2021, from 2.50% in 2020. The results above include operating effects of the Fountain and SCB acquisitions, which were completed on May 3, 2021, and September 1, 2021, respectively. Income tax expense was $9.5 million in 2021 with an effective tax rate of 21.5%, compared to $6.6 million in 2020 with an effective tax rate of 21.2%.

Net Interest Income and Yield Analysis

The management of interest income and expense is fundamental to our financial performance. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). We seek to maximize net interest income without exposing the Company to an excessive level of interest rate risk through our asset and liability policies. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest-earning assets and interest-bearing liabilities. Our net interest margin can also be adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

2022 compared to 2021

Net interest income, taxable equivalent, increased to $138.2 million in 2022 from $114.0 million in 2021. Average earning assets increased from $3.5 billion in 2021 to $4.3 billion in 2022, primarily from organic loan and lease growth, the acquisition of Fountain completed May 3, 2021 and the acquisition of SCB completed September 1, 2021. Over this period, average loan and lease balances increased by $407.9 million and average securities increased by $488.8 million, offset by a decrease in interest-earning cash and federal funds sold of $103.3 million. Average interest-bearing deposits increased by $571.8 million, average noninterest-bearing deposits increased $278.8 million and average borrowings decreased $50.1 million. The tax equivalent net interest margin decreased to 3.20% for 2022, compared to 3.24% for 2021. The yield on earning assets increased from 3.57% for 2021, to 3.70% for 2022, primarily due to the Company’s deployment of excess cash and cash equivalents into loans and leases and securities during 2022 and higher yields on cash deposits in the Federal Reserve System, offset by lower Paycheck Protection Program (“PPP”) fee accretion in loan yields. The cost of average interest-bearing deposits increased from 0.36% for 2021, to 0.60% for 2022, primarily due to the impact of rising Federal Reserve rates and to a lesser extent increased pricing competition.

2021 compared to 2020

Net interest income, taxable equivalent, increased to $114.0 million in 2021 from $101.4 million in 2020. Average earning assets increased from $2.8 billion in 2020 to $3.5 billion in 2021, primarily as a result of the acquisition of PFG completed March 1, 2020, the acquisition of Fountain completed May 3, 2021, the acquisition of SCB completed September 1, 2021, participation in the PPP and continued organic loan and lease growth. Over this period, average loan and lease balances increased by $245.4 million, average interest-earning cash and federal funds sold increased by $372.1 million and average securities increased by $93.5 million. Average interest-bearing deposits increased by $552.5 million, average noninterest-bearing deposits increased $270.5 million and average borrowings decreased $94.1 million. The tax equivalent net interest margin decreased to 3.24% for 2021, compared to 3.61% for 2020. The yield on earning assets decreased from 4.20% for 2020, to 3.57% for 2021, primarily due to the on-going effects of rate cuts by the Federal Reserve during the first quarter of 2020, to a lesser extent loan yields declining from market competition and lower yielding excess liquidity, offset by PPP fee accretion and loan fees. The cost of average interest-bearing deposits decreased from 0.71% for 2020, to 0.36% for 2021, primarily due to a lower interest rate environment during the period.

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Summary of Average Balances, Interest and Rates

The following table presents (dollars in thousands), for the periods indicated, information about: (i) weighted average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields; (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates; (iii) net interest income; (iv) the interest rate spread; and (v) the net interest margin.

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1Loans include PPP loans with an average balance of $14.1 million, $196.1 million and $201.5 million for the years ended December 31, 2022, 2021, and 2020, respectively. Loan fees included in loan income were $4.1 million, $11.1 million, and $9.8 million for 2022, 2021 and 2020, respectively. Loan fee income for the years ended December 31, 2022, 2021 and 2020, respectively, includes $1.9 million, $9.1 million and $5.9 million accretion of loan fees on PPP loans.

2Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 21.0% in 2022, 2021 and 2020. The taxable-equivalent adjustment was $665 thousand, $602 thousand and $572 thousand for 2022, 2021 and 2020, respectively.

3Includes average balance of $91,190 in Paycheck Protection Liquidity Facility (“PPLF”) funding in the twelve month period ended December 31, 2020.  No PPLF funding was used the twelve month periods ended December 31, 2022, and 2021.

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Rate and Volume Analysis

Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest rates. Net interest income, taxable equivalent, increased by $24.2 million between the years ended December 31, 2022 and 2021 and by $12.6 million

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between the years ended December 31, 2021 and 2020. The following is an analysis of the changes in net interest income comparing the changes attributable to rates and those attributable to volumes (in thousands):

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Changes in net interest income are attributed to either changes in average balances (volume change) or changes in average rates (rate change) for earning assets and sources of funds on which interest is received or paid. Volume change is calculated as change in volume times the previous rate while rate change is change in rate times the previous volume. The change attributed to rates and volumes (change in rate times change in volume) is considered above as a change in volume.

Noninterest Income

Noninterest income is an important component of our total revenues. A significant portion of our noninterest income is associated service charges on deposit accounts and mortgage banking fees.

The following table provides a summary of noninterest income for the periods presented (in thousands):

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2022 compared to 2021

Noninterest income increased $3.8 million to $27.7 million in 2022, compared to $23.9 million in 2021. The primary components of the changes in noninterest income were as follows:

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2021 compared to 2020

Noninterest income increased $8.5 million to $23.9 million in 2021, compared to $15.4 million in 2020.  The primary components of the changes in noninterest income were as follows:

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Noninterest Expense

The following table provides a summary of noninterest expense for the periods presented (in thousands):

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2022 compared to 2021

Noninterest expense increased $14.9 million to $106.3 million in 2022, compared to $91.4 million in 2021. The primary components of the changes in noninterest expense were as follows:

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2021 compared to 2020

Noninterest expense increased $14.7 million to $91.4 million in 2021, compared to $76.7 million in 2020. The primary components of the changes in noninterest expense were as follows:

Income Taxes

2022 compared to 2021

In 2022, income tax expense totaled $11.9 million compared to $9.5 million in 2021. The effective tax rate was approximately 21.7% for 2022 compared to 21.5% in 2021.

2021 compared to 2020

In 2021, income tax expense totaled $9.5 million compared to $6.6 million in 2020. The effective tax rate was approximately 21.5% for 2021 compared to 21.2% in 2020.

Loan and Lease Portfolio Composition

Our loans and leases represent the largest portion of our earning assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan and lease portfolio is an important consideration when reviewing our financial condition. The Company had total net loans and leases outstanding, including organic and purchased loans and leases, of approximately $3.23 billion at December 31, 2022 and $2.67 billion at December 31, 2021. Loans secured by real estate, consisting of commercial or residential property, are the principal component of our loan and lease portfolio.

Organic Loans and Leases

Our organic net loans and leases, which excludes loans and leases purchased through acquisitions, increased by $710.0 million, or 31.9% from December 31, 2021, to $2.93 billion at December 31, 2022.  This increase is related to loan production from the addition of the lift-out teams added in Alabama, Florida and Nashville, Tennessee towards the end of 2021.

Purchased Loans and Leases

Net purchased non-credit impaired loans and leases of $267.4 million at December 31, 2022, decreased by $141.2 million from December 31, 2021. Since December 31, 2021, our net purchased credit impaired (“PCI”) loans and leases decreased by $12.6 million to $28.6 million at December 31, 2022. The decrease in net purchased non-credit impaired loans and leases and PCI loans and leases is related to maturities, paydowns and payoffs.

Loan Participation Agreements

The Bank occasionally enters into loan participation agreements with other banks in the ordinary course of business to diversify credit risk. For certain sold participation loans, the Bank has retained effective control of the loans, typically by restricting the participating institutions from pledging or selling their share of the loan without permission from the Bank.

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GAAP requires the participated portion of these loans to be recorded as secured borrowings. The participated portions of these loans are included in the Commercial Real Estate totals below with a corresponding liability reflected in other borrowings. At December 31, 2022, the total participated portions of loans of this nature totaled $24.6 million and none at December 31, 2021. Subsequent to year-end, these loan participation agreements were amended in order to permit sales treatment accounting.

The following tables summarize the composition of our loan and lease portfolio for the periods presented (dollars in thousands):

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Loan and Lease Portfolio Maturities

The following table sets forth the maturity distribution of our loans and leases, including the interest rate sensitivity for loans and leases maturing after one year (in thousands):

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Past Due, Nonaccrual, and Restructured Loans and Leases

Loans and leases are considered past due when the contractual amounts due with respect to principal and interest are not received within 30 days of the contractual due date. Loans and leases are generally classified as nonaccrual if they are past due for a period of 90 days or more, unless such loans and leases are well secured and in the process of collection. If a

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loan or lease, or a portion of a loan or lease is classified as doubtful or as partially charged off, the loan or lease is generally classified as nonaccrual. Loans and leases that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and interest is in doubt. Loans and leases may be returned to accrual status when all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance of interest and principal by the borrower in accordance with the contractual terms.

PCI loans and leases with common risk characteristics are grouped in pools at acquisition and performance is based on our ability to reasonably estimate the amount and timing of future cash flows rather than a borrower’s ability to repay contractual loan or lease amounts. Since we are able to reasonably estimate the amount and timing of future cash flows on the Company’s PCI loan and lease pools, none of these loans and leases have been identified as nonaccrual.

While a loan or lease is classified as nonaccrual and the future collectability of the recorded loan or lease balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans and leases with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectability of the recorded loan and lease balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan and lease had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan and lease balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan and lease losses until prior charge-offs have been fully recovered.

Assets acquired as a result of foreclosure are recorded at estimated fair value in other real estate owned. Any excess of cost over estimated fair value at the time of foreclosure is charged to the allowance for loan losses. Valuations are periodically performed on these properties, and any subsequent write-downs are charged to earnings. Routine maintenance and other holding costs are included in noninterest expense.

Loans, excluding pooled PCI loans, are classified as troubled debt restructurings (“TDR”) by the Company when certain modifications are made to the loan terms and concessions are granted to the borrowers due to financial difficulty experienced by those borrowers. The Company grants concessions by (1) reduction of the stated interest rate for the remaining original life of the debt or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. The Company does not generally grant concessions through forgiveness of principal or accrued interest. The Company’s policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows the capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual until there is demonstrated performance under new terms. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on non-accrual status. The Company closely monitors these loans and ceases accruing interest on them if we believe that the borrowers may not continue performing based on the restructured note terms.

PCI loans that were classified as TDRs prior to acquisition are not classified as TDRs by the Company after the acquisition date. Subsequent modification of a PCI loan accounted for in a pool that would otherwise meet the definition of a TDR is not reported, or accounted for, as a TDR since pooled PCI loans are excluded from the scope of TDR accounting. A PCI loan not accounted for in a pool would be reported, and accounted for, as a TDR if modified in a manner that meets the definition of a TDR after the acquisition date.

Nonperforming loans and leases as a percentage of gross loans and leases, net of deferred fees, was 0.09% as of December 31, 2022, and 0.12% as of December 31, 2021, respectively. Total nonperforming assets as a percentage of total assets as of December 31, 2022, totaled 0.10% compared to 0.11% as of December 31, 2021. PCI loans and leases that are included in loan pools are reclassified at acquisition to accrual status and thus are not included as nonperforming assets.

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The following table is a summary of our loans and leases that were past due at least 30 days but not more than 89 days and 90 days or more past due as of December 31, 2022, and 2021 (dollars in thousands):

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The following table is a summary of our nonaccrual loans and leases as of December 31, 2022, and 2021 (dollars in thousands):

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Potential Problem Loans and Leases

At December 31, 2022, substandard or problem loans and leases amounted to approximately $2.8 million or 0.09% of total loans and leases outstanding. Potential problem loans and leases, which are not included in nonperforming loans and leases, represent those loans and leases with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Bank’s primary regulators, for loans classified as substandard or worse, but not considered nonperforming loans and leases.

Allocation of the Allowance for Loan and Lease Losses

The allowance for loan and lease losses is an estimate of probable incurred losses in the loan and lease portfolio. Loans and leases are charged-off against the allowance when management believes a loan or lease balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance for loan and lease losses. Management’s methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and leases and the formula driven allowances on pools of loans and leases with similar risk characteristics.

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Allocations of the allowance may be made for specific loans or leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off.

The Company is not required to implement the provisions of the CECL accounting standard issued by the FASB in the ASU No. 2016-13 until January 1, 2023, and continued to account for the allowance for loan losses under the incurred loss model as of December 31, 2022.

We assess the adequacy of the allowance at the end of each calendar quarter. This assessment includes procedures to estimate the allowance and test the adequacy and appropriateness of the resulting balance. The level of the allowance is based upon our evaluation of the loan and lease portfolios, past loan and lease loss experience, known and inherent risks in the portfolio, the views of the Bank’s regulators, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan and lease portfolio, economic conditions, industry and peer bank loan and lease quality indications and other pertinent factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans and leases that may be susceptible to significant change.

We maintain the allowance at a level that we deem appropriate to adequately cover the probable losses inherent in the loan and lease portfolio. As of December 31, 2022 and December 31, 2021, our allowance for loan and lease losses was $23.3 million and $19.4 million, respectively, which we deemed to be adequate at each of the respective dates. Our allowance for loan and lease loss as a percentage of total loans and leases was 0.72% at December 31, 2022 and 2021, respectively.

Our purchased loans and leases were recorded at fair value upon acquisition. The fair value adjustments on the performing purchased loans and leases will be accreted into income over the life of the loans or leases. At December 31, 2022, the remaining accretable yield was approximately $16.9 million.  These loans and leases are subject to the same allowance methodology as our legacy portfolio. The calculated allowance is compared to the remaining fair value discount to determine if additional provisioning should be recognized.  Also, at the end of 2022, the outstanding principal balance on PCI loan and leases was $41.5 million and the carrying value was $28.7 million, for a net difference of $12.8 million in discounts. At December 31, 2022, there was an allowance on PCI loans and leases of $121 thousand. The judgments and estimates associated with our allowance determination are described in "Part II - Item 8. Financial Statements and Supplementary Data - Note 1 – Summary of Significant Accounting Policies."

The following table sets forth, based on management’s best estimate, the allocation of the allowance for credit losses on loans and leases to categories of loans and leases and loan and lease balances by category and the percentage of loans and leases in each category to total loans and leases and allowance for credit losses as a percentage of total loans and leases within each loan and lease category as of December 31 for each of the past two years (dollars in thousands):

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The allocation by category is determined based on the assigned risk rating, if applicable, and environmental factors applicable to each category of loans and leases. For impaired loans and leases, those loans and leases are reviewed for a specific allowance allocation. Specific valuation allowances related to impaired loans and leases were approximately $385 thousand at December 31, 2022, compared to $561 thousand at December 31, 2021. Additional information on the allocation of the allowance between performing and impaired loans and leases is provided in Note 5 – Loans and Lease and Allowance for Loan and Lease Losses to our audited consolidated financial statements.

Analysis of the Allowance for Loan and Lease Losses

The following table presents information related to credit losses on loans and lease by loan segment for each of the years in the three year period ended December 31, (dollars in thousands):

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Investment Portfolio

Our investment portfolio is the second largest component of our interest earning assets. The portfolio serves the following purposes: (i) to optimize the Bank’s income consistent with the investment portfolio’s liquidity and risk objectives; (ii) to balance market and credit risks of other assets and the Bank’s liability structure; (iii) to profitably deploy funds which are not needed to fulfill loan demand, deposit redemptions or other liquidity purposes; and (iv) provide collateral which the Bank is required to pledge against public funds.

Our available-for-sale investment portfolio is carried at fair market value and our held-to-maturity investment portfolio is carried at amortized cost, and consists primarily of Federal agency bonds, mortgage-backed securities, state and municipal securities and other debt securities. Our investment portfolio increased from $559.4 million at December 31, 2021, to $769.8 million at December 31, 2022, primarily as a result of strategically deploying a portion of the Bank’s cash position.  New purchases were focused on mortgage-backed securities and Treasuries to provide cash flow and liquidity. Our

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investment to asset ratio has increased from 12.1% at December 31, 2021, to 16.7% at December 31, 2022. Over the past year, the ratio of investments to our total assets has increased, primarily due to growth in the Bank’s cash position driven by the PPP and the desire to deploy in high quality and higher yielding assets compared to cash.

The Company purchased $347.9 million of securities during the year ended December 31, 2022, which was offset by $78.9 million of sales, maturities and payments received during the same period. Net unrealized losses in our available-for-sale securities portfolio were $45.3 million as of December 31, 2022, as compared to a net unrealized gain of $33 thousand as of December 31, 2021. The decrease was attributable to changes in market interest rates related to all our securities, relative to when the securities were purchased. During the first quarter of 2022, we transferred $162.4 million of available-for-sale securities to the held-to-maturity category, reflecting our intent to hold those securities to maturity, which reduced the impact of these interest rate changes.

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The following table presents the contractual maturity of the company’s securities by contractual maturity date and average yields based on amortized cost (for all obligations on a fully taxable basis) at December 31, 2022 (dollars in thousands). The composition and maturity/repricing distribution of the securities portfolio is subject to change depending on rate sensitivity, capital and liquidity needs.

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1Based on amortized cost, taxable equivalent basis.

Deposits

Deposits are the primary source of funds for the Company’s lending and investing activities. The Company provides a range of deposit services to businesses and individuals, including noninterest-bearing checking accounts, interest-bearing checking accounts, savings accounts, money market accounts, Individual Retirement Accounts (“IRAs”) and certificates of deposit (“CDs”). These accounts generally earn interest at rates the Company establishes based on market factors and the anticipated amount and timing of funding needs. The establishment or continuity of a core deposit relationship can be a factor in loan pricing decisions. While the Company’s primary focus is on establishing customer relationships to attract core deposits, at times, the Company uses brokered deposits and other wholesale deposits to supplement its funding sources. As of December 31, 2022, brokered deposits represented approximately 0.90% of total deposits.

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The following table summarizes the average balances outstanding and average interest rates for each major category of deposits for 2022, 2021 and 2020 (dollars in thousands):

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During 2022, average deposits increased in all categories, except for time deposits. The Company believes its deposit product offerings are properly structured to attract and retain core low-cost deposit relationships. The average cost of deposits was 0.44% in 2022 compared to 0.27% in 2021.

Total deposits as of December 31, 2022, were $4.1 billion, which was an increase of $55.2 million from December 31, 2021. This increase is related to organic deposit growth from franchise expansion into new markets.  As of December 31, 2022, the Company had outstanding time deposits under $250,000 of $308.1 million, time deposits over $250,000 of $147.2 million, and a time deposit fair value adjustment of $239 thousand. The following table summarizes the maturities of time deposits of $250,000 or more as of December 31, 2022 (in thousands):

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As of December 31, 2022 and 2021, $1.65 billion and $1.58 billion, respectively, of our deposit portfolio was uninsured. The uninsured amounts are estimated based on the methodologies and assumptions used for the SmartBank’s regulatory reporting requirements.

Borrowings and Subordinated Debt

Other than deposits, the Company uses short-term borrowings and long-term debt to provide both funding and, to a lesser extent, regulatory capital using debt at the Company level which can be downstreamed as Tier 1 capital to the Bank. Total borrowings at December 31, 2022 and 2021, was $41.9 million and $87.6 million, respectively. The $45.7 million reduction in borrowings, was primarily the result of the FHLB calling $75.0 million in FHLB Advances during 2022, offset by $24.6 million in secured borrowings and $5.0 million in additional borrowings on a line credit.  Short-term borrowings, included in borrowings, totaled $4.8 million at December 31, 2022 and $5.1 million at December 31, 2021 and consisted entirely of securities sold under repurchase agreements. Long-term debt totaled $42.0 million at December 31, 2022 and $41.9 million at December 31, 2021 and consisted entirely of subordinated debt.  For more information regarding our borrowings and subordinated debt, see "Part II - Item 8. Financial Statements and Supplementary Data – Note 9 – Borrowings and Line of Credit” and “Note 10 – Subordinated Debt."

Liquidity

Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders.

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Our liquidity position is supported by management of liquid assets and access to alternative sources of funds. Our liquid assets include cash, interest-bearing deposits in correspondent banks, federal funds sold, and fair value of unpledged investment securities. Other available sources of liquidity include wholesale deposits, and additional borrowings from correspondent banks, FHLB advances, and the Federal Reserve discount window.

Our short-term and long-term liquidity requirements are primarily met through cash flow from operations, redeployment of prepaying and maturing balances in our loan and investment portfolios, and increases in customer deposits. Other alternative sources of funds will supplement these primary sources to the extent necessary to meet additional liquidity requirements on either a short-term or long-term basis.

As part of our liquidity management strategy, we open federal funds lines with our correspondent banks. As of December 31, 2022, we had $76.5 million of unsecured federal funds lines with no funds advanced. In addition, we have access to the Federal Reserve’s discount window in the amount $74.1 million with no borrowings outstanding as of December 31, 2022. The Federal Reserve discount window line is collateralized by a pool of commercial real estate loans and commercial and industrial loans totaling $99.7 million as of December 31, 2022.

At December 31, 2022, we had no FHLB advances outstanding. For more information regarding the FHLB advances, see "Part II - Item 8. Financial Statements and Supplementary Data - Note 9 – Borrowings and Line of Credit." Based on the values of loans pledged as collateral, we had $589.8 million of additional borrowing availability with the FHLB as of December 31, 2022. We also maintain relationships in the capital markets with brokers to issue certificates of deposit and money market accounts.

The Company had a Loan and Security Agreement and revolving line of credit for an aggregate amount of $25.0 million. The maturity of the line of credit was March 24, 2023. At December 31, 2022, $12.5 million was outstanding under the line of credit, and $12.5 million of the line of credit remained available to the Company. On February 1, 2023, the Loan and Security Agreement was amended, increasing the revolving line of credit to an aggregate amount of $35.0 million and extending the maturity date to February 1, 2025.

Capital Requirements

The Company and Bank are required under federal law to maintain certain minimum capital levels based on ratios of capital to total assets and capital to risk-weighted assets. The required capital ratios are minimums, and the federal banking agencies may determine that a banking organization, based on its size, complexity or risk profile, must maintain a higher level of capital in order to operate in a safe and sound manner. Risks such as concentration of credit risks and the risk arising from non-traditional activities, as well as the institution’s exposure to a decline in the economic value of its capital due to changes in interest rates, and an institution’s ability to manage those risks are important factors that are to be taken into account by the federal banking agencies in assessing an institution’s overall capital adequacy. The Company uses leverage analysis to examine the potential of the institution to increase assets and liabilities using the current capital base. The key measurements included in this analysis are the Company and Bank’s Common Equity Tier 1 capital, Tier 1 capital, leverage and total capital ratios. At December 31, 2022, and 2021, our capital ratios, including our Company and Bank’s capital ratios, exceeded regulatory minimum capital requirements. From time to time we may be required to support the capital needs the Bank. For more information regarding our capital, leverage and total capital ratios, see “Part II - Item 8. Financial Statements and Supplementary Data - Note 15 - Regulatory Matters.”

The table below (dollars in thousands) summarizes the capital requirements applicable to the Company and Bank in order to be considered “well-capitalized” from a regulatory perspective, as well as the Company and Bank’s capital ratios as of December 31, 2022 and 2021. The Company and Bank exceeded all regulatory capital requirements and was considered to be “well-capitalized” as of December 31, 2022 and 2021. As of December 31, 2022, the FDIC categorized the Bank as well-capitalized under the prompt corrective action framework. There have been no conditions or events since December 31, 2022, that management believes would change this classification.

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1The prompt corrective action provisions are applicable at the Bank level only.

2Average assets for the above calculations were based on the most recent quarter.

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Contractual Obligations

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The following tables present, as of December 31, 2022, our significant fixed and determinable contractual obligations (in thousands):

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Off-Balance Sheet Arrangements

At December 31, 2022, we had $912.0 million of pre-approved but unused lines of credit and $6.9 million of standby letters of credit. These commitments generally have fixed expiration dates and many will expire without being drawn upon. The total commitment level does not necessarily represent future cash requirements. If needed to fund these outstanding commitments, the Bank has the ability to liquidate Federal funds sold or securities available-for-sale, or on a short-term basis to borrow and purchase Federal funds from other financial institutions. Additional information about our off-balance sheet risk exposure is presented in Note 14 – Commitments and Contingent Liabilities to our audited consolidated financial statements.

Critical Accounting Policies

The Company has identified accounting policies that are the most critical to fully understand and evaluate its reported financial results and require management’s most difficult, subjective or complex judgments. Management has reviewed the following critical accounting policies and related disclosures with the Audit Committee of the Board of Directors. These policies, along with a brief discussion of the material implications of the uncertainties of each policy, are below. For a full description of these critical accounting policies, see Note 1 – Summary of Significant Accounting Policies to our audited consolidated financial statements.

Allowance for loan losses – In establishing the allowance we take into account reserves required for impaired loans, historical charge-offs for loan types, and a variety of qualitative factors including economic outlook, portfolio concentrations, and changes in portfolio credit quality. Many of the qualitative factors are measurable but there is also a level of subjective assumptions. If those assumptions change it could have a material impact on the level of the allowance required and as a result the earnings of the Company.

Fair values for acquired assets and assumed liabilities – Assets and liabilities acquired are recorded at their respective fair values as of the date of the acquisition. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities is allocated to identifiable intangible assets with the remaining excess allocated to goodwill. Goodwill has an indefinite useful life and is evaluated for impairment annually, or more frequently if events and circumstances indicate that the asset might be impaired.  An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. As of December 31, 2022, there was approximately $96.1 million in goodwill. The Company performed a qualitative assessment on goodwill and the results indicated that there was no impairment as of December 31, 2022.

Cash flow estimates on purchased credit-impaired loans – Purchase credit impaired loans do not have traditional loan yields and interest income; instead they have accretable yield and accretion. Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized in interest income as accretion over the remaining life of the loan when there is reasonable expectation about the amount and timing of such cash flows. The amount expected to be accreted divided by the accretable discount is the accretable yield. Cash flow estimates are re-evaluated quarterly. If the estimated cash flows increase then the accretable yield over the life of the loan increases. If, however, the estimated cash flows decrease then impairment is generally recognized immediately.

Valuation of Other Real Estate Owned – Other real estate owned properties are initially recorded at fair value less selling costs. If the fair value decreases the assets are written down and are periodically reviewed for further impairment, if needed.

Valuation of deferred tax assets- Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not that the tax position will be realized or sustained upon examination. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized. As of December 31, 2022, there were approximately $24.6 million in net deferred tax assets.

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Evaluation of investment securities for other than temporary impairment- We evaluate investment securities for other than temporary impairment taking into account if we do not have the intent to sell a debt security prior to recovery and it is more likely than not that we will not have to sell the debt security prior to recovery, the security would not be considered other than temporarily impaired unless a credit loss has occurred in the security. Temporary impairments are recognized on the balance sheet in other comprehensive income/loss. If a security becomes permanently impaired the impairment expense would be recognized and reduce earnings. As of December 31, 2022, there was approximately $70.7 million in gross unrealized losses on investment securities that were classified as temporarily impaired.