Stellar Bancorp, Inc. (STEL) FY 2022 MD&A

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

Cautionary Notice Regarding Forward-Looking Statements

This Annual Report on Form 10-K contains forward‑looking statements. These forward‑looking statements reflect the Company’s current views with respect to, among other things, future events and the Company’s financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and “outlook,” or the negative version of those words or other comparable words or phrases of a future or forward‑looking nature. These forward‑looking statements are not historical facts, and are based on current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond the Company’s control. Accordingly, the Company cautions that any such forward‑looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. Although the Company believes that the expectations reflected in these forward‑looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward‑looking statements.

There are or will be important factors that could cause the Company’s actual results to differ materially from those indicated in these forward‑looking statements, including, but not limited to, the risks described in “Part I.—Item 1A.—Risk Factors” and the following:

•the effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board;

◦inflation, interest rate, securities market and monetary fluctuations;

◦local, regional, national and international economic conditions and the impact they may have on the Company and our customers and the Company’s assessment of that impact;

◦sustained instability of the oil and gas industry in general and within Texas;

◦liquidity risks associated with the Company’s business, including lack of access to liquidity;

◦the composition of the Company’s loan portfolio and the concentration of loans in commercial real estate and commercial real estate construction;

◦the geographic concentration of the Company’s markets;

◦the accuracy and sufficiency of the assumptions and estimates the Company makes in establishing reserves for potential loan losses and other estimates;

◦the amount of nonperforming and classified assets that the Company holds and the time and effort necessary to resolve nonperforming assets;

◦deterioration of asset quality;

◦changes in the value of collateral securing the Company’s loans;

◦the risk that the expected cost savings and any revenue synergies from the Merger may not be fully realized or may take longer than anticipated to be realized;

◦the ability to retain personnel after the completion of the Merger;

◦natural disasters and adverse weather on the Company’s market area, acts of terrorism, pandemics, an outbreak of hostilities, such as the conflict in Ukraine, or other international or domestic calamities and other matters beyond the Company’s control;

◦the potential impact of climate change;

◦the impact of pandemics, epidemics or any other health-related crisis;

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◦the Company’s ability to maintain important deposit customer relationships and its reputation;

◦the Company’s ability to maintain effective internal control over financial reporting;

◦the cost and effects of cyber incidents or other failures, interruptions or security breaches of the Company's systems or those of the Company's customers or third-party providers;

◦the failure of certain third- or fourth-party vendors to perform;

◦the institution and outcome of litigation and other legal proceedings against the Company or to which it may become subject;

◦the costs, effects and results of regulatory examinations, investigations, or reviews or the ability to obtain required regulatory approvals or meet conditions associated with the same;

◦changes in the laws, rules, regulations, interpretations or policies relating to financial institution, accounting, tax, trade, monetary and fiscal matters;

◦the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters; and

◦other risks, uncertainties, and factors that are discussed from time to time in the Company’s reports and documents filed with the SEC.

The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with Item 15.—Exhibits and Financial Statement Schedules and the consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis includes forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that the Company believes are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth in “Part I.—Item 1A.—Risk Factors” and elsewhere in this Annual Report on Form 10-K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis.

The Company disclaims any obligation and does not intend to update or revise any forward-looking statements contained in this Annual Report on Form 10-K, which speak only as of the date hereof, whether as a result of new information, future events or otherwise, except as required by federal securities laws. As forward-looking statements involve significant risks and uncertainties, caution should be exercised against placing undue reliance on such statements.

Overview

We generate most of our income from interest income on loans, interest income from investments in securities and service charges on customer accounts. We incur interest expense on deposits and other borrowed funds and noninterest expenses such as salaries and employee benefits and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings that are used to fund those assets. Net interest income is our largest source of revenue. To evaluate net interest income, we measure and monitor (1) yields on our loans and other interest-earning assets, (2) the interest expenses of our deposits and other funding sources, (3) our net interest spread and (4) our net interest margin. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Net interest margin is calculated as net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and shareholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources.

Our net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas and specifically in our markets, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target market and throughout the state of Texas.

Our net interest income is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and borrowed funds, referred to as a “rate change.” Fluctuations in market interest rates are driven by many factors,

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including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets.

Completion of Merger of Equals

On October 1, 2022, Allegiance and CBTX merged with CBTX as the surviving corporation that was renamed Stellar Bancorp, Inc. At the effective time of the Merger, each outstanding share of Allegiance common stock, par value of $1.00 per share, was converted into the right to receive 1.4184 shares of common stock of the Company.

Immediately following the Merger, CommunityBank merged with and into Allegiance Bank with Allegiance Bank as the surviving bank. In connection with the operational conversion during the first quarter of 2023, Allegiance Bank changed its name to Stellar Bank on February 18, 2023. After the merger, Stellar became one of the largest banks based in Houston.

The Merger constituted a business combination and was accounted for as a reverse merger using the acquisition method of accounting. As a result, Allegiance was the accounting acquirer and CBTX was the legal acquirer and the accounting acquiree. Accordingly, the historical financial statements of Allegiance became the historical financial statements of the combined company. In addition, the assets and liabilities of CBTX have been recorded at their estimated fair values and added to those of Allegiance as of October 1, 2022. The determination of fair value required management to make estimates about discount rates, expected future cash flows, market conditions and other future events that are subjective and subject to change.

The Company’s results of operations for the year ended December 31, 2022 reflect Allegiance results for the first nine months of 2022, while the results for the fourth quarter of 2022, after the Merger on October 1, 2022, set forth the results of operations for Stellar. The Company’s historical operating results as of and for the years ended December 31, 2021 and 2020, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. The Company has substantially completed its valuations of CBTX’s assets and liabilities but may refine those valuations for up to a year from the date of the Merger. The Merger had a significant impact on all aspects of the Company’s financial statements, and financial results for periods after the Merger are not comparable to financial results for periods prior to the Merger. The number of shares issued and outstanding, earnings per share, additional paid-in capital, dividends paid and all references to share quantities of the Company have been retrospectively adjusted to reflect the equivalent number of shares issued to holders of Allegiance common stock in the Merger. See Note 2 – Acquisitions in the accompanying notes to the consolidated financial statements for the impact of the Merger.

Critical Accounting Policies

Certain of our accounting estimates are important to the portrayal of our financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Management believes that determining the allowance for credit losses is its most critical accounting estimate. Our accounting policies are discussed in detail in Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies in the accompanying notes to the consolidated financial statements.

Allowance for Credit Losses

The allowance for credit losses is a valuation account which represents management’s best estimate of lifetime expected losses based on reasonable and supportable forecasts, historical loss experience, and other qualitative considerations. The Company bases its estimates of credit losses on three primary components: (1) estimates of expected losses that exist in various segments of performing loans over the remaining life of the loan portfolio using a reasonable and supportable economic forecast, (2) specifically identified losses in individually analyzed credits which are collateral-dependent, which generally include loans internally graded as impaired and purchased credit deteriorated (“PCD”) loans and (3) qualitative factors related to economic conditions, portfolio concentrations, regulatory policy updates, and other relevant factors that address estimates of expected losses not fully addressed based upon management’s judgment of portfolio conditions. One of the most significant judgments used in determining the allowance for credit losses is the reasonable and supportable economic forecast. Estimating the timing and amounts of future losses is subject to significant management judgment as these projected cash flows rely upon the estimates discussed above and factors that are reflective of current or future expected conditions. Volatility in certain credit metrics and differences between expected and actual outcomes are to be expected. Customers may not repay their loans according to the original terms, and the collateral securing the payment of those loans may be insufficient to pay any remaining loan balance.

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The allowance for credit losses includes the allowance for credit losses on loans, which is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on loans, and the allowance for credit losses on unfunded commitments reported in other liabilities. The amount of the allowance for credit losses is affected by the following: (1) charge-offs of loans that decrease the allowance, (2) subsequent recoveries on loans previously charged off that increase the allowance and (3) provisions for (or reversal of) credit losses charged to income that increase or decrease the allowance. Management considers the policies related to the allowance for credit losses as the most critical to the financial statement presentation. The total allowance for credit losses includes activity related to allowances calculated in accordance with Accounting Standards Codification (“ASC”) 326 – Measurement of Credit Losses on Financial Instruments.

In addition, various regulatory agencies, as an integral part of the examination process, periodically review the allowance for credit losses. Such agencies may require the Bank to recognize adjustments to the allowance based on their judgments of the information available to them at the time of their examination.

The allowance for credit losses could be affected by significant downturns in circumstances relating to loan quality and economic conditions and as such may not be sufficient to cover expected losses in the loan portfolio which could necessitate additional provisions or a reduction in the allowance for credit losses if our assumption prove to be incorrect. Unanticipated changes and events could have a significant impact on the financial performance of borrowers and their ability to perform as agreed. We may experience significant credit losses if borrowers experience financial difficulties, which could have a material adverse effect on our operating results.

Fair value of loans acquired in a business combination

On October 1, 2022, the Company recorded $273.6 million of goodwill, based on the fair value of acquired assets and liabilities of CBTX. The fair value often involved third-party estimates utilizing input assumptions by management which may be complex or uncertain. The fair value of acquired loans is based on a discounted cash flow methodology that considers factors such as type of loan and related collateral, and requires management’s judgement on estimates about discount rates, expected future cash flows, market conditions and other future events.

For purchased financial loans with credit deterioration, PCD loans, an estimate of expected credit losses was made for loans with similar risk characteristics and was added to the purchase price to establish the initial amortized cost basis of the PCD loans. Any difference between the unpaid principal balance and the amortized cost basis is considered to relate to noncredit factors and results in a discount or premium. Discounts and premiums are recognized through interest income on a level-yield method over the life of the loans. For acquired loans not deemed PCD at acquisition, the differences between the initial fair value and the unpaid principal balance are recognized as interest income on a level-yield basis over the lives of the related loans.

Management relied on economic forecasts, internal valuations, or other relevant factors which were available at the time of the Merger in the determination of the assumptions used to calculate the fair value of the acquired loans. The estimates about discount rates, expected future cash flows, market conditions and other future events are subjective and may differ from estimates.

The estimate of fair values on acquired loans contributed to the recorded goodwill from the Merger. In future income statement periods, interest income on loans will include the amortization and accretion of any premiums and discounts resulting from the fair value of acquired loans. Additionally, the provision for credit losses on acquired individually analyzed PCD loans may be impacted due to changes in the assumptions used to calculated expected cash flows.

Merger and goodwill

The acquisition method of accounting requires that assets acquired and liabilities assumed in business combinations are recorded at their fair values. This often involves estimates based on third-party or internal valuations based on discounted cash flow analyses or other valuation techniques, which are inherently subjective. Business combinations also typically result in goodwill, which is subject to ongoing periodic impairment tests based on the fair values of the reporting units to which the goodwill relates. The amortization of intangible assets with definite useful lives is based upon the estimated economic benefits to be received, which is also subjective. Provisional estimates of fair values may be adjusted for a period of up to one year from the acquisition date if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. Adjustments recorded during this period are recognized in the current reporting period.

Management uses various valuation methodologies to estimate the fair value of these assets and liabilities, and often involves a significant degree of judgment, particularly when liquid markets do not exist for the particular item being valued. Examples of such

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items include loans, deposits, identifiable intangible assets and certain other assets and liabilities. Management uses significant estimates and assumptions to value such items, including projected cash flows, repayment rates, default rates and losses assuming default, discount rates, and realizable collateral values. The allowance for credit losses on PCD loans is recognized within business combination accounting. The allowance for credit losses for non-purchased credit deteriorated (“non-PCD”) assets is recognized as provision expense in the same reporting period as the business combination. The valuation of other identifiable intangible assets, including core deposit intangibles and other intangibles, requires assumptions such as projected attrition rates, expected revenue and costs, discount rates and other forward-looking factors. The purchase date valuations and any subsequent adjustments also determine the amount of goodwill recognized in connection with the business combination. Our estimates of the fair value of assets acquired and liabilities assumed are based upon assumptions that we believe to be reasonable, and whenever necessary, include assistance from independent third-party appraisal and valuation firms.

Goodwill represents the excess of the consideration paid over the fair value of the net assets acquired in a business

combination. The Company assesses goodwill for impairment at the reporting unit level on an annual basis, or more often if an

event occurs or circumstances change which indicate there may be impairment. The impairment test compares the estimated fair

value of each reporting unit with its net book value. The fair value of the reporting unit is estimated using valuation techniques that market participants would use in an acquisition of the whole reporting unit, such as estimated discounted cash flows, the quoted market price of our common stock adjusted for a control premium, and observable average price-to forward-earnings and price-to-tangible book multiples of observed transactions. If the unit’s fair value is less than its carrying value, an estimate of the implied fair value of the goodwill is compared to the goodwill’s carrying value and any impairment recognized.

The Company performed its annual qualitative assessment to determine if it was more likely than not that a reporting unit’s

fair value was less than its carrying value as of September 30, 2022. Based on this assessment, it was determined the

reporting units’ fair value exceeded their carrying value. See Note 3 – Goodwill and Other Intangible Assets to the consolidated financial statements for additional information on the Company’s goodwill balances and Note 2 – Acquisitions to the consolidated financial statements for goodwill and intangibles recorded in the periods presented.

Recently Issued Accounting Pronouncements

We have evaluated new accounting pronouncements that have recently been issued and have determined that there are no new accounting pronouncements that should be described in this section that will impact the Company’s operations, financial condition or liquidity in future periods. Refer to Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies in the accompanying notes to the consolidated financial statements.

Results of Operations

This section provides a comparative discussion of the Company’s results of operations for the two-year period ended December 31, 2022, unless otherwise specified. See “Item 7 – Management Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2021 for a discussion of 2021 versus 2020 results.

The Company’s results of operations for the year ended December 31, 2022 reflect Allegiance’s activity for the first nine months of 2022 while the results for the fourth quarter of 2022, after the Merger on October 1, 2022, set forth the results of operations for Stellar. Accordingly, the Company’s historical operating results as of and for the years ended December 31, 2021 and 2020, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. The Company has substantially completed its valuations of CBTX’s assets and liabilities. The Company’s taxes are provisional along with the review of certain contracts assumed in the Merger. The Merger had a significant impact on all aspects of the Company’s financial statements, and as a result, financial results after the Merger are not comparable to financial results prior to the Merger. The number of shares issued and outstanding, earnings per share, additional paid-in capital, dividends paid per share and all references to share quantities of the Company have been retrospectively adjusted to reflect the equivalent number of shares issued to holders of Allegiance common stock in the Merger. See Note 2 – Acquisitions in the accompanying notes to the consolidated financial statements for the impact of the Merger.

Net income was $51.4 million, or $1.47 per diluted common share, for the year ended December 31, 2022 compared with $81.6 million, or $2.82 per diluted common share, for the year ended December 31, 2021, a decrease of $30.1 million, or 36.9%. The decrease in net income was primarily due to a $56.5 million increase in noninterest expense and a $53.0 million increase in provision for credit losses, partially offset by a $60.4 million increase in net interest income, an $11.8 million increase in noninterest income and a $7.2 million decrease in the provision for income taxes. The increased provision for credit losses from the prior year was primarily due to the initial provision for credit losses recorded on acquired non-PCD loans of $28.2 million. Acquisition and merger-related

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expenses totaled $24.1 million for the year ended December 31, 2022 compared to $2.0 million for the year ended December 31, 2021. See further analysis of the material fluctuations in the related discussions that follow.

Returns on average equity were 5.69% and 10.38%, returns on average assets were 0.64% and 1.24% and efficiency ratios were 64.23% and 58.86% for the years ended December 31, 2022 and 2021, respectively. The efficiency ratio is calculated by dividing total noninterest expense by the sum of net interest income plus noninterest income, excluding gains and losses on the sale of loans, securities and assets. Additionally, taxes and provision for credit losses are not part of the efficiency ratio calculation.

Net Interest Income

Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is our largest source of revenue, representing 93.4% of total revenue during 2022. Tax equivalent net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.

The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the effective federal funds rate, which is the cost of immediately available overnight funds, and the U.S. prime interest rate. During 2022, the effective federal funds rate increased 425 basis points to end the year at 4.50%. There were no changes to the effective federal funds rate during 2021. During 2020, the effective federal funds rate decreased 150 basis points to end the period at 0.25%. Similarly, during 2022, the U.S. prime rate increased 425 basis points to end the period at 7.50%. There were no changes to the U.S. prime rate during 2021. During 2020, the U.S. prime rate decreased 150 basis points to end the year at 3.25%.

Net interest income before the provision for credit losses for the year ended December 31, 2022 was $289.0 million compared with $228.6 million for the year ended December 31, 2021, an increase of $60.4 million, or 26.4% primarily due to the increase in average interest-earning assets and liabilities as a result of the Merger.

Interest income was $323.0 million for the year ended December 31, 2022, an increase of $69.8 million, or 27.6%, compared with $253.2 million for the year ended December 31, 2021 primarily due to the Merger as average interest-earning asset balances increased along with increased interest rates and an increase in higher-yielding loans during the year. Average interest-earning assets increased $1.48 billion, or 25.0%, for the year ended December 31, 2022 compared with the year ended December 31, 2021 primarily due to the Merger.

Interest expense was $34.0 million for the year ended December 31, 2022, an increase of $9.4 million, or 38.2%, compared with $24.6 million for the year ended December 31, 2021. This increase was primarily due to higher funding costs on interest-bearing deposits due to higher interest rates and an increase in average interest-bearing liabilities. The cost of average interest-bearing liabilities increased to 81 basis points for the year ended December 31, 2022 compared to 66 basis points for the same period in 2021. Average interest-bearing liabilities increased $439.5 million for the year ended December 31, 2022 compared to the year ended December 31, 2021 primarily due to the Merger.

Tax equivalent net interest margin, defined as net interest income adjusted for tax-free income divided by average interest-earning assets, for the year ended December 31, 2022 was 3.94%, an increase of 4 basis points compared to 3.90% for the year ended December 31, 2021. The increase in the net interest margin on a tax equivalent basis was primarily due to the Merger and an increase in the average yield on interest-earning assets partially offset by increased funding costs. The average yield on interest-earning assets of 4.36% and the average rate paid on interest-bearing liabilities of 0.81% for the year ended December 31, 2022 increased by 9 basis points and 15 basis points, respectively, over the same period in 2021. Tax equivalent adjustments to net interest margin are the result of increased or decreased income from tax-free securities by an amount equal to the taxes that would have been paid if the income were fully taxable based on a 21% federal tax rate for the years ended December 31, 2022 and 2021, thus making tax-exempt yields relatively more comparable to taxable asset yields.

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The following table presents, for the periods indicated, the total dollar amount of average balances, interest income from average interest-earning assets and the annualized resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed in both dollars and rates. Any nonaccruing loans have been included in the table as loans carrying a zero yield.

(1)The net interest margin is equal to net interest income divided by average interest-earning assets.

(2)The tax-equivalent adjustment has been computed using a federal income tax rate of 21% for the years ended December 31, 2022, 2021 and 2020 and other applicable effective tax rates.

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The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to rate.

Provision for Credit Losses

Our allowance for credit losses is established through charges to income in the form of the provision in order to bring our allowance for credit losses for various types of financial instruments including loans, securities and unfunded commitments to a level deemed appropriate by management. We recorded a $50.7 million provision for credit losses for the year ended December 31, 2022 compared to a $2.3 million release of provision for credit losses for the year ended December 31, 2021. The provision for credit losses for the year ended December 31, 2022 included an initial provision for credit losses recorded on acquired non-PCD loans of $28.2 million along with a provision for acquired unfunded commitments of $5.0 million as a result of the Merger. The remaining increase in the provision during 2022 compared to the prior year primarily reflects the increase in loans during the year, among other factors.

Noninterest Income

Our primary sources of noninterest income are debit card and ATM card income, service charges on deposit accounts, income earned on bank owned life insurance and nonsufficient funds fees. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method.

Noninterest income totaled $20.4 million for the year ended December 31, 2022 compared to $8.6 million for the year ended December 31, 2021, an increase of $11.8 million, or 137.7%. Noninterest income increased in 2022 primarily due to increased scale as a result of the Merger along with nonrecurring gains on sales of securities, loans and assets held for sale totaling $4.1 million.

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The following table presents, for the periods indicated, the major categories of noninterest income:

(1)Other includes wire transfer and letter of credit fees, among other items.

Noninterest Expense

Noninterest expense was $196.1 million for the year ended December 31, 2022 compared to $139.6 million for the year ended December 31, 2021, an increase of $56.5 million, or 40.5%. The increase in noninterest expense was primarily due to increased salaries and benefits, amortization of core deposit intangibles and acquisition and merger-related expenses associated with the Merger.

The following table presents, for the periods indicated, the major categories of noninterest expense:

(1)Total salaries and employee benefits includes $9.0 million, $4.0 million and $3.4 million in stock based compensation expense for the years ended December 31, 2022, 2021 and 2020, respectively.

Salaries and Employee Benefits. Salaries and benefits were $107.6 million for the year ended December 31, 2022, an increase of $17.4 million, or 19.3%, compared to the year ended December 31, 2021 primarily due to the Merger.

Acquisition and merger-related expenses. Acquisition and merger-related expenses of $24.1 million and $2.0 million incurred during 2022 and 2021, respectively, were primarily related to legal and advisory fees along with compensation associated with the Merger.

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Amortization of intangibles. Core deposit intangible amortization increased $6.0 million for the year ended December 31, 2022 compared to the year ended December 31, 2021 due the $138.2 million core deposit intangible created as a result of the Merger.

Efficiency Ratio

The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of the Company’s performance. We calculate the Company’s efficiency ratio by dividing total noninterest expense by the sum of net interest income and noninterest income, excluding net gains and losses on the sale of loans, securities and assets. Additionally, taxes and provision for credit losses are not part of this calculation. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources. The Company’s efficiency ratio increased to 64.23% for the year ended December 31, 2022 compared to 58.86% for the year ended December 31, 2021 and 60.55% for the year ended December 31, 2020.

We monitor the efficiency ratio in comparison with changes in our total assets and loans, and we believe that maintaining or reducing the efficiency ratio during periods of growth, demonstrates the scalability of our operating platform. We expect to continue to benefit from our scalable platform in future periods as we continue to monitor fixed and variable expenses necessary to support our growth.

Income Taxes

The amount of federal and state income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income and the amount of other nondeductible expenses. Income tax expense decreased $7.2 million, or 39.5%, to $11.1 million for the year ended December 31, 2022 compared with $18.3 million for the same period in 2021 primarily due to a decrease in pre-tax net income. The effective tax rates were 17.7%, 18.4% and 18.6% for the years ended December 31, 2022, 2021 and 2020, respectively.

Quarterly Financial Information

The following table presents certain unaudited consolidated quarterly financial information regarding the results of operations for the quarters ended December 31, September 30, June 30 and March 31 in the years ended December 31, 2022 and 2021. The Company’s results of operations for the year ended December 31, 2022 reflect Allegiance’s activity for the first nine months of 2022 while the results for the fourth quarter of 2022, after the Merger on October 1, 2022, set forth the results of operations for Stellar. Earnings per share have been retrospectively adjusted to reflect the equivalent number of shares issued to holders of Allegiance common stock in the Merger. This information should be read in conjunction with the accompanying consolidated financial statements.

(1)Earnings per share are computed independently for each of the quarters presented and therefore may not total earnings per share for the year.

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Financial Condition

Loan Portfolio

At December 31, 2022, total loans were $7.75 billion, an increase of $3.53 million, or 83.7%, compared with December 31, 2021 primarily due to the Merger.

Total loans as a percentage of deposits were 83.7% and 69.8% as of December 31, 2022 and December 31, 2021, respectively. Total loans as a percentage of assets were 71.1% and 59.4% as of December 31, 2022 and December 31, 2021, respectively.

The following table summarizes our loan portfolio by type of loan as of the dates indicated:

Our lending activities originate from the efforts of our bankers with an emphasis on lending to individuals, professionals, small- to medium-sized businesses and commercial companies generally located in our markets. Our strategy for credit risk management generally includes well-defined, centralized credit policies, uniform underwriting criteria and ongoing risk monitoring and review processes for credit exposures. The strategy generally emphasizes regular credit examinations and management reviews of loans. We have certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. We maintain an independent loan review department that reviews and validates the credit risk program on a periodic basis. In addition, an independent third-party loan review is performed on a periodic basis during the year. Results of these reviews are presented to management and the risk committee of the Board of Directors. The loan review process complements and reinforces the risk identification and assessment decisions made by bankers and credit personnel and contained in our policies and procedures.

The principal categories of our loan portfolio are discussed below:

Commercial and Industrial. We make commercial and industrial loans in our market area that are underwritten on the basis of the borrower’s ability to service the debt from income. In general, commercial loans involve more credit risk than residential mortgage loans and commercial mortgage loans and therefore typically yield a higher return. The increased risk in commercial loans derives from the expectation that commercial and industrial loans generally are serviced principally from the operations of the business, which may not be successful and from the type of collateral securing these loans. As a result, commercial and industrial loans require more extensive underwriting and servicing than other types of loans. Our commercial and industrial loan portfolio increased $762.2 million, or 109.9%, to $1.46 billion as of December 31, 2022 compared to $693.6 million as of December 31, 2021.

Paycheck Protection Program. The CARES Act authorized the SBA to guarantee loans under a 7(a) loan program called the PPP. The balance of PPP loans decreased $132.7 million to $13.2 million as of December 31, 2022 due to loan forgiveness.

Commercial Real Estate (Including Multi-Family Residential). We make loans collateralized by owner-occupied, nonowner-occupied and multi-family real estate to finance the purchase or ownership of real estate. As of December 31, 2022 and December 31, 2021, 45.3% and 54.6%, respectively, of our commercial real estate loans were owner-occupied. Our commercial real estate loan portfolio increased $1.83 billion, or 86.8%, to $3.93 billion as of December 31, 2022 from $2.10 billion as of

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December 31, 2021 primarily due to the Merger as well as organic loan growth. Included in our commercial real estate portfolio are multi-family residential loans. Our multi-family loans increased $394.5 million to $471.6 million as of December 31, 2022 from $77.1 million as of December 31, 2021. We had 234 multi-family loans with an average loan size of $2.0 million as of December 31, 2022.

As of December 31, 2022, the Company’s loan portfolio included $287.3 million of multifamily community development loans with associated tax credits, which fund Texas based projects to promote affordable housing.

Commercial Real Estate Construction and Land Development. We make commercial real estate construction and land development loans to fund commercial construction, land acquisition and real estate development construction. Construction loans involve additional risks as they often involve the disbursement of funds with the repayment dependent on the ultimate success of the project’s completion. Sources of repayment for these loans may be pre-committed permanent financing or sale of the developed property. The loans in this portfolio are monitored closely by management. Due to uncertainties inherent in estimating construction costs, the market value of the completed project and the effects of governmental regulation on real property, it can be difficult to accurately evaluate the total funds required to complete a project and the related loan to value ratio. As a result of these uncertainties, construction lending often includes the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. As of December 31, 2022 and December 31, 2021, 18.2% and 22.3%, respectively, of our commercial real estate construction and land development loans were owner-occupied. Our commercial real estate construction and land development land loans increased $598.6 million, or 136.3%, to $1.04 billion as of December 31, 2022 compared to $439.1 million as of December 31, 2021 primarily as a result of the Merger.

As of December 31, 2022, the Company’s loan portfolio included $79.7 million of construction and development loans to support multifamily community development loans with associated tax credits, which fund Texas based projects to promote affordable housing.

1-4 Family Residential (Including Home Equity). Our residential real estate loans include the origination of 1-4 family residential mortgage loans (including home equity and home improvement loans and home equity lines of credit) collateralized by owner-occupied residential properties located in our market area. Our residential real estate portfolio (including home equity) increased $315.9 million, or 46.1%, to $1.00 billion as of December 31, 2022 from $685.1 million as of December 31, 2021 primarily as a result of the Merger. The home equity, home improvement and home equity lines of credit portion of our residential real estate portfolio increased $1.9 million, or 1.61%, to $120.9 million as of December 31, 2022 from $119.0 million as of December 31, 2021 primarily as a result of the Merger.

Residential Construction. We make residential construction loans to home builders and individuals to fund the construction of single-family residences with the understanding that such loans will be repaid from the proceeds of the sale of the homes by builders or with the proceeds of a mortgage loan. These loans are secured by the real property being built and are made based on our assessment of the value of the property on an as-completed basis. Our residential construction loans portfolio increased $150.2 million, or 127.4%, to $268.2 million as of December 31, 2022 from $117.9 million as of December 31, 2021 primarily due to the Merger.

Consumer and Other. Our consumer and other loan portfolio is made up of loans made to individuals for personal purposes. Generally, consumer loans entail greater risk than residential real estate loans because they may be unsecured or if secured the value of the collateral, such as an automobile or boat, may be more difficult to assess and more likely to decrease in value than real estate. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans. Our consumer and other loan portfolio increased $13.2 million, or 38.5%, to $47.5 million as of December 31, 2022 from $34.3 million as of December 31, 2021 primarily due to the Merger.

The contractual maturity ranges of total loans in our loan portfolio and the amount of such loans with predetermined interest rates in each maturity range and the amount of loans with predetermined (fixed) interest rates and floating interest rates in each maturity range, in each case as of the date indicated, are summarized in the following tables:

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Concentrations of Credit

The vast majority of our lending activity occurs in the Houston and Beaumont regions. Our loans are primarily secured by real estate, including commercial and residential construction, owner-occupied and nonowner-occupied and multi-family commercial real estate, raw land and other real estate based loans located in the Houston and Beaumont regions. As of December 31, 2022 and 2021, commercial real estate and commercial construction loans represented 64.1% and 60.3%, respectively, of our total loans.

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Asset Quality

We have procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our officers and monitor our delinquency levels for any negative or adverse trends.

We had $45.0 million and $24.1 million in nonperforming loans as of December 31, 2022 and 2021, respectively. If interest on nonaccrual loans had been accrued under the original loan terms, $1.7 million, $948 thousand and $902 thousand would have been recorded as income for the years ended December 31, 2022, 2021 and 2020, respectively.

The following table presents information regarding nonperforming assets as of the dates indicated:

(1)Nonperforming loans include nonaccrual loans and loans past due 90 days or more and still accruing interest.

(2)Nonperforming assets include nonaccrual loans, loans past due 90 days or more and still accruing interest, repossessed assets and other real estate.

(3)Restructured loans represent the balance at the end of the respective period for those performing loans modified in a troubled debt restructuring that are not already presented as a nonperforming loan.

Potential problem loans consist of loans that are performing in accordance with contractual terms but for which management has concerns about the ability of an obligor to continue to comply with repayment terms because of the obligor’s potential operating or financial difficulties. Management monitors these loans closely and reviews their performance on a regular basis. Potential problem loans contain potential weaknesses that could improve, persist or further deteriorate. At December 31, 2022 and 2021, we had $51.9 million and $47.1 million, respectively, in loans of this type which are not included in any of the nonaccrual or 90 days past due loan categories. At December 31, 2022, potential problem loans consisted of 50 credit relationships.

Weakness in these organizations’ operating performance, financial condition and borrowing base deficits, among other factors, have caused us to heighten the attention given to these credits. Potential problem loans impact the allocation of our allowance for credit losses on loans as a result of our risk grade based allocation methodology. See Note 6 – Loans and Allowance for Credit Losses in the accompanying notes to consolidated financial statements for details regarding our allowance allocation methodology.

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Nonperforming assets increased $20.9 million to $45.0 million at December 31, 2022, from $24.1 million at December 31, 2021. Nonaccrual loans consisted of 96 separate credits at December 31, 2022 compared to 64 separate credits at December 31, 2021. Nonperforming assets were 0.58% of total loans at December 31, 2022 compared to 0.57% at December 31, 2021.

Allowance for Credit Losses

The allowance for credit losses is a valuation allowance that is established through charges to earnings in the form of a provision for (or reversal of) credit losses calculated in accordance with ASC 326, that is deducted from the amortized cost basis of certain assets to present the net amount expected to be collected. The amount of each allowance account represents management’s best estimate of current expected credit losses on these financial instruments considering available information, from internal and external sources, relevant to assessing exposure to credit loss over the contractual term of the instrument. Relevant available information includes historical credit loss experience, current conditions and reasonable and supportable forecasts. While historical credit loss experience provides the basis for the estimation of expected credit losses, adjustments to historical loss information may be made for differences in current portfolio-specific risk characteristics, environmental conditions or other relevant factors. While management utilizes its best judgment and information available, the ultimate adequacy of our allowance accounts is dependent upon a variety of factors beyond our control, including the performance of our portfolios, the economy, changes in interest rates and the view of the regulatory authorities toward classification of assets. For additional information regarding critical accounting estimates and policies, refer to “Critical Accounting Estimates” in this section, Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies and Note 6 – Loans and Allowance for Credit Losses in the accompanying notes to the consolidated financial statements.

Allowance for Credit Losses on Loans

The allowance for credit losses on loans represents management’s estimates of current expected credit losses in the Company’s loan portfolio. Pools of loans with similar risk characteristics are collectively evaluated, while loans that no longer share risk characteristics with loan pools are evaluated individually.

At December 31, 2022, our allowance for credit losses on loans was $93.2 million, or 1.20% of total loans, compared with $47.9 million, or 1.14% of total loans, as of December 31, 2021. This increase in the allowance for credit losses on loans during 2022 was primarily due to the initial provision for credit losses recorded on acquired non-PCD loans which totaled $28.2 million as well as a $7.6 million day one adjustment to the allowance on acquired PCD loans as a result of the Merger.

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The following table presents, as of and for the periods indicated, an analysis of the allowance for credit losses on loans and other related data:

(1)    Includes a $28.2 million provision credit losses on loans recorded on acquired non-PCD loans as a result of the Merger.

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The following table shows the allocation of the allowance for credit losses on loans among our loan categories and the percentage of the respective loan category to total loans held for investment as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any loan category.

The Company believes that the allowance for credit losses on loans at December 31, 2022 is adequate based upon management’s best estimate of current expected credit losses within the existing portfolio of loans. Nevertheless, the Company could sustain losses in future periods which could be substantial in relation to the size of the allowance at December 31, 2022 should any of the factors considered by management in making this estimate change.

Allowance for Credit Losses on Unfunded Commitments

The allowance for credit losses on unfunded commitments estimates current expected credit losses over the contractual period in which there is exposure to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by us. The allowance for credit losses on unfunded commitments is a liability account reported as a component of other liabilities in our consolidated balance sheets and is adjusted as a provision for credit loss expense. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on the commitments expected to fund. The estimate of commitments expected to fund is affected by historical analysis looking at utilization rates. The expected credit loss rates applied to the commitments expected to fund are affected by the general valuation allowance utilized for outstanding balances with the same underlying assumptions and drivers. At December 31, 2022, our allowance for credit losses on unfunded commitments was $12.0 million compared to $5.3 million at December 31, 2021. The increase in the allowance for credit losses on unfunded commitments during 2022 was primarily due to the additional provision for credit losses on unfunded commitments as a result of the Merger.

See Note 6 – Loans and Allowance for Credit Losses in the accompanying notes to the consolidated financial statement for additional information regarding how we estimate and evaluate the credit risk in our loan portfolio.

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Available for Sale Securities

We use our securities portfolio to provide a source of liquidity, to provide an appropriate return on funds invested, to manage interest rate risk, to meet pledging requirements and to meet regulatory capital requirements. As of December 31, 2022, the carrying amount of investment securities totaled $1.81 billion, an increase of $33.8 million, or 1.91%, compared with $1.77 billion as of December 31, 2021. As a result of the Merger, we acquired $513.2 million of securities on the date of the Merger. During the fourth quarter of 2022, we sold $353.9 million of the acquired securities for a gain of $1.2 million. We also had maturities and payoffs totaling $2.4 million during the year 2022. Securities represented 16.6% and 25.0% of total assets as of December 31, 2022 and 2021, respectively.

All of the securities in our securities portfolio are classified as available for sale. Securities classified as available for sale are measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, as accumulated comprehensive income or loss until realized. Interest earned on securities is included in interest income.

The following table summarizes the amortized cost and fair value of the securities in our securities portfolio as of the dates shown:

Investment securities classified as available for sale or held to maturity are evaluated for expected credit losses under ASC Topic 326, “Financial Instruments – Credit Losses.” See Note 5 – Securities in the accompanying notes to the consolidated financial statements for additional information.

The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased.

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The following table summarizes the contractual maturity of securities and their weighted average yields as of the dates indicated. The contractual maturity of a mortgage-backed security is the date at which the last underlying mortgage matures. Available for sale securities are shown at amortized cost. For purposes of the table below, municipal securities are calculated on a tax equivalent basis.

The contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers generally have the right to prepay their obligations. Mortgage-backed securities and collateralized mortgage obligations are typically issued with stated principal amounts and are backed by pools of mortgage loans with varying maturities. The term of the underlying mortgages and loans may vary significantly due to the ability of a borrower to prepay and, in particular, monthly pay downs on mortgage-backed securities tend to cause the average life of the securities to be much different than the stated contractual maturity. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and, consequently, the average life of this security will be lengthened. If interest rates begin to fall, prepayments may increase, thereby shortening the estimated life of this security.

As of December 31, 2022 and 2021, we did not own securities of any one issuer (other than the U.S. government and its agencies or sponsored entities) for which the aggregate adjusted cost exceeded 10% of our consolidated shareholders’ equity.

The average yield of our securities portfolio was 2.13% during the year ended December 31, 2022 compared with 2.08% for the year ended December 31, 2021. The increase in average yield during 2022 compared to 2021 was primarily due to the higher interest rate environment over the prior year and the growth in our securities portfolio during the year.

Goodwill and Core Deposit Intangibles

Our goodwill was $497.3 million and $223.6 million as of December 31, 2022 and 2021, respectively. The increase during 2022 of $273.6 million was due to the Merger. Goodwill resulting from business combinations represents the excess of the

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consideration paid over the fair value of the net assets acquired. Goodwill is assessed annually for impairment and on an interim basis if an event occurs or circumstances change that would indicate that the carrying amount of the asset may not be recoverable.

Our core deposit intangibles, net, as of December 31, 2022 was $143.5 million compared to $14.7 million as of December 31, 2021. The increase in core deposit intangibles during 2022 was due to the Merger. Core deposit intangibles are amortized using the straight-line or an accelerated method over the estimated useful life of seven to ten years.

Deposits

Our lending and investing activities are primarily funded by deposits. We offer a variety of deposit accounts having a wide range of interest rates and terms including demand, savings, money market and certificates and other time accounts. We rely primarily on convenient locations, personalized service and our customer relationships to attract and retain these deposits. We generally seek customers that will both engage in a lending and deposit relationship with us.

Total deposits at December 31, 2022 were $9.27 billion, an increase of $3.22 billion, or 53.2%, compared with $6.05 billion at December 31, 2021. As a result of the Merger, we acquired $3.72 billion of deposits. Noninterest-bearing deposits at December 31, 2022 were $4.23 billion, an increase of $1.99 billion, or 88.6%, compared with $2.24 billion at December 31, 2021. Interest-bearing deposits at December 31, 2022 were $5.04 billion, an increase of $1.23 billion, or 32.4%, compared with $3.80 billion at December 31, 2021. Our ratio of noninterest-bearing deposits to total deposits was 45.6% and 59.0% for the years ended December 31, 2022, and 2021, respectively.

The following table presents the daily average balances and weighted average rates paid on deposits for the periods indicated:

The following table sets forth the amount of time deposits that met or exceeded the FDIC insurance limit of $250 thousand by time remaining until maturity:

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Borrowings

We have an available line of credit with the Federal Home Loan Bank (“FHLB”) of Dallas, which allows us to borrow on a collateralized basis. FHLB advances are used to manage liquidity as needed. The advances are secured by a blanket lien on certain loans and certain securities. Maturing advances are replaced by drawing on available cash, making additional borrowings or through increased customer deposits. At December 31, 2022, the Company had total borrowing capacity of $2.31 billion, of which $1.16 billion was available under this facility and $1.15 billion was outstanding based on September 30, 2022 financial information for Allegiance prior to the Merger. The amount available under this facility is updated by the FHLB on a quarterly basis after the submission of regulatory Call Reports by the Bank. At December 31, 2022, the Company had FHLB advances of $64.0 million at a weighted average rate of 4.70%. Letters of credit were $1.08 billion at December 31, 2022, of which $1.00 billion will expire in 2023, $57.9 million will expire in 2024, $16.0 million will expire in 2025 and $5.0 million will expire in 2028.

Following submission of the Bank’s regulatory Call Report as of December 31, 2022, the FHLB updated the Company’s total borrowing capacity to reflect the combined financial information of Stellar to be $3.70 billion.

Credit Agreement

On December 13, 2022, the Company entered into a loan agreement with another financial institution, (“Loan Agreement”), which has been periodically amended and provides for a $75.0 million revolving line of credit. At December 31, 2022, there were no outstanding borrowings on this line of credit and the Company did not draw on this line of credit during 2022 or 2021. The Company can make draws on the line of credit for a period of 24 months, which began on December 13, 2022, after which the Company will not be permitted to make further draws and the outstanding balance will amortize over a period of 60 months. Interest accrues on outstanding borrowings at a per annum rate equal to the prime rate quoted by The Wall Street Journal and with a floor rate of 3.50% calculated in accordance with the terms of the revolving promissory note and payable quarterly through the first 24 months. The entire outstanding balance and unpaid interest is payable in full on December 13, 2024.

The Company may prepay the principal amount of the line of credit without premium or penalty. The obligations of the Company under the Loan Agreement are secured by a pledge of all of the issued and outstanding shares of capital stock of Stellar Bank.

Covenants made under the Loan Agreement include, among other things, while there any obligations outstanding under Loan Agreement, the Company shall maintain a cash flow to debt service (as defined in the Loan Agreement) of not less than 1.25, the Bank's Texas Ratio (as defined in the Loan Agreement) shall not exceed 25.0%, the Bank shall maintain a Tier 1 Leverage Ratio (as defined under the Loan Agreement) of at least 7.0% and restrictions on the ability of the Company and its subsidiaries to incur certain additional debt. As of December 31, 2022, we believe we were in compliance with all such debt covenants and had not been made aware of any noncompliance by the lender.

Subordinated Debt

Junior Subordinated Debentures

In connection with the F&M Bancshares, Inc. acquisition, we assumed junior subordinated debentures with an aggregate original principal amount of $11.3 million and a current fair value of $9.9 million at December 31, 2022. At acquisition, we recorded a discount of $2.5 million on the debentures. The difference between the carrying value and contractual balance will be recognized as a yield adjustment over the remaining term for the debentures. See Note 13 – Subordinated Debt to the accompanying audited consolidated financial statements.

Subordinated Notes

In December 2017, the Bank completed the issuance, through a private placement, of $40.0 million aggregate principal amount of Fixed-to-Floating Rate Subordinated Notes (the “Notes”) due December 15, 2027. The Notes were issued at a price equal to 100% of the principal amount, resulting in net proceeds to the Bank of $39.4 million.

As of December 15, 2022, the Notes bear a floating rate of interest equal to 3-Month London Interbank Offered Rate (“LIBOR”)+ 3.03% until the Notes mature on December 15, 2027, or such earlier redemption date, payable quarterly in arrears. The Notes will be redeemable by the Bank, in whole or in part, on or after December 15, 2022 or, in whole but not in part, upon the occurrence of certain specified tax events, capital events or investment company events. Any redemption will be at a redemption price

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equal to 100% of the principal amount of Notes being redeemed, plus accrued and unpaid interest, and will be subject to, and require, prior regulatory approval. The Notes are not subject to redemption at the option of the holders.

In September 2019, we completed the issuance of $60.0 million aggregate principal amount of Fixed-to-Floating Rate Subordinated Notes (the “Company Notes”) due October 1, 2029. The Company Notes were issued at a price equal to 100% of the principal amount, resulting in net proceeds to the Company of $58.6 million.

The Company Notes bear a fixed interest rate of 4.70% per annum until (but excluding) October 1, 2024, payable semi-annually in arrears on April 1 and October 1, commencing on April 1, 2020. Thereafter, from October 1, 2024 through the maturity date, October 1, 2029, or earlier redemption date, the Company Notes will bear interest at a floating rate equal to the then-current three-month LIBOR, plus 313 basis points (3.13%) for each quarterly interest period (subject to certain provisions set forth under “Description of the Notes—Interest Rates and Interest Payment Dates” included in the Prospectus Supplement for the Company Notes), payable quarterly in arrears on January 1, April 1, July 1 and October 1 of each year. Any redemption will be at a redemption price equal to 100% of the principal amount of Company Notes being redeemed, plus accrued and unpaid interest, and will be subject to, and require, prior regulatory approval. The Company Notes are not subject to redemption at the option of the holders.

Liquidity and Capital Resources

Liquidity

Liquidity is 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 and to maintain reserve requirements to operate on an ongoing basis and manage unexpected events, all at a reasonable cost. During the years ended December 31, 2022 and 2021, our liquidity needs have been met by deposits, borrowed funds, security and loan maturities and amortizing investment and loan portfolios. The Bank has access to purchased funds from correspondent banks, and advances from the FHLB are available under a security and pledge agreement to take advantage of investment opportunities.

Average assets totaled $7.99 billion and $6.56 billion for the years ended December 31, 2022 and 2021, respectively. The following table illustrates, during the periods presented, the mix of our funding sources and the average assets in which those funds are invested as a percentage of our average total assets for the period indicated.

Our largest source of funds is deposits and our largest use of funds is loans. Our average deposits increased $1.37 billion, or 25.0%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. Our average loans increased $749.5

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million, or 16.9%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. We predominantly invest excess deposits in Federal Reserve Bank of Dallas balances, securities, interest-bearing deposits at other banks or other short-term liquid investments until the funds are needed to fund loan growth. Our securities portfolio had a weighted average life of 8.3 years and modified duration of 4.8 years at December 31, 2022, and a weighted average life of 6.5 years and modified duration of 4.6 years at December 31, 2021.

As of December 31, 2022 and December 31, 2021, we had outstanding commitments to extend credit of $2.36 billion and $1.09 billion, respectively, and commitments associated with outstanding letters of credit of $35.5 million and $21.2 million, respectively. Since commitments associated with commitments to extend credit and outstanding letters of credit may expire unused, the total outstanding may not necessarily reflect the actual future cash funding requirements. At December 31, 2022 and 2021, the Company had FHLB letters of credit in the amount of $1.08 billion and $1.36 billion, respectively, pledged as collateral for public and other deposits of state and local government agencies. See Note 12 – Borrowings and Borrowing Capacity to the accompanying consolidated financial statements.

As of December 31, 2022 and 2021, we had no exposure to future cash requirements associated with known uncertainties or capital expenditures of a material nature.

As of December 31, 2022, we had cash and cash equivalents of $371.7 million compared with $757.5 million at December 31, 2021, a decrease of $385.8 million, or 50.9%. This decrease in cash and cash equivalents was primarily due to the increase in core loans partially offset by the decrease in deposits.

In the ordinary course of business, we have entered into contractual obligations and have made other commitments to make future payments. Refer to the accompanying notes to accompanying consolidated financial statements for the expected timing of such payments as of December 31, 2022. These include payments related to (1) operating leases (Note 9 – Leases), (2) time deposits with stated maturity dates (Note 10 – Deposits), (3) long-term borrowings (Note 12 – Borrowings and Borrowing Capacity) and (4) commitments to extend credit and standby letters of credit (Note 17 – Off-Balance Sheet Arrangements, Commitments and Contingencies).

Our commitments associated with outstanding standby letters of credit and commitments to extend credit expiring by period are summarized below as of December 31, 2022. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

Commitments to Extend Credit. We enter into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. We minimize our exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. The amount and type of collateral obtained, if considered necessary by us, upon extension of credit, is based on management’s credit evaluation of the customer. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for credit losses.

Standby Letters of Credit. Standby letters of credit are written conditional commitments issued by us to guarantee the performance of a customer to a third party. If the customer does not perform in accordance with the terms of the agreement with the third party, we would be required to fund the commitment and we would have the rights to the underlying collateral. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. Our policies generally require that standby letter of credit arrangements be backed by promissory notes that contain security and debt covenants similar to those contained in loan agreements.

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Capital Resources

Capital management consists of providing equity to support our current and future operations. We are subject to capital adequacy requirements imposed by the Federal Reserve and the Bank is subject to capital adequacy requirements imposed by the FDIC. Both the Federal Reserve and the FDIC have adopted risk-based capital requirements for assessing bank holding companies and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.

Under current guidelines, the minimum ratio of total capital to risk-weighted assets (which are primarily the credit risk equivalents of balance sheet assets and certain off-balance sheet items such as standby letters of credit) is 8.0%. At least half of total capital must be composed of tier 1 capital, which includes common shareholders’ equity (including retained earnings), less goodwill, other disallowed intangibles and disallowed deferred tax assets, among other items. The Federal Reserve also has adopted a minimum leverage ratio, requiring tier 1 capital of at least 4.0% of average quarterly total consolidated assets, net of goodwill and certain other intangible assets, for all but the most highly rated bank holding companies. The federal banking agencies have also established risk-based and leverage capital guidelines that FDIC-insured depository institutions are required to meet. These regulations are generally similar to those established by the Federal Reserve for bank holding companies.

Under the Federal Deposit Insurance Act, the federal bank regulatory agencies must take “prompt corrective action” against undercapitalized U.S. depository institutions. U.S. depository institutions are assigned one of five capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized,” and are subjected to different regulation corresponding to the capital category within which the institution falls. A depository institution is deemed to be “well capitalized” if the banking institution has a total risk-based capital ratio of 10.0% or greater, a tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 6.5% and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific level for any capital measure. Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category.

Failure to meet capital guidelines could subject the institution to a variety of enforcement remedies by federal bank regulatory agencies, including termination of deposit insurance by the FDIC, restrictions on certain business activities and appointment of the FDIC as conservator or receiver. As of December 31, 2022 and 2021, the Bank was well-capitalized.

Basel III Capital Rules impacted regulatory capital ratios of banking organizations in the following manner: created a new requirement to maintain a ratio of “common equity Tier 1 capital” to total risk-weighted assets of not less than 4.5%; increased the minimum leverage capital ratio to 4.0% for all banking organizations; increased the minimum tier 1 risk-based capital ratio from 4.0% to 6.0%; and maintained the minimum total risk-based capital ratio at 8.0%.

In addition, the Basel III Capital Rules subject a banking organization to certain limitations on capital distributions and discretionary bonus payments to executive officers if the organization does not maintain a “capital conservation buffer” of common equity Tier 1 capital of 2.5%. The effect of the capital conservation buffer is to increase the minimum common equity Tier 1 capital ratio to 7.0%, the minimum tier 1 risk-based capital ratio to 8.5% and the minimum total risk-based capital ratio to 10.5%.

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The following table provides a comparison of the Company’s and the Bank’s leverage and risk-weighted capital ratios as of December 31, 2022 to the minimum and well-capitalized regulatory standards:

(1)On February 18, 2023, Allegiance Bank changed its name to Stellar Bank.

Total shareholder’s equity was $1.38 billion at December 31, 2022, compared with $816.5 million at December 31, 2021, an increase of $566.7 million, or 69.4%, primarily due to the impact of the Merger and net income during 2022 partially offset by the increase in unrealized losses on available for sale securities, repurchases of common stock and dividends paid on common stock during the year. During 2022, the Company paid three quarterly cash dividends of $0.10 per share and one quarterly dividend of $0.13 per share on its common stock during the fourth quarter of 2022.

Asset/Liability Management and Interest Rate Risk

Our asset liability and interest rate risk policy provides management with the guidelines for effective balance sheet management. We have established a measurement system for monitoring our net interest rate sensitivity position. We manage our sensitivity position within our established guidelines.

As a financial institution, a component of the market risk that we face is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Interest rate risk is the potential for economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.

Based upon the nature of our operations, we are not subject to foreign exchange rate or commodity price risk. We do not own any trading assets. We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of a community banking business. The Company enters into interest rate swaps as an accommodation to customers.

Our exposure to interest rate risk is managed by our Balance Sheet Risk Committee of the Bank (“BSRC”). The BSRC formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the BSRC considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The BSRC meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the BSRC reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity.

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We use an interest rate risk simulation model and shock analysis to test the interest rate sensitivity of net interest income and the balance sheet, respectively. All instruments on the balance sheet are modeled at the instrument level, incorporating all relevant attributes such as next reset date, reset frequency and call dates, as well as prepayment assumptions for loans and securities and decay rates for nonmaturity deposits. Assumptions based on past experience are incorporated into the model for nonmaturity deposit account decay rates. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

We utilize static balance sheet rate shocks to estimate the potential impact on net interest income of changes in interest rates under various rate scenarios. This analysis estimates a percentage of change in the metric from the stable rate base scenario versus alternative scenarios of rising and falling market interest rates by instantaneously shocking a static balance sheet.

The following table summarizes the simulated change in net interest income and the economic value of equity over a 12-month horizon as of the dates indicated:

These results are primarily due to the size of our cash position, the size and duration of our loan and securities portfolio, the duration of our borrowings and the expected behavior of demand, money market and savings deposits during such rate fluctuations. During 2022, although our assets increased due to the Merger, the overall interest rate risk profile change only slightly. Cash balances declined while the proportion of variable loans to total loans increased. In addition to balance sheet changes, the rise in interest rates also influenced the interest rate risk profile.

LIBOR Transition

The Company’s transition away from LIBOR has been substantially completed. As of December 31, 2022, LIBOR was used as an index rate for one of the Company’s credit participation agreements and twelve loans or less than 1% of the Company’s loans.