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ALERUS FINANCIAL CORP - Quarter Report: 2023 June (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2023

   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-39036

ALERUS FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Delaware

45-0375407

(State or other jurisdiction of incorporation or

(I.R.S. Employer Identification No.)

organization)

401 Demers Avenue

Grand Forks, ND

58201

(Address of principal executive offices)

(Zip Code)

(701) 795-3200

(Registrant’s telephone number, including area code)

Securities registered pursuant to section 12(b) of the Act:

Title of each class

    

Trading symbol

    

Name of each exchange on which registered

Common Stock, par value $1.00 per share

ALRS

The Nasdaq Stock Market LLC

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes   No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer 

Accelerated filer 

Non-accelerated filer 

Smaller reporting company 

Emerging growth company 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes   No 

The number of shares of the registrant’s common stock outstanding at July 31, 2023 was 19,914,884.

Table of Contents

Alerus Financial Corporation and Subsidiaries

Table of Contents

Page

Part 1:

FINANCIAL INFORMATION

Item 1.

Consolidated Financial Statements

1

Consolidated Balance Sheets as of June 30, 2023 and December 31, 2022

1

Consolidated Statements of Income for the three and six months ended June 30, 2023 and 2022

2

Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2023 and 2022

3

Consolidated Statements of Changes in Stockholders’ Equity for the three and six months ended June 30, 2023 and 2022

4

Consolidated Statements of Cash Flows for the six months ended June 30, 2023 and 2022

6

Notes to Consolidated Financial Statements

8

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

44

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

66

Item 4.

Controls and Procedures

68

Part 2:

OTHER INFORMATION

Item 1.

Legal Proceedings

69

Item 1A.

Risk Factors

69

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

69

Item 3.

Defaults Upon Senior Securities

70

Item 4.

Mine Safety Disclosures

70

Item 5.

Other Information

70

Item 6.

Exhibits

71

Signatures

72

Table of Contents

PART 1. FINANCIAL INFORMATION

Item 1 - Consolidated Financial Statements

Alerus Financial Corporation and Subsidiaries

Consolidated Balance Sheets

    

June 30, 

    

December 31, 

(dollars in thousands, except share and per share data)

    

2023

    

2022

Assets

 

(Unaudited)

 

(Audited)

Cash and cash equivalents

$

65,471

$

58,242

Investment securities

 

  

 

  

Available-for-sale, at fair value

 

677,454

 

717,324

Held-to-maturity, at carrying value (allowance for credit losses on investments of $218 June 30, 2023)

 

308,416

 

321,902

Loans held for sale

 

20,893

 

9,488

Loans

 

2,533,522

 

2,443,994

Allowance for credit losses on loans

 

(35,696)

 

(31,146)

Net loans

 

2,497,826

 

2,412,848

Land, premises and equipment, net

 

17,488

 

17,288

Operating lease right-of-use assets

 

6,440

 

5,419

Accrued interest receivable

 

13,587

 

12,869

Bank-owned life insurance

 

32,793

 

33,991

Goodwill

 

47,087

 

47,087

Other intangible assets

 

19,806

 

22,455

Servicing rights

 

2,351

 

2,643

Deferred income taxes, net

 

43,709

 

42,369

Other assets

 

79,657

 

75,712

Total assets

$

3,832,978

$

3,779,637

Liabilities and Stockholders’ Equity

 

  

 

  

Deposits

 

  

 

  

Noninterest-bearing

$

715,534

$

860,987

Interest-bearing

 

2,137,321

 

2,054,497

Total deposits

 

2,852,855

 

2,915,484

Short-term borrowings

 

492,060

 

378,080

Long-term debt

 

58,900

 

58,843

Operating lease liabilities

 

6,746

 

5,902

Accrued expenses and other liabilities

 

64,732

 

64,456

Total liabilities

 

3,475,293

 

3,422,765

Stockholders’ equity

 

  

 

  

Preferred stock, $1 par value, 2,000,000 shares authorized: 0 issued and outstanding

Common stock, $1 par value, 30,000,000 shares authorized: 19,914,884 and 19,991,681 issued and outstanding

 

19,915

 

19,992

Additional paid-in capital

 

152,673

 

155,095

Retained earnings

 

285,839

 

280,426

Accumulated other comprehensive income (loss)

 

(100,742)

 

(98,641)

Total stockholders’ equity

 

357,685

 

356,872

Total liabilities and stockholders’ equity

$

3,832,978

$

3,779,637

See accompanying notes to consolidated financial statements (unaudited)

1

Table of Contents

Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Income (Unaudited)

Three months ended

Six months ended

June 30, 

June 30, 

(dollars and shares in thousands, except per share data)

    

2023

    

2022

    

2023

    

2022

Interest Income

Loans, including fees

$

33,267

$

17,988

$

64,200

$

35,280

Investment securities

 

  

 

  

 

  

 

  

Taxable

 

6,125

 

6,068

 

12,076

 

11,508

Exempt from federal income taxes

 

186

 

213

 

376

 

429

Other

 

762

 

157

 

1,497

 

273

Total interest income

 

40,340

 

24,426

78,149

 

47,490

Interest Expense

 

  

 

  

 

  

 

  

Deposits

 

12,678

 

813

 

21,782

 

1,642

Short-term borrowings

 

4,763

 

278

 

9,156

 

278

Long-term debt

 

665

 

559

 

1,319

 

1,121

Total interest expense

 

18,106

 

1,650

 

32,257

 

3,041

Net interest income

 

22,234

 

22,776

 

45,892

 

44,449

Provision for credit losses

 

 

 

550

 

Net interest income after provision for credit losses

 

22,234

 

22,776

 

45,342

 

44,449

Noninterest Income

 

  

 

  

 

  

 

  

Retirement and benefit services

 

15,890

 

16,293

 

31,372

 

33,939

Wealth management

 

5,449

 

5,548

 

10,644

 

10,874

Mortgage banking

 

2,905

 

6,038

 

4,622

 

10,969

Service charges on deposit accounts

 

311

 

412

 

612

 

775

Other

 

1,223

 

935

 

3,781

 

2,139

Total noninterest income

 

25,778

 

29,226

 

51,031

 

58,696

Noninterest Expense

 

  

 

  

 

  

 

  

Compensation

 

18,847

 

21,248

 

38,005

 

40,299

Employee taxes and benefits

 

4,724

 

5,787

 

10,577

 

11,949

Occupancy and equipment expense

 

1,837

 

1,737

 

3,736

 

3,788

Business services, software and technology expense

 

5,269

 

4,785

 

10,593

 

9,709

Intangible amortization expense

 

1,324

 

1,053

 

2,648

 

2,106

Professional fees and assessments

 

1,530

 

2,246

 

2,682

 

3,787

Marketing and business development

 

648

 

814

 

1,334

 

1,414

Supplies and postage

 

406

 

572

 

866

 

1,218

Travel

 

306

 

356

 

554

 

535

Mortgage and lending expenses

 

215

 

482

 

712

 

1,168

Other

 

1,267

 

904

 

2,535

 

2,082

Total noninterest expense

 

36,373

 

39,984

 

74,242

 

78,055

Income before income taxes

 

11,639

 

12,018

 

22,131

 

25,090

Income tax expense

 

2,535

 

2,725

 

4,841

 

5,613

Net income

$

9,104

$

9,293

$

17,290

$

19,477

Per Common Share Data

Basic earnings per common share

$

0.45

$

0.53

$

0.86

$

1.11

Diluted earnings per common share

$

0.45

$

0.52

$

0.85

$

1.10

Dividends declared per common share

$

0.19

$

0.18

$

0.37

$

0.34

Average common shares outstanding

 

20,033

 

17,297

 

20,030

 

17,271

Diluted average common shares outstanding

 

20,241

 

17,532

 

20,243

 

17,517

See accompanying notes to consolidated financial statements (unaudited)

2

Table of Contents

Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Comprehensive Income (Unaudited)

Three months ended

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

    

2022

Net Income

$

9,104

$

9,293

$

17,290

$

19,477

Other Comprehensive Income (Loss), Net of Tax

 

  

 

  

 

  

 

  

Unrealized gains (losses) on available-for-sale securities

 

(9,636)

 

(37,394)

 

(4,708)

 

(88,119)

Accretion of (gains) losses on debt securities reclassified to held-to-maturity

(84)

(97)

(171)

(199)

Net change in unrealized gain (losses) on derivatives

3,794

2,069

Total other comprehensive income (loss), before tax

 

(5,926)

 

(37,491)

 

(2,810)

 

(88,318)

Income tax expense (benefit) related to items of other comprehensive income (loss)

 

(1,491)

 

(9,410)

 

(709)

 

(22,168)

Other comprehensive income (loss), net of tax

 

(4,435)

 

(28,081)

 

(2,101)

 

(66,150)

Total comprehensive income (loss)

$

4,669

$

(18,788)

$

15,189

$

(46,673)

See accompanying notes to consolidated financial statements (unaudited)

3

Table of Contents

Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)

Three months ended June 30, 2023

Accumulated

Additional

Other

Common

Paid-in

Retained

Comprehensive

(dollars and shares in thousands)

    

Stock

    

Capital

    

Earnings

    

Income (Loss)

    

Total

Balance as of March 31, 2023

$

20,067

$

154,818

$

280,540

$

(96,307)

$

359,118

Net income

 

 

 

9,104

 

 

9,104

Other comprehensive income (loss)

 

 

 

 

(4,435)

 

(4,435)

Common stock repurchased

 

(170)

 

(2,783)

 

 

 

(2,953)

Common stock dividends

 

 

 

(3,805)

 

 

(3,805)

Share‑based compensation expense

 

18

 

638

 

 

 

656

Vesting of restricted stock

 

 

 

 

Balance as of June 30, 2023

$

19,915

$

152,673

$

285,839

$

(100,742)

$

357,685

Six months ended June 30, 2023

Accumulated

Additional

Other

Common

Paid-in

Retained

Comprehensive

(dollars in thousands)

    

Stock

    

Capital

    

Earnings

    

Income (Loss)

    

Total

Balance as of December 31, 2022

$

19,992

$

155,095

$

280,426

$

(98,641)

$

356,872

Cumulative effect of change in accounting principles, net of tax

(4,452)

(4,452)

Balance as of January 1, 2023

19,992

155,095

275,974

(98,641)

352,420

Net income

 

 

 

17,290

 

 

17,290

Other comprehensive income (loss)

 

 

 

 

(2,101)

 

(2,101)

Common stock repurchased

 

(187)

 

(3,127)

 

 

 

(3,314)

Common stock dividends

 

 

 

(7,425)

 

 

(7,425)

Share‑based compensation expense

 

18

 

797

 

 

 

815

Vesting of restricted stock

 

92

 

(92)

 

 

 

Balance as of June 30, 2023

$

19,915

$

152,673

$

285,839

$

(100,742)

$

357,685

Three months ended June 30, 2022

Accumulated

Additional

Other

Common

Paid-in

Retained

Comprehensive

(dollars in thousands)

    

Stock

    

Capital

    

Earnings

    

Income (Loss)

    

Total

Balance as of March 31, 2022

$

17,289

$

92,573

$

260,967

$

(42,324)

$

328,505

Net income

 

 

 

9,293

 

 

9,293

Other comprehensive income (loss)

 

 

 

 

(28,081)

 

(28,081)

Common stock repurchased

 

(4)

 

(86)

 

 

 

(90)

Common stock dividends

 

 

 

(3,132)

 

 

(3,132)

Share‑based compensation expense

 

10

 

653

 

 

 

663

Vesting of restricted stock

 

11

 

(11)

 

 

 

Balance as of June 30, 2022

$

17,306

$

93,129

$

267,128

$

(70,405)

$

307,158

4

Table of Contents

Six months ended June 30, 2022

Accumulated

Additional

Other

Common

Paid-in

Retained

Comprehensive

(dollars in thousands)

    

Stock

    

Capital

    

Earnings

    

Income (Loss)

    

Total

Balance as of December 31, 2021

$

17,213

$

92,878

$

253,567

$

(4,255)

$

359,403

Net income

 

 

 

19,477

 

 

19,477

Other comprehensive income (loss)

 

 

 

 

(66,150)

 

(66,150)

Common stock repurchased

 

(24)

 

(673)

 

 

 

(697)

Common stock dividends

 

 

 

(5,916)

 

 

(5,916)

Share‑based compensation expense

 

10

 

1,031

 

 

 

1,041

Vesting of restricted stock

 

107

 

(107)

 

 

 

Balance as of June 30, 2022

$

17,306

$

93,129

$

267,128

$

(70,405)

$

307,158

See accompanying notes to consolidated financial statements (unaudited)

5

Table of Contents

Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

Six months ended

June 30, 

(dollars in thousands)

    

2023

    

2022

Operating Activities

 

  

 

  

Net income

$

17,290

$

19,477

Adjustments to reconcile net income to net cash provided (used) by operating activities

 

  

 

  

Deferred income taxes

 

857

 

968

Provision for credit losses

 

550

 

Depreciation and amortization

 

4,239

 

3,998

Amortization and accretion of premiums/discounts on investment securities

 

1,092

 

1,829

Amortization of operating lease right-of-use assets

1,571

(51)

Share‑based compensation expense

 

815

 

1,041

Originations on loans held for sale

(146,664)

(353,547)

Proceeds on loans held for sale

138,818

351,625

(Increase) in value of bank-owned life insurance

 

(434)

 

(408)

Realized loss (gain) on sale of fixed assets

(116)

 

Realized loss (gain) on derivative instruments

 

1,344

 

(215)

Realized loss (gain) on loans sold

 

(3,531)

 

(6,037)

Realized loss (gain) on sale of foreclosed assets

 

5

 

(11)

Realized loss (gain) on BOLI mortality

(1,196)

Realized loss (gain) on servicing rights

 

(25)

 

(441)

Net change in:

 

 

Accrued interest receivable

 

(718)

 

(618)

Other assets

 

1,414

 

(9,803)

Accrued expenses and other liabilities

 

(3,311)

 

9,924

Net cash provided (used) by operating activities

 

12,000

 

17,731

Investing Activities

 

  

 

  

Proceeds from maturities of investment securities available-for-sale

 

34,549

 

61,313

Purchases of investment securities available-for-sale

 

 

(95,600)

Proceeds from calls of investment securities held-to-maturity

126

726

Proceeds from maturities of investment securities held-to-maturity

12,492

18,588

Net (increase) decrease in loans

 

(89,295)

 

(132,503)

Net (increase) decrease in FHLB stock

(5,020)

 

(10,132)

Proceeds from BOLI mortality claim

2,828

Purchases of premises and equipment

 

(1,088)

 

(471)

Proceeds from sales of foreclosed assets

 

25

 

117

Net cash provided (used) by investing activities

 

(45,383)

 

(157,962)

Financing Activities

 

  

 

  

Net increase (decrease) in deposits

 

(62,629)

 

(301,001)

Net increase (decrease) in short-term borrowings

 

113,980

 

242,350

Repayments of long-term debt

 

 

(119)

Cash dividends paid on common stock

 

(7,425)

 

(5,570)

Repurchase of common stock

 

(3,314)

 

(697)

Net cash provided (used) by financing activities

 

40,612

 

(65,037)

Net change in cash and cash equivalents

 

7,229

 

(205,268)

Cash and cash equivalents at beginning of period

 

58,242

 

242,311

Cash and cash equivalents at end of period

$

65,471

$

37,043

See accompanying notes to consolidated financial statements (unaudited)

6

Table of Contents

Six months ended

June 30, 

Supplemental Cash Flow Disclosures

    

2023

    

2022

Cash paid for:

 

  

 

  

Interest

$

31,723

$

3,913

Income taxes

 

3,720

 

4,677

Supplemental Disclosures of Noncash Investing and Financing Activities

 

  

 

  

Loan collateral transferred to foreclosed assets

 

 

81

Right-of-use assets obtained in exchange for new operating lease liabilities

2,286

See accompanying notes to consolidated financial statements (unaudited)

7

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Alerus Financial Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

NOTE 1 Significant Accounting Policies

Organization

Alerus Financial Corporation, or the Company, is a financial holding company organized under the laws of the state of Delaware. The Company and its subsidiaries operate as a diversified financial services company headquartered in Grand Forks, North Dakota. Through its subsidiary, Alerus Financial, National Association, or the Bank, the Company provides financial solutions to businesses and consumers through four distinct business lines—banking, retirement and benefit services, wealth management, and mortgage.

Basis of Presentation

The accompanying unaudited consolidated financial statements and notes thereto of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, or SEC, and conform to practices within the banking industry and include all of the information and disclosures required by generally accepted accounting principles in the United States of America, or GAAP, for interim financial reporting. The accompanying unaudited consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that are necessary for a fair presentation of financial results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results for the full year or any other period. The Company has also evaluated all subsequent events for potential recognition and disclosure through the date of the filing of this Quarterly Report on Form 10-Q. These interim unaudited financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto as of and for the year ended December 31, 2022, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 13, 2023.

Principles of Consolidation

The accompanying unaudited consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. The Company’s principal operating subsidiary is the Bank.

In the normal course of business, the Company may enter into a transaction with a variable interest entity or VIE. VIE’s are legal entities whose investors lack the ability to make decisions about the entity’s activities, or whose equity investors do not have the right to receive the residual returns of the entity. The applicable accounting guidance requires the Company to perform ongoing quantitative and qualitative analysis to determine whether it must consolidate any VIE. The Company does not have any ownership interest in, or exert any control, over any VIE, and thus no VIE’s are included in the consolidated financial statements.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change in the near term include the valuation of investment securities, determination of the allowance for credit losses, valuation of reporting units for the purpose of testing goodwill and other intangible assets for impairment, valuation of deferred tax assets, and fair values of financial instruments.

8

Table of Contents

Reclassifications

Certain items previously reported have been reclassified to conform to the current period’s reporting format. Such reclassifications did not affect net income or stockholders’ equity.

Emerging Growth Company

The Company qualifies as an “emerging growth company” under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, even if the Company complies with the greater obligations of public companies that are not emerging growth companies, the Company may avail itself of the reduced requirements applicable to emerging growth companies from time to time in the future, so long as the Company is an emerging growth company. The Company will continue to be an emerging growth company until the earliest to occur of: (1) the end of the fiscal year following the fifth anniversary of the date of the first sale of common equity securities under the Company’s Registration Statement on Form S-1, which was declared effective by the SEC on September 12, 2019; (2) the last day of the fiscal year in which the Company has $1.235 billion or more in annual revenues; (3) the date on which the Company is deemed to be a “large accelerated filer” under the Securities Exchange Act of 1934, as amended, or the Exchange Act; or (4) the date on which the Company has, during the previous three-year period, issued publicly or privately, more than $1.0 billion in non-convertible debt securities.

Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933 for complying with new or revised accounting standards. As an emerging growth company, the Company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. The Company elected to take advantage of the benefits of this extended transition period.

Allowance for credit losses

Investment securities available-for-sale. For available-for-sale investment securities in an unrealized loss position, the Company evaluates the securities to determine whether the decline in fair value below the amortized cost basis, or impairment, is due to credit-related factors or noncredit-related factors. Any impairment that is not credit related is recognized in other comprehensive income (loss), net of applicable taxes. Credit-related impairment is recognized as an allowance for credit losses, or ACL, related to investment securities available-for-sale on the balance sheet, limited to the amount by which the amortized cost basis exceeds the fair value, with a corresponding adjustment to earnings. Both the ACL and the adjustment to net income may be reversed if conditions change. However, if the Company intends to sell an impaired available-for-sale investment security or is required to sell such a security before recovering its amortized cost basis, the entire impairment amount must be recognized in earnings with a corresponding adjustment to the security’s amortized cost basis. Because the security’s amortized cost basis is adjusted to fair value, there is no ACL in this situation.

In evaluating available-for-sale securities in unrealized loss positions for impairment and the criteria regarding its intent or requirement to sell such securities, the Company considers the extent to which fair value is less than amortized cost, whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuers’ financial condition, among other factors.

Accrued interest receivable is excluded from the estimate of credit losses.

Investment securities held-to-maturity. Management measures expected credit losses on held-to-maturity investment securities on a collective basis by major security type. The Company evaluates held-to-maturity investment securities by credit rating and an external study, updated annually, that includes historical information such as

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probability of default and loss going back several years. Accrued interest receivable on held-to-maturity investment securities is excluded from the estimate of credit losses.

Loans held for investment. Under the current expected credit loss, or CECL, accounting standard the ACL is a valuation estimated at each balance sheet date and deducted from the amortized cost basis of loans held for investment to present the net amount expected to be collected.

The Company estimates the ACL based on the underlying assets’ amortized cost basis, which is the amount at which the financing receivable is originated or acquired, adjusted for collection of cash and charge-offs, as well as applicable accretion or amortization of premium, discount and net deferred fees or costs. In the event that collection of principal becomes uncertain, the Company has policies in place to reverse accrued interest in a timely manner. Therefore, the Company has made the policy election to exclude accrued interest from the measurement of ACL.

Expected credit losses are reflected in the ACL through a charge to provision for credit losses when the Company deems all or a portion of the financial asset will be uncollectible; the appropriate amount is written off and the ACL is reduced by the same amount. The Company applies judgement to determine when a financial asset is deemed uncollectible; however, generally, an asset will be considered uncollectible no later than when all efforts of collection have been exhausted. Subsequent recoveries, if any, are credited to the ACL when received.

Upon the adoption of the CECL accounting standard, the Company elected to maintain pools of loans that were previously accounted for under ASC 310-30 and will continue to account for these pools as a unit of account. Upon the adoption of the CECL accounting standard, the ACL was determined for each pool and added to the pools’ carrying amount to establish a new amortized cost basis. Loans that do not share similar risk characteristics are evaluated on an individual basis.

Management estimates the ACL using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable supportable forecasts. Historical loss experience provides the basis for estimation of expected credit losses. Adjustments to historical loss information are made for differences in the current loan-specific risk characteristics such as different underwriting standards, portfolio mix, delinquency level, or life of the loan, as well as changes in environmental conditions, levels of economic activity, unemployment rates, property values and other relevant factors. The calculation also contemplates that the Company may not be able to make or obtain such forecasts for the entire life of the financial assets and requires a reversion to historical loss information.

Ongoing impacts of CECL will be dependent upon changes in economic conditions and forecasts, originated and acquired loan portfolio composition, credit performance trends, portfolio duration and other forecasts.

Loans that do not share risk characteristics are evaluated on an individual basis. Loans evaluated individually are not also included in the collective evaluation. The ACL on individually evaluated loans is recognized on the basis of the present value of expected future cash flows discounted at the effective interest rate, the fair value of collateral adjusted of estimated costs to sell, or observable market price as of the relevant date.

Reserve for off-balance sheet credit exposures. In estimating expected credit losses for off-balance sheet credit exposures, the Company is required to estimate expected credit losses over the contractual period in which it is exposed to credit risk via a present contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the issuer. To be considered unconditionally cancellable for accounting purposes, the Company must have the ability to, at any time, with or without cause, refuse to extend credit under the commitment. Off-balance sheet credit exposure segments share the same risk characteristics as portfolio loans. The Company incorporates a probability of funding and utilizes the ACL loss rates to calculate the reserve. The reserve for off-balance sheet credit exposure is carried on the balance sheet in accrued expenses and other liabilities rather than as a component of the allowance. The reserve for off-balance sheet credit exposure is adjusted as a provision for off-balance sheet credit exposure reported as a component of the provision for credit loss expense in the accompanying unaudited Consolidated Statements of Income.

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NOTE 2 Recent Accounting Pronouncements

The following Financial Accounting Standards Board, or FASB, Accounting Standards Updates, or ASUs, are divided into pronouncements which have been adopted by the Company since January 1, 2023, and those which are not yet effective and have been evaluated or are currently being evaluated by management as of June 30, 2023.

Adopted Pronouncements

On January 1, 2023, the Company adopted ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The measurement of expected credit losses under the CECL accounting standard is applicable to financial assets measured at amortized cost, including loan receivables. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar agreements). In addition, ASC 326 made changes to the accounting for held-to-maturity debt securities. One such change is to require credit losses to be presented as an allowance, rather than as a write-down.

The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost, off-balance sheet credit exposures, and held-to-maturity securities. Results for reporting periods beginning after December 31, 2022, are presented under ASC 326, while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded a net decrease to retained earnings of $4.5 million as of January 1, 2023, for the cumulative effect of adopting ASC 326.

The Company adopted ASC 326 using the prospective transition approach for financial assets purchased with credit deterioration previously classified as purchased credit impaired and accounted for under ASC 310-30. In accordance with the standard, management did not reassess whether purchased credit impaired, or PCI, assets met the criteria of purchased credit deteriorated, or PCD, assets as of the date of adoption.

The following table illustrates the impact of ASC 326:

January 1, 2023

As reported

Pre-tax impact of

(dollars in thousands)

    

under

Pre-ASC 326

ASC 326

Assets:

 

ASC 326

Adoption

Adoption

Investments

Held-to-maturity

Obligations of state and political agencies

$

110

$

$

110

Mortgage backed securities

Residential agency

62

62

Total allowance for held-to-maturity investment securities

172

172

Loans

Commercial

Commercial and industrial

8,296

9,158

(862)

Real estate construction

3,964

1,446

2,518

Commercial real estate

12,264

12,688

(424)

Total commercial

24,524

23,292

1,232

Consumer

Residential real estate first mortgage

7,849

5,769

2,080

Residential real estate junior lien

1,222

1,289

(67)

Other revolving and installment

424

528

(104)

Total consumer

9,495

7,586

1,909

Unallocated

984

268

716

Total allowance for loans

35,003

31,146

3,857

Allowance for credit losses on loans and investments securities

$

35,175

$

31,146

$

4,029

Liabilities:

Allowance for credit losses on unfunded commitments

$

5,159

$

3,244

$

1,915

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In March 2022, the FASB issued ASU No. 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method, which clarifies the guidance on fair value hedge accounting of interest rate risk portfolios of financial assets. ASU 2022-01 updates guidance in Topic 815, to expand the scope of the current last-of-layer method to allow multiple hedged layers to be designated for a single closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments on a prospective basis. Additionally, ASU 2022-01 clarifies that basis adjustments related to existing portfolio layer hedge relationships should not be considered when measuring credit losses on the financial assets included in the closed portfolio. Further, ASU 2022-01 clarifies that any reversal of fair value hedge basis adjustments associated with an actual breach should be recognized in interest income immediately. ASU 2022-01 was effective for fiscal years beginning after December 15, 2022, with early adoption permitted. The Company adopted ASU 2022-01 effective January 1, 2023, and entered into a fair value hedge agreement on February 10, 2023 and adopted the portfolio layer method of accounting for this transaction. This adoption had no impact on our consolidated financial statements as the Company did not have any hedged assets using the last-of-layer hedge accounting method.

In March 2022, the FASB issued ASU No. 2022-02, Financial Instruments – Credit Losses Troubled Debt Restructurings and Vintage Disclosures. The amendments in this update eliminate the accounting guidance for Troubled Debt Restructurings, or TDRs, by creditors in Subtopic 310-40. Receivables – Troubled Debt Restructurings by Creditors, while enhancing the disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. For public business entities, this amendment also has vintage disclosures that require that an entity disclose current-period gross write-offs by year of origination for financing receivables and net investments in leases within the scope of Subtopic 326-20 Financial Instruments – Credit Losses – Measured at Amortized Cost. For entities that had not yet adopted the amendment in ASU 2016-13, the effective date for the amendments in this update are same as the effective date for ASU 2016-13. The Company adopted this ASU on January 1, 2023, and had no loans experience financial difficulty in the current period.

NOTE 3 Investment Securities

The following tables present amortized cost, gross unrealized gains and losses, allowance for credit losses, and fair value of the available-for-sale investment securities and the amortized cost, gross unrealized gains and losses and fair value of held-to-maturity securities as of June 30, 2023 and December 31, 2022:

June 30, 2023

Amortized

Unrealized

Unrealized

Allowance for

Fair

(dollars in thousands)

    

Cost

Gains

Losses

Credit Losses

    

Value

Available-for-sale

U.S. Treasury and agencies

$

2,915

$

11

$

(20)

$

$

2,906

Mortgage backed securities

 

  

 

 

 

Residential agency

 

673,586

 

1

 

(115,131)

 

558,456

Commercial

 

68,379

 

 

(7,470)

 

60,909

Asset backed securities

 

28

 

 

 

28

Corporate bonds

 

69,497

 

 

(14,342)

 

55,155

Total available-for-sale investment securities

814,405

12

(136,963)

677,454

Held-to-maturity

Obligations of state and political agencies

131,016

 

 

(15,447)

115

 

115,569

Mortgage backed securities

Residential agency

177,618

 

 

(32,477)

103

 

145,141

Total held-to-maturity investment securities

308,634

(47,924)

218

260,710

Total investment securities

$

1,123,039

$

12

$

(184,887)

$

218

$

938,164

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December 31, 2022

Amortized

Unrealized

Unrealized

Allowance for

Fair

(dollars in thousands)

    

Cost

Gains

Losses

Credit Losses

    

Value

Available-for-sale

U.S. Treasury and agencies

$

3,518

$

19

$

(17)

N/A

$

3,520

Mortgage backed securities

 

  

 

 

 

  

Residential agency

 

705,845

 

2

 

(118,168)

N/A

 

587,679

Commercial

 

70,669

 

 

(7,111)

N/A

 

63,558

Asset backed securities

 

34

 

 

N/A

 

34

Corporate bonds

 

69,501

 

 

(6,968)

N/A

 

62,533

Total available-for-sale investment securities

849,567

21

(132,264)

N/A

717,324

Held-to-maturity

Obligations of state and political agencies

137,787

 

 

(17,736)

N/A

120,051

Mortgage backed securities

Residential agency

184,115

 

 

(33,254)

N/A

150,861

Total held-to-maturity investment securities

321,902

(50,990)

N/A

270,912

Total investment securities

$

1,171,469

$

21

$

(183,254)

N/A

$

988,236

The adequacy of the allowance for credit losses on investment securities is assessed at the end of each quarter. The Company does not believe that the available-for-sale debt securities that were in an unrealized loss position as of June 30, 2023, represent a credit loss impairment. As of June 30, 2023, and December 31, 2022, the gross unrealized loss positions were primarily related to mortgage-backed securities issued by U.S. government agencies or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. Total gross unrealized losses were attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to the credit quality of the investment securities. The Company does not intend to sell the investment securities that were in an unrealized loss position and it is not more likely than not that the Company will be required to sell the investment securities before recovery of their amortized cost basis, which may be at maturity.

The allowance for credit losses on held-to-maturity debt securities is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable supportable forecasts. Using a probability of default and loss on given default analysis an allowance for credit losses was established in the amount of $218 thousand as of June 30, 2023.

Accrued interest receivable on available-for-sale investment securities and held-to-maturity investment securities is recorded in accrued interest receivable and is excluded from the estimate of credit losses. As of June 30, 2023 the accrued interest receivable on available-for-sale investment securities and held-to-maturity investment securities totaled $2.0 million and $1.4 million, respectively. As of December 31, 2022, the accrued interest receivable on available-for-sale investment securities and held-to-maturity investment securities totaled $1.9 million and $1.5 million, respectively.

The following table presents investment securities available-for-sale in an unrealized loss position for which an allowance for credit losses has not been recorded as of June 30, 2023:

June 30, 2023

Less than 12 Months

Over 12 Months

Total

Unrealized

Fair

Unrealized

Fair

Unrealized

Fair

(dollars in thousands)

    

Losses

    

Value

    

Losses

    

Value

    

Losses

    

Value

Available-for-sale

U.S. Treasury and agencies

$

(20)

$

420

$

$

$

(20)

$

420

Mortgage backed securities

 

  

 

  

 

  

 

  

 

  

 

  

Residential agency

 

(76)

 

2,148

 

(115,055)

 

556,258

 

(115,131)

 

558,406

Commercial

 

(32)

 

570

 

(7,438)

 

60,339

 

(7,470)

 

60,909

Asset backed securities

 

 

27

 

 

1

 

 

28

Corporate bonds

 

(867)

 

7,109

 

(13,475)

 

48,046

 

(14,342)

 

55,155

Total available-for-sale investment securities

$

(995)

$

10,274

$

(135,968)

$

664,644

$

(136,963)

$

674,918

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Gross unrealized losses on investment securities and the fair value of the related securities aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2022, were as follows:

December 31, 2022

Less than 12 Months

Over 12 Months

Total

Unrealized

Fair

Unrealized

Fair

Unrealized

Fair

(dollars in thousands)

    

Losses

    

Value

    

Losses

    

Value

    

Losses

    

Value

Available-for-sale

U.S. Treasury and agencies

$

(17)

$

509

$

$

$

(17)

$

509

Mortgage backed securities

 

  

 

  

 

  

 

  

 

  

 

  

Residential agency

 

(10,457)

 

79,693

 

(107,711)

 

507,418

 

(118,168)

 

587,111

Commercial

 

(4,835)

 

50,437

 

(2,276)

 

13,120

 

(7,111)

 

63,557

Asset backed securities

 

 

32

 

 

2

 

 

34

Corporate bonds

 

(4,452)

 

48,048

 

(2,516)

 

14,484

 

(6,968)

 

62,532

Total available-for-sale investment securities

(19,761)

178,719

(112,503)

535,024

(132,264)

713,743

Held-to-maturity

Obligations of state and political agencies

(3,336)

18,788

(14,400)

98,762

(17,736)

117,550

Mortgage backed securities

Residential agency

(33,254)

150,861

(33,254)

150,861

Total held-to-maturity investment securities

(3,336)

18,788

(47,654)

249,623

(50,990)

268,411

Total investment securities

$

(23,097)

$

197,507

$

(160,157)

$

784,647

$

(183,254)

$

982,154

Unrealized losses on available-for-sale investments securities have not been recognized into income because the issuers’ bonds are of high credit quality. Furthermore, the Company does not intend to sell, and it is likely that management will not be required to sell, the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates. The issuers continue to make timely principal and interest payments on their bonds. The Company expects that it could see a continued increase in unrealized losses if the Federal Reserve continues to raise interest rates.

The following table presents amortized cost and fair value of available-for-sale investment securities and the carrying value and fair value of held-to-maturity investment securities as of June 30, 2023, by contractual maturity:

Held-to-maturity

Available-for-sale

Carrying

Fair

Amortized

Fair

(dollars in thousands)

    

Value

Value

Cost

    

Value

Due within one year or less

$

6,098

$

5,946

$

$

Due after one year through five years

 

44,352

 

40,512

 

17,461

 

16,096

Due after five years through ten years

 

67,751

 

58,000

 

78,734

 

63,524

Due after 10 years

 

12,815

 

11,111

 

44,624

 

39,378

131,016

115,569

140,819

118,998

Mortgage-backed securities

Residential agency

177,618

145,141

673,586

558,456

Total investment securities

$

308,634

$

260,710

$

814,405

$

677,454

Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

Investment securities with a total carrying value of $388.0 million and $260.7 million were pledged as of June 30, 2023 and December 31, 2022, respectively, to secure public deposits and for other purposes required or permitted by law.

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The company had no sales or calls of available-for-sale investment securities, for the three and six months ended June 30, 2023 and 2022

Proceeds from the call of held-to-maturity investment securities, for the three and six months ended June 30, 2023 and 2022, are displayed in the table below:

Three months ended

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

    

2022

Proceeds

$

$

211

$

126

$

726

Realized gains

 

 

 

 

Realized losses

 

 

 

 

As of June 30, 2023 and December 31, 2022, the carrying value of the Company’s Federal Reserve stock and Federal Home Loan Bank of Des Moines, or FHLB, stock was as follows:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

Federal Reserve

$

4,623

$

4,595

FHLB

 

24,382

 

19,362

These securities can only be redeemed or sold at their par value and only to the respective issuing institution or to another member institution. The Company records these non-marketable equity securities as a component of other assets and periodically evaluates these securities for impairment. Management considers these non-marketable equity securities to be long-term investments. Accordingly, when evaluating these securities for impairment, management considers the ultimate recoverability of the par value rather than recognizing temporary declines in value.

Visa Class B Restricted Shares

In 2008, the Company received Visa Class B restricted shares as part of Visa’s initial public offering. These shares are transferable only under limited circumstances until they can be converted into the publicly traded Class A common shares. This conversion will not occur until the settlement of certain litigation which will be indemnified by Visa members, including the Company. Visa funded an escrow account from its initial public offering to settle these litigation claims. Should this escrow account be insufficient to cover these litigation claims, Visa is entitled to fund additional amounts to the escrow account by reducing each member bank’s Class B conversion ratio to unrestricted Class A shares. As of June 30, 2023, the conversion ratio was 1.5902. Based on the existing transfer restriction and the uncertainty of the outcome of the Visa litigation mentioned above, the 6,924 Class B shares (11,010 Class A equivalents) that the Company owned as of June 30, 2023 and December 31, 2022, were carried at a zero cost basis.

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NOTE 4 Loans and Allowance for Credit Losses

The following table presents total loans outstanding, by portfolio segment, as of June 30, 2023 and December 31, 2022:

    

June 30, 

    

December 31, 

(dollars in thousands)

    

2023

    

2022

Commercial

Commercial and industrial

$

551,860

$

583,876

Real estate construction

 

78,428

 

97,810

Commercial real estate

 

1,003,821

 

881,670

Total commercial

 

1,634,109

 

1,563,356

Consumer

 

  

 

  

Residential real estate first mortgage

 

707,630

 

679,551

Residential real estate junior lien

 

157,231

 

150,479

Other revolving and installment

 

34,552

 

50,608

Total consumer

 

899,413

 

880,638

Total loans

$

2,533,522

$

2,443,994

Total loans included net deferred loan fees and costs of $0.8 million and $0.9 million at June 30, 2023 and December 31, 2022, respectively. Unearned discounts associated with the acquisition of Metro Phoenix Bank totaled $6.2 million as of June 30, 2023.

Accrued interest receivable on loans is recorded within accrued interest receivable, and totaled $9.8 million at both June 30, 2023 and December 31, 2022.

Management monitors the credit quality of its loan portfolio on an ongoing basis. Measurements of delinquency and past due status are based on the contractual terms of each loan. Past due loans are reviewed regularly to identify loans for nonaccrual status.

The following tables present a past due aging analysis of total loans outstanding, by portfolio segment, as of June 30, 2023 and December 31, 2022:

June 30, 2023

90 Days

Accruing

30 - 89 Days

or More

Total

(dollars in thousands)

    

Current

    

Past Due

    

Past Due

    

Nonaccrual

    

Loans

Commercial

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

$

542,769

$

8,710

$

$

381

$

551,860

Real estate construction

 

78,277

 

 

 

151

 

78,428

Commercial real estate

 

1,002,925

 

 

 

896

 

1,003,821

Total commercial

 

1,623,971

 

8,710

 

 

1,428

 

1,634,109

Consumer

 

  

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

704,957

 

2,027

 

347

299

 

707,630

Residential real estate junior lien

 

156,626

 

105

 

 

500

 

157,231

Other revolving and installment

 

34,400

 

146

 

 

6

 

34,552

Total consumer

 

895,983

 

2,278

 

347

 

805

 

899,413

Total loans

$

2,519,954

$

10,988

$

347

$

2,233

$

2,533,522

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December 31, 2022

90 Days

Accruing

30 - 89 Days

or More

Total

(dollars in thousands)

    

Current

    

Past Due

    

Past Due

    

Nonaccrual

    

Loans

Commercial

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

$

580,288

$

2,426

$

$

1,162

$

583,876

Real estate construction

 

97,370

 

 

 

440

 

97,810

Commercial real estate

 

879,830

 

368

 

 

1,472

 

881,670

Total commercial

 

1,557,488

 

2,794

 

 

3,074

 

1,563,356

Consumer

 

  

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

677,471

 

1,545

 

 

535

 

679,551

Residential real estate junior lien

 

149,918

 

377

 

 

184

 

150,479

Other revolving and installment

 

50,360

 

247

 

 

1

 

50,608

Total consumer

 

877,749

 

2,169

 

 

720

 

880,638

Total loans

$

2,435,237

$

4,963

$

$

3,794

$

2,443,994

In calculating expected credit losses, the Company includes loans on nonaccrual status and loans 90 days or more past due and still accruing. The following table presents the amortized cost basis on nonaccrual status loans and loans 90 days or more past due and still accruing as of June 30, 2023:

As of June 30, 2023

Nonaccrual

90 Days

with no Allowance

or More

(dollars in thousands)

for Credit Losses

Nonaccrual

Past Due

Commercial

Commercial and industrial

$

119

$

381

$

Real estate construction

151

151

Commercial real estate

896

Total commercial

270

1,428

Consumer

Residential real estate first mortgage

293

299

347

Residential real estate junior lien

500

500

Other revolving and installment

6

Total consumer

793

805

347

Total loans

$

1,063

$

2,233

$

347

Loans with a carrying value of $1.6 billion as of June 30, 2023 and $1.5 billion as of December 31, 2022, were pledged to secure public deposits, and for other purposes required or permitted by law.

A loan for which the terms have been modified resulting in a concession represents a loan experiencing financial difficulty. Loans experiencing financial difficulty can include modifications for an interest rate reduction below current market rates, a forgiveness of principal balance, an extension of the loan term, an-other than significant payment delay, or some combination of similar types of modifications. During the three and six months ended June 30, 2023, the Company did not provide any modifications to loans under these circumstances that were experiencing financial difficulty.

The Company’s consumer loan portfolio is primarily comprised of secured loans that are evaluated at origination on a centralized basis against standardized underwriting criteria. The Company generally does not risk rate consumer loans unless a default event such as bankruptcy or extended nonperformance takes place. Credit quality for the consumer loan portfolio is measured by delinquency rates, nonaccrual amounts and actual losses incurred.

The Company assigns a risk rating to all commercial loans, except pools of homogeneous loans, and performs detailed internal and external reviews of risk rated loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. These risk ratings are also subject to examination by the Company’s regulators. During the internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors,

17

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trends in the industries in which the borrowers operate and the estimated fair values of collateral securing the loans. These credit quality indicators are used to assign a risk rating to each individual loan.

The Company’s ratings are aligned to pass and criticized categories. The criticized category includes special mention, substandard, and doubtful risk ratings. The risk ratings are defined as follows:

Pass: A pass loan is a credit with no existing or known potential weaknesses deserving of management’s close attention.

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, this potential weakness may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date. Special mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification.

Substandard: Loans classified as substandard are not adequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Well-defined weaknesses include a borrower’s lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time, or the failure to fulfill economic expectations. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or repayment in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss: Loans classified as loss are considered uncollectible and charged off immediately.

The following table sets forth the amortized cost basis of loans by credit quality indicator and vintage based on the most recent analysis performed, as of June 30, 2023:

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Table of Contents

Revolving

(dollars in thousands)

    

Term Loans Amortized Cost Basis by Origination Year

Loans Amortized

As of June 30, 2023

2023

2022

2021

2020

2019

Prior

Cost Basis

Total

Commercial and industrial

    

    

    

    

    

    

    

Pass

$

72,021

$

124,487

$

81,827

$

72,874

$

40,610

$

24,848

$

102,467

$

519,134

Substandard

5,223

415

8,463

186

823

17,616

32,726

Subtotal

72,021

129,710

82,242

81,337

40,796

25,671

120,083

551,860

Real estate construction

Pass

6,263

37,948

19,315

4,440

9,150

1,006

306

78,428

Substandard

 

 

 

 

 

 

Subtotal

6,263

37,948

19,315

4,440

9,150

1,006

306

78,428

Commercial real estate

Pass

105,650

278,338

150,233

160,601

110,705

176,802

14,685

997,014

Substandard

886

4,096

1,825

6,807

Subtotal

105,650

278,338

151,119

160,601

114,801

178,627

14,685

1,003,821

Residential real estate first mortgage

Pass

40,090

202,056

226,785

111,801

34,894

91,680

216

707,522

Substandard

108

108

Subtotal

40,090

202,056

226,785

111,801

34,894

91,788

216

707,630

Residential real estate junior lien

Pass

13,552

17,683

6,751

4,936

1,947

6,939

105,066

156,874

Substandard

357

357

Subtotal

13,552

17,683

6,751

4,936

1,947

7,296

105,066

157,231

Other revolving and installment

Pass

4,090

9,031

1,467

6,071

2,506

2,037

9,350

34,552

Substandard

Subtotal

4,090

9,031

1,467

6,071

2,506

2,037

9,350

34,552

Total Loans

Pass

241,666

669,543

486,378

360,723

199,812

303,312

232,090

2,493,524

Substandard

5,223

1,301

8,463

4,282

3,113

17,616

39,998

Total loans

$

241,666

$

674,766

$

487,679

$

369,186

$

204,094

$

306,425

$

249,706

$

2,533,522

The following table sets forth the risk category of loans by class of loans and credit quality indicator used on the most recent analysis performed as of December 31, 2022:

December 31, 2022

Criticized

Special

(dollars in thousands)

    

Pass

    

Mention

    

Substandard

    

Doubtful

    

Total

Commercial

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

$

558,694

$

21,969

$

3,213

$

$

583,876

Real estate construction

 

97,548

 

 

262

 

 

97,810

Commercial real estate

 

873,270

 

 

8,400

 

 

881,670

Total commercial

1,529,512

21,969

11,875

1,563,356

Consumer

 

  

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

678,743

 

63

 

745

 

 

679,551

Residential real estate junior lien

 

149,847

 

 

632

 

 

150,479

Other revolving and installment

 

50,607

 

 

1

 

 

50,608

Total consumer

 

879,197

 

63

 

1,378

 

 

880,638

Total loans

$

2,408,709

$

22,032

$

13,253

$

$

2,443,994

The adequacy of the allowance for credit losses on loans is assessed at the end of each quarter. The allowance for credit losses is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable supportable forecasts. Historical data is evaluated in multiple components of the expected credit loss, including the reasonable and supportable forecast of each loan segment. Historical experience is used to infer probability of default and loss given the reasonable and supportable forecast period. Qualitative reserves reflect management’s overall estimate of the extent to which current expected credit losses on collectively evaluated loans will differ from historical loss experience. The analysis takes into consideration other analytics performed within the organization, such as enterprise and concentration management, along with other credit-related analytics as deemed appropriate.

19

Table of Contents

The following tables present, by loan portfolio segment, a summary of the changes in the allowance for credit losses on loans for the three and six months ended June 30, 2023 and 2022:

Three months ended June 30, 2023

Beginning

Provision for

Loan

Loan

Ending

(dollars in thousands)

    

Balance

    

Credit Losses(1)

    

Charge-offs

    

Recoveries

    

Balance

Commercial

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

$

7,800

$

(340)

$

(85)

$

438

$

7,813

Real estate construction

 

4,406

 

(760)

 

 

 

3,646

Commercial real estate

 

12,344

 

609

 

 

12

 

12,965

Total commercial

 

24,550

 

(491)

 

(85)

 

450

 

24,424

Consumer

 

  

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

8,060

 

(159)

 

 

 

7,901

Residential real estate junior lien

 

1,277

 

28

 

 

46

 

1,351

Other revolving and installment

 

314

 

(13)

 

(23)

 

15

 

293

Total consumer

 

9,651

 

(144)

 

(23)

 

61

 

9,545

Unallocated

 

901

 

826

 

 

 

1,727

Total

$

35,102

$

191

$

(108)

$

511

$

35,696

(1)The difference in the credit loss expense reported herein compared to the Consolidated Statements of Income is associated with the credit loss expense reversal of $186 thousand related to off-balance sheet credit exposures and $5 thousand related to investment securities held-to-maturity.

Six months ended June 30, 2023

Beginning

Adoption

Provision for

Loan

Loan

Ending

(dollars in thousands)

    

Balance

    

of ASC 326

    

Credit Losses(1)

    

Charge-offs

    

Recoveries

    

Balance

Commercial

Commercial and industrial

$

9,158

$

(862)

$

(717)

$

(260)

$

494

$

7,813

Real estate construction

1,446

2,518

(318)

3,646

Commercial real estate

12,688

(424)

678

23

12,965

Total commercial

23,292

1,232

(357)

(260)

517

24,424

Consumer

Residential real estate first mortgage

5,769

2,080

50

2

7,901

Residential real estate junior lien

1,289

(67)

154

(77)

52

1,351

Other revolving and installment

528

(104)

(130)

(28)

27

293

Total consumer

7,586

1,909

74

(105)

81

9,545

Unallocated

268

716

743

1,727

Total

$

31,146

$

3,857

$

460

$

(365)

$

598

$

35,696

(1)The difference in the credit loss expense reported herein compared to the Consolidated Statements of Income is associated with the credit loss expense of $44 thousand related to off-balance sheet credit exposures and $46 thousand related to investment securities held-to-maturity.

Three months ended June 30, 2022

Beginning

Provision for

Loan

Loan

Ending

(dollars in thousands)

    

Balance

    

Loan Losses

    

Charge-offs

    

Recoveries

    

Balance

Commercial

Commercial and industrial

$

9,795

$

1,085

$

(637)

$

90

$

10,333

Real estate construction

810

 

68

 

 

878

Commercial real estate

11,946

 

(1,123)

 

 

11

10,834

Total commercial

22,551

 

30

 

(637)

 

101

22,045

Consumer

 

  

 

  

 

  

Residential real estate first mortgage

6,661

 

(486)

 

 

6,175

Residential real estate junior lien

1,400

 

(134)

 

 

201

1,467

Other revolving and installment

644

 

(5)

 

(37)

 

32

634

Total consumer

8,705

(625)

(37)

233

8,276

Unallocated

457

 

595

1,052

Total

$

31,713

$

$

(674)

$

334

$

31,373

20

Table of Contents

Six months ended June 30, 2022

Beginning

Provision for

Loan

Loan

Ending

(dollars in thousands)

    

Balance

    

Loan Losses

    

Charge-offs

    

Recoveries

    

Balance

Commercial

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

$

8,925

$

1,856

$

(664)

$

216

$

10,333

Real estate construction

 

783

 

95

 

 

 

878

Commercial real estate

 

12,376

 

(1,564)

 

 

22

 

10,834

Total commercial

 

22,084

 

387

 

(664)

 

238

 

22,045

Consumer

 

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

6,532

 

(357)

 

 

 

6,175

Residential real estate junior lien

 

1,295

 

(42)

 

214

 

1,467

Other revolving and installment

 

481

 

140

 

(55)

 

68

 

634

Total consumer

 

8,308

 

(259)

 

(55)

 

282

 

8,276

Unallocated

 

1,180

 

(128)

 

 

 

1,052

Total

$

31,572

$

$

(719)

$

520

$

31,373

The following table presents, by loan portfolio segment, a summary of charge-offs, by vintage, for the six months ended June 30, 2023:

Gross Charge-offs for six months ended June 30,  2023

(dollars in thousands)

2023

2022

2021

2020

2019

Prior

Total

Commercial

Commercial and industrial

$

39

$

$

25

$

9

$

187

$

$

260

Real estate construction

Commercial real estate

Total commercial

39

25

9

187

260

Consumer

Residential real estate first mortgage

Residential real estate junior lien

77

77

Other revolving and installment

2

21

4

1

28

Total consumer

2

21

4

78

105

Total loans

$

39

$

2

$

25

$

30

$

191

$

78

$

365

The following tables present the amortized cost and related allowance for credit losses on loans, by portfolio segment, as of June 30, 2023 and December 31, 2022:

June 30, 2023

Amortized Cost

Allowance for Credit Losses on Loans

Individually

Collectively

Individually

Collectively

Evaluated for

Evaluated for

Evaluated for

Evaluated for

(dollars in thousands)

    

Impairment

    

Impairment

    

Total

    

Impairment

    

Impairment

    

Total

Commercial

  

 

  

 

  

Commercial and industrial

$

381

$

551,479

$

551,860

$

78

$

7,735

$

7,813

Real estate construction

 

 

78,428

 

78,428

3,646

3,646

Commercial real estate

 

886

 

1,002,935

 

1,003,821

572

12,393

12,965

Total commercial

 

1,267

 

1,632,842

 

1,634,109

650

23,774

24,424

Consumer

 

  

 

  

 

  

Residential real estate first mortgage

 

299

 

707,331

 

707,630

5

7,896

7,901

Residential real estate junior lien

 

500

 

156,731

 

157,231

1,351

1,351

Other revolving and installment

 

6

 

34,546

 

34,552

6

287

293

Total consumer

 

805

 

898,608

 

899,413

11

9,534

9,545

Unallocated

1,727

Total loans

$

2,072

$

2,531,450

$

2,533,522

$

661

$

33,308

$

35,696

21

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December 31, 2022

Recorded Investment

Allowance for Loan Losses

Individually

Collectively

Individually

Collectively

(dollars in thousands)

    

Evaluated

    

Evaluated

    

Total

    

Evaluated

    

Evaluated

    

Total

Commercial

  

 

  

 

  

Commercial and industrial

$

1,313

$

582,563

$

583,876

$

275

$

8,883

$

9,158

Real estate construction

 

262

 

97,548

 

97,810

97

1,349

1,446

Commercial real estate

 

1,472

 

880,198

 

881,670

582

12,106

12,688

Total commercial

 

3,047

 

1,560,309

 

1,563,356

954

22,338

23,292

Consumer

 

  

 

  

 

  

Residential real estate first mortgage

 

535

 

679,016

 

679,551

5,769

5,769

Residential real estate junior lien

 

184

150,295

 

150,479

1,289

1,289

Other revolving and installment

 

1

 

50,607

 

50,608

528

528

Total consumer

 

720

 

879,918

 

880,638

7,586

7,586

Unallocated

268

Total loans

$

3,767

$

2,440,227

$

2,443,994

$

954

$

29,924

$

31,146

The following table presents the amortized cost basis of collateral dependent loans, by the primary collateral type, which are individually evaluated to determine expected credit losses, and the related ACL allocated to these loans, as of June 30, 2023:

As of June 30, 2023

Primary Type of Collateral

Allowance for

(dollars in thousands)

Real estate

Equipment

Other

Total

Credit Losses

Commercial

Commercial and industrial

$

$

188

$

$

188

$

68

Commercial real estate

Total commercial

188

188

68

Consumer

Residential real estate first mortgage

299

299

5

Residential real estate junior lien

500

500

Other revolving and installment

6

6

6

Total consumer

799

6

805

11

Total loans

$

799

$

188

$

6

$

993

$

79

22

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Pre-ASC 326 Adoption impaired loan disclosures

The table below summarizes key information on impaired loans as of December 31, 2022:

December 31, 2022

Recorded

Unpaid

Related

(dollars in thousands)

    

Investment

    

Principal

    

Allowance

Impaired loans with a valuation allowance

Commercial and industrial

$

675

$

711

$

275

Real estate construction

262

440

97

Commercial real estate

 

896

 

900

 

582

Residential real estate first mortgage

Total impaired loans with a valuation allowance

1,833

2,051

954

Impaired loans without a valuation allowance

 

  

 

  

 

  

Commercial and industrial

638

767

Real estate construction

Commercial real estate

576

 

660

 

Residential real estate first mortgage

535

 

573

 

Residential real estate junior lien

184

 

218

 

Other revolving and installment

1

 

1

 

Total impaired loans without a valuation allowance

1,934

2,219

Total impaired loans

  

 

  

 

  

Commercial and industrial

1,313

1,478

275

Real estate construction

262

440

97

Commercial real estate

 

1,472

 

1,560

 

582

Residential real estate first mortgage

535

573

Residential real estate junior lien

 

184

 

218

 

Other revolving and installment

 

1

 

1

 

Total impaired loans

$

3,767

$

4,270

$

954

23

Table of Contents

The table below presents the average recorded investment in impaired loans and interest income for the three and six months ended June 30, 2022:

Three months ended June 30, 

2022

Average

Recorded

Interest

(dollars in thousands)

    

Investment

    

Income

Impaired loans with a valuation allowance

Commercial and industrial

$

1,018

$

2

Commercial real estate

176

2

Other revolving and installment

75

Total impaired loans with a valuation allowance

1,269

4

Impaired loans without a valuation allowance

 

Commercial and industrial

761

Commercial real estate

629

Residential real estate first mortgage

1,962

Residential real estate junior lien

196

Other revolving and installment

Total impaired loans without a valuation allowance

3,548

Total impaired loans

Commercial and industrial

1,779

2

Commercial real estate

805

2

Residential real estate first mortgage

1,962

Residential real estate junior lien

196

Other revolving and installment

75

Total impaired loans

$

4,817

$

4

Six Months Ended June 30, 

2022

Average

Recorded

Interest

(dollars in thousands)

    

Investment

    

Income

Impaired loans with a valuation allowance

 

  

 

  

Commercial and industrial

$

1,156

$

6

Commercial real estate

 

177

 

3

Other revolving and installment

 

157

 

Total impaired loans with a valuation allowance

1,490

9

Impaired loans without a valuation allowance

  

 

  

Commercial and industrial

761

Commercial real estate

 

629

 

Residential real estate first mortgage

 

1,953

 

Residential real estate junior lien

 

198

Total impaired loans without a valuation allowance

3,541

Total impaired loans

 

  

 

  

Commercial and industrial

1,917

6

Commercial real estate

 

806

 

3

Residential real estate first mortgage

 

1,953

 

Residential real estate junior lien

 

198

 

Other revolving and installment

 

157

 

Total impaired loans

$

5,031

$

9

24

Table of Contents

NOTE 5 Goodwill and Other Intangible Assets

The following table summarizes the carrying amount of goodwill, by segment, as of June 30, 2023 and December 31, 2022:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

Banking

$

35,260

$

35,260

Retirement and benefit services

11,827

11,827

Total goodwill

$

47,087

$

47,087

Goodwill is evaluated for impairment on an annual basis, at a minimum, and more frequently when the economic environment warrants. The Company determined that there was no goodwill impairment as of June 30, 2023.

The gross carrying amount and accumulated amortization for each type of identifiable intangible asset, as of June 30, 2023 and December 31, 2022, were as follows:

June 30, 2023

December 31, 2022

(dollars in thousands)

    

Gross Carrying Amount

    

Accumulated Amortization

    

Total

    

Gross Carrying Amount

    

Accumulated Amortization

    

Total

Identifiable customer intangibles

$

41,423

$

(27,944)

$

13,479

$

41,423

$

(25,927)

$

15,496

Core deposit intangible assets

7,592

(1,265)

6,327

7,592

(633)

6,959

Total intangible assets

$

49,015

$

(29,209)

$

19,806

$

49,015

$

(26,560)

$

22,455

Amortization of intangible assets was $1.3 million and $1.1 million for the three months ended June 30, 2023 and 2022. Amortization of intangible assets was $2.6 million and $2.1 million for the six months ended June 30, 2023 and 2022, respectively.

NOTE 6 Loan Servicing

Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of loans serviced for others totaled $367.8 million and $357.2 million as of June 30, 2023 and December 31, 2022, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and collection and foreclosure processing. Loan servicing income is recorded on an accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees, and is net of fair value adjustments to capitalized mortgage servicing rights.

The following table summarizes the Company’s activity related to servicing rights for the three and six months ended June 30, 2023 and 2022:

    

Three months ended

    

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

    

2022

Balance, beginning of period

$

2,421

$

1,771

$

2,643

$

1,880

Additions

20

13

 

23

 

17

Amortization

(134)

(96)

 

(318)

 

(256)

Fair value adjustments

44

376

 

3

 

423

Balance, end of period

$

2,351

$

2,064

$

2,351

$

2,064

25

Table of Contents

The following is a summary of key data and assumptions used in the valuation of servicing rights as of June 30, 2023 and December 31, 2022. Increases or decreases in any one of these assumptions would result in lower or higher fair value measurements.

    

June 30, 

    

December 31, 

 

(dollars in thousands)

2023

2022

Fair value of servicing rights

$

2,351

$

2,643

Weighted-average remaining term, years

 

19.0

 

20.5

Prepayment speeds

 

6.1

%  

 

6.9

%

Discount rate

 

11.0

%  

 

10.5

%

NOTE 7 Leases

Substantially all of the leases in which the Company is the lessee are comprised of real property for offices and office equipment rentals with terms extending through 2032. Portions of certain properties are subleased for terms extending through 2024. Substantially all of the Company’s leases are classified as operating leases. The Company has no existing finance leases.

The Company elected not to include short-term leases (i.e., leases with initial terms of twelve months or less), or equipment leases (deemed immaterial) on the consolidated financial statements. The following table presents the classification of the Company’s right-of-use, or ROU, assets and lease liabilities on the consolidated financial statements as of June 30, 2023 and December 31, 2022:

    

    

    

June 30, 

    

December 31, 

(dollars in thousands)

 

 

2023

 

2022

Lease Right-of-Use Assets

Classification

Operating lease right-of-use assets

 

Operating lease right-of-use assets

$

6,440

$

5,419

Lease Liabilities

 

  

 

 

  

Operating lease liabilities

 

Operating lease liabilities

$

6,746

$

5,902

The calculated amount of the ROU assets and lease liabilities in the table above are impacted by the length of the lease term and the discount rate used to present value the minimum lease payments. The Company’s lease agreements often include one or more options to renew at the Company’s discretion. If at lease inception, the Company considers the exercising of a renewal option to be reasonably certain, the Company will include the extended term in the calculation of the ROU asset and lease liability. The Company utilizes its incremental borrowing rate at lease inception, on a collateralized basis, over a similar term for the discount rate. For the Company’s only finance lease, the Company utilized its incremental borrowing rate at lease inception.

June 30, 

December 31, 

 

    

2023

    

2022

Weighted-average remaining lease term, years

Operating leases

 

4.5

5.0

Weighted-average discount rate

 

  

Operating leases

 

3.6

%

3.1

%

As the Company elected, for all classes of underlying assets, not to separate lease and non-lease components and instead to account for them as a single lease component, the variable lease cost primarily represents variable payments such as common area maintenance and utilities. Variable lease cost also includes payments for usage or maintenance of those capitalized equipment operating leases.

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The following table presents lease costs and other lease information for the three and six months ended June 30, 2023 and 2022:

    

Three months ended

    

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

2022

Lease costs

 

 

  

Operating lease cost

$

354

$

414

$

935

$

825

Variable lease cost

474

150

 

699

 

363

Short-term lease cost

39

43

 

82

 

88

Finance lease cost

 

  

 

  

Interest on lease liabilities

1

 

 

5

Amortization of right-of-use assets

29

 

 

58

Sublease income

(60)

(59)

 

(119)

 

(116)

Net lease cost

$

807

$

578

$

1,597

$

1,223

Other information

 

  

Cash paid for amounts included in the measurement of lease liabilities operating cash flows from operating leases

$

474

$

393

$

953

$

784

Right-of-use assets obtained in exchange for new operating lease liabilities

2,029

2,286

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Future minimum payments for finance and operating leases with initial or remaining terms of one year or more as of June 30, 2023 were as follows:

Operating

(dollars in thousands)

    

Leases

Twelve months ended

June 30, 2024

$

1,861

June 30, 2025

 

1,428

June 30, 2026

 

1,158

June 30, 2027

 

791

June 30, 2028

 

408

Thereafter

 

2,135

Total future minimum lease payments

$

7,781

Amounts representing interest

 

(1,035)

Total operating lease liabilities

$

6,746

NOTE 8 Deposits

The components of deposits in the consolidated balance sheets as of June 30, 2023 and December 31, 2022 were as follows:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

Noninterest-bearing

$

715,534

$

860,987

Interest-bearing

 

  

 

  

Interest-bearing demand

 

753,194

 

706,275

Savings accounts

 

93,557

 

99,882

Money market savings

 

986,403

 

1,035,981

Time deposits

 

304,167

 

212,359

Total interest-bearing

 

2,137,321

 

2,054,497

Total deposits

$

2,852,855

$

2,915,484

Certificates of deposit in excess of $250,000 totaled $94.2 million and $51.1 million at June 30, 2023 and December 31, 2022, respectively.

NOTE 9 Short-Term Borrowings

Short-term borrowings at June 30, 2023 and December 31, 2022 consisted of the following:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

Fed funds purchased

$

492,060

$

153,080

FHLB short-term advances

 

 

225,000

Total

$

492,060

$

378,080

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The following table presents information related to short-term borrowings for the three and six months ended June 30, 2023 and 2022:

Three months ended

June 30, 

(dollars in thousands)

    

2023

    

2022

Fed funds purchased

 

Balance as of end of period

$

492,060

$

117,350

Average daily balance

360,033

81,506

Maximum month-end balance

492,060

117,350

Weighted-average rate

During period

5.31

%

1.18

%

End of period

5.35

%

1.44

%

FHLB short-term advances

Balance as of end of period

$

$

125,000

Average daily balance

9,615

Maximum month-end balance

125,000

Weighted-average rate

During period

N/A

%

1.59

%

End of period

N/A

%

1.80

%

Six months ended

June 30, 

(dollars in thousands)

    

2023

    

2022

Fed funds purchased

 

Balance as of end of period

$

492,060

$

117,350

Average daily balance

325,303

40,978

Maximum month-end balance

492,060

117,350

Weighted-average rate

During period

5.10

%

1.18

%

End of period

5.35

%

1.44

%

FHLB short-term advances

Balance as of end of period

$

$

125,000

Average daily balance

39,779

4,834

Maximum month-end balance

225,000

125,000

Weighted-average rate

During period

4.69

%

1.59

%

End of period

N/A

%

1.80

%

NOTE 10 Long-Term Debt

Long-term debt as of June 30, 2023 and December 31, 2022 consisted of the following:

June 30, 2023

Period End

Face

Carrying

Interest

Maturity

(dollars in thousands)

    

Value

    

Value

    

Interest Rate

    

Rate

    

Date

    

Call Date

Subordinated notes payable

$

50,000

$

50,000

Fixed

3.50

%  

3/30/2031

3/31/2026

Junior subordinated debenture (Trust I)

4,124

3,560

 

Three-month LIBOR 3.10%

8.64

%  

6/26/2033

 

6/26/2008

Junior subordinated debenture (Trust II)

 

6,186

 

5,340

 

Three-month LIBOR 1.80%

7.35

%  

9/15/2036

 

9/15/2011

Total long-term debt

$

60,310

$

58,900

 

  

 

  

 

  

 

  

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December 31, 2022

Period End

Face

Carrying

Interest

Maturity

(dollars in thousands)

    

Value

    

Value

    

Interest Rate

    

Rate

    

Date

    

Call Date

Subordinated notes payable

$

50,000

$

50,000

 

Fixed

 

3.50

%  

3/30/2031

 

3/31/2026

Junior subordinated debenture (Trust I)

 

4,124

 

3,537

 

Three-month LIBOR 3.10%

7.82

%  

6/26/2033

 

6/26/2008

Junior subordinated debenture (Trust II)

 

6,186

 

5,306

 

Three-month LIBOR 1.80%

6.57

%  

9/15/2036

 

9/15/2011

Total long-term debt

$

60,310

$

58,843

 

  

 

  

 

  

 

  

NOTE 11 Financial Instruments with Off-Balance Sheet Risk

In the normal course of business, the Company has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying consolidated financial statements. The Company exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making such commitments as it does for instruments that are included in the statements of financial condition.

A summary of the contractual amounts of the Company’s exposure to off-balance sheet risk as of June 30, 2023 and December 31, 2022, respectively, was as follows:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

Commitments to extend credit

$

786,451

$

806,431

Standby letters of credit

 

9,784

 

13,089

Total

$

796,235

$

819,520

The Company had an allowance for loan losses on unfunded commitments of $3.2 million as of December 31, 2022. Upon the adoption of the CECL accounting standard, the Company recorded an additional $1.9 million reserve for unfunded commitments. For the six months ending June 30, 2023, the Company recorded an additional $44 thousand in provision for credit losses on unfunded commitments for a total of $5.1 million of allowance for credit losses on unfunded commitments as of June 30, 2023.

Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each client’s creditworthiness on a case by case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income producing commercial properties.

The Company was not required to perform on any financial guarantees and did not incur any losses on its commitments during the past two years.

The Company utilizes standby letters of credit issued by either the FHLB or the Bank of North Dakota to secure public unit deposits. The Company had no letters of credit outstanding with the FHLB as of June 30, 2023 or December 31, 2022. With the Bank of North Dakota, the Company had a no letters of credit outstanding as of June 30, 2023 and December 31, 2022. Letters of credit with the Bank of North Dakota were collateralized by loans pledged to the Bank of North Dakota in the amount of $230.3 million and $215.5 million as of June 30, 2023 and December 31, 2022, respectively.

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NOTE 12 Share-Based Compensation

On May 6, 2019, the Company’s stockholders approved the Alerus Financial Corporation 2019 Equity Incentive Plan. This plan gives the compensation committee the ability to grant a wide variety of equity awards, including stock options, stock appreciation rights, restricted stock, restricted stock units and cash incentive awards in such forms and amounts as it deems appropriate to accomplish the goals of the plan. Any shares subject to an award that is cancelled, forfeited, or expires prior to exercise or realization, either in full or in part, shall again become available for issuance under the plan. However, shares subject to an award shall not again be made available for issuance or delivery under the plan if such shares are (a) tendered in payment of the exercise price of a stock option, (b) delivered to, or withheld by, the Company to satisfy any tax withholding obligation, or (c) covered by a stock-settled stock appreciation right or other awards and were not issued upon the settlement of the award. Shares vest, become exercisable and contain such other terms and conditions as determined by the compensation committee and set forth in individual agreements with the participant receiving the award. The plan authorizes the issuance of up to 1,100,000 shares of common stock. As of June 30, 2023, 810,277 shares of common stock are still available for issuance under the plan.

The compensation expense relating to awards under these plans was $656 thousand and $663 thousand for the three months ended June 30, 2023 and 2022. The compensation expense relating to awards under these plans was $815 thousand and $1.0 million for the six months ended June 30, 2023 and 2022, respectively.

The following table presents the activity in the stock plans for the six months ended June 30, 2023 and 2022:

Six months ended June 30, 

2023

2022

Weighted-

Weighted-

    

Average Grant

Average Grant

    

Awards

    

Date Fair Value

    

Awards

    

Date Fair Value

Restricted Stock and Restricted Stock Unit Awards

 

 

 

Outstanding at beginning of period

 

238,929

 

$

23.66

260,850

 

$

21.04

Granted

 

82,810

 

20.85

94,592

 

19.01

Vested

 

(91,867)

 

21.29

(107,113)

 

19.19

Forfeited or cancelled

 

(22,204)

 

21.39

(10,624)

 

23.71

Outstanding at end of period

207,668

$

23.83

237,705

$

20.95

As of June 30, 2023, there was $3.0 million of unrecognized compensation expense related to non-vested awards granted under the plans. The expense is expected to be recognized over a weighted-average period of 2.5 years.

NOTE 13 Income Taxes

The components of income tax expense (benefit) for the three and six months ended June 30, 2023 and 2022 were as follows:

Three months ended June 30, 

2023

2022

    

    

Percent of

  

  

    

Percent of

  

(dollars in thousands)

Amount

Pretax Income

  

Amount

Pretax Income

  

Taxes at statutory federal income tax rate

$

2,444

 

21.0

%

$

2,524

 

21.0

Tax effect of:

 

 

Tax exempt income

(156)

 

(1.3)

%

(122)

 

(1.0)

State income taxes, net of federal benefits

485

4.1

%

531

4.4

Nondeductible items and other

(238)

 

(2.0)

%

(208)

 

(1.7)

Applicable income taxes

$

2,535

21.8

%

$

2,725

22.7

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Six months ended June 30, 

2023

2022

    

    

Percent of

  

  

    

Percent of

 

(dollars in thousands)

Amount

Pretax Income

  

Amount

Pretax Income

 

Taxes at statutory federal income tax rate

$

4,648

 

21.0

$

5,269

 

21.0

%

Tax effect of:

 

  

 

  

 

  

 

  

Tax exempt income

 

(300)

 

(1.4)

 

(239)

 

(1.0)

%

State income taxes, net of federal benefits

 

946

 

4.3

 

1,109

 

4.4

%

Nondeductible items and other

(453)

(2.0)

(526)

(2.1)

%

Applicable income taxes

$

4,841

 

21.9

$

5,613

 

22.3

%

It is the opinion of management that the Company has no significant uncertain tax positions that would be subject to change upon examination.

NOTE 14 Tax Credit Investments

The Company invests in qualified affordable housing projects for the purpose of community reinvestment and obtaining tax credits. The Company’s tax credit investments are limited to existing lending relationships with well-known developers and projects within the Company’s market area.

The following table presents a summary of the Company’s investments in qualified affordable housing project tax credits as of June 30, 2023 and December 31, 2022:

    

    

June 30, 2023

December 31, 2022

(dollars in thousands)

 

Investment

Unfunded Commitment

Investment

Unfunded Commitment

Investment

Accounting Method

Low income housing tax credit

 

Proportional amortization

$

17,906

    

$

15,202

    

$

17,906

    

$

15,559

Total

 

$

17,906

 

$

15,202

 

$

17,906

 

$

15,559

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The following table presents a summary of the amortization expense and tax benefit recognized for the Company’s qualified affordable housing projects for the three and six months ended June 30, 2023 and 2022:

Three months ended June 30, 

2023

2022

Amortization

Tax Benefit

Amortization

Tax Benefit

(dollars in thousands)

Expense (1)

    

Recognized (2)

    

Expense (1)

    

Recognized (2)

    

Low income housing tax credit

$

278

 

$

(509)

 

$

111

 

$

(156)

 

Total

$

278

$

(509)

$

111

$

(156)

(1)The amortization expense for low income housing tax credits were included in the income tax expense.
(2)All of the tax benefits recognized were included in income tax expense.

Six months ended June 30, 

2023

2022

Amortization

Tax Benefit

Amortization

Tax Benefit

(dollars in thousands)

Expense (1)

Recognized (2)

Expense (1)

Recognized (2)

Low income housing tax credit

$

639

 

$

(735)

 

$

111

 

$

(156)

Total

$

639

$

(735)

$

111

$

(156)

(1)The amortization expense for low income housing tax credits were included in income tax expense.
(2)All of the tax benefits recognized were included in income tax expense.

NOTE 15 Segment Reporting

The Company determines reportable segments based on the services offered, the significance of the services offered, the significance of those services to the Company’s financial statements, and management’s regular review of the operating results of those services. The Company operates through four operating segments: Banking, Retirement and Benefit Services, Wealth Management, and Mortgage.

The financial information presented for each segment includes net interest income, provision for credit losses, direct noninterest income, and direct noninterest expense, before indirect allocations. Corporate Administration includes the indirect overhead and is set forth in the table below. The segment net income before taxes represents direct revenue and expense before indirect allocations and income taxes.

The following table presents key metrics related to the Company’s segments for the periods presented:

Three months ended June 30, 2023

Retirement and

Wealth

Corporate

(dollars in thousands)

    

Banking

    

Benefit Services

    

Management

    

Mortgage

    

Administration

    

Consolidated

Net interest income (loss)

$

22,681

$

$

$

218

$

(665)

$

22,234

Provision for credit losses

 

 

 

Noninterest income

 

1,336

 

15,890

 

5,449

 

2,905

 

198

 

25,778

Intercompany revenue (expense)

(2,933)

1,331

 

(257)

 

286

1,573

Noninterest expense

 

11,548

 

8,290

 

2,100

 

3,882

 

10,553

 

36,373

Net income (loss) before taxes

$

9,536

$

8,931

$

3,092

$

(473)

$

(9,447)

$

11,639

    

Six months ended June 30, 2023

Retirement and

Wealth

Corporate

(dollars in thousands)

    

Banking

    

Benefit Services

    

Management

    

Mortgage

    

Administration

    

Consolidated

Net interest income (loss)

$

46,832

$

$

$

380

$

(1,320)

$

45,892

Provision for credit losses

550

550

Noninterest income

4,158

31,372

10,644

4,622

235

51,031

Intercompany revenue (expense)

(5,980)

2,672

 

(425)

 

512

3,221

Noninterest expense

25,503

 

15,600

 

3,613

 

6,667

22,859

74,242

Net income (loss) before taxes

$

18,957

$

18,444

$

6,606

$

(1,153)

$

(20,723)

$

22,131

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Three months ended June 30, 2022

Retirement and

Wealth

Corporate

(dollars in thousands)

    

Banking

    

Benefit Services

    

Management

    

Mortgage

    

Administration

    

Consolidated

Net interest income (loss)

$

22,779

$

$

$

558

$

(561)

$

22,776

Provision for credit losses

Noninterest income

1,341

16,293

5,548

6,038

6

29,226

Intercompany revenue (expense)

(3,829)

1,095

 

(337)

 

1,334

1,737

Noninterest expense

11,790

 

7,693

 

1,293

 

6,543

12,665

39,984

Net income (loss) before taxes

$

8,501

$

9,695

$

3,918

$

1,387

$

(11,483)

$

12,018

    

Six months ended June 30, 2022

Retirement and

Wealth

Corporate

(dollars in thousands)

    

Banking

    

Benefit Services

    

Management

    

Mortgage

    

Administration

    

Consolidated

Net interest income (loss)

$

44,304

$

$

$

1,267

$

(1,122)

$

44,449

Provision for credit losses

 

 

 

Noninterest income

 

2,879

33,939

10,874

10,969

 

35

 

58,696

Intercompany revenue (expense)

(4,988)

692

 

(851)

 

1,828

3,319

Noninterest expense

 

23,325

 

15,722

 

2,617

 

12,057

 

24,334

 

78,055

Net income (loss) before taxes

$

18,870

$

18,909

$

7,406

$

2,007

$

(22,102)

$

25,090

Banking

The Banking division offers a complete line of loan, deposit, cash management, and treasury services through fourteen offices in North Dakota, Minnesota, and Arizona. These products and services are supported through web and mobile based applications. The majority of the Company’s assets and liabilities are in the Banking segment’s balance sheet.

Retirement and Benefit Services

Retirement and Benefit Services provides the following services nationally: recordkeeping and administration services to qualified retirement plans; recordkeeping, and administration; investment fiduciary services to retirement plans; health savings accounts, flex spending accounts, and COBRA recordkeeping and administration services. In addition, the division operates within each of the banking markets, as well as in Lansing, Michigan and Littleton, Colorado.

Wealth Management

The Wealth Management division provides advisory and planning services, investment management, and trust and fiduciary services to clients across the Company’s footprint.

Mortgage

The Mortgage division offers first and second mortgage loans through a centralized mortgage unit in Minneapolis, Minnesota, as well as through the Banking office locations.

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Table of Contents

NOTE 16 Earnings Per Share

The calculation of basic and diluted earnings per share using the two-class method for the three and six months ended June 30, 2023 and 2022 are presented below:

Three months ended

Six months ended

June 30, 

June 30, 

(dollars and shares in thousands, except per share data)

    

2023

    

2022

    

2023

    

2022

Net income

$

9,104

$

9,293

$

17,290

$

19,477

Dividends and undistributed earnings allocated to participating securities

62

101

120

225

Net income available to common shareholders

$

9,042

$

9,192

$

17,170

$

19,252

Weighted-average common shares outstanding for basic earnings per share

20,033

17,297

20,030

 

17,271

Dilutive effect of stock-based awards

208

 

235

 

213

 

246

Weighted-average common shares outstanding for diluted earnings per share

20,241

17,532

20,243

17,517

Earnings per common share:

Basic earnings per common share

$

0.45

$

0.53

$

0.86

$

1.11

Diluted earnings per common share

$

0.45

$

0.52

$

0.85

$

1.10

NOTE 17 Derivative Instruments

The following table presents the total notional amounts and gross fair values of the Company’s derivatives as of June 30, 2023 and December 31, 2022:

June 30, 2023

December 31, 2022

Fair

Notional

Fair

Notional

(dollars in thousands)

    

    

Value

    

Amount

    

Value

    

Amount

Designated as hedging instruments:

Consolidated Balance Sheet Location

Fair value hedges:

Interest rate swaps

Other assets

$

2,069

$

200,000

$

$

Total derivatives designated as hedging instruments

$

2,069

$

200,000

$

$

Not designated as hedging instruments:

Asset Derivatives

 

 

  

 

  

 

  

 

  

Interest rate swaps

 

Other assets

$

6,049

$

42,716

$

6,277

$

43,430

Interest rate lock commitments

 

Other assets

523

34,602

121

10,462

Forward loan sales commitments

 

Other assets

 

71

 

4,193

 

7

 

351

To-be-announced mortgage backed securities

 

Other assets

 

210

 

68,750

 

 

Total asset derivatives not designated as hedging instruments

 

  

$

6,853

$

150,261

$

6,405

$

54,243

Liability Derivatives

 

  

 

  

 

  

 

  

 

  

Interest rate swaps

 

Accrued expenses and other liabilities

$

6,049

$

42,716

$

6,277

$

43,430

To-be-announced mortgage backed securities

 

Accrued expenses and other liabilities

26

25,750

Total liability derivatives not designated as hedging instruments

 

  

$

6,049

$

42,716

$

6,303

$

69,180

Derivatives Designated as Hedging Instruments

The Company uses derivative instruments to hedge its exposure to economic risks, including interest rate, liquidity and credit risk. Certain hedging relationships are formally designated and qualify for hedge accounting under GAAP as fair value hedges.

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Fair value hedges: Derivatives are designated as fair value hedges to limit the Company’s exposure to changes in the fair value of assets or liabilities due to movements in interest rates. During the first quarter of 2023, the Company entered into an interest rate swap, with an effective date of February 10, 2023. This transaction was designated a fair value hedge of certain mortgage-backed investment securities. The Company will pay the counterparty a fixed rate of 4.019% and will receive a floating rate based on the Secured Overnight Financing Rate. The fair value hedge has a maturity date of February 10, 2026. The interest rate swap is carried on the Company’s consolidated balance sheet at its fair value in other assets (when the fair value is positive) or in accrued expenses and other liabilities (when the fair value is negative). The changes in the fair value of the interest rate swap are recorded in interest income. The unrealized gains or losses due to changes in fair value of the hedged debt securities due to changes in benchmark interest rates are recorded as an adjustment to the hedged debt securities and offset in the same interest income line items.

The following table shows the carrying amount and associated cumulative basis adjustments related to the application of hedge accounting that is included in the carrying amount of hedged assets and liabilities in fair value hedging relationships at June 30, 2023:

June 30, 2023

Cumulative Fair

Value Hedging

Adjustment in the

Carrying Amount

Carrying Amount of

of Hedge Assets/

Hedged Assets/

Liabilities

Liabilities

(dollars in thousands)

    

    

Mortgage-backed securities

Residential agency

$

284,584

$

(2,073)

Total

$

284,584

$

(2,073)

Derivatives Not Designated as Hedging Instruments

Interest rate swaps: The Company periodically enters into commercial loan interest rate swap agreements in order to provide commercial loan customers with the ability to convert from variable to fixed interest rates. These derivative contracts relate to transactions in which the Company enters into an interest rate swap with a customer, while simultaneously entering into an offsetting interest rate swap with an institutional counterparty.

Interest rate lock commitments, forward loan sales commitments and to be announced (TBA) mortgage backed securities: The Company enters into forward delivery contracts to sell mortgage loans at specific prices and dates in order to hedge the interest rate risk in its portfolio of mortgage loans held for sale and its residential mortgage interest rate lock commitments.

The gain (loss) recognized on derivative instruments for the three and six months ended June 30, 2023 and 2022 was as follows:

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(dollars in thousands)

Three months ended June 30, 

Six months ended June 30, 

Derivatives designated as hedging instruments

    

Consolidated Statements of Income Location

    

2023

    

2022

    

2023

    

2022

Interest rate swaps

 

Interest income

$

$

$

$

Total gain (loss) from derivatives designated as hedging instruments

$

$

$

$

Derivatives not designated as hedging instruments

Interest rate swaps

 

Other noninterest income

$

$

1

$

$

1

Interest rate lock commitments

 

Mortgage banking

89

563

429

(147)

Forward loan sales commitments

 

Mortgage banking

70

542

64

52

To-be-announced mortgage backed securities

 

Mortgage banking

302

1,246

 

129

 

3,749

Total gain (loss) from derivatives not designated as hedging instruments

 

$

461

$

2,352

$

622

$

3,655

The Company has third party agreements that require a minimum dollar transfer amount upon a margin call. These requirements are dependent on certain specified credit measures. The amount of collateral posted with third parties was $290 thousand at June 30, 2023 and $309 thousand at December 31, 2022. The amount of collateral posted with third parties was deemed to be sufficient as of those dates to collateralize both the fair market value change as well as any additional amounts that may be required as a result of a change in the specified credit measures.

NOTE 18 Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of common equity tier 1, tier 1, and total capital (as defined in the regulations) to risk weighted assets (as defined) and of tier 1 capital (as defined) to average assets (as defined). Management believes at June 30, 2023 and December 31, 2022, each of the Company and the Bank had met all of the capital adequacy requirements to which it was subject.

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The following table presents the Company’s and the Bank’s actual capital amounts and ratios as of June 30, 2023 and December 31, 2022:

June 30, 2023

 

Minimum to be

Requirements

Well Capitalized

 

for Capital

Under Prompt

 

Actual

Adequacy Purposes

Corrective Action

 

(dollars in thousands)

    

Amount

    

Ratio

    

Amount

    

Ratio

    

Amount

    

Ratio

 

Common equity tier 1 capital to risk weighted assets

 

  

 

  

 

  

 

  

 

  

 

  

Consolidated

$

395,276

 

13.30

%  

$

133,728

 

4.50

%  

$

N/A

 

N/A

Bank

 

383,663

 

12.93

%  

 

133,585

 

4.50

%  

 

192,895

 

6.50

%

Tier 1 capital to risk weighted assets

 

  

 

 

 

  

 

  

 

 

.

 

  

Consolidated

 

404,176

 

13.60

%  

 

178,304

 

6.00

%  

 

N/A

 

N/A

Bank

 

383,663

 

12.93

%  

 

178,113

 

6.00

%  

 

237,409

 

8.00

%

Total capital to risk weighted assets

 

  

 

 

 

  

 

  

 

 

  

 

  

Consolidated

 

490,091

 

16.49

%  

 

237,738

 

8.00

%  

 

N/A

 

N/A

Bank

 

419,578

 

14.14

%  

 

237,486

 

8.00

%  

 

296,762

 

10.00

%

Tier 1 capital to average assets

 

  

 

  

 

 

 

  

 

 

  

 

  

Consolidated

 

404,176

 

11.15

%  

 

144,987

 

4.00

%  

 

N/A

 

N/A

Bank

 

383,663

 

10.59

%  

 

144,890

 

4.00

%  

 

181,112

 

5.00

%

December 31, 2022

 

Minimum to be

Requirements

Well Capitalized

 

for Capital

Under Prompt

 

Actual

Adequacy Purposes

Corrective Action

 

(dollars in thousands)

    

Amount

    

Ratio

    

Amount

    

Ratio

    

Amount

    

Ratio

 

Common equity tier 1 capital to risk weighted assets

 

  

 

  

 

  

 

  

 

  

 

  

Consolidated

$

389,335

 

13.39

%  

$

130,862

 

4.50

%  

$

N/A

 

N/A

Bank

 

370,749

 

12.76

%  

 

130,791

 

4.50

%  

 

188,920

 

6.50

%

Tier 1 capital to risk weighted assets

 

  

 

 

 

  

 

  

 

 

.

 

  

Consolidated

 

398,179

 

13.69

%  

 

174,482

 

6.00

%  

 

N/A

 

N/A

Bank

 

370,749

 

12.76

%  

 

174,388

 

6.00

%  

 

232,517

 

8.00

%

Total capital to risk weighted assets

 

  

 

 

 

  

 

  

 

 

  

 

  

Consolidated

 

479,325

 

16.48

%  

 

232,643

 

8.00

%  

 

N/A

 

N/A

Bank

 

401,895

 

13.83

%  

 

232,517

 

8.00

%  

 

290,646

 

10.00

%

Tier 1 capital to average assets

 

  

 

  

 

 

 

  

 

 

  

 

  

Consolidated

 

398,179

 

11.25

%  

 

141,514

 

4.00

%  

 

N/A

 

N/A

Bank

 

370,749

 

10.48

%  

 

141,440

 

4.00

%  

 

176,800

 

5.00

%

The Bank is subject to certain restrictions on the amount of dividends that it may pay without prior regulatory approval. The Company and the Bank are subject to the rules of the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act rules. The rules include a 2.5 percent capital conservation buffer that is added to the minimum requirements for capital adequacy purposes. A banking organization with a conservation buffer of less than the required amount will be subject to the limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. As of June 30, 2023, the capital ratios for the Company and the Bank were sufficient to meet the conservation buffer. In addition, the Company must adhere to various U.S. Department of Housing and Urban Development, or HUD, regulatory guidelines including required minimum capital and liquidity to maintain their Federal Housing Administration approval status. Failure to comply with the HUD guidelines could result in withdrawal of this certification. As of June 30, 2023 and December 31, 2022, the Company was in compliance with the aforementioned guidelines.

NOTE 19 Stock Repurchase Program

On February 18, 2021, the Board of Directors of the Company approved a stock repurchase program, or the Program, which authorizes the Company to repurchase up to 770,000 shares of its common stock subject to certain limitations and conditions. The Program was effective immediately and will continue for a period of 36 months, until

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February 28, 2024. The Program does not obligate the Company to repurchase any shares of its common stock and there is no assurance that the Company will do so. For the six months ended June 30, 2023, the Company repurchased 170,046 shares of common stock under the Program. The Company also repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units.

NOTE 20 Fair Value of Assets and Liabilities

The Company categorizes its assets and liabilities measured at estimated fair value into a three level hierarchy based on the priority of the inputs to the valuation technique used to determine estimated fair value. The estimated fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used in the determination of the estimated fair value measurement fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the estimated fair value measurement. Assets and liabilities valued at estimated fair value are categorized based on the following inputs to the valuation techniques as follows:

Level 1—Inputs that utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that an entity has the ability to access.

Level 2—Inputs that include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Estimated fair values for these instruments are estimated using pricing models, quoted prices of investment securities with similar characteristics, or discounted cash flows.

Level 3—Inputs that are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. Subsequent to initial recognition, the Company may re-measure the carrying value of assets and liabilities measured on a nonrecurring basis to estimated fair value. Adjustments to estimated fair value usually result when certain assets are impaired. Such assets are written down from their carrying amounts to their estimated fair value.

Professional standards allow entities the irrevocable option to elect to measure certain financial instruments and other items at estimated fair value for the initial and subsequent measurement on an instrument-by-instrument basis. The Company adopted the policy to value certain financial instruments at estimated fair value. The Company has not elected to measure any existing financial instruments at estimated fair value; however, it may elect to measure newly acquired financial instruments at estimated fair value in the future.

Recurring Basis

The Company uses estimated fair value measurements to record estimated fair value adjustments to certain assets and liabilities and to determine estimated fair value disclosures.

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The following tables present the balances of the assets and liabilities measured at estimated fair value on a recurring basis as of June 30, 2023 and December 31, 2022:

    

June 30, 2023

(dollars in thousands)

    

Level 1

    

Level 2

    

Level 3

    

Total

Available-for-sale

 

  

 

  

 

  

 

  

U.S. treasury and government agencies

$

$

2,906

$

$

2,906

Mortgage backed securities

 

  

 

  

 

  

 

  

Residential agency

 

 

558,456

 

 

558,456

Commercial

 

 

60,909

 

 

60,909

Asset backed securities

 

 

28

 

 

28

Corporate bonds

 

 

55,155

 

 

55,155

Total available-for-sale investment securities

$

$

677,454

$

$

677,454

Other assets

 

  

 

  

 

  

 

  

Derivatives

$

$

6,853

$

$

6,853

Other liabilities

 

  

 

  

 

  

 

  

Derivatives

$

$

8,118

$

$

8,118

December 31, 2022

(dollars in thousands)

    

Level 1

    

Level 2

    

Level 3

    

Total

Available-for-sale

 

  

 

  

 

  

 

  

U.S. treasury and government agencies

$

$

3,520

$

$

3,520

Mortgage backed securities

 

  

 

  

 

  

 

  

Residential agency

 

 

587,679

 

 

587,679

Commercial

 

 

63,558

 

 

63,558

Asset backed securities

 

 

34

 

 

34

Corporate bonds

 

 

62,533

 

 

62,533

Total available-for-sale investment securities

$

$

717,324

$

$

717,324

Other assets

 

  

 

  

 

  

 

  

Derivatives

$

$

6,405

$

$

6,405

Other liabilities

 

  

 

  

 

  

 

  

Derivatives

$

$

6,303

$

$

6,303

The following is a description of the valuation methodologies used for instruments measured at estimated fair value on a recurring basis, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Investment Securities, Available-for-Sale

Generally, debt securities are valued using pricing for similar securities, recently executed transactions, and other pricing models utilizing observable inputs and therefore are classified as Level 2.

Derivatives

All of the Company’s derivatives are traded in over-the-counter markets where quoted market prices are not readily available. For these derivatives, estimated fair value is measured using internally developed models that use primarily market observable inputs, such as yield curves and option volatilities, and accordingly, classify as Level 2. Examples of Level 2 derivatives are basic interest rate swaps and forward contracts.

Nonrecurring Basis

Certain assets are measured at estimated fair value on a nonrecurring basis. These assets are not measured at estimated fair value on an ongoing basis; however, they are subject to estimated fair value adjustments in certain circumstances, such as when there is evidence of impairment or a change in the amount of previously recognized impairment.

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Net impairment related to nonrecurring estimated fair value measurements of certain assets as of June 30, 2023 and December 31, 2022 consisted of the following:

June 30, 2023

(dollars in thousands)

    

Level 2

    

Level 3

    

Total

    

Impairment

Loans held for sale

$

20,893

$

$

20,893

$

Individually evaluated

 

 

2,390

 

2,390

 

288

Servicing rights

 

 

2,351

 

2,351

 

December 31, 2022

(dollars in thousands)

    

Level 2

    

Level 3

    

Total

    

Impairment

Loans held for sale

$

9,488

$

$

9,488

$

Individually evaluated

 

 

2,813

 

2,813

 

954

Foreclosed assets

 

 

30

 

30

 

Servicing rights

 

 

2,643

 

2,643

 

Loans Held for Sale

Loans originated and held for sale are carried at the lower of cost or estimated fair value. The Company obtains quotes or bids on these loans directly from purchasing financial institutions. Typically, these quotes include a premium on the sale and thus these quotes indicate estimated fair value of the held for sale loans is greater than cost.

Impairment losses for loans held for sale that are carried at the lower of cost or estimated fair value represent additional net write-downs during the period to record these loans at the lower of cost or estimated fair value, subsequent to their initial classification as loans held for sale.

The valuation techniques and significant unobservable inputs used to measure Level 3 estimated fair values as of June 30, 2023 and December 31, 2022, were as follows:

June 30, 2023

(dollars in thousands)

Weighted

Asset Type

    

Valuation Technique

    

Unobservable Input

Fair Value

    

Range

    

Average

  

Individually evaluated

 

Appraisal value

 

Property specific adjustment

$

2,390

 

N/A

N/A

 

Foreclosed assets

 

Appraisal value

 

Property specific adjustment

 

 

N/A

 

N/A

 

Servicing rights

 

Discounted cash flows

 

Prepayment speed assumptions

 

2,351

 

83-134

 

101

 

 

  

 

Discount rate

 

  

 

11.0

%  

11.0

December 31, 2022

(dollars in thousands)

Weighted

 

Asset Type

    

Valuation Technique

    

Unobservable Input

Fair Value

    

Range

    

Average

 

Individually evaluated

 

Appraisal value

 

Property specific adjustment

$

2,813

 

N/A

 

N/A

Foreclosed assets

 

Appraisal value

 

Property specific adjustment

 

30

 

N/A

 

N/A

Servicing rights

 

Discounted cash flows

 

Prepayment speed assumptions

 

2,643

 

103-137

 

115

 

  

 

Discount rate

 

  

 

10.5

%  

10.5

%

Disclosure of estimated fair value information about financial instruments, for which it is practicable to estimate that value, is required whether or not recognized in the consolidated balance sheets. In cases in which quoted market prices are not available, estimated fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimate of future cash flows. In that regard, the derived estimated fair value estimates cannot be substantiated by comparison to independent markets and, in many cases could not be realized in immediate settlement of the instruments. Certain

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financial instruments, with an estimated fair value that is not practicable to estimate and all non-financial instruments, are excluded from the disclosure requirements. Accordingly, the aggregate estimated fair value amounts presented do not necessarily represent the underlying value of the Company.

The following disclosures represent financial instruments in which the ending balances, as of June 30, 2023 and December 31, 2022, were not carried at estimated fair value in their entirety on the consolidated balance sheets.

Cash and Cash Equivalents and Accrued Interest

The carrying amounts reported in the consolidated balance sheets approximate those assets and liabilities estimated fair values.

Investment Securities, Held-to-Maturity

The fair values of debt securities held-to-maturity are based on quoted market prices for the same or similar securities, recently executed transactions and pricing models.

Loans

For variable-rate loans that reprice frequently and with no significant change in credit risk, estimated fair values are based on carrying values. The estimated fair values of other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

Bank-Owned Life Insurance

Bank-owned life insurance is carried at the amount due upon surrender of the policy, which is also the estimated fair value. This amount was provided by the insurance companies based on the terms of the underlying insurance contract.

Deposits

The estimated fair values of demand deposits are, by definition, equal to the amount payable on demand at the consolidated balance sheet date. The estimated fair values of fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies current incremental interest rates being offered on certificates of deposit to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit.

Short-Term Borrowings and Long-Term Debt

For variable-rate borrowings that reprice frequently, estimated fair values are based on carrying values. The estimated fair values of fixed-rate borrowings are estimated using discounted cash flow analysis, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance Sheet Credit-Related Commitments

Off-balance sheet credit related commitments are generally of short-term nature. The contract amount of such commitments approximates their estimated fair value since the commitments are comprised primarily of unfunded loan commitments which are generally priced at market at the time of funding.

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Table of Contents

The estimated fair values, and related carrying or notional amounts, of the Company’s financial instruments at the dates indicated are as follows:

June 30, 2023

Carrying

Estimated Fair Value

(dollars in thousands)

    

Amount

    

Level 1

    

Level 2

    

Level 3

    

Total

Financial Assets

 

  

 

  

 

  

 

  

 

  

Cash and cash equivalents

$

65,471

$

65,471

$

$

$

65,471

Investment securities held-to-maturity

308,416

260,710

260,710

Loans, net

 

2,497,826

 

 

 

2,403,819

 

2,403,819

Accrued interest receivable

 

13,587

 

13,587

 

 

 

13,587

Bank-owned life insurance

 

32,793

 

 

32,793

 

 

32,793

Financial Liabilities

 

  

 

  

 

  

 

  

 

  

Noninterest-bearing deposits

$

715,534

$

$

715,534

$

$

715,534

Interest-bearing deposits

 

1,833,154

 

 

1,833,154

 

 

1,833,154

Time deposits

 

304,167

 

 

 

300,375

 

300,375

Short-term borrowings

 

492,060

 

492,060

 

 

 

492,060

Long-term debt

 

58,900

 

 

56,008

 

 

56,008

Accrued interest payable

 

2,960

 

2,960

 

 

 

2,960

December 31, 2022

Carrying

Estimated Fair Value

(dollars in thousands)

    

Amount

    

Level 1

    

Level 2

    

Level 3

    

Total

Financial Assets

 

  

 

  

 

  

 

  

 

  

Cash and cash equivalents

$

58,242

$

58,242

$

$

$

58,242

Investment securities held-to-maturity

321,902

270,912

270,912

Loans, net

 

2,412,848

 

 

 

2,311,956

 

2,311,956

Accrued interest receivable

 

12,869

 

12,869

 

 

 

12,869

Bank-owned life insurance

 

33,991

 

 

33,991

 

 

33,991

Financial Liabilities

 

  

 

  

 

  

 

  

 

  

Noninterest-bearing deposits

$

860,987

$

$

860,987

$

$

860,987

Interest-bearing deposits

 

1,842,138

 

 

1,842,138

 

 

1,842,138

Time deposits

 

212,359

 

 

 

208,550

 

208,550

Short-term borrowings

 

378,080

 

378,080

 

 

 

378,080

Long-term debt

 

58,843

 

 

56,116

 

 

56,116

Accrued interest payable

 

2,426

 

2,426

 

 

 

2,426

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Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

The following discussion explains our financial condition and results of operations as of and for the three and six months ended June 30, 2023 and 2022. Annualized results for this interim period may not be indicative of results for the full year or future periods. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes presented elsewhere in this report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission on March 13, 2023.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements include, without limitation, statements concerning plans, estimates, calculations, forecasts and projections with respect to the anticipated future performance of Alerus Financial Corporation. These statements are often, but not always, identified by words such as “may”, “might”, “should”, “could”, “predict”, “potential”, “believe”, “expect”, “continue”, “will”, “anticipate”, “seek”, “estimate”, “intend”, “plan”, “projection”, “would”, “annualized”, “target” and “outlook”, or the negative version of those words or other comparable words of a future or forward-looking nature. Examples of forward-looking statements include, among others, statements we make regarding our projected growth, anticipated future financial performance, financial condition, credit quality and management’s long-term performance goals and the future plans and prospects of Alerus Financial Corporation.

Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based only on our current beliefs, expectations and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and many of which are outside of our control. Our actual results and financial condition may differ materially from those indicated in forward-looking statements. Therefore, you should not rely on any of these forward-looking statements. Important factors that could cause our actual results and financial condition to differ materially from those indicated in forward-looking statements include, among others, the following:

interest rate risks associated with our business, including the effects of recent and anticipated rate increases by the Federal Reserve;
our ability to successfully manage credit risk and maintain an adequate level of allowance for credit losses;
new or revised accounting standards, including as a result of the implementation of the CECL accounting standard;
business and economic conditions generally and in the financial services industry, nationally and within our market areas, including continued rising rates of inflation and possible recession, the effects of recent developments and events in the financial services industry, including the large-scale deposit withdrawals over a short period of time at Silicon Valley Bank, Signature Bank and First Republic Bank that resulted in the failure of those institutions;
our ability to manage liquidity risk, including our need to access higher cost sources of funds such as fed funds purchased and short-term borrowings;
the concentration of large deposits from certain clients, who have balances above current Federal Deposit Insurance Corporation, or FDIC, insurance limits and may withdraw deposits to diversify their exposure;

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fluctuations in the values of securities held in our securities portfolio, including as a result of changes in interest rates;
the overall health of the local and national real estate market;
concentrations within our loan portfolio;
the level of nonperforming assets on our balance sheet;
our ability to implement our organic and acquisition growth strategies, including the integration of Metro Phoenix Bank which we acquired in 2022;
the impact of economic or market conditions on our fee-based services;
our ability to continue to grow our retirement and benefit services business;
our ability to continue to originate a sufficient volume of residential mortgages;
the occurrence of fraudulent activity, breaches or failures of our information security controls or cybersecurity-related incidents, including as a result of sophisticated attacks using artificial intelligence and similar tools;
interruptions involving our information technology and telecommunications systems or third-party servicers;
potential losses incurred in connection with mortgage loan repurchases;
the composition of our executive management team and our ability to attract and retain key personnel;
the rapid technological change in the financial services industry;
increased competition in the financial services industry from non-banks such as credit unions and Fintech companies, including digital asset service providers;
the effectiveness of our risk management framework;
the commencement and outcome of litigation and other legal proceedings and regulatory actions against us or to which we may become subject;
potential impairment to the goodwill we recorded in connection with our past acquisitions; including the acquisition of Metro Phoenix Bank;
the extensive regulatory framework that applies to us;
the impact of recent and future legislative and regulatory changes, including in response to the recent failures of Silicon Valley Bank, Signature Bank and First Republic Bank;
governmental monetary, trade and fiscal policies;
risks related to climate change and the negative impact it may have on our customers and their businesses;

45

Table of Contents

severe weather, natural disasters, widespread disease or pandemics, such as the COVID-19 global pandemic;
acts of war or terrorism, including the Russian invasion of Ukraine, or other adverse external events;
any material weaknesses in our internal control over financial reporting;
changes to U.S. or state tax laws, regulations and guidance, including the new 1.0% excise tax on stock buybacks to publicly traded companies;
talent and labor shortages and employee turnover; our success at managing the risks involved in the foregoing items; and
any other risks described in the “Risk Factors” sections of the reports filed by Alerus Financial Corporation with the Securities and Exchange Commission.

Any forward-looking statement made by us in this report is based only on information currently available to us and speaks only as of the date on which it is made. We undertake no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future developments or otherwise.

Overview

We are a diversified financial services company headquartered in Grand Forks, North Dakota. Through our subsidiary, Alerus Financial, National Association, or the Bank, we provide financial solutions to businesses and consumers through four distinct business lines—banking, retirement and benefit services, wealth management and mortgage. These solutions are delivered through a relationship-oriented primary point of contact along with responsive and client-friendly technology.

Our business model produces strong financial performance and a diversified revenue stream, which has helped us establish a brand and culture yielding both a loyal client base and passionate and dedicated employees. We generate a majority of our overall revenue from noninterest income, which is driven primarily by our retirement and benefit services, wealth management and mortgage business lines. The remainder of our revenue consists of net interest income, which we derive from offering our traditional banking products and services.

Critical Accounting Policies

Our consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States, or GAAP. The preparation of our consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances. These estimates form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions. The estimates and judgments that management believes have the most effect on the Company’s reported financial position and results of operations are set forth in Note 1 – Significant Accounting Policies of the Notes to the Consolidated Statements, included in our Annual Report on Form 10-K for the year ended December 31, 2022.

On January 1, 2023, the Company adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which created material changes to the Company’s existing critical accounting policy that existed at December 31, 2022. Effective January 1, 2023, through March 31, 2023, the significant accounting policy which we believe to be critical in preparing our consolidated financial is the determination of the allowance for credit losses.

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Management considers the policies related to the allowance for credit losses critical to the financial statement presentation. The allowance for credit losses is established through the provision for credit losses charged to current earnings. The Company’s methodologies for estimating the allowance for credit losses consider available relevant information about the collectability of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts. Refer to Note 1 – Significant Accounting Policies in the accompanying notes to the consolidated financial statements for further discussion on the methodology in establishing the allowance for credit losses.

The JOBS Act permits the Company an extended transition period for complying with new or revised accounting standards affecting public companies. The Company has elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements filed in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as the Company remains an emerging growth company or until the Company affirmatively and irrevocably opts out of the extended transition period under the JOBS Act.

Recent Developments

Shareholder Dividend

On May 11, 2023, the Board of Directors of the Company declared a quarterly cash dividend of $0.19 per common share. This dividend was paid on July 14, 2023, to stockholders of record at the close of business on June 15, 2023.

Operating Results Overview

The following table summarizes key financial results as of and for the periods indicated:

Three months ended

Six months ended

June 30, 

March 31, 

June 30, 

June 30, 

June 30, 

(dollars and shares in thousands, except per share data)

    

2023

    

2023

    

2022

    

2023

    

2022

    

Performance Ratios

 

 

 

 

 

Return on average total assets

 

0.96

%  

 

0.88

%  

 

1.14

%  

 

0.92

%  

 

1.20

%  

Return on average common equity

 

10.14

%  

 

9.17

%  

 

11.93

%  

 

9.66

%  

 

11.85

%  

Return on average tangible common equity (1)

 

13.71

%  

 

12.58

%  

 

15.25

%  

 

13.15

%  

 

14.97

%  

Noninterest income as a % of revenue

 

53.69

%  

 

51.63

%  

 

56.20

%  

 

52.65

%  

 

56.91

%  

Net interest margin (taxable-equivalent basis)

 

2.52

%  

 

2.70

%  

 

2.98

%  

 

2.61

%  

 

2.91

%  

Efficiency ratio (1)

 

72.79

%  

 

74.53

%  

 

74.72

%  

 

73.67

%  

 

73.50

%  

Average equity to average assets

 

9.52

%  

 

9.54

%  

 

9.59

%  

9.53

%  

10.13

%  

Net charge-offs/(recoveries) to average loans

(0.07)

%  

 

0.03

%  

 

0.07

%  

 

(0.02)

%  

 

0.02

%  

Dividend payout ratio

 

42.22

%  

45.00

%  

34.62

%  

43.53

%  

30.91

%  

Per Common Share

 

 

 

 

 

Earnings per common share - basic

$

0.45

$

0.41

$

0.53

$

0.86

$

1.11

Earnings per common share - diluted

$

0.45

$

0.40

$

0.52

$

0.85

$

1.10

Dividends declared per common share

$

0.19

$

0.18

$

0.18

$

0.37

$

0.34

Book value per common share

$

17.96

$

17.90

$

17.75

Tangible book value per common share (1)

$

14.60

$

14.50

$

14.93

Average common shares outstanding - basic

 

20,033

 

20,028

 

17,297

 

20,030

 

17,271

Average common shares outstanding - diluted

 

20,241

 

20,246

 

17,532

 

20,243

 

17,517

Other Data

 

 

 

 

Retirement and benefit services assets under administration/management

$

35,052,652

$

33,404,342

$

31,749,157

Wealth management assets under administration/management

$

3,857,710

$

3,675,684

$

4,147,763

Mortgage originations

$

111,261

$

77,728

$

269,397

$

188,989

$

456,159

(1)Represents a non-GAAP financial measure. See “Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures.”

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Table of Contents

Selected Financial Data

The following tables summarize selected financial data as of and for the periods indicated:

Three months ended

Six months ended

June 30, 

March 31, 

June 30, 

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2023

    

2022

    

2023

    

2022

Selected Average Balance Sheet Data

 

 

 

 

 

Loans

$

2,482,413

$

2,457,154

$

1,838,631

$

2,469,853

$

1,803,623

Investment securities

 

1,007,792

 

1,034,288

 

1,164,625

 

1,020,967

 

1,190,298

Assets

 

3,785,487

 

3,791,536

 

3,258,655

 

3,788,494

 

3,272,654

Deposits

 

2,940,216

 

2,933,022

 

2,740,417

 

2,936,638

 

2,778,411

Fed funds purchased

 

360,033

 

290,187

 

81,506

 

325,303

 

40,978

Short-term borrowings

80,000

9,615

39,779

4,834

Long-term debt

 

58,886

 

58,858

 

58,876

 

58,872

 

58,892

Stockholders’ equity

 

360,216

 

361,857

 

312,515

 

361,032

 

331,425

June 30, 

March 31, 

December 31, 

June 30, 

(dollars in thousands)

    

2023

    

2023

    

2022

    

2022

Selected Period End Balance Sheet Data

Loans

$

2,533,522

$

2,486,625

$

2,443,994

$

1,890,243

Allowance for credit losses on loans

 

(35,696)

 

(35,102)

 

(31,146)

 

(31,373)

Investment securities

 

985,870

 

1,019,473

 

1,039,226

 

1,130,538

Assets

 

3,832,978

 

3,886,773

 

3,779,637

 

3,295,065

Deposits

 

2,852,855

 

3,031,978

 

2,915,484

 

2,619,550

Long-term debt

 

58,900

 

58,872

 

58,843

 

58,870

Total stockholders’ equity

 

357,685

 

359,118

 

356,872

 

307,158

Three months ended

Six months ended

June 30, 

March 31, 

June 30, 

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2023

    

2022

    

2023

    

2022

Selected Income Statement Data

Net interest income

$

22,234

$

23,658

$

22,776

$

45,892

$

44,449

Provision for credit losses

 

 

550

 

 

550

 

Noninterest income

 

25,778

 

25,253

 

29,226

 

51,031

 

58,696

Noninterest expense

 

36,373

 

37,869

 

39,984

 

74,242

 

78,055

Income before income taxes

 

11,639

 

10,492

 

12,018

 

22,131

 

25,090

Income tax expense

 

2,535

 

2,306

 

2,725

 

4,841

 

5,613

Net income

$

9,104

$

8,186

$

9,293

$

17,290

$

19,477

Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures

In addition to the results presented in accordance with GAAP, we routinely supplement our evaluation with an analysis of certain non-GAAP financial measures. These non-GAAP financial measures include the ratio of tangible common equity to tangible assets, tangible book value per common share, return on average tangible common equity, net interest margin (tax-equivalent), and the efficiency ratio, as adjusted. Management uses these non-GAAP financial measures in its analysis of its performance, and believes financial analysts and others frequently use these measures, and other similar measures, to evaluate capital adequacy. Management calculates: (i) tangible common equity as total common stockholders' equity less goodwill and other intangible assets; (ii) tangible book value per common share as tangible common equity divided by shares of common stock outstanding; (iii) tangible assets as total assets, less goodwill and other intangible assets; (iv) return on average tangible common equity as net income adjusted for intangible amortization net of tax, divided by average tangible common equity; and (v) efficiency ratio, as adjusted, as noninterest expense less intangible amortization expense, divided by net interest income plus noninterest income plus a tax-equivalent adjustment.

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Table of Contents

The following tables present these non-GAAP financial measures along with the most directly comparable financial measures calculated in accordance with GAAP as of and for the periods indicated:

    

June 30, 

March 31, 

December 31, 

June 30, 

(dollars and shares in thousands, except per share data)

    

2023

    

2023

    

2022

    

2022

    

Tangible common equity to tangible assets

 

  

 

Total common stockholders’ equity

$

357,685

$

359,118

$

356,872

$

307,158

Less: Goodwill

 

47,087

 

47,087

 

47,087

 

31,337

Less: Other intangible assets

 

19,806

 

21,131

 

22,455

 

17,511

Tangible common equity (a)

 

290,792

 

290,900

 

287,330

 

258,310

Total assets

 

3,832,978

 

3,886,773

 

3,779,637

 

3,295,065

Less: Goodwill

 

47,087

 

47,087

 

47,087

 

31,337

Less: Other intangible assets

 

19,806

 

21,131

 

22,455

 

17,511

Tangible assets (b)

 

3,766,085

 

3,818,555

 

3,710,095

 

3,246,217

Tangible common equity to tangible assets (a)/(b)

 

7.72

%  

 

7.62

%  

 

7.74

%  

 

7.96

%  

Tangible book value per common share

Total common stockholders’ equity

$

357,685

$

359,118

$

356,872

$

307,158

Less: Goodwill

47,087

47,087

47,087

31,337

Less: Other intangible assets

19,806

21,131

22,455

17,511

Tangible common equity (c)

290,792

290,900

287,330

258,310

Total common shares issued and outstanding (d)

19,915

20,067

 

19,992

 

17,306

Tangible book value per common share (c)/(d)

$

14.60

$

14.50

$

14.37

$

14.93

Three months ended

Six months ended

June 30, 

March 31, 

June 30, 

June 30, 

June 30, 

(dollars and shares in thousands, except per share data)

    

2023

    

2023

    

2022

    

2023

    

2022

    

Return on average tangible common equity

Net income

$

9,104

$

8,186

$

9,293

$

17,290

$

19,477

Add: Intangible amortization expense (net of tax)

 

1,046

 

1,046

 

832

 

2,092

 

1,664

Net income, excluding intangible amortization (e)

 

10,150

 

9,232

 

10,125

 

19,382

 

21,141

Average total equity

 

360,216

 

361,857

 

312,515

 

361,032

 

331,425

Less: Average goodwill

 

47,087

 

47,087

 

31,488

 

47,087

 

31,489

Less: Average other intangible assets (net of tax)

 

16,153

 

17,208

 

14,737

 

16,678

 

15,151

Average tangible common equity (f)

 

296,976

 

297,562

 

266,290

 

297,267

 

284,785

Return on average tangible common equity (e)/(f)

 

13.71

%  

 

12.58

%  

 

15.25

%  

 

13.15

%  

 

14.97

%  

Efficiency ratio

 

 

 

 

 

Noninterest expense

$

36,373

$

37,869

$

39,984

$

74,242

$

78,055

Less: Intangible amortization expense

 

1,324

 

1,324

 

1,053

 

2,648

 

2,106

Adjusted noninterest expense (g)

 

35,049

 

36,545

 

38,931

 

71,594

 

75,949

Net interest income

 

22,234

 

23,658

 

22,776

 

45,892

 

44,449

Noninterest income

 

25,778

 

25,253

 

29,226

 

51,031

 

58,696

Tax-equivalent adjustment

 

140

 

124

 

100

 

264

 

194

Total tax-equivalent revenue (h)

 

48,152

 

49,035

 

52,102

 

97,187

 

103,339

Efficiency ratio (g)/(h)

 

72.79

%  

 

74.53

%  

 

74.72

%  

 

73.67

%  

 

73.50

%  

Discussion and Analysis of Results of Operations

Net Income

Net income for the three months ended June 30, 2023 was $9.1 million, or $0.45 per diluted common share a $189 thousand or 2%, decrease compared to $9.3 million, or $0.52 per diluted common share for the three months ended June 30, 2022. Earnings for the second quarter of 2023 compared to the second quarter of 2022 decreased primarily due to a $3.4 million decrease in noninterest income and a $0.5 million decrease in net interest income. These negative results were partially offset by a $3.6 million decrease in noninterest expense.

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Table of Contents

Net income for the six months ended June 30, 2023, was $17.3 million, or $0.85 per diluted common share, a $2.2 million, or 11.2%, decrease compared to $19.5 million, or $1.10 per diluted common share, for the six months ended June 30, 2022. Earnings for the six months ended June 30, 2023 compared to the six months ended June 30, 2022 decreased primarily due to a $7.7 million decrease in noninterest income and a $0.6 million increase in provision for credit losses. These negative results were partially offset by a $1.4 million increase in net interest income and a $3.8 million decrease in noninterest expense.

Net Interest Income

Net interest income is the difference between interest income and yield-related fees earned on assets and interest expense paid on liabilities. Net interest margin is the difference between the yield on interest earning assets and the cost of interest-bearing liabilities as a percentage of interest earning assets. Net interest margin is presented on a tax-equivalent basis, which means that tax-free interest income has been adjusted to a pre-tax-equivalent income, assuming a federal income tax rate of 21% for the three and six months ended June 30, 2023 and 2022.

Net interest income for the three months ended June 30, 2023, was $22.2 million, a decrease of $542 thousand, or 2.4%, compared to $22.8 million for the three months ended June 30, 2022. Net interest income for the second quarter of 2023 decreased compared to the second quarter of 2022 primarily due to the increasing cost of interest-bearing liabilities as interest expense increased $16.5 million mainly driven by an increase of 246 basis points in the average rate paid on interest-bearing liabilities. In addition the average balance of interest-bearing liabilities increased $503.1 million. This was partially offset by a $16.0 million increase in interest income, as interest earning assets increased $490.3 million while the interest earning asset yield increased 135 basis points. The increase in interest earning assets was due to a combination of organic growth and the acquisition of Metro Phoenix Bank. The increase in interest-bearing liabilities was due to the acquisition of Metro Phoenix Bank and a decrease in noninterest-bearing liabilities.

Net interest income for the six months ended June 30, 2023, was $45.9 million, an increase of $1.4 million, or 3.2%, compared to the $44.4 million for the six months ended June 30, 2022. Net interest income for the six months ended June 30, 2023 increased compared to the six months ended June 30, 2022 primarily due to a 133 basis point increase in the earning asset yield in addition to an increase of $468.3 million in the average balance of interest earning assets. This was partially offset by an increase of 221 basis points in the average rate paid on interest-bearing liabilities. The average balance in interest-bearing liabilities increased $515.8 million. The increase in interest earning assets was due to a combination of organic growth and the acquisition of Metro Phoenix Bank. The increase in interest-bearing liabilities was due to the acquisition of Metro Phoenix Bank and a decrease in noninterest-bearing liabilities.

Net interest margin (on a FTE basis) for the three months ended June 30, 2023, was 2.52%, compared to 2.98% for the same period in 2022.

Net interest margin (on a FTE basis) for the six months ended June 30, 2023, was 2.61%, compared to 2.91% for the same period in 2022.

As a result of the recent and expected increases in the target federal funds interest rate, we anticipate that our net interest income and net interest margin (on a FTE basis) will remain under pressure in future periods.

50

Table of Contents

The following table presents average balance sheet information, interest income, interest expense and the corresponding average yields on assets, average yields earned, and rates paid for the three and six months ended June 30, 2023 and 2022. We derived these yields and rates by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. Average loan balances include loans that have been placed on nonaccrual, while interest previously accrued on these loans is reversed against interest income. In these tables, adjustments are made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis.

Three months ended June 30, 

2023

2022

Interest

Average

Interest

Average

Average

Income/

Yield/

Average

Income/

Yield/

(dollars in thousands)

    

Balance

    

Expense

    

Rate

    

Balance

    

Expense

    

Rate

    

Interest Earning Assets

Interest-bearing deposits with banks

$

36,418

$

363

 

4.00

%  

$

28,920

$

28

 

0.39

%  

Investment securities (1)

 

1,007,792

 

6,360

 

2.53

%  

 

1,164,625

 

6,338

 

2.18

%  

Loans held for sale

 

14,536

 

189

 

5.22

%  

 

31,878

 

250

 

3.15

%  

Loans

 

  

 

  

 

  

 

  

 

  

 

  

Commercial:

 

  

 

 

  

 

  

 

 

  

Commercial and industrial

 

545,357

 

9,386

 

6.90

%  

 

463,215

 

5,053

 

4.38

%  

Real estate construction

 

87,905

 

1,629

 

7.43

%  

 

44,627

 

449

 

4.04

%  

Commercial real estate

 

956,828

 

12,138

 

5.09

%  

 

601,765

 

5,701

 

3.80

%  

Total commercial

 

1,590,090

 

23,153

 

5.84

%  

 

1,109,607

 

11,203

 

4.05

%  

Consumer

 

  

 

  

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

698,288

 

6,548

 

3.76

%  

 

543,023

 

4,458

 

3.29

%  

Residential real estate junior lien

 

156,276

 

2,900

 

7.44

%  

 

132,082

 

1,528

 

4.64

%  

Other revolving and installment

 

37,759

 

568

 

6.03

%  

 

53,919

 

592

 

4.40

%  

Total consumer

 

892,323

 

10,016

 

4.50

%  

 

729,024

 

6,578

 

3.62

%  

Total loans (1)

 

2,482,413

 

33,169

 

5.36

%  

 

1,838,631

 

17,781

 

3.88

%  

Federal Reserve/FHLB Stock

 

23,724

 

399

 

6.75

%  

 

10,564

 

129

 

4.90

%  

Total interest earning assets

 

3,564,883

40,480

 

4.55

%  

 

3,074,618

 

24,526

 

3.20

%  

Noninterest earning assets

220,604

184,037

Total assets

$

3,785,487

  

 

  

$

3,258,655

 

  

 

  

Interest-Bearing Liabilities

 

  

 

  

 

  

 

  

 

  

 

  

Interest-bearing demand deposits

$

775,818

$

2,431

 

1.26

%  

$

703,365

$

212

 

0.12

%  

Money market and savings deposits

 

1,145,335

 

8,033

 

2.81

%  

 

1,041,898

 

373

 

0.14

%  

Time deposits

 

270,121

 

2,214

 

3.29

%  

 

211,787

 

228

 

0.43

%  

Fed funds purchased

 

360,033

 

4,763

 

5.31

%  

 

81,506

 

240

 

1.18

%  

Short-term borrowings

 

 

%  

 

9,615

 

38

 

1.59

%  

Long-term debt

 

58,886

 

665

 

4.53

%  

 

58,876

 

559

 

3.81

%  

Total interest-bearing liabilities

 

2,610,193

 

18,106

 

2.78

%  

 

2,107,047

 

1,650

 

0.31

%  

Noninterest-Bearing Liabilities and Stockholders' Equity

 

 

  

 

 

  

 

  

Noninterest-bearing deposits

 

748,942

 

  

 

783,367

 

  

 

  

Other noninterest-bearing liabilities

 

66,136

 

  

 

55,726

 

  

 

  

Stockholders’ equity

 

360,216

 

  

 

312,515

 

  

 

  

Total liabilities and stockholders’ equity

$

3,785,487

 

  

$

3,258,655

 

  

 

  

Net interest income

$

22,374

 

  

 

  

$

22,876

 

  

Net interest rate spread

 

 

1.77

%  

 

  

 

  

 

2.89

%  

Net interest margin on FTE basis (1)

 

 

2.52

%  

 

  

 

  

 

2.98

%  

(1)Taxable equivalent adjustment was calculated utilizing a marginal income tax rate of 21.0 percent.

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Six months ended June 30, 

2023

2022

   

   

Interest

   

Average

   

   

Interest

   

Average

Average

Income/

Yield/

Average

Income/

Yield/

(dollars in thousands)

Balance

Expense

Rate

Balance

Expense

Rate

Interest Earning Assets

 

  

 

  

 

  

 

  

 

  

 

  

 

Interest-bearing deposits with banks

$

39,167

$

697

3.59

%

$

67,111

$

74

0.22

%

Investment securities (1)

 

1,020,967

 

12,552

2.48

%

 

1,190,298

 

12,051

2.04

%

Loans held for sale

 

12,452

 

316

5.12

%

 

28,287

 

407

2.90

%

Loans

 

  

 

  

  

 

  

 

  

  

Commercial:

 

  

 

  

 

  

 

  

Commercial and industrial

 

552,348

 

17,779

6.49

%

 

449,014

 

10,068

4.52

%

Real estate construction

 

95,460

 

3,297

6.96

%

 

42,893

 

844

3.97

%

Commercial real estate

 

934,356

 

23,265

5.02

%

 

601,397

 

11,100

3.72

%

Total commercial

 

1,582,164

 

44,341

5.65

%

 

1,093,304

 

22,012

4.06

%

Consumer

 

  

 

  

  

 

  

 

  

  

Residential real estate first mortgage

 

693,547

 

12,935

3.76

%

 

528,952

 

8,891

3.39

%

Residential real estate junior lien

 

153,016

 

5,561

7.33

%

 

129,056

 

2,910

4.55

%

Other revolving and installment

 

41,126

 

1,211

5.94

%

 

52,311

 

1,140

4.39

%

Total consumer

 

887,689

 

19,707

4.48

%

 

710,319

 

12,941

3.67

%

Total loans (1)

 

2,469,853

 

64,048

5.23

%

 

1,803,623

 

34,953

3.91

%

Federal Reserve/FHLB Stock

 

23,697

 

801

6.82

%

 

8,536

 

199

4.70

%

Total interest earning assets

 

3,566,136

 

78,414

4.43

%

 

3,097,855

 

47,684

3.10

%

Noninterest earning assets

222,358

174,799

Total assets

$

3,788,494

 

  

  

$

3,272,654

 

  

  

Interest-Bearing Liabilities

 

  

 

  

  

 

  

 

  

  

Interest-bearing demand deposits

$

761,319

$

4,025

1.07

%

$

708,888

$

426

0.12

%

Money market and savings deposits

 

1,155,247

 

14,265

2.49

%

 

1,042,660

 

741

0.14

%

Time deposits

 

251,145

 

3,492

2.80

%

 

219,592

 

475

0.44

%

Fed funds purchased

 

325,303

 

8,231

5.10

%

 

40,978

 

240

1.18

%

Short-term borrowings

39,779

 

926

4.69

%

 

4,834

 

38

1.59

%

Long-term debt

 

58,872

 

1,318

4.51

%

 

58,892

 

1,121

3.84

%

Total interest-bearing liabilities 

 

2,591,665

 

32,257

2.51

%

 

2,075,844

 

3,041

0.30

%

Noninterest-Bearing Liabilities and Stockholders' Equity

 

 

  

  

 

 

  

  

Noninterest-bearing deposits

768,927

 

  

  

 

807,271

Other noninterest-bearing liabilities

 

66,870

 

  

  

 

58,114

 

  

  

Stockholders’ equity

 

361,032

 

  

  

 

331,425

 

  

  

Total liabilities and stockholders’ equity

$

3,788,494

 

  

  

$

3,272,654

 

  

  

Net interest income

 

  

$

46,157

  

 

  

$

44,643

  

Net interest rate spread

 

  

 

  

1.92

%

 

  

 

  

2.80

%

Net interest margin on FTE basis (1)

 

  

 

  

2.61

%

 

  

 

  

2.91

%

(1)Taxable equivalent adjustment was calculated utilizing a marginal income tax rate of 21.0 percent.

Interest Rates and Operating Interest Differential

Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest earning assets and interest-bearing liabilities, as well as changes in average interest rates. The following table shows the effect that these factors had on the interest earned on our interest earning assets and the interest incurred on our interest-bearing liabilities. The effect of changes in volume is determined by multiplying the

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change in volume by the previous period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume.

Three Months Ended June 30, 2023

Six months ended June 30, 2023

Compared with

Compared with

Three Months Ended June 30, 2022

Six months ended June 30, 2022

Change due to:

Interest

Change due to:

Interest

(tax-equivalent basis, dollars in thousands)

    

Volume

    

Rate

    

Variance

    

Volume

    

Rate

    

Variance

Interest earning assets

 

  

 

  

 

  

Interest-bearing deposits with banks

$

7

$

328

$

335

$

(30)

$

653

$

623

Investment securities

 

(852)

 

874

 

22

 

(1,713)

 

2,214

 

501

Loans held for sale

 

(136)

 

75

 

(61)

 

(228)

 

137

 

(91)

Loans

 

  

 

  

 

  

 

  

 

  

 

  

Commercial:

 

  

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

 

897

 

3,436

 

4,333

 

2,316

 

5,395

 

7,711

Real estate construction

 

436

 

744

 

1,180

 

1,035

 

1,418

 

2,453

Commercial real estate

 

3,364

 

3,073

 

6,437

 

6,142

 

6,023

 

12,165

Total commercial

 

4,697

 

7,253

 

11,950

 

9,493

 

12,836

 

22,329

Consumer

 

 

  

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

1,274

 

816

 

2,090

 

2,767

 

1,277

 

4,044

Residential real estate junior lien

 

280

 

1,092

 

1,372

 

541

 

2,110

 

2,651

Other revolving and installment

 

(177)

 

153

 

(24)

 

(243)

 

314

 

71

Total consumer

 

1,377

 

2,061

 

3,438

 

3,065

 

3,701

 

6,766

Total loans

 

6,074

 

9,314

 

15,388

 

12,558

 

16,537

 

29,095

Federal Reserve/FHLB Stock

 

161

 

109

 

270

 

353

 

249

 

602

Total interest income

 

5,254

 

10,700

 

15,954

 

10,940

 

19,790

 

30,730

Interest-bearing liabilities

 

  

 

  

 

  

 

  

 

  

 

  

Interest-bearing demand deposits

 

22

 

2,197

 

2,219

 

31

 

3,568

 

3,599

Money market and savings deposits

 

36

 

7,624

 

7,660

 

78

 

13,446

 

13,524

Time deposits

 

63

 

1,923

 

1,986

 

69

 

2,948

 

3,017

Fed funds purchased

 

819

 

3,704

 

4,523

 

1,664

 

6,327

 

7,991

Short-term borrowings

(38)

 

 

(38)

 

276

 

612

 

888

Long-term debt

 

 

106

 

106

 

 

197

 

197

Total interest expense

 

902

 

15,554

 

16,456

 

2,118

 

27,098

 

29,216

Change in net interest income

$

4,352

$

(4,854)

$

(502)

$

8,822

$

(7,308)

$

1,514

Provision for Credit Losses

The Company recorded no provision for credit loss expense for the three months ending June 30, 2023 and June 30, 2022.

The Company recorded a provision for credit loss expense of $550 thousand for the six months ended June 30, 2023, a $550 thousand increase compared to the six months ended June 30, 2022. The provision for credit loss expense for the six months ended June 30, 2023 included $269 thousand in provision for credit loss on loans, $230 thousand in provision for credit loss on unfunded commitments and $51 thousand in provision for credit loss on investment securities held-to-maturity. The CECL accounting standard requires us to recognize losses over the expected life of the loan as opposed to the losses expected to already have been incurred. The increase in provision for credit losses is primarily a result of a change in forecasting assumptions brought about by the new methodology.

Noninterest Income

Our noninterest income is generated from four primary sources: (1) retirement and benefit services; (2) wealth management; (3) mortgage banking; and (4) other general banking services.

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The following table presents our noninterest income for the three and six months ended June 30, 2023 and 2022:

Three months ended

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

    

2022

    

Retirement and benefit services

$

15,890

$

16,293

$

31,372

$

33,939

Wealth management

 

5,449

 

5,548

 

10,644

 

10,874

Mortgage banking

 

2,905

 

6,038

 

4,622

 

10,969

Service charges on deposit accounts

 

311

 

412

 

612

 

775

Other

 

1,223

 

935

 

3,781

 

2,139

Total noninterest income

$

25,778

$

29,226

$

51,031

$

58,696

Noninterest income as a % of revenue

53.69

%  

56.20

%  

52.65

%  

56.91

%  

Total noninterest income for the three months ended June 30, 2023 was $25.8 million, a $3.4 million, or 11.8%, decrease compared to $29.2 million for the three months ended June 30, 2022. The decrease in noninterest income was primarily driven by a decrease of $3.1 million in mortgage banking revenue as mortgage originations decreased $158.1 million, or 58.7%, compared to 2022, as higher interest rates dramatically impacted demand. Retirement and benefit services decreased $402 thousand mainly from the exit of the payroll services business and one time non-recurring document restatement fees.

Total noninterest income for the six months ended June 30, 2023, was $51.0 million, a $7.7 million, or 13.1%, decrease compared to $58.7 million for the six months ended June 30, 2022. The decrease in noninterest income was primarily driven by a decrease of $6.3 million in mortgage banking revenue as mortgage originations decreased $267.2 million, or 58.6%, compared to 2022 as higher interest rates dramatically impacted demand. Retirement and benefit services decreased $2.6 million mainly from the exit of the payroll services business, document restatement fees and asset based fees.

We anticipate that our noninterest income will continue to be significantly adversely affected in future periods as a result of increasing interest rates and inflationary pressure, which have begun to and will continue to adversely affect mortgage originations and mortgage banking revenue.

Noninterest income as a percentage of total operating revenue was 53.7% for the three months ended June 30, 2023, compared to 56.2% for the three months ended June 30, 2022.

Noninterest income as a percentage of total operating revenue was 52.7% for the six months ended June 30, 2023, compared to 56.9% for the six months ended June 30, 2022.

See “NOTE 15 Segment Reporting” of the consolidated financial statements for additional discussion regarding our business lines.

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Noninterest Expense

The following table presents noninterest expense for the three and six months ended June 30, 2023 and 2022:

Three months ended

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

    

2022

Compensation

$

18,847

$

21,248

$

38,005

$

40,299

Employee taxes and benefits

 

4,724

 

5,787

 

10,577

 

11,949

Occupancy and equipment expense

 

1,837

 

1,737

 

3,736

 

3,788

Business services, software and technology expense

 

5,269

 

4,785

 

10,593

 

9,709

Intangible amortization expense

 

1,324

 

1,053

 

2,648

 

2,106

Professional fees and assessments

1,530

 

2,246

 

2,682

 

3,787

Marketing and business development

648

 

814

 

1,334

 

1,414

Supplies and postage

406

 

572

 

866

 

1,218

Travel

306

 

356

 

554

 

535

Mortgage and lending expenses

215

 

482

 

712

 

1,168

Other

 

1,267

 

904

 

2,535

 

2,082

Total noninterest expense

$

36,373

$

39,984

$

74,242

$

78,055

Total noninterest expense for the three months ended June 30, 2023, was $36.4 million, a $3.6 million, or 9%, decrease compared to $40.0 million for the three months ended June 30, 2022. The year over year decrease was primarily due to a $2.4 million decrease in compensation, $1.1 million decrease in employee taxes and benefits, and $716 thousand decrease in professional fees and assessments. Compensation decreased primarily due to a decrease in mortgage related incentive compensation as a result of lower mortgage originations. The decrease in employee taxes and benefits resulted from lower group insurance claims, reduced headcount, and lower compensation costs. The number of full time equivalent employees was reduced by 65, or 8.1%, from the second quarter of 2022 after adjusting for the acquired employees from the Metro Phoenix Bank transaction.

Total noninterest expense for the six months ended June 30, 2023, was $74.2 million, a $3.8 million, or 4.9%, decrease compared to $78.1 million for the six months ended June 30, 2022. The decrease was driven by decreases of $2.3 million in compensation, $1.4 million in employee taxes and benefits, $1.1 million in professional fees and assessments, $456 thousand in mortgage lending expense, and $352 thousand in supplies and postage. The decrease in compensation expense was primarily due to a decrease in mortgage related incentive compensation as a result of lower mortgage originations, which was also the primary driver for the decrease in mortgage lending expense. The decrease in employee taxes and benefits was primarily due to lower group insurance claims driven by a reduction in headcount along with a decrease in taxes driven by lower compensation expense. The decrease in professional fees and assessments was primarily driven by lower merger and acquisition and recruitment expenses offset by an increase in FDIC assessments. The decrease in supplies and postage was driven by transitioning our retirement and benefit services fulfillment services from a mostly paper based to an electronic delivery method. These decreases were partially offset by increases of $884 thousand in business services, software and technology expense, $542 thousand in intangible amortization, and $453 thousand in other expenses. The increases in business services, software, and technology as well as intangible amortization were driven by our acquisition of Metro Phoenix Bank. The increase in other expenses was primarily due to provision of unfunded commitments and an increase in expenses incurred related to the payroll services line of business which we exited in 2022.

Income Tax Expense

Income tax expense is an estimate based on the amount we expect to owe the respective taxing authorities, plus the impact of deferred tax items. Accrued taxes represent the net estimated amount due, or to be received from, taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account statutory, judicial, and regulatory guidance in the context of our tax position. If the final resolution of taxes payable differs from our estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required.

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Table of Contents

For the three months ended June 30, 2023, we recognized income tax expense of $2.5 million on $11.6 million of pre-tax income, resulting in an effective tax rate of 21.8%, compared to income tax expense of $2.7 million on $12.0 million of pre-tax income for the three months ended June 30, 2022, resulting in an effective tax rate of 22.7%.

For the six months ended June 30, 2023, we recognized income tax expense of $4.8 million on $22.1 million of pre-tax income, resulting in an effective tax rate of 21.9%, compared to income tax expense of $5.6 million on $25.1 million of pre-tax income for the six months ended June 30, 2022, resulting in an effective tax rate of 22.3%.

Financial Condition

Overview

Total assets were $3.8 billion as of June 30, 2023, an increase of $53.3 million, or 1.4%, as compared to December 31, 2022. The increase was primarily due to a $89.5 million increase in loans, $11.4 million increase in loans held for sale and $7.2 million increase in cash and cash equivalents, offset by a decrease of $53.4 million in investment securities.

Loans

The loan portfolio represents a broad range of borrowers comprised of commercial and industrial, commercial real estate, residential real estate, and other revolving and installment loans. As of June 30, 2023, the portfolio mix was 21.8% commercial and industrial, 39.6% commercial real estate, 34.1% residential real estate and 4.5% in other categories.

The following table presents the composition of total loans outstanding by portfolio segment as of June 30, 2023 and December 31, 2022:

June 30, 2023

December 31, 2022

Percent of

Percent of

Change

(dollars in thousands)

Balance

    

Portfolio

    

Balance

    

Portfolio

    

    

Amount

    

Percent

    

Commercial

    

 

 

 

 

 

Commercial and industrial

 

$

551,860

21.8

%  

$

583,876

23.9

%  

$

(32,016)

(5.5)

%  

Real estate construction

 

78,428

3.1

%  

 

97,810

4.0

%  

 

(19,382)

(19.8)

%  

Commercial real estate

 

1,003,821

39.6

%  

 

881,670

36.0

%  

 

122,151

13.9

%  

Total commercial

 

1,634,109

64.5

%  

 

1,563,356

63.9

%  

 

70,753

4.5

%  

Consumer

 

 

 

Residential real estate first mortgage

 

707,630

27.9

%  

 

679,551

27.8

%  

 

28,079

4.1

%  

Residential real estate junior lien

 

157,231

6.2

%  

 

150,479

6.2

%  

 

6,752

4.5

%  

Other revolving and installment

 

34,552

1.4

%  

 

50,608

2.1

%  

 

(16,056)

(31.7)

%  

Total consumer

 

899,413

35.5

%  

 

880,638

36.1

%  

 

18,775

2.1

%  

Total loans

$

2,533,522

100.0

%  

$

2,443,994

100.0

%  

$

89,528

3.7

%  

Total loans outstanding were $2.5 billion as of June 30, 2023, an increase of $89.5 million, or 3.7%, from December 31, 2022. The increase was primarily driven by a $122.2 million increase in commercial real estate and a $34.8 million increase in residential real estate loans, offset by a $32.0 million decrease in commercial and industrial, a $19.4 million decrease in real estate construction and a $16.1 million decrease in other consumer revolving and installment loans.

We anticipate that loan growth will slow down in future periods for our commercial and industrial, commercial real estate, residential real estate, and consumer loan portfolios as a result of the increasing interest rate environment and competition in our market areas.

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Table of Contents

The following table presents the maturities and types of interest rates for the loan portfolio as of June 30, 2023:

June 30, 2023

After one

After five

One year

but within

but within

After

(dollars in thousands)

    

or less

    

five years

    

fifteen years

fifteen years

    

Total

Commercial

 

  

 

  

 

  

 

  

Commercial and industrial

$

140,538

$

248,600

$

161,983

$

739

$

551,860

Real estate construction

 

25,301

 

42,706

 

8,375

 

2,046

 

78,428

Commercial real estate

 

57,619

 

414,874

 

470,975

 

60,353

 

1,003,821

Total commercial

 

223,458

 

706,180

 

641,333

 

63,138

 

1,634,109

Consumer

 

  

 

  

 

  

 

 

  

Residential real estate first mortgage

 

10,094

 

28,622

 

46,078

 

622,836

 

707,630

Residential real estate junior lien

 

8,990

 

24,807

 

35,574

 

87,860

 

157,231

Other revolving and installment

 

9,120

 

22,565

 

2,867

 

 

34,552

Total consumer

 

28,204

 

75,994

 

84,519

 

710,696

 

899,413

Total loans

$

251,662

$

782,174

$

725,852

$

773,834

$

2,533,522

Loans with fixed interest rates:

  

 

  

 

  

 

  

Commercial

 

  

 

  

 

  

 

  

Commercial and industrial

$

14,520

$

213,065

$

64,592

$

740

$

292,917

Real estate construction

 

5,915

 

2,601

 

6,168

 

 

14,684

Commercial real estate

 

42,073

 

322,046

 

296,216

 

21,158

 

681,493

Total commercial

 

62,508

 

537,712

 

366,976

 

21,898

 

989,094

Consumer

 

  

 

  

 

  

 

 

  

Residential real estate first mortgage

 

6,892

 

25,171

 

38,390

 

409,946

 

480,399

Residential real estate junior lien

 

1,381

 

6,312

 

22,717

 

14,684

 

45,094

Other revolving and installment

 

3,815

 

18,759

 

2,867

 

 

25,441

Total consumer

 

12,088

 

50,242

 

63,974

 

424,630

 

550,934

Total loans with fixed interest rates

$

74,596

$

587,954

$

430,950

$

446,528

$

1,540,028

Loans with floating interest rates:

 

  

 

  

 

  

 

  

Commercial

  

 

  

 

  

 

  

Commercial and industrial

$

126,018

$

35,535

$

97,391

$

$

258,944

Real estate construction

 

19,386

 

40,105

 

2,207

 

2,046

 

63,744

Commercial real estate

 

15,546

 

92,828

 

174,759

 

39,195

 

322,328

Total commercial

 

160,950

 

168,468

 

274,357

 

41,241

 

645,016

Consumer

 

  

 

  

 

  

 

 

  

Residential real estate first mortgage

 

3,202

 

3,451

 

7,688

212,890

 

227,231

Residential real estate junior lien

 

7,609

 

18,495

 

12,857

 

73,176

 

112,137

Other revolving and installment

 

5,305

 

3,806

 

 

 

9,111

Total consumer

 

16,116

 

25,752

 

20,545

 

286,066

 

348,479

Total loans with floating interest rates

$

177,066

$

194,220

$

294,902

$

327,307

$

993,495

The expected life of our loan portfolio will differ from contractual maturities because borrowers may have the right to curtail or prepay their loans with or without penalties. Consequently, the table above includes information limited to contractual maturities of the underlying loans.

Asset Quality

Our strategy for credit risk management includes well-defined, centralized credit policies; uniform underwriting criteria; and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The strategy also emphasizes diversification on a geographic, industry, and client level; regular credit examinations; and management reviews of loans experiencing deterioration of credit quality. We strive to identify potential problem loans early, take necessary charge-offs promptly, and maintain adequate reserve levels for credit losses inherent in the portfolio. Management performs ongoing, internal reviews of any problem credits and continually assesses the adequacy of the allowance. We utilize an internal lending division, Special Credit Services, to develop and implement strategies for the management of individual nonperforming loans.

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Table of Contents

Credit Quality Indicators

Loans are assigned a risk rating and grouped into categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The risk ratings are aligned to pass and criticized categories. The criticized categories include special mention, substandard, and doubtful risk ratings. See “NOTE 4 Loans and Allowance for Credit Losses on Loans” to the consolidated financial statements for a definition of each of the risk ratings.

The table below presents criticized loans outstanding by loan portfolio segment as of June 30, 2023 and December 31, 2022:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

    

Commercial

 

  

Commercial and industrial

$

32,733

$

25,182

Real estate construction

 

262

Commercial real estate

 

6,806

8,400

Total commercial

 

39,539

33,844

Consumer

 

  

Residential real estate first mortgage

 

467

808

Residential real estate junior lien

 

357

632

Other revolving and installment

6

1

Total consumer

 

830

1,441

Total loans

$

40,369

$

35,285

Criticized loans as a percent of total loans

1.59

%

1.44

%

The following table presents information regarding nonperforming assets as of June 30, 2023 and December 31, 2022:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

    

Nonaccrual loans

 

$

2,233

 

$

3,794

 

Accruing loans 90+ days past due

 

347

 

 

Total nonperforming loans

2,580

3,794

OREO and repossessed assets

 

 

30

Total nonperforming assets

2,580

3,824

Total restructured accruing loans

151

Total nonperforming assets and restructured accruing loans

$

2,580

$

3,975

Nonperforming loans to total loans

 

0.10

%

 

0.16

%

Nonperforming assets to total assets

 

0.07

%

 

0.10

%

Allowance for credit losses on loans to nonperforming loans

 

1,384

%

 

821

%

Interest income lost on nonaccrual loans approximated $101 thousand and $107 thousand for the six months ended June 30, 2023 and 2022, respectively. There was no interest income included in net interest income related to nonaccrual loans for the six months ended June 30, 2023 and 2022.

Allowance for Credit Losses on Loans

The allowance for credit losses is a significant estimate in the Company’s Consolidated Balance Sheet, affecting both earnings and capital. Its methodology influences and is influenced by the Company’s overall credit risk management processes. The allowance for credit losses is managed in accordance with GAAP to provide an adequate reserve for expected credit losses that is reflective of management’s best estimate of what is expected to be collected. All estimates of credit losses should be based on a careful consideration of all significant factors affecting the collectability as of the evaluation date. The allowance for credit losses is established through provision for credit loss expense charged to income.

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The Company calculates the allowance for credit losses at each reporting date. The Company recognizes an allowance for the lifetime expected credit losses for the amount the Company does not expect to collect. Subsequent changes in expected credit losses are recognized immediately in earnings. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio, after consideration of risk characteristics of the loans and prevailing and anticipated economic and other conditions. A risk system, consisting of multiple grading categories for each portfolio class, is utilized as an analytical tool to assess risk and appropriate reserves. In addition to the risk system, management further evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, expected loss experience, and other relevant information from internal and external sources which management feels deserve recognition in establishing an appropriate reserve. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change.

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The following table presents, by loan type, the changes in the allowance for credit losses on loans for the periods presented:

Three months ended

Six months ended

June 30, 

June 30, 

(dollars in thousands)

    

2023

    

2022

    

2023

    

2022

    

Balance—beginning of period

$

35,102

$

31,713

$

35,003

$

31,572

Commercial loan charge-offs

 

  

 

  

 

  

 

  

Commercial and Industrial

 

(85)

 

(637)

 

(260)

 

(664)

Real estate construction

 

 

 

 

Commercial real estate

 

 

 

 

Total commercial loan charge-offs

 

(85)

 

(637)

 

(260)

 

(664)

Consumer loan charge-offs

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

 

 

 

Residential real estate junior lien

 

 

 

(77)

 

Other revolving and installment

 

(23)

 

(37)

 

(28)

 

(55)

Total consumer loan charge-offs

 

(23)

 

(37)

 

(105)

 

(55)

Total loan charge-offs

 

(108)

 

(674)

 

(365)

 

(719)

Commercial loan recoveries

 

  

 

  

 

  

 

  

Commercial and Industrial

 

438

 

90

 

494

 

216

Real estate construction

 

 

 

 

Commercial real estate

 

12

 

11

 

23

 

22

Total commercial recoveries

 

450

 

101

 

517

 

238

Consumer loan recoveries

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

 

 

2

 

Residential real estate junior lien

 

46

 

201

 

52

 

214

Other revolving and installment

 

15

 

32

 

27

 

68

Total consumer loan recoveries

 

61

 

233

 

81

 

282

Total loan recoveries

 

511

 

334

 

598

 

520

Net loan charge-offs (recoveries)

 

(403)

 

340

 

(233)

 

199

Commercial loan provision

 

  

 

  

 

  

 

  

Commercial and Industrial

 

(340)

 

1,085

 

(717)

 

1,856

Real estate construction

 

(760)

 

68

 

(318)

 

95

Commercial real estate

 

609

 

(1,123)

 

678

 

(1,564)

Total commercial loan provision

 

(491)

 

30

 

(357)

 

387

Consumer loan provision

 

  

 

  

 

  

 

  

Residential real estate first mortgage

 

(159)

 

(486)

 

50

 

(357)

Residential real estate junior lien

 

28

 

(134)

 

154

 

(42)

Other revolving and installment

 

(13)

 

(5)

 

(130)

 

140

Total consumer loan provision

 

(144)

 

(625)

 

74

 

(259)

Unallocated provision expense

 

826

 

595

 

743

 

(128)

Total provision for credit losses on loans

 

191

 

 

460

 

Balance—end of period

$

35,696

$

31,373

$

35,696

$

31,373

Total loans

$

2,533,522

$

1,890,243

$

2,533,522

$

1,890,243

Average total loans

2,482,413

1,838,631

2,469,853

1,803,623

Allowance for credit losses on loans to total loans

 

1.41

%  

 

1.66

%  

 

1.41

%  

 

1.66

%  

Net charge-offs/(recoveries) to average total loans (annualized)

 

(0.07)

%  

 

0.07

%  

 

(0.02)

%  

 

0.02

%  

Effective January 1, 2023, the Company adopted the new CECL accounting standard. The adoption of the CECL accounting standard resulted in the Company’s allowance for credit losses increasing by approximately $5.9 million relative to the allowance held as of December 31, 2022. The adoption of the CECL accounting standard resulted in an additional allowance of $3.9 million in the allowance for credit losses on loans and $1.9 million in additional allowance for credit losses on unfunded commitments. The allowance for credit losses on loans was $35.7 million as of June 30, 2023, compared to $31.1 million as of December 31, 2022. The $4.6 million increase was the result of a $3.9 million increase from the adoption of the CECL accounting standard as well as a $269 thousand provision for credit losses on loans expense. As of June 30, 2023, the allowance for credit losses on loans represented 1.41% of total loans.

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The following table summarizes the activity in the allowance for credit losses on loans for the periods indicated:

Three months ended

Six months ended

June 30, 

June 30, 

(dollars in thousands)

2023

2022

2023

    

2022

Balance—beginning of period

$

35,102

$

31,713

$

35,003

$

31,572

Net charge-offs (recoveries):

    

 

 

 

 

Commercial net charge-offs (recoveries)

 

 

 

 

Commercial and Industrial

 

(353)

547

 

(234)

448

Real estate construction

Commercial real estate

(12)

(11)

(23)

(22)

Total commercial net charge-offs (recoveries)

(365)

536

(257)

426

Consumer net charge-offs (recoveries)

Residential real estate first mortgage

(2)

Residential real estate junior lien

(46)

(201)

25

(214)

Other revolving and installment

8

5

1

(13)

Total consumer net charge-offs (recoveries)

(38)

(196)

24

(227)

Total net charge-offs (recoveries)

(403)

340

(233)

199

Provision for credit losses on loans

191

460

Balance—end of period

$

35,696

$

31,373

$

35,696

$

31,373

Net charge-offs (recoveries) to average loans

Commercial net charge-offs (recoveries) to average loans

Commercial and Industrial

(0.06)

%  

0.12

%  

(0.02)

%  

0.05

%  

Real estate construction

%  

%  

%  

%  

Commercial real estate

%  

%  

%  

%  

Total commercial net charge-offs (recoveries) to average loans

(0.06)

%  

0.12

%  

(0.02)

%  

0.05

%  

Consumer net charge-offs (recoveries) to average loans

Residential real estate first mortgage

%  

%  

%  

%  

Residential real estate junior lien

(0.01)

%  

(0.04)

%  

%  

(0.02)

%  

Other revolving and installment

%  

%  

%  

%  

Total consumer net charge-offs (recoveries) to average loans

(0.01)

%  

(0.04)

%  

%  

(0.03)

%  

Total net charge-offs (recoveries) to average loans

(0.07)

%  

0.07

%  

(0.02)

%  

0.02

%  

Allowance for credit losses on loans to total loans

1.41

%  

1.66

%  

1.41

%  

1.66

%  

Allowance for credit losses on loans to nonaccrual loans

1,599

%  

827

%  

1,599

%  

827

%  

Allowance for credit losses on loans to nonperforming loans

1,384

%  

821

%  

1,384

%  

821

%  

The following table presents the allocation of the allowance for credit losses on loans as of the dates presented:

June 30, 2023

December 31, 2022

Percentage

Percentage

Allocated

of loans to

Allocated

of loans to

(dollars in thousands)

    

Allowance

    

total loans

    

Allowance

    

total loans

Commercial and industrial

$

7,813

21.8

%

$

9,158

23.9

%

Real estate construction

 

3,646

3.1

%

 

1,446

4.0

%

Commercial real estate

 

12,965

39.6

%

 

12,688

36.0

%

Residential real estate first mortgage

 

7,901

27.9

%

 

5,769

27.8

%

Residential real estate junior lien

 

1,351

6.2

%

 

1,289

6.2

%

Other revolving and installment

 

293

1.4

%

 

528

2.1

%

Unallocated

 

1,727

%

 

268

%

Total loans

$

35,696

100.0

%

$

31,146

100.0

%

In the ordinary course of business, we enter into commitments to extend credit, including commitments under credit arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. An allowance was established for off-balance sheet credit exposures as part of the adoption of the CECL accounting standard and is measured using similar internal and external assumptions. This allowance is located in

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accrued expenses and other liabilities on the Consolidated Balance Sheets. The reserve for unfunded commitments was $5.2 million as of June 30, 2023.

Investment Securities

The composition of our investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity for normal operations while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral.

The following table presents the fair value composition of our investment securities portfolio as of June 30, 2023 and December 31, 2022:

    

June 30, 2023

    

December 31, 2022

    

Percent of

Percent of

(dollars in thousands)

    

Balance

    

Portfolio

    

Balance

    

Portfolio

    

Available-for-sale

 

U.S. Treasury and agencies

$

2,906

0.3

%  

$

3,520

0.3

%  

Mortgage backed securities

Residential agency

558,456

56.6

%  

587,679

56.6

%  

Commercial

60,909

6.2

%  

63,558

6.1

%  

Asset backed securities

28

%  

34

%  

Corporate bonds

55,155

5.6

%  

62,533

6.0

%  

Total available-for-sale investment securities

 

677,454

68.7

%  

 

717,324

69.0

%  

Held-to-maturity

Obligations of state and political agencies

 

131,016

13.3

%  

 

137,787

13.3

%  

Mortgage backed securities

Residential agency

177,618

18.0

%

184,115

17.7

%  

Total held-to-maturity investment securities

308,634

31.3

%  

321,902

31.0

%  

Total investment securities

$

986,088

100.0

%  

$

1,039,226

100.0

%  

The investment securities presented in the following table are reported at fair value and by contractual maturity as of June 30, 2023. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage backed securities and

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collateralized mortgage obligations receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax-equivalent basis.

Maturity as of June 30, 2023

 

One year or less

One to five years

Five to ten years

After ten years

 

    

Fair

    

Average

    

Fair

    

Average

    

Fair

    

Average

    

Fair

    

Average

 

(dollars in thousands)

Value

Yield

Value

Yield

Value

Yield

Value

Yield

 

Available-for-sale

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

U.S. Treasury and agencies

$

 

%  

$

420

 

4.47

%  

$

674

 

5.45

%  

$

1,812

 

5.41

%

Mortgage backed securities

 

  

 

  

 

  

 

 

  

 

  

 

  

 

  

Residential agency

 

23

 

3.10

%  

 

3,750

 

2.23

%  

 

5,761

 

2.78

%  

 

548,922

 

1.81

%

Commercial

 

 

%  

 

15,676

 

2.77

%  

 

7,686

 

2.81

%  

 

37,547

 

2.47

%

Asset backed securities

 

 

%  

 

 

%  

 

8

 

5.54

%  

 

20

 

5.22

%

Corporate bonds

 

 

%  

 

 

%  

 

55,155

 

3.83

%  

 

 

%

Total available-for-sale investment securities

23

 

3.10

%  

19,846

 

2.71

%  

69,284

 

3.67

%  

588,301

 

1.86

%

Held-to-maturity

Obligations of state and political agencies

5,946

0.60

%  

40,512

1.31

%  

58,000

2.00

%  

11,111

2.21

%

Mortgage backed securities

 

  

 

  

 

  

 

 

  

 

  

 

  

 

  

Residential agency

 

 

%  

 

 

%  

 

 

%  

 

145,141

 

2.21

%

Total held-to-maturity investment securities

5,946

0.60

%  

40,512

1.31

%  

58,000

2.00

%  

156,252

2.21

%

Total investment securities

$

5,969

0.61

%  

$

60,358

1.77

%  

$

127,284

2.93

%  

$

744,553

1.94

%

Deposits

Deposit inflows and outflows are influenced by prevailing market interest rates, competition, local and economic conditions, and fluctuations in our customers’ own liquidity needs and may also be influenced by recent developments in the financial services industry, including the large-scale deposit withdrawals over a short period of time at Silicon Valley Bank, Signature Bank, and First Republic Bank that resulted in the failure of those institutions. Total deposits were $2.9 billion as of June 30, 2023, a decrease of $62.6 million, or 2.1%, from December 31, 2022. Interest-bearing deposits increased $82.8 million while noninterest-bearing deposits decreased $145.5 million. The decrease in total deposits was due to both public unit depositor seasonality and clients using excess liquidity and paying down revolving debt. Noninterest-bearing deposits decreased from 29.5% of total deposits to 25.1% as higher yields on interest-bearing accounts and other investment alternatives, such as U.S. treasuries, attracted funds. Time deposit balances increased as higher short-term CD rates attracted both existing non-maturity deposits as well as new deposits to the Company.

The following table presents the composition of our deposit portfolio as of June 30, 2023 and December 31, 2022:

    

June 30, 2023

December 31, 2022

Percent of

Percent of

Change

(dollars in thousands)

    

Balance

    

Portfolio

    

Balance

    

Portfolio

    

Amount

    

Percent

    

Noninterest-bearing demand

$

715,534

25.1

%

$

860,987

29.5

%

$

(145,453)

(16.9)

%

Interest-bearing demand

 

753,194

26.4

%

 

706,275

24.2

%

 

46,919

6.6

%

Money market and savings

 

1,079,960

37.8

%

 

1,135,863

39.0

%

 

(55,903)

(4.9)

%

Time deposits

 

304,167

10.7

%

 

212,359

7.3

%

 

91,808

43.2

%

Total deposits

$

2,852,855

100.0

%

$

2,915,484

100.0

%

$

(62,629)

(2.1)

%

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The following table presents the average balances and rates of our deposit portfolio for the three months ended June 30, 2023 and 2022:

Three months ended June 30, 

2023

2022

Average

Average

Average

Average

(dollars in thousands)

    

Balance

    

Rate

    

Balance

    

Rate

    

Noninterest-bearing demand

$

768,927

%

$

807,271

%

Interest-bearing demand

761,319

1.26

%

708,888

0.12

%

Money market and savings

1,155,247

2.81

%

1,042,660

0.14

%

Time deposits

251,145

3.29

%

219,592

0.43

%

Total deposits

$

2,936,638

1.73

%

$

2,778,411

0.12

%

The following table presents the contractual maturity of time deposits, including certificate of deposit account registry services and IRA deposits of $250 thousand and over, that were outstanding as of June 30, 2023:

June 30, 

(dollars in thousands)

    

2023

Maturing in:

 

  

3 months or less

$

89,190

3 months to 6 months

 

3,453

6 months to 1 year

 

821

1 year or greater

 

752

Total

$

94,216

The Company’s total uninsured deposits, which are amounts of deposit accounts that exceed the FDIC insurance limit, currently $250,000, were approximately $983.6 million at June 30, 2023 These amounts were estimated based on the same methodologies used for regulatory reporting purposes.

Borrowings

Borrowings as of June 30, 2023 and December 31, 2022 were as follows:

June 30, 2023

December 31, 2022

Percent of

Percent of

(dollars in thousands)

    

Balance

    

Portfolio

    

Balance

    

Portfolio

    

Fed funds purchased

 

$

492,060

 

89.3

%

$

153,080

35.0

%

FHLB Short-term advances

%

225,000

51.6

%

Subordinated notes

50,000

9.1

%

50,000

11.4

%

Junior subordinated debentures

 

8,900

1.6

%

8,843

2.0

%

Total borrowed funds

$

550,960

100.0

%

$

436,923

100.0

%

Capital Resources

Stockholders' equity is influenced primarily by earnings, dividends, the Company's sales and repurchases of its common stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized gains or losses, net of taxes, on available-for-sale securities.

Stockholders' equity increased $813 thousand, or 0.2%, to $357.7 million as of June 30, 2023, compared to $356.9 million as of December 31, 2022 Tangible common equity to tangible assets, a non-GAAP financial measure, decreased to 7.72% as of June 30, 2023, from 7.74% as of December 31, 2022. Common equity tier 1 capital to risk weighted assets decreased to 13.30% as of June 30, 2023, from 13.39% as of December 31, 2022.

We strive to maintain an adequate capital base to support our activities in a safe and sound manner while at the same time attempting to maximize stockholder value. Capital adequacy is assessed against the risk inherent in our

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balance sheet, recognizing that unexpected loss is the common denominator of risk, and that common equity has the greatest capacity to absorb unexpected loss.

We are subject to various regulatory capital requirements both at the Company and at the Bank level. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. We have consistently maintained regulatory capital ratios at or above the well-capitalized standards.

At June 30, 2023 and December 31, 2022, we met all the capital adequacy requirements to which we were subject. The table below presents the Company’s and the Bank’s regulatory capital ratios as of June 30, 2023 and December 31, 2022:

June 30, 

December 31, 

Capital Ratios

    

2023

    

2022

    

Alerus Financial Corporation Consolidated

 

  

 

  

 

Common equity tier 1 capital to risk weighted assets

13.30

%

13.39

%

Tier 1 capital to risk weighted assets

13.60

%

13.69

%

Total capital to risk weighted assets

16.49

%

16.48

%

Tier 1 capital to average assets

11.15

%

11.25

%

Tangible common equity to tangible assets (1)

7.72

%

7.74

%

 

 

Alerus Financial, National Association

 

 

Common equity tier 1 capital to risk weighted assets

12.93

%

12.76

%

Tier 1 capital to risk weighted assets

12.93

%

12.76

%

Total capital to risk weighted assets

14.14

%

13.83

%

Tier 1 capital to average assets

10.59

%

10.48

%

(1)Represents a non-GAAP financial measure. See “Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures.”

The capital ratios for the Company and the Bank, as of June 30, 2023, as shown in the above table, were at levels above the regulatory minimums to be considered “well capitalized”. See “NOTE 18 Regulatory Matters” to the consolidated financial statements for additional information.

Off-Balance Sheet Arrangements

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be required based on management’s assessment of the customer’s creditworthiness. The fair value of these commitments is considered immaterial for disclosure purposes.

A summary of the contractual amounts of our exposure to off-balance sheet agreements as of June 30, 2023 and December 31, 2022, was as follows:

June 30, 

December 31, 

(dollars in thousands)

    

2023

    

2022

Commitments to extend credit

$

786,451

$

806,431

Standby letters of credit

 

9,784

 

13,089

Total

$

796,235

$

819,520

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Liquidity

Liquidity management is the process by which we manage the flow of funds necessary to meet our financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of our operations, and capital expenditures. Liquidity is monitored and closely managed by our asset and liability committee, or the ALCO, a group of senior officers from the finance, enterprise risk management, deposit, investment, treasury, and lending areas. It is the ALCO’s responsibility to ensure we have the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for, quickly identified, and management has plans in place to respond. The ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources.

As of June 30, 2023, we had on balance sheet liquidity of $654.4 million, compared to $778.9 million as of December 31, 2022. On balance sheet liquidity includes cash and cash equivalents, federal funds sold, unencumbered securities available-for-sale, and over collateralized securities pledging positions available-for-sale.

The Bank is a member of the FHLB, which provides short- and long-term funding to its members through advances collateralized by real estate related assets and other select collateral, most typically in the form of debt securities. Actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As of June 30, 2023, we had $492.1 million in federal funds purchased, and no short-term borrowings from the FHLB. As of June 30, 2023, we had $1.5 billion of collateral pledged to the FHLB and based on this collateral, we were eligible to borrow up to an additional $493.5 million from the FHLB. In addition, we can borrow up to $107.0 million through the unsecured lines of credit we have established with four other correspondent banks.

In addition, because the Bank is “well capitalized,” we can accept wholesale deposits up to 20.0% of total assets based on current policy limits, or $766.6 million, as of June 30, 2023. Management believed that we had adequate resources to fund all of our commitments as of June 30, 2023 and December 31, 2022.

Our primary sources of liquidity include liquid assets, as well as unencumbered securities that can be used to collateralize additional funding.

Though remote, the possibility of a funding crisis exists at all financial institutions. The economic impact of the recent rise in inflation and rising interest rates could place increased demand on our liquidity if we experience significant credit deterioration and as we meet borrowers’ needs. Accordingly, management has addressed this issue by formulating a liquidity contingency plan, which has been reviewed and approved by both the Bank’s board of directors and the ALCO. The plan addresses the actions that we would take in response to both a short-term and long-term funding crisis.

A short-term funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly short-term funding operations. Such a crisis would likely be temporary in nature and would not involve a change in credit ratings. A long-term funding crisis would most likely be the result of both external and internal factors and would most likely result in drastic credit deterioration. Management believes that both potential circumstances have been fully addressed through detailed action plans and the establishment of trigger points for monitoring such events.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates. Interest-rate risk is the risk to earnings and equity value arising from changes in market interest rates and arises in the normal course of business to the extent that there is a divergence between the amount of interest-earning assets and the amount of interest-bearing liabilities that are prepaid/withdrawn, re-price, or mature in specified periods. We seek to achieve consistent growth in net interest income and equity while managing volatility arising from shifts in market interest rates. The ALCO oversees market risk management, monitoring risk measures,

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limits, and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. The Bank’s board of directors approves policy limits with respect to interest rate risk.

Interest Rate Risk

Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective interest rate risk management begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk position given business activities, management objectives, market expectations and ALCO policy limits and guidelines.

Interest rate risk can come in a variety of forms, including repricing risk, basis risk, yield curve risk and option risk. Repricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes impact our assets and liabilities. Basis risk is the risk of adverse consequence resulting from unequal change in the spread between two or more rates for different instruments with the same maturity. Yield curve risk is the risk of adverse consequences resulting from unequal changes in the spread between two or more rates for different maturities for the same or different instruments. Option risk in financial instruments arises from embedded options such as options provided to borrowers to make unscheduled loan prepayments, options provided to debt issuers to exercise call options prior to maturity, and depositor options to make withdrawals and early redemptions.

Management regularly reviews our exposure to changes in interest rates. Among the factors considered are changes in the mix of interest-earning assets and interest-bearing liabilities, interest rate spreads and repricing periods. The ALCO reviews, on at least a quarterly basis, the interest rate risk position.

The interest-rate risk position is measured and monitored at the Bank using net interest income simulation models and economic value of equity sensitivity analysis that capture both short-term and long-term interest-rate risk exposure.

Modeling the sensitivity of net interest income and the economic value of equity to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. The models used for these measurements rely on estimates of the potential impact that changes in interest rates may have on the value and prepayment speeds on all components of our loan portfolio, investment portfolio, as well as embedded options and cash flows of other assets and liabilities. The balance sheet composition and size are assumed to remain static in the simulation modeling process. The analysis provides a framework as to what our overall sensitivity position is as of our most recent reported position and the impact that potential changes in interest rates may have on net interest income and the economic value of our equity.

Net interest income simulation involves forecasting net interest income under a variety of interest rate scenarios including instantaneous shocks.

The estimated impact on our net interest income as of June 30, 2023 and December 31, 2022, assuming immediate parallel moves in interest rates, is presented in the table below:

June 30, 2023

December 31, 2022

 

    

Following

    

Following

    

Following

    

Following

 

12 months

24 months

12 months

24 months

 

+400 basis points

 

−35.0

%  

−18.2

%  

−25.1

%  

−8.2

%

+300 basis points

 

−26.3

%  

−13.8

%  

−18.9

%  

−6.4

%

+200 basis points

 

−17.5

%  

−9.2

%  

−12.7

%  

−4.4

%

+100 basis points

 

−8.5

%  

−4.1

%  

−6.2

%  

−1.8

%

−100 basis points

 

7.7

%  

2.8

%  

5.2

%  

0.5

%

−200 basis points

 

13.3

%  

3.3

%  

7.9

%  

−1.7

%

Management strategies may impact future reporting periods, as actual results may differ from simulated results due to the timing, magnitude, and frequency of interest rate changes, the difference between actual experience, and the

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characteristics assumed, as well as changes in market conditions. Market-based prepayment speeds are factored into the analysis for loan and securities portfolios. Rate sensitivity for transactional deposit accounts is modeled based on both historical experience and external industry studies.

Management uses an economic value of equity sensitivity analysis to understand the impact of interest rate changes on long-term cash flows, income, and capital. Economic value of equity is based on discounting the cash flows for all balance sheet instruments under different interest rate scenarios. Deposit premiums are based on external industry studies and utilizing historical experience.

The table below presents the change in the economic value of equity as of June 30, 2023 and December 31, 2022, assuming immediate parallel shifts in interest rates:

June 30, 

December 31, 

 

    

2023

    

2022

 

+400 basis points

 

−27.7

%  

−19.5

%

+300 basis points

 

−21.6

%  

−15.3

%

+200 basis points

 

−14.6

%  

−10.4

%

+100 basis points

 

−6.9

%  

−4.9

%

−100 basis points

 

5.7

%  

4.0

%

−200 basis points

 

8.7

%  

5.0

%

Operational Risk

Operational risk is the risk of loss due to human behavior, inadequate or failed internal systems and controls, and external influences such as market conditions, fraudulent activities, disasters, and security risks. Management continuously strives to strengthen its system of internal controls, enterprise risk management, operating processes and employee awareness to assess the impact on earnings and capital and to improve the oversight of our operational risk.

Compliance Risk

Compliance risk represents the risk of regulatory sanctions, reputational impact or financial loss resulting from failure to comply with rules and regulations issued by the various banking agencies and standards of good banking practice. Activities which may expose us to compliance risk include, but are not limited to, those dealing with the prevention of money laundering, privacy and data protection, community reinvestment initiatives, fair lending challenges resulting from the expansion of our banking center network, employment and tax matters.

Strategic and/or Reputation Risk

Strategic and/or reputation risk represents the risk of loss due to impairment of reputation, failure to fully develop and execute business plans, failure to assess current and new opportunities in business, markets and products, and any other event not identified in the defined risk types mentioned previously. Mitigation of the various risk elements that represent strategic and/or reputation risk is achieved through initiatives to help management better understand and report on various risks, including those related to the development of new products and business initiatives.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company’s management, including our President and Chief Executive Officer, our Chief Financial Officer, and our Chief Accounting Officer have evaluated the effectiveness of our “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, or the Exchange Act), as of the end of the period covered by this report. Based on such evaluation, our President and Chief Executive Officer, our Chief Financial Officer and our Chief Accounting Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective as of that date to provide reasonable assurance that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized

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and reported within the time periods specified in the rules and forms of the SEC and that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its President and Chief Executive Officer, its Chief Financial Officer and its Chief Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II—OTHER INFORMATION

Item 1 – Legal Proceedings

There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business of the Company or its subsidiaries, to which we or any of our subsidiaries are a party or to which our property is the subject. The Company does not know of any proceeding contemplated by a governmental authority against the Company or any of its subsidiaries.

Item 1A – Risk Factors

There have been no material changes to the risk factors disclosed in the Company’s Annual Report on Form 10-K filed with the SEC on March 13, 2023.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

Unregistered Sales of Equity Securities

None.

Issuer Repurchases of Equity Securities

The following table presents information related to repurchases of shares of our common stock for each calendar month in the second quarter of 2023:

Total Number of

Maximum Number of

Total Number

Average

Shares Purchased as

Shares that May

of Shares

Price Paid

Part of Publicly

Yet be Purchased

(dollars in thousands, except per share data)

    

Purchased (1)

    

per Share

    

Announced Plans

    

Under the Plan (2)

April 1-30, 2023

 

 

$

 

 

770,000

May 1-31, 2023

 

62,513

 

 

16.13

 

62,513

 

770,000

June 1-30, 2023

 

107,533

 

 

18.09

 

107,533

 

770,000

Total

 

170,046

 

$

17.37

 

170,046

 

770,000

(1)Shares repurchased by the Company represent shares surrendered by employees to the Company to pay withholding taxes on the vesting of restricted stock awards.
(2)On February 18, 2021, the Board of Directors of the Company approved a stock repurchase program, or the Program, which authorizes the Company to repurchase up to 770,000 shares of its common stock, subject to certain limitations and conditions. The Program was effective immediately and will continue for a period of 36 months, until February 28, 2024. The Program does not obligate the Company to repurchase any shares of its common stock and there is no assurance that the Company will do so. For the three months ended June 30, 2023, the Company repurchased 170,046 shares of common stock under the Program.

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Use of Proceeds from Registered Securities

None.

Item 3 – Defaults Upon Senior Securities

None.

Item 4 – Mine Safety Disclosures

Not Applicable.

Item 5 – Other Information

During the fiscal quarter ended June 30, 2023, none of the Company’s directors or executive officers adopted or terminated any contract, instruction or written plan for the purchase or sale of Company securities that was intended to satisfy the affirmative defense conditions of Rule10b5-1(c) or any non-Rule 10b5-1 trading arrangement.

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Item 6 – Exhibits

Exhibit No.

    

Description

3.1

Third Amended and Restated Certificate of Incorporation of Alerus Financial Corporation (incorporated herein by reference to Exhibit 3.1 on Form S-1 filed on August 16, 2019).

3.2

Second Amended and Restated Bylaws of Alerus Financial Corporation (incorporated herein by reference to Exhibit 3.2 on Form S-1 filed on August 16, 2019).

31.1

Chief Executive Officers Certifications required by Rule 13(a)-14(a) – filed herewith.

31.2

Chief Financial Officers Certifications required by Rule 13(a)-14(a) – filed herewith.

32.1

Chief Executive Officer Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.

32.2

Chief Financial Officer Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.

101.INS

iXBRL Instance Document

101.SCH

iXBRL Taxonomy Extension Schema

101.CAL

iXBRL Taxonomy Extension Calculation Linkbase

101.DEF

iXBRL Taxonomy Extension Definition Linkbase

101.LAB

iXBRL Taxonomy Extension Label Linkbase

101.PRE

iXBRL Taxonomy Extension Presentation Linkbase

104

Cover Page Interactive Data File (formatted Inline XBRL and contained in Exhibits 101)

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

ALERUS FINANCIAL CORPORATION

Date: August 3, 2023

By:

/s/ Katie A. Lorenson

Name:    Katie A. Lorenson

Title:      President and Chief Executive Officer (Principal Executive Officer)

Date: August 3, 2023

By:

/s/ Alan A. Villalon

Name:    Alan A. Villalon

Title:      Executive Vice President and Chief Financial Officer (Principal Financial Officer)

72