Stellar Bancorp, Inc. (STEL) FY 2023 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:

•disruptions to the economy and the U.S. banking system caused by recent bank failures;

•risks associated with uninsured deposits and responsive measures by federal or state governments or banking regulators, including increases in our deposit insurance assessments and other actions of the Board of Governors of the Federal Reserve System, FDIC and Texas Department of Banking and legislative and regulatory actions and reforms;

•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, capital and securities markets and monetary fluctuations;

•changes in the interest rate environment, the value of the Company’s assets and obligations and the availability of capital and liquidity;

•general competitive, economic, political and market conditions and other factors that may affect future results of the Company including changes in asset quality and credit risk;

•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;

•the inability to sustain revenue and earnings growth;

•impairment of the Company’s goodwill or other intangible assets;

•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 market;

•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;

•customer borrowing, repayment, investment and deposit practices;

•the ability to maintain important deposit customer relationships;

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

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•the risk that the anticipated benefits from the Merger may not be fully realized or may take longer than anticipated to be realized;

•the amount of the costs, fees, expenses and charges related to the Merger and the integration;

•natural disasters and adverse weather in the Company’s market area;

•the potential impact of climate change;

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

•acts of terrorism, an outbreak of hostilities, such as the conflicts in Ukraine or the Middle East, or other international or domestic calamities;

•the 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 impact, extent and timing of technological changes;

•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

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factors, economic and competitive conditions in Texas and specifically in our market, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our 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, 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.

Merger of Equals

On October 1, 2022, Allegiance and CBTX merged with and into CBTX and the surviving corporation was renamed Stellar Bancorp, Inc. At the effective time of the Merger, each outstanding share of Allegiance common stock 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. Allegiance Bank changed its name to Stellar Bank on February 18, 2023 in connection with the operational conversion. After the merger, Stellar became one of the largest banks based in Houston, Texas.

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 were 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. During the third quarter of 2023, the Company completed the final tax returns related to CBTX's business and operations through September 30, 2022 and finalized all purchase accounting adjustments for the Merger.

The 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 set forth the results of operations for the Company. The Company’s historical operating results as of and for the years ended December 31, 2021, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. 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. 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. Management considers the policies related to the allowance for credit losses as the most critical to the financial statement presentation. 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 nonaccrual loans 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. Estimating the timing and amounts of future losses is subject to management’s judgment as these projected cash flows rely upon the estimates discussed above and factors that are reflective of current or future expected conditions using analytical and forecasting models and tools. Volatility in certain credit metrics and differences between expected and actual outcomes are to be expected. For example, customers may not repay their loans

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according to the original terms, and the collateral securing the payment of those loans may be insufficient to pay any remaining loan balance.

Loans with similar risk characteristics are aggregated into homogenous pools and are collectively evaluated by applying reserve factors, such as historical lifetime loss, concentration risk, volume, growth and composition of the loan portfolio, current and forecasted economic conditions to amortized cost balances over the remaining contractual life of the collectively evaluated portfolio. Historical lifetime loss is determined by utilizing an open-pool (“cumulative loss rate”) methodology, adjusted for credit risk characteristics and current and forecasted economic conditions. Losses are predicted over a reasonable and supportable period of one year for all loan pools, followed by an immediate reversion to long-term historical averages. The reasonable and supportable period and reversion period are re-evaluated as needed by the Company and are dependent on the current economic environment among other factors.

Loans that no longer share risk characteristics with the collectively evaluated loan pools are evaluated on an individual basis and are excluded from the collectively evaluated pools. In order to assess which loans are to be individually evaluated, the Company follows a loan review program to evaluate the credit risk in the total loan portfolio and assigns risk grades to each loan. Individual credit loss estimates are typically performed for nonaccrual loans, modified loans classified as troubled loan modifications and all other loans identified by management. All loans deemed as being individually evaluated are reviewed on a quarterly basis in order to determine whether a specific reserve is required. The Company considers certain loans to be collateral dependent if the borrower is experiencing financial difficulty and management expects repayment for the loan to be substantially through the operation or sale of the collateral. For collateral dependent loans, loss estimates are based on the fair value of collateral, less estimated cost to sell (if applicable). Collateral values supporting individually evaluated loans are assessed quarterly and appraisals are typically obtained at least annually. The Company allocates a specific loan loss reserve on an individual loan basis primarily based on the value of the collateral securing the individually evaluated loan. Through this loan review process, the Company assesses the overall quality of the loan portfolio and the adequacy of the allowance for credit losses on loans while considering risk elements attributable to particular loan types in assessing the quality of individual loans. In addition, for each category of loans, the Company considers secondary sources of income and the financial strength and credit history of the borrower and any guarantors.

A change in the allowance for credit losses on loans can be attributable to several factors, most notably historical lifetime loss, specific reserves for individually evaluated loans and changes in qualitative factors and growth within the loan portfolio. The estimated loan losses for all loan pools are adjusted for changes in qualitative factors not inherently considered in the quantitative analyses to bring the allowance to the level management believes is appropriate based on factors that have not otherwise been fully accounted for, including adjustments for foresight risk, input imprecision and model imprecision. The qualitative categories and the measurements used to quantify the risks within each of these categories are subjectively selected by management, but measured by objective measurements period over period. The data for each measurement may be obtained from internal or external sources. The current period measurements are evaluated and assigned a factor commensurate with the current level of risk relative to past measurements over time. The resulting qualitative adjustments are applied to the relevant collectively evaluated loan portfolios. These adjustments are based upon quarterly trend assessments in portfolio concentrations, changes in lending policies and procedures, policy exceptions, independent loan review results, internal risk ratings and peer group credit quality trends. Additional qualitative considerations are made for any identified risk which did not exist within our portfolio historically and therefore may not be adequately addressed through evaluation of such risk factors based on historical portfolio trends. Qualitative adjustments also include current and forecasted economic conditions primarily measured by local and national economic metrics, such as GDP, unemployment rates, interest rates and oil and gas prices based on historical and forecasted economic research scenarios provided by industry-leading financial intelligence and analytical solutions, which the Company has subscribed to. The qualitative allowance allocation is increased or decreased for each loan pool based on the assessment of these various qualitative factors. Management recognizes the sensitivity of various assumptions made in the quantitative modeling of expected losses and may adjust reserves depending upon the level of uncertainty that currently exists in one or more assumptions.

Based on sensitivity analyses across all segments of the performing loan portfolio, a 5% increase in historical loss rates would have an impact of $1.9 million increase in funded reserves. On the other hand, a 5% increase in each qualitative risk factor across all segments (where assigned) would have an impact of $3.3 million increase in funded reserves. Increasing estimated loss rates (i.e. quantitative and qualitative) by 5 basis points would have a $3.8 million impact.

During the year ended 2023, management evaluated the credit quality and risk characteristics of the loan portfolio amidst the geopolitical and economic outlook. As a result, the risk assessments were updated for certain qualitative factors of affected segments, along with our annual model recalibration process. Our annual review includes peer analysis, updates of delay periods and qualitative factor scorecard ranges as needed. In total, compared to the year 2022, the above-mentioned changes reduced total funded and unfunded reserves by $2.2 million. This decrease in reserves during 2023 was primarily due to a decrease in specific reserves of $8.5

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million and unfunded reserves of $682 thousand partially offset by increases in the qualitative reserve of $6.1 million and quantitative reserves of $902 thousand.

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.

Goodwill

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

combination. During the measurement period, the Company may record subsequent adjustments to goodwill for provisional amounts recorded at the acquisition date. During the third quarter of 2023, the Company completed the final tax returns related to CBTX's business and operations through September 30, 2022. After completion of these tax returns, the Company increased income tax balances and goodwill in the amount of $58 thousand which finalized all purchase accounting adjustments for the Merger.

Goodwill is subject to impairment testing, which must be conducted at least annually or upon the occurrence of a triggering event. Goodwill is recorded and evaluated for impairment at its reporting unit, the Company. The Company's policy is to test goodwill for impairment at least annually as of October 1st, or on an interim basis if an event triggering an impairment assessment is determined to have occurred. Various factors, such as the Company’s results of operations, the trading price of the Company’s common stock relative to the book value per share, macroeconomic conditions and conditions in the banking sector, inform whether a triggering event for an interim goodwill impairment test has occurred. The impairment test compares the estimated fair value of each reporting unit with its net book value. If the unit’s fair value is less than its carrying value, an impairment loss is recognized in our results of operations in the periods in which they become known in an amount equal to this excess.

During 2023, economic uncertainty and market volatility resulting from the rising interest rate environment and the recent banking failures resulted in a decrease in the Company's stock price and market capitalization. Management believed the collective events met the requirements of a triggering event and an interim goodwill impairment quantitative analysis was performed as of September 30, 2023. The Company engaged an independent third-party service provider to assist management with the determination of the fair value of the Company as of September 30, 2023. A weighted combination of the guideline public company method and income approach method was employed.

In performing the discount cash flow analysis, the Company utilized multi-year cash projections that rely on internal forecasts of loan and deposit growth, bond mix, financing composition, market pricing of securities, credit performance, forward interest rates, future returns driven by net interest margin, fee generation and expense incurrence, industry and economic trends, and other relevant considerations.

The discount rate was calculated as the cost of equity capital using the modified capital asset pricing model, which includes variables including the risk-free interest rate, beta, equity risk premium, size premium, and company-specific risk premium.

The market approach considers a combination of price to book value and price to earnings, adjusted based on companies similar to the reporting unit and adjusted for selected multiples, along with a control premium based on a review of transactions in the banking industry in order to calculate the indicated value of the Company's equity on a control, marketable basis. The analysis resulted in the Company's fair value exceeding its carrying value resulting in no impairment charge for the period.

A significant amount of judgment is involved in the determination of the fair value of a reporting unit. Future events could cause the Company to conclude that the Company’s goodwill has become impaired, which would result in recording an impairment loss. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations. Management will continue evaluating the economic conditions at future reporting periods for triggering events.

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 related to the Merger.

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Recently Issued Accounting Pronouncements

We have evaluated new accounting pronouncements that have recently been issued. Refer to Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies in the accompanying notes to the consolidated financial statements for a discussion of recent accounting pronouncements that have been adopted by the Company or that will require enhanced disclosures in the Company’s financial statements in future periods.

Results of Operations

This section provides a comparative discussion of the Company’s results of operations for the two-year period ended December 31, 2023, 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, 2022 for a discussion of 2022 versus 2021 results.

The 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 the Company. Accordingly, the Company’s historical operating results as of and for the years ended December 31, 2021, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. 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. See Note 2 – Acquisitions in the accompanying notes to the consolidated financial statements for the impact of the Merger.

Net income was $130.5 million, or $2.45 per diluted common share, for the year ended December 31, 2023 compared with $51.4 million, or $1.47 per diluted common share, for the year ended December 31, 2022, an increase of $79.1 million, or 153.7%, primarily as a result of the Merger in 2022. The increase in net income was primarily due to a $147.8 million increase in net interest income, a $41.8 million decrease in the provision for credit losses and a $4.2 million increase in noninterest income, partially offset by a $94.4 million increase in noninterest expense and a $20.3 million increase in the provision for income taxes, as a result of the increase in income. See further analysis of the material fluctuations in the related discussions that follow.

Returns on average equity were 8.96% and 5.69%, returns on average assets were 1.21% and 0.64% and efficiency ratios were 63.02% and 64.23% for the years ended December 31, 2023 and 2022, 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 94.7% of total revenue during 2023. 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.

Net interest income before the provision for credit losses for the year ended December 31, 2023 was $436.8 million compared with $289.0 million for the year ended December 31, 2022, an increase of $147.8 million, or 51.1% primarily due to the increase in average interest-earning assets and liabilities as a result of the Merger.

Interest income was $590.8 million for the year ended December 31, 2023, an increase of $267.8 million, or 82.9%, compared with $323.0 million for the year ended December 31, 2022 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 $2.28 billion, or 30.8%, for the year ended December 31, 2023 compared with the year ended December 31, 2022 primarily due the full year impact of the Merger in 2023.

Interest expense was $154.1 million for the year ended December 31, 2023, an increase of $120.0 million, or 352.6%, compared with $34.0 million for the year ended December 31, 2022. This increase was primarily due to higher funding costs on interest-bearing deposits and borrowings due to higher interest rates and an increase in average interest-bearing liabilities due to the Merger. The cost of average interest-bearing liabilities increased to 286 basis points for the year ended December 31, 2023 compared

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to 81 basis points for the same period in 2022. Average interest-bearing liabilities increased $1.20 billion for the year ended December 31, 2023 compared to the year ended December 31, 2022 primarily due to the full year impact of 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, 2023 was 4.51%, an increase of 57 basis points compared to 3.94% for the year ended December 31, 2022. 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 6.09% and the average rate paid on interest-bearing liabilities of 2.86% for the year ended December 31, 2023 increased by 173 basis points and 205 basis points, respectively, over the same period in 2022. Tax equivalent adjustments to net interest margin are the result of increasing income from tax-free securities and loans 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, 2023 and 2022, thus making tax-exempt yields comparable to taxable asset yields.

The following table presents, for the periods indicated, the total dollar amount of average balances, interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed in both dollars and rates. Average loans include loans on nonaccrual status 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 adjustments have been computed using a federal income tax rate of 21% for the years ended December 31, 2023, 2022 and 2021.

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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-earnings 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 a 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 an $8.9 million provision for credit losses for the year ended December 31, 2023 compared to a $50.7 million provision for credit losses for the year ended December 31, 2022. 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.

Net charge-offs were $11.1 million for the year ended December 31, 2023 compared to net charge-offs of $6.4 million for the year ended December 31, 2022. The increase in charge-offs during 2023 was primarily due to a single commercial and industrial loan relationship that was placed on nonaccrual status at December 31, 2022. During 2023, the borrower’s financial condition further deteriorated, which prompted a charge-off of $8.0 million on the loan relationship.

Noninterest Income

Our primary sources of noninterest income are service charges on deposit accounts, income earned on bank owned life insurance and debit card and ATM income. 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 $24.6 million for the year ended December 31, 2023 compared to $20.4 million for the year ended December 31, 2022, an increase of $4.2 million, or 20.7%. Noninterest income increased in 2023 primarily due to increased scale as a result of the Merger along with increased Small Business Investment Company income. The increase in noninterest income was partially offset by the decrease in debit card and ATM income due to the impact of the Durbin Amendment and change in our policy on charging nonsufficient funds fees along with gains on sale of securities, loans and assets during 2022.

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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 $290.5 million for the year ended December 31, 2023 compared to $196.1 million for the year ended December 31, 2022, an increase of $94.4 million, or 48.2%. The increase in noninterest expense was primarily due to increased scale as a result of the Merger primarily within categories such as salaries and benefits and amortization of intangibles along with higher professional fees associated with various projects some of which related to crossing the $10 billion asset threshold, partially offset by a decrease in acquisition and merger-related expenses to $15.6 million from $24.1 million in 2022.

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

(1)Total salaries and employee benefits includes $9.9 million, $9.0 million and $4.0 million in stock based compensation expense for the years ended December 31, 2023, 2022 and 2021, respectively.

Salaries and employee benefits. Salaries and benefits were $157.0 million for the year ended December 31, 2023, an increase of $49.5 million, or 46.0%, compared to the year ended December 31, 2022 primarily due to the Merger.

Amortization of intangibles. Amortization of intangibles increased $17.6 million for the year ended December 31, 2023 compared to the year ended December 31, 2022 due to amortization of the $138.2 million core deposit intangible created as a result of the Merger.

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Professional fees. Professional fees increased $4.4 million for the year ended December 31, 2023 compared to the year ended December 31, 2022 primarily due to various projects, some of which related to the Company’s assets crossing the $10 billion threshold.

Regulatory assessments and FDIC insurance. Regulatory assessments and FDIC insurance increased $6.1 million for the year ended December 31, 2023 compared to the year ended December 31, 2022 primarily due to a $2.4 million accrual for future payments to the FDIC pursuant to the final FDIC rule implementing a special insurance assessment to recover losses to the Deposit Insurance Fund associated with protecting uninsured depositors following several bank failures during 2023.

Acquisition and merger-related expenses. Acquisition and merger-related expenses decreased $8.6 million for the year ended December 31, 2023 compared to the year ended December 31, 2022 due to a reduction in legal and advisory fees associated with the Merger in 2022.

Efficiency Ratio

The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of the Company’s performance. We calculate our 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 decreased to 63.02% for the year ended December 31, 2023 compared to 64.23% for the year ended December 31, 2022 and 58.86% for the year ended December 31, 2021.

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 overhead 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 other nondeductible expenses. Income tax expense increased $20.3 million, or 183.0%, to $31.4 million for the year ended December 31, 2023 compared with $11.1 million for the same period in 2022 primarily due to an increase in pre-tax net income. The effective tax rates were 19.4%, 17.7% and 18.4% for the years ended December 31, 2023, 2022 and 2021, respectively.

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Financial Condition

Loan Portfolio

At December 31, 2023, total loans were $7.93 billion, an increase of $170.4 million, or 2.2%, compared with December 31, 2022 primarily due to organic growth within our loan portfolio. Total loans as a percentage of deposits were 89.3% and 83.7% as of December 31, 2023 and December 31, 2022, respectively. Total loans as a percentage of assets were 74.4% and 71.1% as of December 31, 2023 and December 31, 2022, 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 market. 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 which includes third-party loan review services to review the credit risk on a periodic basis. The internal loan review department focuses on credits not reviewed by the third-party loan reviewer to ensure more complete coverage of credit risk. 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 decreased $46.8 million, or 3.2%, to $1.41 billion as of December 31, 2023 compared to $1.46 billion as of December 31, 2022.

Paycheck Protection Program. The balance of PPP loans decreased $8.1 million to $5.1 million as of December 31, 2023 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, 2023 and December 31, 2022, 46.6% and 45.3%, respectively, of our commercial real estate loans were owner-occupied. Our commercial real estate loan portfolio increased $140.3 million, or 3.6%, to $4.07 billion as of December 31, 2023 from $3.93 billion as of December 31, 2022 primarily due to organic loan growth. Included in our commercial real estate portfolio are multi-family residential

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loans. Our multi-family loans increased $17.2 million to $488.8 million as of December 31, 2023 from $471.6 million as of December 31, 2022. We had 236 multi-family loans with an average loan size of $2.1 million as of December 31, 2023.

As of December 31, 2023, the Company’s commercial real estate (including multi-family residential) loan portfolio included $298.9 million of multi-family community development loans with associated tax credits, which fund Texas based projects to promote affordable housing, compared to $287.3 million as of December 31, 2022.

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, 2023 and December 31, 2022, 21.1% and 18.2%, respectively, of our commercial real estate construction and land development loans were owner-occupied. Our commercial real estate construction and land development loans increased $22.7 million, or 2.2%, to $1.06 billion as of December 31, 2023 compared to $1.04 billion as of December 31, 2022.

As of December 31, 2023, the Company’s commercial real estate construction and land development loan portfolio included $80.5 million of construction and development loans to support multi-family community development loans with associated tax credits, which fund Texas based projects to promote affordable housing, compared to $79.7 million as of December 31, 2022.

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 areas. Our residential real estate portfolio (including home equity) increased $46.2 million, or 4.6%, to $1.05 billion as of December 31, 2023 from $1.00 billion as of December 31, 2022.

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 decreased $793 thousand, or 0.3%, to $267.4 million as of December 31, 2023 from $268.2 million as of December 31, 2022.

Consumer and Other. Our consumer and other loan portfolio is made up of loans made to individuals for personal purposes and deferred fees and costs on all loan types. 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 $16.8 million, or 35.4%, to $64.3 million as of December 31, 2023 from $47.5 million as of December 31, 2022.

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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:

Concentrations of Credit

The vast majority of our lending activity occurs in the Houston and Beaumont MSAs. 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 MSAs. As of December 31, 2023 and 2022,

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commercial real estate and commercial construction loans represented 64.7% and 64.1%, respectively, of our total loans.

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.

Nonperforming Assets

Nonperforming assets totaled $39.2 million, or 0.37% of total assets at December 31, 2023, compared to $45.0 million, or 0.41% of total assets in nonperforming loans at December 31, 2022. Nonaccrual loans consisted of 114 separate credits at December 31, 2023 compared to 96 separate credits at December 31, 2022. The following table presents information regarding nonperforming assets as of the dates indicated:

(1)On January 1, 2023, the Company adopted Accounting Standards Update (“ASU”) 2022-02, which replaced the troubled debt restructuring classification with a modified loan classification that is assessed in a different manner. Modified/restructured loans represent the balance at the end of the respective period for those loans that are not already presented as a nonperforming loan.

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 Topic 326- Measurement of Credit Losses on Financial Instruments (“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

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section, Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies and Note 5 – 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, 2023, our allowance for credit losses on loans was $91.7 million, or 1.16% of total loans, compared with $93.2 million, or 1.20% of total loans, as of December 31, 2022. The decrease in the allowance for credit losses on loans during 2023 primarily resulted from changes to specific reserves, among other things. The following table presents an analysis of the allowance for credit losses on loans and other related data as of and for the periods indicated:

(1)    The 2022 provision for credit losses on loans includes a $28.2 million provision on non-PCD loans as a result of the Merger.

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

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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, 2023, our allowance for credit losses on unfunded commitments was $11.3 million compared to $12.0 million at December 31, 2022.

See Note 5 – 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.

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 and to meet pledging and regulatory capital requirements. As of December 31, 2023, the carrying amount of investment securities totaled $1.40 billion, a decrease of $411.9 million, or 22.8%, compared with $1.81 billion as of December 31, 2022. Securities represented 13.1% and 16.6% of total assets as of December 31, 2023 and 2022, 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 tables summarize 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. See Note 4 – Securities in the accompanying notes to the consolidated financial statements for additional information. Management does not have the intent to sell any of these securities and believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Accordingly, as of December 31, 2023, management believes that the unrealized losses detailed in the previous table are due to noncredit-related factors, including changes in interest rates and other market conditions, and therefore, no losses have been recognized in the Company’s consolidated statements of income.

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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 tables below, the yields on municipal securities were 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 may 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 the security.

As of December 31, 2023 and 2022, 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 2.75% during the year ended December 31, 2023 compared with 2.13% for the year ended December 31, 2022. The increase in average yield during 2023 compared to 2022 was primarily due to reinvestment at higher interest rates during 2023 and changes in the mix of securities within the portfolio.

Goodwill and Core Deposit Intangibles

Goodwill was $497.3 million as of both December 31, 2023 and 2022. Goodwill resulting from business combinations represents the excess of the consideration paid over the fair value of the net assets acquired. Goodwill is assessed annually for

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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.

Core deposit intangibles, net, as of December 31, 2023 was $116.7 million compared to $143.5 million as of December 31, 2022. 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 seek customers that will engage in both a lending and deposit relationship with us.

Total deposits at December 31, 2023 were $8.87 billion, a decrease of $394.2 million, or 4.3%, compared with $9.27 billion at December 31, 2022 primarily driven by industry-wide pressures and the maintenance of pricing discipline in an intensely competitive market for deposits. Noninterest-bearing deposits at December 31, 2023 were $3.55 billion, a decrease of $683.4 million, or 16.2%, compared with $4.23 billion at December 31, 2022. Interest-bearing deposits at December 31, 2023 were $5.33 billion, an increase of $289.2 million, or 5.7%, compared with $5.04 billion at December 31, 2022. Our ratio of noninterest-bearing deposits to total deposits was 40.0% and 45.6% for the years ended December 31, 2023, and 2022, 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 at December 31, 2023 (in thousands):

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Borrowings

The Company has an available line of credit with the FHLB, which allows the Company 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. Maturing advances are replaced by drawing on available cash, making additional borrowings or through increased customer deposits. At December 31, 2023, the Company had total borrowing capacity of $3.48 billion of which $1.61 billion was available under this agreement and $1.87 billion was outstanding pursuant to FHLB advances and letters of credit. FHLB advances of $50.0 million were outstanding at December 31, 2023, at a weighted average rate of 5.75%.

FHLB letters of credit were $1.82 billion at December 31, 2023 and will expire in the following periods (in thousands):

Subordinated Debt

Junior Subordinated Debentures

In connection with the acquisition of F&M Bancshares, Inc.in 2015, the Company assumed Farmers & Merchants Capital Trust II and Farmers & Merchants Capital Trust III. Each of these trusts is a capital or statutory business trust organized for the sole purpose of issuing trust securities and investing the proceeds in the Company’s junior subordinated debentures. The preferred trust securities of each trust represent preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payment of the junior subordinated debentures held by the trust. The common securities of each trust are wholly owned by the Company. Each trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon the Company making payment on the related junior subordinated debentures. The debentures, which are the only assets of each trust, are subordinate and junior in right of payment to all of the Company’s present and future senior indebtedness. The Company has fully and unconditionally guaranteed each trust’s obligations under the trust securities issued by such trust to the extent not paid or made by such trust, provided such trust has funds available for such obligations. The trust preferred securities bear a floating rate of interest equal to the 3-Month SOFR plus a comparable spread adjustment. The junior subordinated debentures are included in Tier 1 capital under current regulatory guidelines and interpretations. Under the provisions of each issue of the debentures, the Company has the right to defer payment of interest on the debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on either issue of the debentures are deferred, the distributions on the applicable trust preferred securities and common securities will also be deferred.

A summary of pertinent information related to the Company’s issuances of junior subordinated debentures outstanding at December 31, 2023 is set forth in the table below:

(1)    All debentures were callable at December 31, 2023.

Subordinated Notes

In December 2017, the Bank issued $40.0 million aggregate principal amount of Fixed-to-Floating Rate Subordinated Notes (the “Bank Notes”) due December 15, 2027. As of December 15, 2022, the Bank Notes bore a floating rate of interest equal to 3-Month LIBOR + 3.03%, which transitioned to 3-Month SOFR plus a spread adjustment immediately after June 30, 2023, until the

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Bank Notes mature on December 15, 2027, or such earlier redemption date, payable quarterly in arrears. The Bank Notes are redeemable by the Bank, in whole or in part, 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 equal to 100% of the principal amount of Bank Notes being redeemed, plus accrued and unpaid interest, and will be subject to, and require, prior regulatory approval. The Bank Notes are not subject to redemption at the option of the holders. The Bank Notes are eligible for Tier 2 capital treatment, however, during the last five years of the instrument, the amount eligible must be reduced by 20% of the original amount annually and that no amount of the instrument is eligible for inclusion in Tier 2 capital when the remaining maturity of the instrument is less than one year. As the Bank Notes were within five years of maturity, only 60% of the notes are eligible for Tier 2 capital treatment at December 31, 2023.

In September 2019, the Company issued $60.0 million aggregate principal amount of Fixed-to-Floating Rate Subordinated Notes (the “Company Notes”) due October 1, 2029. 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 3-Month SOFR, plus 3.13%, which transitioned from LIBOR immediately after June 30, 2023, for each quarterly interest period, 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.

Credit Agreement

On December 13, 2022, the Company entered into a loan agreement with another financial institution (the “Loan Agreement”), that provides for a $75.0 million revolving line of credit. At December 31, 2023, there were no outstanding borrowings on this line of credit and the Company did not draw on this line of credit during 2023 or 2022. 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 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) not to exceed 25.0% and 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, 2023, the Company believes it was in compliance with all such debt covenants and had not been made aware of any noncompliance by the lender.

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, 2023 and 2022, our liquidity needs have primarily been met by deposits, borrowed funds and securities. The Bank has access to purchased funds from correspondent banks, the Federal Reserve discount window and advances from the FHLB, on a collateralized basis, are available under a security and pledge agreement to take advantage of investment opportunities.

Liquidity risk management is an important element in our asset/liability management process. Our liquidity position is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. We regularly model liquidity stress scenarios to assess potential liquidity outflows or funding problems resulting from economic disruptions, volatility in the financial markets, unexpected credit events or other significant occurrences deemed problematic by management. Liquidity stress scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs.

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Our largest source of funds is deposits and our largest use of funds is loans. Our average deposits increased $1.93 billion, or 28.1%, for the year ended December 31, 2023 compared to the year ended December 31, 2022. Our average loans increased $2.79 billion, or 53.9%, for the year ended December 31, 2023 compared to the year ended December 31, 2022. 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 7.6 years and 8.3 years at December 31, 2023 and 2022, 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 periods indicated.

As of December 31, 2023 and 2022, we had outstanding commitments to extend credit of $1.79 billion and $2.36 billion, respectively, and commitments associated with outstanding letters of credit of $37.7 million and $35.5 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, 2023 and 2022, the Company had FHLB letters of credit in the amount of $1.82 billion and $1.08 billion, respectively, pledged as collateral for public and other deposits of state and local government agencies. See Note 10 – Borrowings and Borrowing Capacity to the accompanying consolidated financial statements.

Total immediate contingent funding sources, including unrestricted cash, available-for-sale securities that are not pledged and total available borrowing capacity was $3.62 billion, or 40.8%, of total deposits at December 31, 2023. Estimated uninsured deposits net of collateralized deposits were 42.6% of total deposits at December 31, 2023. Including policy-driven capacity for brokered deposits, the Bank would have been able to add approximately $1.16 billion to its contingent sources of liquidity, bringing total contingent funding sources to approximately $4.78 billion, or 53.9%, of deposits at December 31, 2023.

As of December 31, 2023 and 2022, the Company had no exposure to future cash requirements associated with known uncertainties or capital expenditures of a material nature.

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, 2023. These include payments related to (1) operating leases (Note 6 – Premises and Equipment and Leases), (2) time deposits with stated maturity dates (Note 8 – Deposits), (3) borrowings (Note 10 – Borrowings and Borrowing Capacity) and (4) commitments to extend credit and standby letters of credit (Note 15 – Off-Balance Sheet Arrangements, Commitments and Contingencies).

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Our commitments associated with outstanding standby letters of credit and commitments to extend credit expiring by period are summarized below as of December 31, 2023. 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.

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 company 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 intangible assets 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.

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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, 2023 and 2022, the Bank was well-capitalized. Total shareholders' equity was $1.52 billion at December 31, 2023 compared with $1.38 billion at December 31, 2022, an increase of $137.8 million. This increase was primarily due to net income of $130.5 million and the decrease in unrealized losses on available for sale securities partially offset by dividends paid of $0.52 per common share during 2023.

The following table provides a comparison of the Company’s and the Bank’s leverage and risk-weighted capital ratios as of December 31, 2023 to the minimum and well-capitalized regulatory standards, as well as with the capital conservation buffer:

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 Asset Liability Committee (“ALCO”). The ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the ALCO 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 ALCO 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 ALCO reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity.

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. Where applicable, instruments on the balance sheet are modeled at the instrument level, incorporating

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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 the economic value of equity and net interest income 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 2023, changes in our overall interest rate profile were driven by the decrease in noninterest bearing deposits and certain interest bearing deposits, increases in certificates of deposits and borrowed funds, an increase in loans and decreases in securities and cash and cash equivalents.