HERITAGE FINANCIAL CORP /WA/ - Quarter Report: 2023 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 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 September 30, 2023 or

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

For the transition period from __________ to __________

Commission File Number 000-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington

91-1857900

(State or other jurisdiction of
incorporation or organization)

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

201 Fifth Avenue SW,

Olympia

98501

(Address of principal executive offices)

(Zip Code)

(360) 943-1500

(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, no par value	HFWA	NASDAQ

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 Exchange Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:

As of October 25, 2023, there were 34,901,076 shares of the registrant's common stock, no par value per share, outstanding.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

FORM 10-Q

September 30, 2023

TABLE OF CONTENTS


			Page
GLOSSARY OF ACRONYMS, ABBREVIATIONS AND TERMS			3
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS			3

PART I.	FINANCIAL INFORMATION		5
ITEM 1.	FINANCIAL STATEMENTS		5
	CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED) AS OF SEPTEMBER 30, 2023 AND DECEMBER 31, 2022		5
	CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022		6
	CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED) FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022		7
	CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED) FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022		8
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022		10
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)		12
	NOTE 1.	DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS	12
	NOTE 2.	INVESTMENT SECURITIES	13
	NOTE 3.	LOANS RECEIVABLE	16
	NOTE 4.	ALLOWANCE FOR CREDIT LOSSES ON LOANS	24

	NOTE 5.	GOODWILL AND OTHER INTANGIBLE ASSETS	27
	NOTE 6.	DERIVATIVE FINANCIAL INSTRUMENTS	27
	NOTE 7.	STOCKHOLDERS’ EQUITY	28
	NOTE 8.	FAIR VALUE MEASUREMENTS	29
	NOTE 9.	CASH RESTRICTION	33
	NOTE 10.	COMMITMENTS AND CONTINGENCIES	33

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		33
	OVERVIEW		33
	RECENT DEVELOPMENTS		34
	RESULTS OF OPERATIONS		35
		NET INTEREST INCOME AND MARGIN OVERVIEW	35
		PROVISION FOR CREDIT LOSSES OVERVIEW	39
		NONINTEREST INCOME OVERVIEW	40
		NONINTEREST EXPENSE OVERVIEW	41
		INCOME TAX EXPENSE OVERVIEW	42
	FINANCIAL CONDITION OVERVIEW		43
		INVESTMENT ACTIVITIES OVERVIEW	43
		LOAN PORTFOLIO OVERVIEW	44
		ALLOWANCE FOR CREDIT LOSSES ON LOANS OVERVIEW	46
		DEPOSITS OVERVIEW	47
		BORROWINGS OVERVIEW	47
		STOCKHOLDERS' EQUITY OVERVIEW	48
	REGULATORY REQUIREMENTS OVERVIEW		48
	LIQUIDITY AND CAPITAL RESOURCES		48
	CRITICAL ACCOUNTING ESTIMATES		49

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		49
ITEM 4.	CONTROLS AND PROCEDURES		50

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PART II.	OTHER INFORMATION	50
ITEM 1.	LEGAL PROCEEDINGS	50
ITEM 1A.	RISK FACTORS	50
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES , USE OF PROCEEDS, AND ISSUER PURCHASES OF EQUITY SECURITIES	50
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	51
ITEM 4.	MINE SAFETY DISCLOSURES	51
ITEM 5.	OTHER INFORMATION	51
ITEM 6.	EXHIBITS	51
	SIGNATURES	52

GLOSSARY OF ACRONYMS, ABBREVIATIONS, AND TERMS

The acronyms, abbreviations, and terms listed below are used in various sections of this Form 10-Q. As used throughout this report, the terms “we”, “our”, or “us” refer to Heritage Financial Corporation and its consolidated subsidiaries, unless the context otherwise requires.


2022 Annual Form 10-K			Company's Annual Report on Form 10-K for the year ended December 31, 2022
ACL			Allowance for credit losses
AOCI			Accumulated other comprehensive income (loss), net

ASU			Accounting Standards Update
Bank			Heritage Bank
BTFP			Bank Term Funding Program
CECL			Current Expected Credit Loss
CMO			Collateralized Mortgage Obligations
Company			Heritage Financial Corporation
CRE			Commercial real estate
FASB			Financial Accounting Standards Board
FDIC			Federal Deposit Insurance Corporation
Federal Reserve			Board of Governors of the Federal Reserve System
FRB			Federal Reserve Bank of San Francisco
FHLB			Federal Home Loan Bank of Des Moines
GAAP			U.S. Generally Accepted Accounting Principles
LIBOR			London Interbank Offering Rate
LIHTC			Low-Income Housing Tax Credit
MBS			Mortgage-backed securities
SBA			Small Business Administration
SEC			Securities and Exchange Commission
SM			Special Mention
SS			Substandard
TDR			Troubled debt restructured

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical fact, are based on certain assumptions and often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These statements relate to our financial condition, results of operations, beliefs, plans, objectives, goals, expectations, assumptions and statements about future performance or business. The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements whether as a result of new information, future events or otherwise. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause our actual

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results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating results and stock price performance. These risks include, but are not limited to:

•potential adverse impacts to economic conditions nationally or in our local market areas, other markets where the Company has lending relationships, or other aspects of the Company’s business operations or financial markets, including, without limitation, as a result of employment levels, labor shortages and the effects of inflation, a potential recession or slowed economic growth;

•changes in the interest rate environment, including the recent increases in the Federal Reserve benchmark rate and duration at which such increased interest rate levels are maintained, which could adversely affect our revenues and expenses, the value of assets and obligations, and the availability and cost of capital and liquidity;

•the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our ACL on loans and provision for credit losses on loans that may be affected by deterioration in the housing and CRE markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our ACL on loans no longer being adequate to cover actual losses, and require us to increase our ACL on loans;

•the impact of continuing inflation and the current and future monetary policies of the Federal Reserve in response thereto;

•changes in the levels of general interest rates, and the relative differences between short-term and long-term interest rates, deposit interest rates, our net interest margin and funding sources;

•the transition away from LIBOR toward new interest rate benchmarks;

•the impact of repricing and competitors' pricing initiatives on loan and deposit products;

•fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas;

•secondary market conditions for loans and our ability to sell loans in the secondary market;

•results of examinations of us by the bank regulators, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our ACL on loans, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings;

•legislative or regulatory changes that adversely affect our business, including changes in banking, securities, and tax law, regulatory policies and principles, or the interpretation of regulatory capital or other rules;

•our ability to attract and retain deposits;

•liquidity issues, including our ability to borrow funds or raise additional capital, if necessary;

•our ability to control operating costs and expenses;

•effects of critical accounting policies and judgments, including the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;

•the effectiveness of our risk management framework;

•difficulties in reducing risk associated with our loans;

•staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;

•disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions;

•our ability to retain key members of our senior management team;

•costs and effects of litigation, including settlements and judgments;

•our ability to implement our business strategies and manage our growth;

•future goodwill impairment due to changes in our business, market conditions, or other factors;

•our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected;

•risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar;

•increased competitive pressures among financial service companies;

•changes in consumer spending, borrowing and savings habits;

•the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions;

•our ability to pay dividends on our common stock;

•the quality and composition of our securities portfolio and the impact of any adverse changes in the securities markets, including market liquidity;

•inability of key third-party providers to perform their obligations to us;

•changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the FASB, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods;

•the impact of bank failures or adverse developments at other banks and the related negative press about the banking industry in general on investor and depositor sentiment;

•the effects of climate change, severe weather events, natural disasters, pandemics, epidemics and other public health crises, acts of war or terrorism, and other external events on our business;

•other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services; and

•other risks detailed from time to time in our reports filed with or furnished to the SEC, including our 2022 Annual Form 10-K which are available on our website at www.hf-wa.com and on the SEC's website at www.sec.gov.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)

(Dollars in thousands, except shares)


	September 30, 2023		December 31 2022
ASSETS
Cash on hand and in banks	$	61,568	$	74,295
Interest earning deposits	158,935		29,295
Cash and cash equivalents	220,503		103,590
Investment securities available for sale, at fair value, net (amortized cost of $1,292,500 and $1,460,033, respectively)	1,147,547		1,331,443
Investment securities held to maturity, at amortized cost, net (fair value of $636,257 and $673,434, respectively)	746,845		766,396
Total investment securities	1,894,392		2,097,839
Loans held for sale	263		—
Loans receivable	4,266,858		4,050,858
Allowance for credit losses on loans	(46,947)		(42,986)
Loans receivable, net	4,219,911		4,007,872

Premises and equipment, net	76,436		76,930
Federal Home Loan Bank stock, at cost	8,373		8,916
Bank owned life insurance	123,639		122,059
Accrued interest receivable	18,794		18,547
Prepaid expenses and other assets	341,952		296,181
Other intangible assets, net	5,386		7,227
Goodwill	240,939		240,939
Total assets	$	7,150,588	$	6,980,100
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	5,635,187	$	5,907,420
Deposits held for sale	—		17,420
Total deposits	5,635,187		5,924,840
Borrowings	450,000		—
Junior subordinated debentures	21,692		21,473
Securities sold under agreement to repurchase	23,158		46,597
Accrued expenses and other liabilities	207,005		189,297
Total liabilities	6,337,042		6,182,207
Commitments and contingencies (Note 10)
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding, respectively	—		—
Common stock, no par value, 50,000,000 shares authorized; 34,901,076 and 35,106,697 shares issued and outstanding, respectively	548,652		552,397
Retained earnings	377,522		345,346
Accumulated other comprehensive loss, net	(112,628)		(99,850)
Total stockholders’ equity	813,546		797,893
Total liabilities and stockholders’ equity	$	7,150,588	$	6,980,100

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Dollars in thousands, except shares and per share amounts)



	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022
INTEREST INCOME:
Interest and fees on loans	$	56,119	$	43,847	$	160,192	$	125,762
Taxable interest on investment securities	14,590		12,362		44,021		25,972
Nontaxable interest on investment securities	448		892		1,554		2,645
Interest on interest earning deposits	2,310		4,009		4,436		7,057
Total interest income	73,467		61,110		210,203		161,436
INTEREST EXPENSE:
Deposits	11,877		1,478		25,012		4,315
Junior subordinated debentures	540		312		1,521		745
Securities sold under agreement to repurchase	38		34		148		98
Borrowings	5,394		—		12,238		—
Total interest expense	17,849		1,824		38,919		5,158
Net interest income	55,618		59,286		171,284		156,278
(Reversal of) provision for credit losses	(878)		1,945		2,856		(2,836)
Net interest income after (reversal of) provision for credit losses	56,496		57,341		168,428		159,114
NONINTEREST INCOME:
Service charges and other fees	2,856		2,688		8,162		7,739
Card revenue	2,273		2,365		6,396		6,774
Loss on sale of investment securities, net	(1,940)		—		(2,226)		—
Gain on sale of loans, net	157		133		307		593
Interest rate swap fees	62		78		230		383
Bank owned life insurance income	734		723		2,280		3,182
Gain on sale of other assets, net	—		265		2		469
Other income	2,129		1,201		6,659		3,867
Total noninterest income	6,271		7,453		21,810		23,007
NONINTEREST EXPENSE:
Compensation and employee benefits	25,008		24,206		75,325		67,236
Occupancy and equipment	4,814		4,422		14,372		12,924
Data processing	4,366		4,185		13,208		12,431
Marketing	389		358		1,232		968
Professional services	582		639		1,961		1,867
State/municipal business and use taxes	1,088		963		3,150		2,626
Federal deposit insurance premium	818		500		2,465		1,525

Amortization of intangible assets	595		671		1,841		2,079
Other expense	3,310		3,203		10,346		8,918
Total noninterest expense	40,970		39,147		123,900		110,574
Income before income taxes	21,797		25,647		66,338		71,547
Income tax expense	3,578		4,657		10,816		12,216
Net income	$	18,219	$	20,990	$	55,522	$	59,331
Basic earnings per share	$	0.52	$	0.60	$	1.58	$	1.69
Diluted earnings per share	$	0.51	$	0.59	$	1.57	$	1.67
Dividends declared per share	$	0.22	$	0.21	$	0.66	$	0.63
Average number of basic shares outstanding	35,022,676		35,103,984		35,062,760		35,103,048
Average number of diluted shares outstanding	35,115,165		35,468,890		35,305,456		35,438,672

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)

(Dollars in thousands thousands)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022
Net Income	$	18,219	$	20,990	$	55,522	$	59,331
Change in fair value of investment securities available for sale, net of tax of $(4,673), $(12,027), $(4,258) and $(31,778), respectively	(16,627)		(43,143)		(14,332)		(114,022)
Amortization of net unrealized gain for the reclassification of investment securities available for sale to held to maturity, net of tax of $(17), $(20), $(51) and $(103), respectively	(60)		(75)		(183)		(375)
Reclassification adjustment for net loss from sale of investment securities available for sale included in income, net of tax of $426, $0, $489 and $0, respectively	1,514		—		1,737		—
Other comprehensive loss	(15,173)		(43,218)		(12,778)		(114,397)
Comprehensive income (loss)	$	3,046	$	(22,228)	$	42,744	$	(55,066)

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)

(Dollars in thousands, except shares and per share amounts)


	Three Months Ended September 30, 2023
	Number of common shares	Common stock		Retained earnings		AOCI		Total stockholders’ equity
Balance at June 30, 2023	35,047,800	$	550,103	$	367,085	$	(97,455)	$	819,733

Restricted stock units vested	1,730
Stock-based compensation expense		1,120						1,120
Common stock repurchased	(148,454)	(2,571)						(2,571)
Net income				18,219				18,219
Other comprehensive loss, net of tax						(15,173)		(15,173)

Cash dividends declared on common stock ($0.22 per share)				(7,782)				(7,782)
Balance at September 30, 2023	34,901,076	$	548,652	$	377,522	$	(112,628)	$	813,546


	Nine Months Ended September 30, 2023
	Number of common shares	Common stock		Retained earnings		AOCI		Total stockholders’ equity
Balance at December 31, 2022	35,106,697	$	552,397	$	345,346	$	(99,850)	$	797,893

Restricted stock units vested	156,370
Stock-based compensation expense	—	3,204						3,204
Common stock repurchased	(361,991)	(6,949)						(6,949)
Net income				55,522				55,522
Other comprehensive loss, net of tax						(12,778)		(12,778)

Cash dividends declared on common stock (0.66 per share)				(23,346)				(23,346)
Balance at September 30, 2023	34,901,076	$	548,652	$	377,522	$	(112,628)	$	813,546


	Three Months Ended September 30, 2022
	Number of common shares	Common stock		Retained earnings		AOCI		Total stockholders’ equity
Balance at June 30, 2022	35,103,929	$	550,417	$	316,732	$	(61,783)	$	805,366

Restricted stock units vested	419
Stock-based compensation expense	—	1,004						1,004
Common stock repurchased	(100)	(2)						(2)
Net income				20,990				20,990
Other comprehensive loss, net of tax						(43,218)		(43,218)

Cash dividends declared on common stock ($0.21 per share)				(7,438)				(7,438)
Balance at September 30, 2022	35,104,248	$	551,419	$	330,284	$	(105,001)	$	776,702

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	Nine Months Ended September 30, 2022
	Number of common shares	Common stock		Retained earnings		AOCI		Total stockholders’ equity
Balance at December 31, 2021	35,105,779	$	551,798	$	293,238	$	9,396	$	854,432

Restricted stock units vested	124,839
Stock-based compensation expense		2,797						2,797
Common stock repurchased	(126,370)	(3,176)						(3,176)
Net income				59,331				59,331
Other comprehensive loss, net of tax						(114,397)		(114,397)

Cash dividends declared on common stock ($0.63 per share)				(22,285)				(22,285)
Balance at September 30, 2022	35,104,248	$	551,419	$	330,284	$	(105,001)	$	776,702

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)


	Nine Months Ended September 30,
	2023		2022
Cash flows from operating activities:
Net income	$	55,522	$	59,331
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion	2,370		(620)
Provision for (reversal of) credit losses	2,856		(2,836)
Stock-based compensation expense	3,204		2,797
Amortization of intangible assets	1,841		2,079
Origination of mortgage loans held for sale	(13,685)		(15,190)
Proceeds from sale of mortgage loans held for sale	13,729		17,259
Bank owned life insurance income	(2,280)		(3,182)

Valuation adjustment on interest rate swaps	—		(67)
Gain on sale of mortgage loans held for sale, net	(307)		(593)
Loss on sale of investment securities available for sale, net	2,226		—

Gain on sale of premises and equipment	—		(403)
Gain on sale of branch including related deposits, net	(610)		—
Other	13,698		3,865
Net cash provided by operating activities	78,564		62,440
Cash flows from investing activities:
Loan originations and purchases, net of payments	(212,222)		(176,700)
Maturities and repayments of investment securities available for sale	135,084		132,854
Maturities and repayments of investment securities held to maturity	18,876		21,620
Purchase of investment securities available for sale	(37,724)		(742,801)
Purchase of investment securities held to maturity	—		(412,835)
Purchase of premises and equipment	(9,250)		(2,295)
Purchase of bank owned life insurance	—		(105)
Proceeds from bank owned life insurance death benefit	—		2,114
Purchases of Federal Home Loan Bank stock	(45,588)		(985)


Proceeds from sales of investment securities available for sale	67,900		—
Proceeds from redemption of Federal Home Loan Bank stock	46,131		2

Proceeds from sales of premises and equipment	2		2,208
Capital contributions to low-income housing tax credit partnerships	(32,517)		(9,245)


Net cash paid related to branch divestiture	(13,826)		—
Net cash used by investing activities	(83,134)		(1,186,168)
Cash flows from financing activities:
Net decrease in deposits	(274,988)		(156,555)
Proceeds from borrowings	1,789,700		50
Repayment of borrowings	(1,339,700)		(50)
Common stock cash dividends paid	(23,141)		(22,119)
Net decrease in securities sold under agreement to repurchase	(23,439)		(10,390)
Repurchase of common stock	(6,949)		(3,176)
Net cash provided (used) by financing activities	121,483		(192,240)
Net increase (decrease) in cash and cash equivalents	116,913		(1,315,968)
Cash and cash equivalents at beginning of period	103,590		1,723,292
Cash and cash equivalents at end of period	$	220,503	$	407,324

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	Nine Months Ended September 30,
	2023		2022

Supplemental disclosures of cash flow information:
Cash paid for interest	$	29,921	$	4,939
Cash paid for income taxes, net of refunds	1,634		1,987

Supplemental non-cash disclosures of cash flow information:


Investment in LIHTC partnership and related funding commitment	37,042		10,728
Right of use assets obtained in exchange for new operating lease liabilities	6,663		2,869
Transfer of bank owned life insurance to prepaid expenses and other assets due to death benefit accrued	700		—
Transfers of premises and equipment classified as held for sale to prepaid expenses and other assets from premises and equipment, net	5,074		910



Transfer of deposits to deposits held for sale	—		22,771

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(1)Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements

(a) Description of Business

The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, the Bank. The Bank is headquartered in Olympia, Washington and conducts business from its 50 branch offices located throughout Washington State, the greater Portland, Oregon area, Eugene, Oregon and Boise, Idaho. The Bank’s business consists primarily of commercial lending and deposit relationships with small and medium-sized businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas. The Bank's deposits are insured by the FDIC subject to limitations.

(b) Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with GAAP for interim financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. It is recommended these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the 2022 Annual Form 10-K. In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2023 are not necessarily indicative of the results that may be expected for the year ending December 31, 2023.

The accompanying Condensed Consolidated Financial Statements presented for the year end December 31, 2022 were derived from audited financial statements and do not include all disclosures required by GAAP.

To prepare unaudited Condensed Consolidated Financial Statements in conformity with GAAP, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Management believes the judgments, estimates and assumptions used in the preparation of the unaudited Condensed Consolidated Financial Statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to management's estimate of the ACL on investment securities, management's estimate of the ACL on loans, management's estimate of the ACL on unfunded commitments, management's evaluation of goodwill impairment and management's estimate of the fair value of financial instruments.

The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiary, the Bank. All significant intercompany balances and transactions among the Company and the Bank have been eliminated in consolidation.

There have been reclassifications in certain prior year amounts in the unaudited Condensed Consolidated Statements of Income. Reclassifications had no effect on the prior year's net income or stockholders’ equity.

The significant accounting policies used in preparation of the unaudited Condensed Consolidated Financial Statements are disclosed in greater detail in the 2022 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2022 Annual Form 10-K during the nine months ended September 30, 2023.

(d) Recently Issued or Adopted Accounting Pronouncements

FASB ASU 2020-04, Reference Rate Reform (Topic 848), as amended by ASU 2021-01, and ASU 2022-06 was issued in March 2020 and provides optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments in this ASU are effective for all entities as of March 12, 2020. In December 2022, FASB amended this ASU and deferred the sunset date of Topic 848 from December 31, 2022, to December 31, 2024. The amendments are elective, apply to all entities, and provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. Effective January 25, 2021, the Company adhered to the Interbank Offered Rate Fallbacks Protocol as published by the International Swaps and Derivatives Association, Inc. and recommended by the Alternative Reference Rates Committee. The majority of the Bank’s interest rate swap-related transactions indexed to LIBOR were transferred to another index during the three months ended June 30, 2023. The remaining instruments including loans and investments are either in the process of transition or will transition to a new index at the next repricing date. The Company does not expect the adoption of this ASU to have a material impact on its business operations or Consolidated Statements of Financial Condition.

FASB ASU 2022-02, Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, was issued in March 2022. The ASU eliminates the accounting guidance for TDR loans by creditors while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. Specifically, rather than applying the recognition and measurement guidance for TDRs, the entity will apply the loan refinancing and restructuring guidance to determine whether a modification or other form of restructuring results in a new loan or continuation of an existing loan. Additionally, the ASU requires public business entities to disclose current-period gross write-offs

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by year of origination for financing receivables and net investments in leases. These amendments are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted in any interim period if an entity has adopted ASU 2016-13 and such election may be made individually to adopt the guidance related to TDRs, including related disclosures, and the presentation of gross write-offs in the vintage disclosure. This update requires prospective transition for the disclosures related to loan restructurings for borrowers experiencing financial difficulty and the presentation of gross write-offs in the vintage disclosures. The guidance related to the recognition and measurement of TDRs may be adopted on a prospective or modified retrospective transition method.

The Company adopted ASU 2022-02 on a prospective basis January 1, 2023. The Company elected at the date of adoption to account for existing TDR loans as of December 31, 2022 under the Company's TDR accounting policy which is disclosed in the 2022 Annual Form 10-K. All loan modifications post adoption are accounted for under the loan modification guidance in ASC 310-20. The adoption of this ASU did not have a material impact on business operations or the Consolidated Statements of Financial Condition.

FASB ASU 2023-02, Investments - Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method (a consensus of the Emerging Issues Task Force), was issued in February 2023. The amendments in this ASU permit companies to elect to account for their tax equity investments, regardless of the tax credit program from which the income tax credits are received, using the proportional amortization method, if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the income tax credits and other income tax benefits received and recognizes the net amortization and income tax credits and other income tax benefits in the statement of operations as a component of income tax expense (benefit). The amendments also require that a reporting entity disclose certain information in annual and interim reporting periods that enable investors to understand the investments that generate income tax credits and other income tax benefits from a tax credit program. The ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2023, with early adoption permitted. The amendments in the ASU can be applied either on a modified retrospective or a retrospective basis. The Company does not expect the adoption of this ASU to have a material impact on its business operations or Consolidated Statements of Financial Condition.

(2)Investment Securities

The Company’s investment policy is designed primarily to provide and maintain liquidity, generate a favorable return on assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities.

There were no investment securities classified as trading at September 30, 2023 or December 31, 2022.

(a) Investment Securities by Classification, Type and Maturity

The following tables present the amortized cost and fair value of investment securities, and the corresponding amounts of gross unrealized and unrecognized gains and losses including the corresponding amounts of gross unrealized gains and losses on investment securities available for sale recognized in AOCI, at the dates indicated:


	September 30, 2023
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(Dollars in thousands)
Investment securities available for sale:
U.S. government and agency securities	$	23,533	$	—	$	(3,109)	$	20,424
Municipal securities	126,763		7		(19,965)		106,805
Residential CMO and MBS(1)	468,174		—		(66,993)		401,181
Commercial CMO and MBS(1)	651,713		5		(54,505)		597,213
Corporate obligations	4,000		—		(220)		3,780
Other asset-backed securities	18,317		62		(235)		18,144
Total	$	1,292,500	$	74	$	(145,027)	$	1,147,547

(1) U.S. government agency and government-sponsored enterprise CMO and MBS.

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	September 30, 2023
	Amortized Cost		Gross Unrecognized Gains		Gross Unrecognized Losses		Fair Value
	(Dollars in thousands)
Investment securities held to maturity:
U.S. government and agency securities	$	151,040	$	—	$	(35,221)	$	115,819
Residential CMO and MBS(1)	273,609		—		(27,445)		246,164
Commercial CMO and MBS(1)	322,196		—		(47,922)		274,274
Total	$	746,845	$	—	$	(110,588)	$	636,257

(1) U.S. government agency and government-sponsored enterprise CMO and MBS.


	December 31, 2022
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(Dollars in thousands)
Investment securities available for sale:
U.S. government and agency securities	$	68,912	$	—	$	(5,053)	$	63,859
Municipal securities	171,087		172		(18,233)		153,026
Residential CMO and MBS(1)	479,473		—		(55,087)		424,386
Commercial CMO and MBS(1)	714,136		19		(49,734)		664,421
Corporate obligations	4,000		—		(166)		3,834
Other asset-backed securities	22,425		14		(522)		21,917
Total	$	1,460,033	$	205	$	(128,795)	$	1,331,443

(1) U.S. government agency and government-sponsored enterprise CMO and MBS.


	December 31, 2022
	Amortized Cost		Gross Unrecognized Gains		Gross Unrecognized Losses		Fair Value
	(Dollars in thousands)
Investment securities held to maturity:
U.S. government and agency securities	$	150,936	$	—	$	(33,585)	$	117,351
Residential CMO and MBS(1)	290,318		—		(17,440)		272,878
Commercial CMO and MBS(1)	325,142		—		(41,937)		283,205
Total	$	766,396	$	—	$	(92,962)	$	673,434

(1) U.S. government agency and government-sponsored enterprise CMO and MBS.

The following table presents the amortized cost and fair value of investment securities by contractual maturity at the date indicated. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.


	September 30, 2023
	Securities Available for Sale				Securities Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Dollars in thousands)
Due in one year or less	$	14,139	$	14,016	$	—	$	—
Due after one year through five years	4,983		4,714		—		—
Due after five years through ten years	43,247		38,366		83,252		66,660
Due after ten years	91,927		73,913		67,788		49,159
Total investment securities due at a single maturity date	154,296		131,009		151,040		115,819

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	September 30, 2023
	Securities Available for Sale				Securities Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Dollars in thousands)
MBS(1)	1,138,204		1,016,538		595,805		520,438
Total investment securities	$	1,292,500	$	1,147,547	$	746,845	$	636,257

(1) MBS, which have prepayment provisions, are not assigned to maturity categories due to fluctuations in their payment speed.

There were no holdings of investment securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of stockholders’ equity at September 30, 2023 and December 31, 2022.

(b) Unrealized Losses on Investment Securities Available for Sale

The following tables present the gross unrealized losses and fair value of the Company’s investment securities available for sale for which an ACL on investment securities available for sale has not been recorded, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position at the dates indicated:


	September 30, 2023
	Less than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(Dollars in thousands)
U.S. government and agency securities	$	—	$	—	$	20,424	$	(3,109)	$	20,424	$	(3,109)
Municipal securities	17,390		(485)		84,118		(19,480)		101,508		(19,965)
Residential CMO and MBS(1)	35,167		(515)		366,014		(66,478)		401,181		(66,993)
Commercial CMO and MBS(1)	44,981		(785)		549,283		(53,720)		594,264		(54,505)
Corporate obligations	—		—		3,780		(220)		3,780		(220)
Other asset-backed securities	466		—		7,469		(235)		7,935		(235)
Total	$	98,004	$	(1,785)	$	1,031,088	$	(143,242)	$	1,129,092	$	(145,027)

(1) U.S. government agency and government-sponsored enterprise CMO and MBS.


	December 31, 2022
	Less than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(Dollars in thousands)
U.S. government and agency securities	$	51,900	$	(2,031)	$	11,959	$	(3,022)	$	63,859	$	(5,053)
Municipal securities	82,580		(5,585)		40,945		(12,648)		123,525		(18,233)
Residential CMO and MBS(1)	217,949		(14,770)		206,437		(40,317)		424,386		(55,087)
Commercial CMO and MBS(1)	473,580		(16,971)		181,692		(32,763)		655,272		(49,734)
Corporate obligations	3,834		(166)		—		—		3,834		(166)
Other asset-backed securities	16,489		(510)		721		(12)		17,210		(522)
Total	$	846,332	$	(40,033)	$	441,754	$	(88,762)	$	1,288,086	$	(128,795)

(1) U.S. government agency and government-sponsored enterprise CMO and MBS.

The Company evaluated investment securities available for sale as of September 30, 2023 and December 31, 2022 and determined that any declines in fair value were attributable to changes in interest rates relative to where these investments fall within the yield curve and individual characteristics. Management monitors published credit ratings for adverse changes for all rated investment securities and none of these securities had a below investment grade credit rating as of both September 30, 2023 and December 31, 2022. In addition, the Company does not intend to sell these securities nor does the Company consider it more likely than not that it will be required to sell these securities before the recovery of the amortized cost basis, which may be upon maturity. Therefore, no ACL on investment securities available for sale was recorded as of September 30, 2023 and December 31, 2022.

The Company also evaluated investment securities held to maturity for current expected credit losses as of September 30, 2023 and December 31, 2022. There were no investment securities held to maturity classified as nonaccrual or past due as of September 30, 2023 and December 31, 2022 and all were issued by the U.S. government and its agencies and either

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explicitly or implicitly guaranteed by the U.S. government, highly rated by major credit rating agencies and had a long history of no credit losses. Accordingly, the Company did not measure expected credit losses on investment securities held to maturity since the historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero. Therefore, no ACL on investment securities held to maturity was recorded as of September 30, 2023 and December 31, 2022.

(d) Realized Gains and Losses

The following table presents the gross realized gains and losses on the sale of investment securities available for sale determined using the specific identification method for the dates indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022
	(Dollars in thousands)
Gross realized gains	$	—	$	—	$	36	$	—
Gross realized losses	(1,940)		—		(2,262)		—
Net realized gains	$	(1,940)	$	—	$	(2,226)	$	—

(e) Pledged Securities

The following table summarizes the amortized cost and fair value of investment securities that were pledged as collateral for the following obligations at the dates indicated:


	September 30, 2023				December 31, 2022
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Dollars in thousands)
State and local governments public deposits	$	242,616	$	220,348	$	156,784	$	137,931
FRB	852,720		712,009		60,660		49,506
Securities sold under agreement to repurchase	28,104		25,654		63,685		55,836
Other securities pledged	53,883		45,922		54,910		48,358
Total	$	1,177,323	$	1,003,933	$	336,039	$	291,631

(f) Accrued Interest Receivable

Accrued interest receivable excluded from the amortized cost of investment securities available for sale totaled $3.8 million and $4.8 million at September 30, 2023 and December 31, 2022, respectively. Accrued interest receivable excluded from the amortized cost on investment securities held to maturity totaled $2.3 million and $2.4 million at September 30, 2023 and December 31, 2022, respectively.

No amounts of accrued interest receivable on investment securities available for sale or held to maturity were reversed against interest income on investment securities during the nine months ended September 30, 2023 and 2022.

(g) Non-Marketable Securities

At December 31, 2022, as a member bank of Visa U.S.A., we held 6,549 shares of Visa Inc. Class B common stock. These shares had a carrying value of zero and were restricted from resale to non-member banks of Visa U.S.A. until their conversion into Class A (voting) shares upon the termination of Visa Inc.'s Covered Litigation escrow account. During the nine months ended September 30, 2023, the Bank sold all shares of Visa Inc. Class B common stock and recognized a $1.6 million gain which is included in other income.

(3)Loans Receivable

The Bank originates loans in the ordinary course of business and has also acquired loans through mergers and acquisitions. Accrued interest receivable was excluded from disclosures presenting the Bank's amortized cost of loans receivable as it was deemed insignificant. In addition to originating loans, the Bank may also purchase loans through pool purchases, participation purchases and syndicated loan purchases.

(a) Loan Origination/Risk Management

The Bank categorizes the individual loans in the total loan portfolio into four segments: commercial business; residential real estate; real estate construction and land development; and consumer. Within these segments are classes of loans for which management monitors and assesses credit risk in the loan portfolios. A detailed description of the portfolio segments and classes is contained in the 2022 Annual Form 10-K.

The Bank has certain lending policies and guidelines in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and guidelines on a regular basis. A reporting system

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supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and criticized loans. The Bank also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel.

The amortized cost of loans receivable, net of ACL on loans, consisted of the following portfolio segments and classes at the dates indicated:


	September 30, 2023		December 31, 2022
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	691,318	$	693,568
Owner-occupied CRE	953,779		937,040
Non-owner occupied CRE	1,690,099		1,586,632
Total commercial business	3,335,196		3,217,240
Residential real estate	377,448		343,631
Real estate construction and land development:
Residential	70,804		80,074
Commercial and multifamily	310,024		214,038
Total real estate construction and land development	380,828		294,112
Consumer	173,386		195,875
Loans receivable	4,266,858		4,050,858
ACL on loans	(46,947)		(42,986)
Loans receivable, net	$	4,219,911	$	4,007,872

Balances included in the amortized cost of loans receivable:
Unamortized net discount on acquired loans	$	(2,036)	$	(2,501)
Unamortized net deferred fee	$	(10,949)	$	(10,016)

(b) Concentrations of Credit

Most of the Bank’s lending activity occurs within its primary market areas which are concentrated along the I-5 corridor from Whatcom County, Washington to Lane County, Oregon, as well as Yakima County in Washington and Ada County in Idaho. Additionally, the Bank's loan portfolio is concentrated in commercial business loans, which include commercial and industrial, owner-occupied and nonowner-occupied CRE, and commercial and multifamily real estate construction and land development loans. Commercial business loans are generally considered as having a more inherent risk of default than residential real estate loans or other consumer loans. Also, the commercial loan balance per borrower is typically larger than that for residential real estate loans and consumer loans, implying higher potential losses on an individual loan basis.

As part of the on-going monitoring of the credit quality of the Bank’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans, (v) past due status, and (vi) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon.

The Bank utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 10. Risk grades are aggregated to create the risk categories of Pass for grades 1 to 6, Special Mention or "SM" for grade 7, Substandard or "SS" for grade 8, Doubtful for grade 9 and Loss for grade 10. Descriptions of the general characteristics of the risk grades, including qualitative information on how the risk grades relate to the risk of loss, are contained in the 2022 Annual Form 10-K. Numerical loan grades for loans are established at the origination of the loan. Changes to loan grades are considered at the time new information about the performance of a loan becomes available, including the receipt of updated financial information from the borrower, results of annual term loan reviews and scheduled loan reviews. For consumer loans, the Bank follows the FDIC’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower or other borrower information that becomes known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.

Loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The SM loan grade is

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transitory in that the Bank is waiting on additional information to determine the likelihood and extent of any potential loss. The likelihood of loss for SM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a SS grade have further credit deterioration and include both accrual loans and nonaccrual loans. For Doubtful and Loss graded loans, the Bank is almost certain of the losses and the outstanding principal balances are generally charged off to the realizable value.

The following tables present the amortized cost of loans receivable by risk grade and origination year, and the gross charge-offs by loan class and origination year, at the dates indicated. The Bank adopted the vintage disclosure requirements of ASU 2022-02 prospectively as described in Note 1 beginning January 1, 2023.


	September 30, 2023												Revolving Loans		Revolving Loans Converted(1)		Loans Receivable
	Term Loans Amortized Cost Basis by Origination Year
	2023		2022		2021		2020		2019		Prior
	(Dollars in thousands)
Commercial business:
Commercial and industrial
Pass	$	72,204	$	157,851	$	80,225	$	72,575	$	44,139	$	87,318	$	141,690	$	290	$	656,292
SM	—		201		254		1,748		4,413		3,911		846		—		11,373
SS	—		1,239		2,667		1,541		1,220		5,137		11,849		—		23,653
Total	72,204		159,291		83,146		75,864		49,772		96,366		154,385		290		691,318
Owner-occupied CRE
Pass	67,181		139,102		161,632		84,403		149,576		311,216		—		—		913,110
SM	—		—		3,565		2,012		710		16,108		—		—		22,395
SS	—		—		3,090		658		—		14,526		—		—		18,274
Total	67,181		139,102		168,287		87,073		150,286		341,850		—		—		953,779
Non-owner occupied CRE
Pass	137,013		260,502		206,919		154,132		242,200		647,754		—		—		1,648,520
SM	—		601		8,217		—		575		19,479		—		—		28,872
SS	—		—		—		—		—		12,707		—		—		12,707
Total	137,013		261,103		215,136		154,132		242,775		679,940		—		—		1,690,099
Total commercial business
Pass	276,398		557,455		448,776		311,110		435,915		1,046,288		141,690		290		3,217,922
SM	—		802		12,036		3,760		5,698		39,498		846		—		62,640
SS	—		1,239		5,757		2,199		1,220		32,370		11,849		—		54,634
Total	276,398		559,496		466,569		317,069		442,833		1,118,156		154,385		290		3,335,196
Commercial business gross charge-offs
Current period	—		—		15		61		—		100		—		—		176
Residential real estate
Pass(1)	37,158		139,887		143,647		24,868		15,134		16,590		—		—		377,284

SS	—		—		—		—		—		164		—		—		164
Total	37,158		139,887		143,647		24,868		15,134		16,754		—		—		377,448


Real estate construction and land development:
Residential
Pass	26,212		30,529		5,024		1,488		822		732		—		—		64,807

SS	997		319		4,495		—		—		186		—		—		5,997
Total	27,209		30,848		9,519		1,488		822		918		—		—		70,804
Commercial and multifamily
Pass	26,072		158,782		106,134		5,391		764		3,369		—		—		300,512
SM	—		—		—		3,452		5,687		373		—		—		9,512

Total	26,072		158,782		106,134		8,843		6,451		3,742		—		—		310,024

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	September 30, 2023												Revolving Loans		Revolving Loans Converted(1)		Loans Receivable
	Term Loans Amortized Cost Basis by Origination Year
	2023		2022		2021		2020		2019		Prior
	(Dollars in thousands)
Total real estate construction and land development
Pass	52,284		189,311		111,158		6,879		1,586		4,101		—		—		365,319
SM	—		—		—		3,452		5,687		373		—		—		9,512
SS	997		319		4,495		—		—		186		—		—		5,997
Total	53,281		189,630		115,653		10,331		7,273		4,660		—		—		380,828


Consumer
Pass	1,713		2,314		332		7,016		18,305		23,514		117,681		653		171,528

SS	—		—		—		150		286		1,023		375		24		1,858
Total	1,713		2,314		332		7,166		18,591		24,537		118,056		677		173,386
Consumer gross charge-offs:
Current period	7		10		12		21		54		122		194		—		420
Loans receivable
Pass	367,553		888,967		703,913		349,873		470,940		1,090,493		259,371		943		4,132,053
SM	—		802		12,036		7,212		11,385		39,871		846		—		72,152
SS	997		1,558		10,252		2,349		1,506		33,743		12,224		24		62,653
Total	$	368,550	$	891,327	$	726,201	$	359,434	$	483,831	$	1,164,107	$	272,441	$	967	$	4,266,858
Gross charge-offs:
Total	$	7	$	10	$	27	$	82	$	54	$	222	$	194	$	—	$	596

(1) Represents the loans receivable balance at September 30, 2023 which was converted from a revolving loan to a non-revolving amortizing loan during the nine months ended September 30, 2023.


	December 31, 2022												Revolving Loans		Revolving Loans Converted(1)		Loans Receivable
	Term Loans Amortized Cost Basis by Origination Year
	2022		2021		2020		2019		2018		Prior
	(Dollars in thousands)
Commercial business:
Commercial and industrial
Pass	$	168,818	$	94,653	$	82,554	$	61,160	$	33,957	$	74,181	$	146,795	$	172	$	662,290
SM	212		109		443		4,637		362		4,447		5,433		—		15,643
SS	773		188		1,710		3,465		559		5,098		3,674		168		15,635
Total	169,803		94,950		84,707		69,262		34,878		83,726		155,902		340		693,568
Owner-occupied CRE
Pass	134,432		167,927		93,834		157,096		62,876		282,212		—		—		898,377
SM	—		1,744		—		—		2,540		16,664		—		247		21,195
SS	—		—		671		—		3,722		13,075		—		—		17,468
Total	134,432		169,671		94,505		157,096		69,138		311,951		—		247		937,040
Non-owner-occupied CRE
Pass	240,151		189,300		160,930		258,778		121,369		561,645		—		—		1,532,173
SM	—		8,349		—		4,172		—		12,190		—		—		24,711
SS	—		—		—		—		3,627		26,121		—		—		29,748
Total	240,151		197,649		160,930		262,950		124,996		599,956		—		—		1,586,632

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	December 31, 2022												Revolving Loans		Revolving Loans Converted(1)		Loans Receivable
	Term Loans Amortized Cost Basis by Origination Year
	2022		2021		2020		2019		2018		Prior
	(Dollars in thousands)
Total commercial business
Pass	543,401		451,880		337,318		477,034		218,202		918,038		146,795		172		3,092,840
SM	212		10,202		443		8,809		2,902		33,301		5,433		247		61,549
SS	773		188		2,381		3,465		7,908		44,294		3,674		168		62,851
Total	544,386		462,270		340,142		489,308		229,012		995,633		155,902		587		3,217,240
Residential real estate
Pass	132,510		149,934		24,668		16,803		4,207		15,337		—		—		343,459

SS	—		—		—		—		—		172		—		—		172
Total	132,510		149,934		24,668		16,803		4,207		15,509		—		—		343,631
Real estate construction and land development:
Residential
Pass	45,521		26,675		2,891		3,061		871		1,055		—		—		80,074



Commercial and multifamily
Pass	71,168		123,626		6,272		1,084		2,562		995		—		—		205,707
SM	—		—		2,213		5,687		—		—		—		—		7,900
SS	—		—		—		37		—		394		—		—		431
Total	71,168		123,626		8,485		6,808		2,562		1,389		—		—		214,038
Total real estate construction and land development
Pass	116,689		150,301		9,163		4,145		3,433		2,050		—		—		285,781
SM	—		—		2,213		5,687		—		—		—		—		7,900
SS	—		—		—		37		—		394		—		—		431
Total	116,689		150,301		11,376		9,869		3,433		2,444		—		—		294,112
Consumer
Pass	3,379		509		9,848		27,370		15,563		19,855		116,605		435		193,564

SS	—		—		168		559		320		1,120		44		100		2,311
Total	3,379		509		10,016		27,929		15,883		20,975		116,649		535		195,875
Loans receivable
Pass	795,979		752,624		380,997		525,352		241,405		955,280		263,400		607		3,915,644
SM	212		10,202		2,656		14,496		2,902		33,301		5,433		247		69,449
SS	773		188		2,549		4,061		8,228		45,980		3,718		268		65,765
Total	$	796,964	$	763,014	$	386,202	$	543,909	$	252,535	$	1,034,561	$	272,551	$	1,122	$	4,050,858

(1) Represents the loans receivable balance at December 31, 2022 which was converted from a revolving loan to non-revolving amortizing loan during the year ended December 31, 2022.

(d) Nonaccrual Loans

The following tables present the amortized cost of nonaccrual loans at the dates indicated:


	September 30, 2023
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	2,172	$	686	$	2,858
Owner-occupied CRE	—		207		207








Total	$	2,172	$	893	$	3,065

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	December 31, 2022
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	4,503	$	1,154	$	5,657
Owner-occupied CRE	—		212		212

Total commercial business	4,503		1,366		5,869

Real estate construction and land development:

Commercial and multifamily	—		37		37


Total	$	4,503	$	1,403	$	5,906

The following table presents the reversal of interest income on loans due to the write-off of accrued interest receivable upon the initial classification of loans as nonaccrual loans and the interest income recognized due to payment in full or sale of previously classified nonaccrual loans during the following periods:


	Three Months Ended September 30,
	2023				2022
	Interest Income Reversed		Interest Income Recognized		Interest Income Reversed		Interest Income Recognized
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	(10)	$	18	$	—	$	31









Total	$	(10)	$	18	$	—	$	31


	Nine Months Ended September 30,
	2023				2022
	Interest Income Reversed		Interest Income Recognized		Interest Income Reversed		Interest Income Recognized
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	(24)	$	48	$	(14)	$	260
Owner-occupied CRE	—		—		—		53
Non-owner occupied CRE	—		—		—		774
Total commercial business	(24)		48		(14)		1,087
Residential real estate	—		—		—		19




Consumer	—		—		—		68
Total	$	(24)	$	48	$	(14)	$	1,174

For the three and nine months ended September 30, 2023 and 2022, no interest income was recognized subsequent to a loan’s classification as nonaccrual, except as indicated in the tables above due to payment in full or sale.

(e) Past due loans

The Bank performs an aging analysis of past due loans using policies consistent with regulatory reporting requirements with categories of 30-89 days past due and 90 or more days past due. The following tables present the amortized cost of past due loans at the dates indicated:


	September 30, 2023
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	1,126	$	2,883	$	4,009	$	687,309	$	691,318

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	September 30, 2023
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(Dollars in thousands)
Owner-occupied CRE	426		635		1,061		952,718		953,779
Non-owner occupied CRE	—		—		—		1,690,099		1,690,099
Total commercial business	1,552		3,518		5,070		3,330,126		3,335,196
Residential real estate	—		—		—		377,448		377,448
Real estate construction and land development:
Residential	505		—		505		70,299		70,804
Commercial and multifamily	—		—		—		310,024		310,024
Total real estate construction and land development	505		—		505		380,323		380,828
Consumer	635		325		960		172,426		173,386
Total	$	2,692	$	3,843	$	6,535	$	4,260,323	$	4,266,858


	December 31, 2022
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	822	$	6,104	$	6,926	$	686,642	$	693,568
Owner-occupied CRE	—		189		189		936,851		937,040
Non-owner occupied CRE	—		—		—		1,586,632		1,586,632
Total commercial business	822		6,293		7,115		3,210,125		3,217,240
Residential real estate	3,066		—		3,066		340,565		343,631
Real estate construction and land development:
Residential	—		—		—		80,074		80,074
Commercial and multifamily	—		—		—		214,038		214,038
Total real estate construction and land development	—		—		—		294,112		294,112
Consumer	1,561		—		1,561		194,314		195,875
Total	$	5,449	$	6,293	$	11,742	$	4,039,116	$	4,050,858

Loans 90 days or more past due and still accruing interest were $2.2 million and $1.6 million as of September 30, 2023 and December 31, 2022, respectively.

(f) Collateral-dependent Loans

The following tables present the type of collateral securing loans individually evaluated for credit losses and for which the repayment was expected to be provided substantially through the operation or sale of the collateral at the dates indicated, with balances representing the amortized cost of the loan classified by the primary collateral category of each loan if multiple collateral sources secure the loan:


	September 30, 2023
	CRE		Farmland		Residential Real Estate		Equipment		Total
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	260	$	389	$	630	$	541	$	1,820
Owner-occupied CRE	189		—		—		—		189








Total	$	449	$	389	$	630	$	541	$	2,009

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	December 31, 2022
	CRE		Farmland		Residential Real Estate		Equipment		Total
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	1,239	$	1,977	$	929	$	—	$	4,145
Owner-occupied CRE	189		—		—		—		189








Total	$	1,428	$	1,977	$	929	$	—	$	4,334

There have been no significant changes to the collateral securing loans individually evaluated for credit losses and for which repayment was expected to be provided substantially through the operation or sale of the collateral during the nine months ended September 30, 2023, except changes due to additions or removals of loans in this classification.

(g) Modification of Loans

In January 2023, the Company adopted ASU 2022-02, “Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures” (“ASU 2022-02”), which eliminated the accounting guidance for TDRs while enhancing disclosure requirements for certain loan refinancing and restructurings by creditors when a borrower is experiencing financial difficulty. This guidance was applied on a prospective basis.

Modifications of loans to borrowers experiencing financial difficulty may include interest rate reductions, principal or interest forgiveness, term extensions, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral.

The following table presents loan modifications by type of modification at amortized cost that were modified as a result of experiencing both financial difficulty and modified during the period indicated:


	Three Months Ended September 30, 2023
	Term Extension		Term Extension & Int. Rate Reduction		Total Modified Loans		% of Modified Loans to Loans Receivable, net

	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	313	$	—	$	313	0.05	%

Non-owner occupied CRE	—		239		239		0.01







Total	$	313	$	239	$	552	0.01	%


	Nine Months Ended September 30, 2023
	Term Extension		Term Extension & Int. Rate Reduction		Total Modified Loans		% of Modified Loans to Loans Receivable, net

	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	6,516	$	—	$	6,516	0.94	%

Non-owner occupied CRE	2,716		239		2,955		0.17
Total commercial business	9,232		239		9,471		0.28

Real estate construction and land development:

Commercial and multifamily	3,452		—		3,452		1.11	%

Consumer	28		17		45		0.03	%
Total	$	12,712	$	256	$	12,968	0.30	%

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The following tables present the financial effect of the loan modifications presented in the preceding table during the periods indicated:


	Three Months Ended September 30, 2023			Nine Months Ended September 30, 2023
	Weighted Average % of Interest Rate Reductions		Weighted Average Years of Term Extensions	Weighted Average % of Interest Rate Reductions		Weighted Average Years of Term Extensions
Commercial business:
Commercial and industrial	—	%	1.82	—	%	0.58
Owner-occupied CRE	—	%		—	%
Non-owner occupied CRE	3.00		2.00	3.00		1.09
Total commercial business	3.00		1.90	3.00		0.74

Real estate construction and land development:

Commercial and multifamily	—			—		0.42

Consumer	—			1.00		2.62
Total	3.00	%	1.90	3.00	%	0.66

There were no modified loans included in the tables above that were past due or on nonaccrual as of September 30, 2023.

There were no modified loans made during the three and nine months ended September 30, 2023, that subsequently defaulted.

(h) Accrued interest receivable on loans receivable

Accrued interest receivable on loans receivable totaled $12.5 million and $11.3 million at September 30, 2023 and December 31, 2022, respectively, and is excluded from the calculation of the ACL on loans as interest accrued, but not received, is reversed timely.

(i) Foreclosure proceedings in process

At September 30, 2023, there were no consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process.

(4)Allowance for Credit Losses on Loans

The Company's methodology for determining the ACL on loans is based upon key assumptions, including the lookback periods, historic net charge-off factors, economic forecasts, reversion periods, prepayments and qualitative adjustments. The allowance is measured on a collective, or pool, basis when similar risk characteristics exist. Loans that do not share common risk characteristics are evaluated on an individual basis and are excluded from the collective evaluation. For a description of the Company's ACL policy, see Note 1 - Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements included in Item 8. Financial Statements And Supplementary Data in our 2022 Annual Form 10-K.

GAAP requires the Company to develop reasonable and supportable forecasts of future conditions, and estimate how those forecasts are expected to impact a borrower’s ability to satisfy their obligation to the Company and the ultimate collectability of future cash flows over the life of a loan. The Company uses macroeconomic scenarios from an independent third party. These scenarios are based on past events, current conditions, the likelihood of future events occurring and include consideration of the forecasted direction of the economic and business environment and its likely impact on the estimated allowance as compared to the historical losses over the reasonable and supportable time frame. Economic forecast models for the current period are uploaded to the model, which targets certain forecasted macroeconomic factors, such as unemployment rate, gross domestic product, housing price index, commercial real estate price index, and certain rate and market indices. Macroeconomic factor multipliers are determined through regression analysis and applied to loss rates for each segment of loans with similar risk characteristics. Each of the forecasted segment balances is impacted by a mix of these macroeconomic factors. Further, each of the macroeconomic factors is utilized differently by segment, including the application of lagged factors and various transformations such as percent change year over year. A macroeconomic sensitive model is developed for each segment given the current and forecasted conditions and a macroeconomic multiplier is calculated for each forecast period considering the forecasted losses as compared to the long-term average actual losses of the dataset. The impact of those macroeconomic factors on each segment, both positive or negative, using the reasonable and supportable period, are added to the calculated baseline loss allowance. After the reasonable and supportable period, forecasted loss rates revert to historical baseline loss levels over the predetermined reversion period on a straight-lined basis.

At September 30, 2023, the Company upgraded the version of the model used to calculate the ACL for collectively evaluated loans. This new version includes changes to the macroeconomic variables used for each of the loan segments to either add or eliminate variables based upon regression testing and the relationship to expected results and the lookback period

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was changed to look back to 2000 as compared to 1991 to improve data relevance. The most significant changes to macroeconomic variables were in the commercial and industrial segment and commercial real estate segments. The commercial and industrial segment had previously used unemployment as a macroeconomic variable which was removed and replaced with a market index, rate index and real estate price index. The commercial real estate segments had previously used gross domestic product as a macroeconomic variable which was removed and replaced with a housing price index. The new version also added a segment for home equity lines of credit. The overall impact to the ACL for collectively evaluated loans due to this version change prior to applying qualitative adjustments was not considered to be material.

The Company recognizes that historical information used as the basis for determining future expected credit losses may not always, by itself, provide a sufficient basis for determining future expected credit losses. The Company, therefore, considers the need for qualitative adjustments to the ACL on a quarterly basis. Qualitative adjustments may be related to and include, but not be limited to, factors such as: (i) management’s assessment of economic forecasts used in the model and how those forecasts align with management’s overall evaluation of current and expected economic conditions, (ii) organization specific risks such as credit concentrations, collateral specific risks, regulatory risks, and external factors that may ultimately impact credit quality, (iii) potential model limitations such as limitations identified through back-testing, and other limitations associated with factors such as underwriting changes, acquisition of new portfolios and changes in portfolio segmentation, and (iv) management’s overall assessment of the adequacy of the ACL, including an assessment of model data inputs used to determine the ACL.

As of September 30, 2023, qualitative adjustments primarily relate to certain segments of the loan portfolio deemed by management to be of a higher-risk profile where management believes the quantitative component of the Company’s ACL model may not have fully captured the associated impact to the ACL. In addition, qualitative adjustments also relate to heightened uncertainty as to future macroeconomic conditions and the related impact on certain loan segments. Management reviews the need for an appropriate level of qualitative adjustments on a quarterly basis, and as such, the amount and allocation of qualitative adjustments may change in future periods.

During the nine months ended September 30, 2023, the ACL on loans increased $3.9 million to $46.9 million from $43.0 million at December 31, 2022 due primarily to a provision for credit losses on loans of $3.1 million driven by growth in loans receivable, net and secondarily due to net recoveries of $895,000 as a result of a $1.1 million recovery from the payoff of a nonaccrual loan.

The following tables detail the activity in the ACL on loans by segment and class for the periods indicated:


	Three Months Ended September 30, 2023
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	13,288	$	(15)	$	1,253	$	(2,781)	$	11,745
Owner-occupied CRE	8,503		—		—		191		8,694
Non-owner occupied CRE	9,482		—		—		1,184		10,666
Total commercial business	31,273		(15)		1,253		(1,406)		31,105
Residential real estate	2,865		—		—		684		3,549
Real estate construction and land development:
Residential	1,671		—		—		(163)		1,508
Commercial and multifamily	8,014		—		—		437		8,451
Total real estate construction and land development	9,685		—		—		274		9,959
Consumer	2,585		(123)		59		(187)		2,334
Total	$	46,408	$	(138)	$	1,312	$	(635)	$	46,947


	Nine Months Ended September 30, 2023
	Beginning Balance		Charge-offs		Recoveries		Provision for (Reversal of) Credit Losses		Ending Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	13,962	$	(176)	$	1,342	$	(3,383)	$	11,745
Owner-occupied CRE	7,480		—		—		1,214		8,694
Non-owner occupied CRE	9,276		—		—		1,390		10,666
Total commercial business	30,718		(176)		1,342		(779)		31,105

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	Nine Months Ended September 30, 2023
	Beginning Balance		Charge-offs		Recoveries		Provision for (Reversal of) Credit Losses		Ending Balance
	(Dollars in thousands)
Residential real estate	2,872		—		—		677		3,549
Real estate construction and land development:
Residential	1,654		—		—		(146)		1,508
Commercial and multifamily	5,409		—		—		3,042		8,451
Total real estate construction and land development	7,063		—		—		2,896		9,959
Consumer	2,333		(420)		149		272		2,334
Total	$	42,986	$	(596)	$	1,491	$	3,066	$	46,947


	Three Months Ended September 30, 2022
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	14,033	$	—	$	455	$	180	$	14,668
Owner-occupied CRE	8,162		—		—		(443)		7,719
Non-owner occupied CRE	9,512		—		—		41		9,553
Total commercial business	31,707		—		455		(222)		31,940
Residential real estate	2,137		—		—		408		2,545
Real estate construction and land development:
Residential	1,081		—		5		208		1,294
Commercial and multifamily	2,203		—		102		1,505		3,810
Total real estate construction and land development	3,284		—		107		1,713		5,104
Consumer	2,568		(138)		50		20		2,500
Total	$	39,696	$	(138)	$	612	$	1,919	$	42,089


	Nine Months Ended September 30, 2022
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	17,777	$	(280)	$	876	$	(3,705)	$	14,668
Owner-occupied CRE	6,411		(36)		—		1,344		7,719
Non-owner occupied CRE	8,861		—		—		692		9,553
Total commercial business	33,049		(316)		876		(1,669)		31,940
Residential real estate	1,409		(30)		3		1,163		2,545
Real estate construction and land development:
Residential	1,304		—		19		(29)		1,294
Commercial and multifamily	3,972		—		155		(317)		3,810
Total real estate construction and land development	5,276		—		174		(346)		5,104
Consumer	2,627		(396)		669		(400)		2,500
Total	$	42,361	$	(742)	$	1,722	$	(1,252)	$	42,089

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The following table details the activity in the ACL on unfunded commitments during the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022
	(Dollars in thousands)
Balance, beginning of period	$	1,777	$	997	$	1,744	$	2,607
(Reversal of) provision for credit losses on unfunded commitments	(243)		26		(210)		(1,584)
Balance, end of period	$	1,534	$	1,023	$	1,534	$	1,023

(5)Goodwill and Other Intangible Assets

(a) Goodwill

There were no additions to goodwill during the nine months ended September 30, 2023 and 2022. Additionally, management analyzes its goodwill on an annual basis on December 31 and between annual tests in certain circumstances such as material adverse changes in legal, business, regulatory and economic factors. An impairment loss is recorded to the extent the carrying amount of goodwill exceeds its implied fair value. The Company performed an annual impairment assessment as of December 31, 2022 and concluded that there was no impairment.

Due to a sustained decline in stock price during the three months ended June 30, 2023, the Company determined a triggering event occurred and consequently performed a quantitative assessment of goodwill as of May 31, 2023. We estimated the fair value of the reporting unit by weighting results from the market approach and the income approach. Significant assumptions inherent in the valuation methodologies for goodwill were employed and included, but were not limited to, prospective financial information, growth rates, terminal value, discount rates, and comparable multiples from publicly traded companies in our industry. Based on this quantitative test, we determined that the fair value of the reporting unit more likely than not exceeded the carrying value.

At September 30, 2023, the Company determined that no material adverse changes had occurred since the quantitative assessment was performed as of May 31, 2023 and concluded that there continues to be no impairment of goodwill.

(b) Other Intangible Assets

Other intangible assets represent core deposit intangible acquired in business combinations with estimated useful lives of ten years. There were no additions to other intangible assets during the nine months ended September 30, 2023 and 2022.

(6)Derivative Financial Instruments

The Company utilizes interest rate swap derivative contracts to facilitate the needs of its commercial customers whereby it enters into an interest rate swap with a customer while at the same time entering into an offsetting interest rate swap with another financial institution. The transaction allows the Company’s customer to effectively convert a variable rate loan to a fixed rate loan, or a fixed rate loan to a variable rate loan, and the Company recognizes immediate income based upon the difference in the bid/ask spread of the underlying transactions with its customers and the third-party. These interest rate swaps are not designated as hedging instruments.

The Company is exposed to interest rate risk as part of the transaction. However, the Company acts as an intermediary for its customer therefore changes in the fair value of the underlying derivative contracts for the most part offset each other and do not significantly impact the Company’s results of operations.

Fee income related to interest rate swap derivative contract transactions is recorded in Interest rate swap fees on the unaudited Condensed Consolidated Statements of Income. The fair value of derivative positions outstanding is included in Prepaid expenses and other assets and Accrued expenses and other liabilities in the unaudited Condensed Consolidated Statements of Financial Condition. The gains and losses due to changes in fair value and all cash flows are included in Other income in the unaudited Condensed Consolidated Statements of Income, but typically net to zero based on the identical back-to-back interest rate swap derivative contracts unless a credit valuation adjustment is recorded to appropriately reflect nonperformance risk in the fair value measurement. Various factors impact changes in the credit valuation adjustments over time, including changes in the risk ratings of the parties to the contracts, as well as changes in market rates and volatilities, which affect the total expected exposure of the derivative instruments.

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The following table presents the notional amounts and estimated fair values of interest rate derivative contracts outstanding at the dates indicated:


	September 30, 2023			December 31, 2022
	Notional Amounts		Estimated Fair Value	Notional Amounts		Estimated Fair Value
	(Dollars in thousands)
Non-hedging interest rate derivatives
Interest rate swap asset (1)	$	289,978	33,840	$	288,785	$	30,107
Interest rate swap liability (1)	289,978		(33,840)	288,785		(30,107)

(1) The estimated fair value of derivatives with customers was $(33.7) million and $(30.1) million as of September 30, 2023 and December 31, 2022, respectively. The estimated fair value of derivatives with third-parties was $33.7 million and $30.1 million as of September 30, 2023 and December 31, 2022, respectively.

The Company is exposed to credit-related losses in the event of nonperformance by the counterparty to these agreements. Credit risk for derivatives with the customer is controlled through the credit approval process, amount limits, and monitoring procedures and is concentrated within our primary market areas. Credit risk for derivatives with third-parties is concentrated among four well-known broker dealers.

(7)Stockholders’ Equity

(a) Earnings Per Common Share

The following table illustrates the calculation of weighted average shares used for earnings per common share computations for the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022
	(Dollars in thousands, except shares)



Net income allocated to common shareholders	$	18,219	$	20,990	$	55,522	$	59,331

Basic:
Weighted average common shares outstanding	35,022,676		35,103,984		35,062,760		35,103,048


Diluted:
Basic weighted average common shares outstanding	35,022,676		35,103,984		35,062,760		35,103,048
Effect of potentially dilutive common shares (1)	92,489		364,906		242,696		335,624
Total diluted weighted average common shares outstanding	35,115,165		35,468,890		35,305,456		35,438,672
Potentially dilutive shares that were excluded from the computation of diluted earnings per share because to do so would be anti-dilutive (2)	312,539		3,026		163,860		13,662

(1) Represents the effect of the vesting of restricted stock units.

(2) Anti-dilution occurs when the unrecognized compensation cost per share of a restricted stock unit exceeds the market price of the Company’s stock.

(b) Dividends

The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.

The following table summarizes the dividend activity during the nine months ended September 30, 2023 and the calendar year 2022:

Declared

Cash Dividend per Share

Record Date

Paid Date

January 26, 2022

$0.21

February 9, 2022

February 23, 2022

April 20, 2022

$0.21

May 4, 2022

May 18, 2022

July 20, 2022

$0.21

August 3, 2022

August 17, 2022

October 19, 2022

$0.21

November 2, 2022

November 16, 2022

January 25, 2023

$0.22

February 8, 2023

February 22, 2023

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Declared

Cash Dividend per Share

Record Date

Paid Date

April 19, 2023

$0.22

May 4, 2023

May 18, 2023

July 19, 2023

$0.22

August 2, 2023

August 16, 2023

The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Federal Reserve provides, among other things, that dividends per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four fiscal quarters. Current regulations allow the Company and the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

The Company has had various stock repurchase programs since March 1999. On March 12, 2020, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or 1,799,054 shares, under the twelfth stock repurchase plan with 307,790 shares remaining available for repurchase as of September 30, 2023. The number, timing and price of shares repurchased under the twelfth stock repurchase plan will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.

The following table provides total repurchased shares and average share prices under the repurchase plan for the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022		Plan Total(1)




Twelfth Stock Repurchase Plan
Repurchased shares	148,119		—		330,424		100,090		1,491,264
Stock repurchase average share price	$	17.08	$	—	$	18.82	$	25.07	$	22.80

(1) Represents total shares repurchased and average price per share paid during the duration of the repurchase plan.

In addition to the stock repurchases under a stock repurchase plan, the Company repurchases shares to pay withholding taxes on the vesting of restricted stock units. The following table provides total shares repurchased to pay withholding taxes during the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2023		2022		2023		2022
Repurchased shares to pay withholding taxes	335		100		31,567		26,280
Stock repurchase to pay withholding taxes average share price	$	17.26	$	26.94	$	22.03	$	25.40

(8)Fair Value Measurements

Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1: Valuations for assets and liabilities traded in active exchange markets, or interest in open-end mutual funds that allow the Company to sell its ownership interest back to the fund at net asset value on a daily basis. Valuations are obtained from readily available pricing sources for market transactions involving identical assets, liabilities, or funds.

Level 2: Valuations for assets and liabilities traded in less active dealer or broker markets, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or valuations using methodologies with observable inputs.

Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing models, discounted cash flow models and similar techniques using unobservable inputs, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

(a) Recurring and Nonrecurring Basis

The Company used the following methods and significant assumptions to measure the fair value of certain assets on a recurring and nonrecurring basis:

Investment Securities:

The fair values of all investment securities are based upon the assumptions that market participants would use in pricing the security. If available, fair values of investment securities are determined by quoted market prices (Level 1). For investment securities where quoted market prices are not available, fair values are calculated based on market prices on similar

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securities (Level 2). For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market indicators (Level 3). Investment security valuations are obtained from third-party pricing services.

Collateral-Dependent Loans:

Collateral-dependent loans are identified for the calculation of the ACL on loans. The fair value used to measure credit loss for this type of loan is commonly based on recent real estate appraisals which are generally obtained at least every 18 months or earlier if there are changes to risk characteristics of the underlying loan. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. The Bank also incorporates an estimate of cost to sell the collateral when the sale is probable. Such adjustments may be significant and result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value based on the borrower’s financial statements or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the customer and customer’s business (Level 3). Individually evaluated loans are analyzed for credit loss on a quarterly basis and the ACL on loans is adjusted as required based on the results.

Appraisals on collateral-dependent loans are performed by certified general appraisers for commercial properties or certified residential appraisers for residential properties whose qualifications and licenses have been reviewed and verified by the Bank. Once received, the Bank's internal appraisal department reviews and approves the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics.

Derivative Financial Instruments:

The Bank obtains broker or dealer quotes to value its interest rate derivative contracts, which use valuation models using observable market data as of the measurement date (Level 2), and incorporates credit valuation adjustments to reflect nonperformance risk in the measurement of fair value (Level 3). Although the Bank has determined that the majority of the inputs used to value its interest rate swap derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as borrower risk ratings, to evaluate the likelihood of default by itself and its counterparties. As of September 30, 2023 and December 31, 2022, the Bank assessed the significance of the impact of the credit valuation adjustment on the overall valuation of its interest rate swap derivatives and determined the credit valuation adjustment was not significant to the overall valuation of its interest rate swap derivatives. As a result, the Bank has classified its interest rate swap derivative valuations in Level 2 of the fair value hierarchy.

Recurring Basis

The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis at the dates indicated:


	September 30, 2023
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities	$	20,424	$	—	$	20,424	$	—
Municipal securities	106,805		5,137		101,668		—
Residential CMO and MBS	401,181		—		401,181		—
Commercial CMO and MBS	597,213		—		597,213		—
Corporate obligations	3,780		—		3,780		—
Other asset-backed securities	18,144		—		18,144		—
Total investment securities available for sale	1,147,547		5,137		1,142,410		—
Equity security	256		256		—		—
Derivative assets - interest rate swaps	33,840		—		33,840		—
Liabilities
Derivative liabilities - interest rate swaps	$	33,840	$	—	$	33,840	$	—


	December 31, 2022
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities	$	63,859	$	19,779	$	44,080	$	—

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	December 31, 2022
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Municipal securities	153,026		5,399		147,627		—
Residential CMO and MBS	424,386		—		424,386		—
Commercial CMO and MBS	664,421		—		664,421		—
Corporate obligations	3,834		—		3,834		—
Other asset-backed securities	21,917		—		21,917		—
Total investment securities available for sale	1,331,443		25,178		1,306,265		—
Equity security	185		185		—		—
Derivative assets - interest rate swaps	30,107		—		30,107		—
Liabilities
Derivative liabilities - interest rate swaps	$	30,107	$	—	$	30,107	$	—

Nonrecurring Basis

The Company may be required to measure certain financial assets and liabilities at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The following tables represent assets measured at fair value on a nonrecurring basis at the dates indicated:


			Fair Value at September 30, 2023
	Basis(1)		Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Collateral-dependent loans:
Commercial business:

Owner-occupied CRE	613		178		—		—		178











Total assets measured at fair value on a nonrecurring basis	$	613	$	178	$	—	$	—	$	178

(1) Basis represents the outstanding principal balance of collateral-dependent loans.


			Fair Value at December 31, 2022
	Basis(1)		Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Collateral-dependent loans:
Commercial business:

Owner-occupied CRE	$	613	$	182	$	—	$	—	$	182











Total assets measured at fair value on a nonrecurring basis	$	613	$	182	$	—	$	—	$	182

(1) Basis represents the outstanding principal balance of collateral-dependent loans.

The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at the dates indicated:

September 30, 2023

Fair
Value

Valuation
Technique(s)

Unobservable Input(s)

Range of Inputs

Weighted

Average (1)

(Dollars in thousands)

Collateral-dependent loans

178

Market approach

Adjustments to reflect current conditions and selling costs

16.7% - 16.7%

16.7%

(1) Weighted by net discount to net appraisal fair value

December 31, 2022

Fair
Value

Valuation
Technique(s)

Unobservable Input(s)

Range of Inputs

Weighted

Average (1)

(Dollars in thousands)

Collateral-dependent loans

182

Market approach

Adjustments to reflect current conditions and selling costs

14.6% - 14.6%

14.6%

(1) Weighted by net discount to net appraisal fair value

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(b) Fair Value of Financial Instruments

Broadly traded markets do not exist for most of the Company’s financial instruments; therefore, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein does not represent, and should not be construed to represent, the underlying value of the Company.

The following tables present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated:


	September 30, 2023
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	220,503	$	220,503	$	220,503	$	—	$	—
Investment securities available for sale	1,147,547		1,147,547		5,137		1,142,410		—
Investment securities held to maturity	746,845		636,257		—		636,257		—
Loans held for sale	263		268		—		268		—
Loans receivable, net	4,219,911		4,072,296		—		—		4,072,296
Accrued interest receivable	18,794		18,794		271		6,001		12,522
Derivative assets - interest rate swaps	33,840		33,840		—		33,840		—
Equity security	256		256		256		—		—
Financial Liabilities:
Non-maturity deposits	$	5,006,581	$	5,006,581	$	5,006,581	$	—	$	—
Certificates of deposit	628,606		637,048		—		637,048		—
Borrowings	450,000		447,952		—		447,952		—
Securities sold under agreement to repurchase	23,158		23,158		23,158		—		—
Junior subordinated debentures	21,692		19,750		—		—		19,750
Accrued interest payable	8,922		8,922		65		8,782		75
Derivative liabilities - interest rate swaps	33,840		33,840		—		33,840		—


	December 31, 2022
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	103,590	$	103,590	$	103,590	$	—	$	—
Investment securities available for sale	1,331,443		1,331,443		25,178		1,306,265		—
Investment securities held to maturity	766,396		673,434		—		673,434		—

Loans receivable, net	4,007,872		3,841,821		—		—		3,841,821
Accrued interest receivable	18,547		18,547		349		6,892		11,306
Derivative assets - interest rate swaps	30,107		30,107		—		30,107		—
Equity security	185		185		185		—		—
Financial Liabilities:
Non-maturity deposits	$	5,617,267	$	5,617,267	$	5,617,267	$	—	$	—
Certificates of deposit	307,573		308,325		—		308,325		—

Securities sold under agreement to repurchase	46,597		46,597		46,597		—		—
Junior subordinated debentures	21,473		20,000		—		—		20,000

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	December 31, 2022
	Carrying Value	Fair Value	Fair Value Measurements Using:
			Level 1	Level 2	Level 3
	(Dollars in thousands)
Accrued interest payable	143	143	57	13	73
Derivative liabilities - interest rate swaps	30,107	30,107	—	30,107	—

(9)Cash Restriction

The Bank had no cash restrictions at September 30, 2023 and December 31, 2022.

(10)Commitments and Contingencies

In the ordinary course of business, the Bank may enter into various types of transactions that include commitments to extend credit that are not included in its unaudited Condensed Consolidated Financial Statements. The Bank applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations. The majority of the commitments presented below are variable rate. Loan commitments can be either revolving or non-revolving. The Bank’s exposure to credit and market risk under commitments to extend credit is represented by the amount of these commitments.

The following table presents outstanding commitments to extend credit, including letters of credit, at the dates indicated:


	September 30, 2023		December 31, 2022
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	536,785	$	548,438
Owner-occupied CRE	9,477		3,083
Non-owner occupied CRE	32,680		13,396
Total commercial business	578,942		564,917

Real estate construction and land development:
Residential	49,008		43,460
Commercial and multifamily	345,464		348,956
Total real estate construction and land development	394,472		392,416
Consumer	336,206		323,016
Total outstanding commitments	$	1,309,620	$	1,280,349

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company as of and for the three and nine months ended September 30, 2023. The information contained in this section should be read together with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, the Cautionary Note Regarding Forward-Looking Statements included herein and the December 31, 2022 audited Consolidated Financial Statements, and the accompanying Notes included in our 2022 Annual Form 10-K.

Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.

Our business consists primarily of commercial lending and deposit relationships with small to medium sized businesses and their owners in our market areas and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans. We additionally originate for sale or for investment purposes residential real estate loans on single family properties located primarily in our markets.

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Our core profitability depends primarily on our net interest income. Net interest income is the difference between interest income, which is the income that we earn on interest earning assets, comprised primarily of loans and investment securities, and interest expense, which is the amount we pay on our interest bearing liabilities, consisting primarily of deposits and borrowings. Management manages the repricing characteristics of the Company's interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve. Like most financial institutions, our net interest income is significantly affected by general and local economic conditions, particularly changes in market interest rates including most recently significant changes as a result of inflation, and by governmental policies and actions of regulatory agencies. Net interest income is additionally affected by changes in the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.

Our net income is affected by many factors, including the provision for credit losses on loans. The provision for credit losses on loans is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. Management believes that the ACL on loans reflects the amount that is appropriate to provide for current expected credit losses in our loan portfolio based on our methodology.

Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, card revenue and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, data processing and professional services. Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses are the fixed and variable costs of buildings and equipment, and consist primarily of lease expenses, depreciation charges, maintenance and utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including the account processing system, electronic payments processing of products and services, internet and mobile banking channels and software-as-a-service providers. Professional services consist primarily of third-party service providers such as auditors, consultants and lawyers.

Results of operations may also be significantly affected by general and local economic and competitive conditions, changes in accounting, tax, and regulatory rules, governmental policies and actions of regulatory authorities, including changes resulting from inflation and the governmental actions taken to address this issue. Net income is also impacted by growth of operations through organic growth or acquisitions. See also "Cautionary Note Regarding Forward-Looking Statements."

Recent Developments

Since March 2022, inflationary pressures have resulted in higher costs for consumers and businesses. To address inflation, the Federal Open Market Committee (“FOMC”) has taken steps to tighten monetary policy through a cumulative 525 basis point increase to the federal funds rate from March 2022 through September 30, 2023. Management notes that the rapid intervals of rate increases by the Federal Reserve and flattening or inversion of the yield curve, have boosted expectations of the US entering a recession within the next 12 months. Should these ongoing economic pressures persist, we anticipate it could have an impact on the following:

•Loan growth and interest income - If economic activity begins to wane, it may have an impact on our borrowers, the businesses they operate, and their financial condition. Our borrowers may have less demand for credit needed to invest in and expand their businesses, as well as less demand for real estate loans. Such factors would place pressure on the level of interest-earning assets, which may negatively impact our interest income.

•Credit quality - Should there be a decline in economic activity, the markets we serve could experience increases in unemployment, declines in consumer confidence, and a reluctance on the part of businesses to invest in and expand their operations, among other things. Such factors may result in weakened economic conditions, place strain on our borrowers, and ultimately impact the credit quality of our loan portfolio. We expect this could result in increases in the level of past due, nonaccrual, and classified loans, as well as higher net charge-offs. While economic conditions have generally been favorable thus far, notwithstanding higher levels of inflation, there can be no assurance favorable economic conditions will continue. As such, should we experience future deterioration in the credit quality of our loan portfolio, it may contribute to the need for additional provisions for credit losses.

•ACL - The Company is required to record credit losses on certain financial assets in accordance with the CECL model stipulated under ASC 326, which is highly dependent upon expectations of future economic conditions and requires management judgment. Should expectations of future economic conditions deteriorate, the Company may be required to record additional provisions for credit losses.

•Impairment charges - If economic conditions deteriorate, it could adversely impact the Company’s operating results and the value of certain of our assets. As a result, the Company may be required to write-down the value of certain assets such as goodwill, intangible assets, or deferred tax assets when there is evidence to suggest their value has become impaired or will not be realizable at a future date.

•AOCI - Unrealized gains and losses on AFS investment securities are recognized in stockholders’ equity as accumulated other comprehensive income (loss). If economic conditions deteriorate, and/or if the interest rates continue to increase, the valuation of the Company’s AFS investment securities could be negatively impacted, which may lead to increases in other comprehensive loss, decreases to the Company’s stockholders’ equity.

•Deposits and deposit costs - Given the significant rate increases by the FOMC, it is likely that deposit costs will continue to increase and it may become more challenging for the Company to retain and attract deposit relationships.

•Liquidity - Consistent with our prudent, proactive approach to liquidity management, we may take certain actions to further enhance our liquidity, including but not limited to, increasing our FHLB borrowings, and increasing our brokered deposits.

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Further, recent developments and events in the financial services industry, including the failures of two large U.S. banks in the span of three days during March 2023 and another failure in early May 2023, created industry-wide concerns related to liquidity, deposit outflows, uninsured deposit concentrations and eroding consumer confidence in the banking system. These events have occurred against the backdrop of a rapidly rising interest rate environment which, among other things, has resulted in unrealized losses in longer duration securities and loans held by banks and more competition for bank deposits. While many factors played a role in the ultimate failures, these institutions had significant industry/demographic concentrations within their deposit bases and high ratios of uninsured deposits. Lack of diversity within a deposit base may increase the risk of events or trends that could prompt a larger-scale demand for deposits outflow. Further, concerns over a financial institution's ability to protect deposit balances in excess of the federally insured limit may increase the risk of a deposit run.

Heritage’s business, overall financial condition and depositor profiles differ substantially from the banking institutions that are the focus of the recent bank failures. We consider our deposit base to be seasoned, stable and well-diversified, and we do not have any significant industry concentrations among our non-insured deposits. At September 30, 2023, our average deposit account size, calculated by dividing period-end deposits by the population of accounts with balances, was approximately $52,000. The recent industry events and developments have not had a material impact on our financial condition, operations, customer base, liquidity capital position or risk profile, nor have they required us to make any significant changes to our interest rate risk and asset/liability management policies following a review by our Asset Liability Committee. Nevertheless, in response to these recent developments, we have (1) reviewed our contingent liquidity funding plan, including validating procedures and reviewing execution risks in the event of a sudden critical liquidity event, (2) enhanced communication with our customers by holding a bank-wide training session to provide client-facing personnel with information on FDIC insurance, alternative product offerings, and data demonstrating the financial strength of the Bank, and (3) enhanced our monitoring of deposit flows and liquidity including monitoring of (i) deposits by segment, region and location, (ii) liquidity levels and (iii) transaction volumes to better enable us to detect any potential material changes in our financial condition.

Notwithstanding the above, the continued effects of recent industry events and developments could materially and adversely impact our business or financial condition, including through potential liquidity pressures, reduced net interest margins, and potential increased credit losses. Moreover, these recent events and developments have, and could continue to, adversely impact the market price and volatility of Heritage’s securities. These recent events may also result in changes to laws or regulations governing banks and bank holding companies or result in the impositions of restrictions through supervisory or enforcement activities, including higher capital requirements, which could have a material impact on our business. The cost of resolving the recent failures may prompt the FDIC to increase its premiums above the recently increased levels or to issue additional special assessments. We are generally unable to control the amount of premiums or special assessments that our banking subsidiary may be required to pay for FDIC insurance.

The Company continues to focus on serving its customers and communities, maintaining the well-being of its employees, and executing its strategic initiatives. The Company continues to monitor the economic environment and makes changes as appropriate.

Results of Operations

Net Income Overview

Comparison of the quarter ended September 30, 2023 to the comparable quarter in the prior year

Net income decreased $2.8 million, or 13.2%, to $18.2 million, or $0.51 per diluted common share, for the three months ended September 30, 2023, compared to $21.0 million, or $0.59 per diluted common share, for the same period in 2022.

The decrease in net income was due primarily to a decrease in net interest income of $3.7 million, a decrease in noninterest income of $1.2 million and an increase in noninterest expense of $1.8 million.

The decrease in net income was partially offset by a $2.8 million decrease in provision for credit losses, reflect a $878,000 reversal of provision for credit losses for the three months ended September 30, 2023 compared to a $1.9 million provision for credit losses for the same period in 2022.

Comparison of the nine months ended September 30, 2023 to the comparable period in the prior year.

Net income decreased $3.8 million, or 6.4%, to $55.5 million, or $1.57 per diluted common share, for the nine months ended September 30, 2023 compared to $59.3 million, or $1.67 per diluted common share, for the same period in 2022. The decrease was due primarily to an increase in noninterest expense of $13.3 million and a $5.7 million increase in the provision for credit losses reflecting a $2.9 million provision for credit losses for the nine months ended September 30, 2023, compared to a $2.8 million reversal of provision for credit losses for the same period in 2022. The decrease in net income was partially offset by an increase in net interest income of $15.0 million, or 9.6%.

Net Interest Income and Margin Overview

One of the Company's key sources of earnings is net interest income. There are several factors that affect net interest income, including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities; the volume of noninterest earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' equity; market interest rate fluctuations; and asset quality.

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Market rates impact the results of the Company's net interest income, including the significant increases in the federal funds target rate by the Federal Reserve in response to inflation during 2023 and 2022. The following table provides the federal funds target rate history and changes from each period since December 31, 2021:


Change Date	Rate (%)	Rate Change (%)
December 31, 2021	0.00% - 0.25%	N/A
March 17, 2022	0.25% - 0.50%	0.25	%
May 5, 2022	0.75% - 1.00%	0.50	%
June 16, 2022	1.50% - 1.75%	0.75	%
July 28, 2022	2.25% - 2.50%	0.75	%
September 22, 2022	3.00% - 3.25%	0.75	%
November 3, 2022	3.75% - 4.00%	0.75	%
December 15, 2022	4.25% - 4.50%	0.50	%
February 2, 2023	4.50% - 4.75%	0.25	%
March 23, 2023	4.75% - 5.00%	0.25	%
May 4, 2023	5.00% - 5.25%	0.25	%
July 27, 2023	5.25% - 5.50%	0.25	%

Comparison of the quarter ended September 30, 2023 to the comparable quarter in the prior year

The following table provides relevant net interest income information for the periods indicated:


	Three Months Ended September 30,
	2023						2022						Change
	Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate(1)		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net (2)(3)	$	4,201,554	$	56,119	5.30	%	$	3,859,839	$	43,847	4.51	%	$	341,715	$	12,272	0.79	%
Taxable securities	1,931,649		14,590		3.00		1,868,900		12,362		2.62		62,749		2,228		0.38
Nontaxable securities (3)	60,654		448		2.93		133,022		892		2.66		(72,368)		(444)		0.27
Interest earning deposits	169,186		2,310		5.42		730,600		4,009		2.18		(561,414)		(1,699)		3.24
Total interest earning assets	6,363,043		73,467		4.58	%	6,592,361		61,110		3.68	%	(229,318)		12,357		0.90	%
Noninterest earning assets	849,689						775,375						74,314
Total assets	$	7,212,732					$	7,367,736					$	(155,004)
Interest Bearing Liabilities:
Certificates of Deposit	$	553,015	$	4,585	3.29	%	$	297,786	$	290	0.39	%	$	255,229	$	4,295	2.90	%
Savings accounts	523,882		172		0.13		654,697		99		0.06		(130,815)		73		0.07
Interest bearing demand and money market accounts	2,764,251		7,120		1.02		3,065,007		1,089		0.14		(300,756)		6,031		0.88
Total interest bearing deposits	3,841,148		11,877		1.23		4,017,490		1,478		0.15		(176,342)		10,399		1.08
Junior subordinated debentures	21,649		540		9.90		21,356		312		5.80		293		228		4.10
Securities sold under agreement to repurchase	31,729		38		0.48		42,959		34		0.31		(11,230)		4		0.17
Borrowings	451,032		5,394		4.74		—		—		—		451,032		5,394		4.74
Total interest bearing liabilities	4,345,558		17,849		1.63	%	4,081,805		1,824		0.18	%	263,753		16,025		1.45	%
Noninterest bearing demand deposits	1,859,374						2,356,688						(497,314)

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	Three Months Ended September 30,
	2023						2022						Change
	Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate(1)		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Other noninterest bearing liabilities	186,306						118,191						68,115
Stockholders’ equity	821,494						811,052						10,442
Total liabilities and stock-holders’ equity	$	7,212,732					$	7,367,736					$	(155,004)
Net interest income and spread			$	55,618	2.95	%			$	59,286	3.50	%			$	(3,668)	(0.55)	%
Net interest margin					3.47	%					3.57	%					(0.10)	%

(1) Average balances are calculated using daily balances. Average yield/rate is annualized.

(2) Average loans receivable, net includes loans held for sale and loans classified as nonaccrual, which carry a zero yield. Interest earned on loans receivable, net includes the amortization of net deferred loan fees of $940,000 and $857,000 for the three months ended September 30, 2023 and 2022, respectively.

(3) Yields on tax-exempt loans and securities have not been stated on a tax-equivalent basis.

The following table provides the changes in net interest income for the three months ended September 30, 2023 compared to the same period in 2022 due to changes in average asset and liability balances (volume), changes in average yields/rates (rate) and changes attributable to the combined effect of volume and rates allocated proportionately to the absolute value of changes due to volume and changes due to rates:


	Increase (Decrease) Due to Changes In:
	Volume		Yield/Rate		Total		% Change
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net	$	4,110	$	8,162	$	12,272	28.0	%
Taxable securities	426		1,802		2,228		18.0
Nontaxable securities	(527)		83		(444)		(49.8)
Interest earning deposits	(4,643)		2,944		(1,699)		(42.4)
Total interest income	$	(634)	$	12,991	$	12,357	20.2	%
Interest Bearing Liabilities:
Certificates of deposit	$	441	$	3,854	$	4,295	1,481.0	%
Savings accounts	(23)		96		73		73.7
Interest bearing demand and money market accounts	(117)		6,148		6,031		553.8
Total interest bearing deposits	301		10,098		10,399		703.6
Junior subordinated debentures	4		224		228		73.1
Securities sold under agreement to repurchase	(11)		15		4		11.8
Borrowings	5,394		—		5,394		100.0
Total interest expense	$	5,688	$	10,337	$	16,025	878.6	%
Net interest income	$	(6,322)	$	2,654	$	(3,668)	(6.2)	%

Net interest income decreased $3.7 million, or 6.2%, to $55.6 million for the three months ended September 30, 2023 as compared to $59.3 million for the same period in 2022 due primarily to a $16.0 million increase in total interest expense offset partially by a $12.4 million increase in total interest income.

Total interest expense increased to $17.8 million during the three months ended September 30, 2023 compared to $1.8 million for the same period in 2022 due primarily to a 108 basis point increase in the cost of interest bearing deposits to 1.23% for the three months ended September 30, 2023, as compared to 0.15% for the same period in 2022 due to competitive rate pressures and the addition of interest expense on borrowings during the three months ended September 30, 2023 as compared to no interest expense on borrowings during the same period in 2022.

Total interest income increased to $73.5 million for the three months ended September 30, 2023, compared to $61.1 million for the same period in 2022 primarily due to a 90 basis point increase to the yield on interest earning assets to 4.58% for the three months ended September 30, 2023, as compared to 3.68% for the same period in 2022 due to an increase in market interest rates.

Net interest margin decreased ten basis points to 3.47% for the three months ended September 30, 2023 compared to 3.57% for the same period in 2022.

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Comparison of nine months ended September 30, 2023 to the comparable period in the prior year

The following table provides relevant net interest income information for the periods indicated:


	Nine Months Ended September 30,
	2023						2022						Change
	Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate(1)		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net (2)(3)	$	4,129,429	$	160,192	5.19	%	$	3,815,387	$	125,762	4.41	%	$	314,042	$	34,430	0.78	%
Taxable securities	1,975,818		44,021		2.98		1,532,450		25,972		2.27		443,368		18,049		0.71
Nontaxable securities (3)	71,702		1,554		2.90		138,904		2,645		2.55		(67,202)		(1,091)		0.35
Interest earning deposits	114,753		4,436		5.17		1,146,183		7,057		0.82		(1,031,430)		(2,621)		4.35
Total interest earning assets	6,291,702		210,203		4.47	%	6,632,924		161,436		3.25	%	(341,222)		48,767		1.22	%
Noninterest earning assets	848,035						762,877						85,158
Total assets	$	7,139,737					$	7,395,801					$	(256,064)
Interest Bearing Liabilities:
Certificates of Deposit	$	442,301	$	8,292	2.51	%	$	318,547	$	952	0.40	%	$	123,754	$	7,340	2.11	%
Savings accounts	558,467		471		0.11		651,292		274		0.06		(92,825)		197		0.05
Interest bearing demand and money market accounts	2,791,695		16,249		0.78		3,066,229		3,089		0.13		(274,534)		13,160		0.65
Total interest bearing deposits	3,792,463		25,012		0.88		4,036,068		4,315		0.14		(243,605)		20,697		0.74
Junior subordinated debentures	21,576		1,521		9.43		21,286		745		4.68		290		776		4.75
Securities sold under agreement to repurchase	38,187		148		0.52		47,057		98		0.28		(8,870)		50		0.24
Borrowings	339,296		12,238		4.82		—		—		—	%	339,296		12,238		4.82
Total interest bearing liabilities	4,191,522		38,919		1.24	%	4,104,411		5,158		0.17	%	87,111		33,761		1.07	%
Noninterest bearing demand deposits	1,942,134						2,355,285						(413,151)
Other noninterest bearing liabilities	186,469						113,534						72,935
Stockholders’ equity	819,612						822,571						(2,959)
Total liabilities and stock-holders’ equity	$	7,139,737					$	7,395,801					$	(256,064)
Net interest income and spread			$	171,284	3.23	%			$	156,278	3.08	%			$	15,006	0.15	%
Net interest margin					3.64	%					3.15	%					0.49	%

(1) Average balances are calculated using daily balances. Average yield/rate is annualized.

(2) Average loans receivable, net includes loans held for sale and loans classified as nonaccrual, which carry a zero yield. Interest earned on loans receivable, net includes the amortization of net deferred loan fees of $2.4 million and $6.7 million for the nine months ended September 30, 2023 and 2022, respectively.

(3) Yields on tax-exempt loans and securities have not been stated on a tax-equivalent basis.

The following table provides the changes in net interest income for the nine months ended September 30, 2023 compared to the same period in 2022 due to changes in average asset and liability balances (volume), changes in average yields/rates (rate) and changes attributable to the combined effect of volume and rates allocated proportionately to the absolute value of changes due to volume and changes due to rates:


	Increase (Decrease) Due to Changes In:
	Volume		Yield/Rate		Total		% Change
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net	$	10,932	$	23,498	$	34,430	27.4	%
Taxable securities	8,646		9,403		18,049		69.5
Nontaxable securities	(1,417)		326		(1,091)		(41.2)
Interest earning deposits	(11,234)		8,613		(2,621)		(37.1)
Total interest income	$	6,927	$	41,840	$	48,767	30.2	%
Interest Bearing Liabilities:
Certificates of deposit	$	504	$	6,836	$	7,340	771.0	%

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	Increase (Decrease) Due to Changes In:
	Volume		Yield/Rate		Total		% Change
	(Dollars in thousands)
Savings accounts	(44)		241		197		71.9
Interest bearing demand and money market accounts	(301)		13,461		13,160		426.0
Total interest bearing deposits	159		20,538		20,697		479.7
Junior subordinated debentures	10		766		776		104.2
Securities sold under agreement to repurchase	(21)		71		50		51.0
Borrowings	12,238		—		12,238		100.0
Total interest expense	$	12,386	$	21,375	$	33,761	654.5	%
Net interest income	$	(5,459)	$	20,465	$	15,006	9.6	%

Net interest income increased $15.0 million, or 9.6%, to $171.3 million for the nine months ended September 30, 2023 as compared to $156.3 million for the same period in 2022 due primarily to an increase in total interest income offset partially by an increase in total interest expense.

Total interest income increased $48.8 million, or 30.2%, to $210.2 million for the nine months ended September 30, 2023, compared to $161.4 million for the same period in 2022. The increase was the result of a 122 basis point increase on the yield on interest earning assets to 4.47% for the nine months ended September 30, 2023, as compared to 3.25% for the same period in 2022, due to an increase in market interest rates as well as change in the mix of total interest earning assets into higher yielding assets.

Total interest expense increased $33.8 million, or 654.5%, to $38.9 million during the nine months ended September 30, 2023 compared to $5.2 million for the same period in 2022 due primarily to a 74 basis point increase in cost of interest bearing deposits to 0.88% for the nine months ended September 30, 2023, as compared to 0.14% for the same period in 2022, due to competitive rate pressures as well as the addition of interest expense on borrowings during the nine months ended September 30, 2023 as compared to no interest expense on borrowings during the same period in 2022.

Net interest margin increased 49 basis points to 3.64% for the nine months ended September 30, 2023 compared to 3.15% for the same period in 2022.

Provision for Credit Losses Overview

The aggregate of the provision for credit losses on loans and the provision for credit losses on unfunded commitments is presented on the unaudited Condensed Consolidated Statements of Income as the (reversal of) provision for credit losses. The ACL on unfunded commitments is included on the unaudited Condensed Consolidated Statements of Financial Condition within accrued expenses and other liabilities.

Comparison of the quarter ended September 30, 2023 to the comparable quarter in the prior year

The following table presents the (reversal of) provision for credit losses for the periods indicated:


	Three Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
(Reversal of) provision for credit losses on loans	$	(635)	$	1,919	$	(2,554)	133.1	%
(Reversal of) provision for credit losses on unfunded commitments	(243)		26		(269)		1034.6
(Reversal of) provision for credit losses	$	(878)	$	1,945	$	(2,823)	145.1	%

The provision for credit losses on loans reflects the amount required to maintain the ACL on loans at an appropriate level based upon management’s evaluation of the adequacy of collective and individual loss reserves. The reversal of provision for credit losses on loans was $635,000 during the three months ended September 30, 2023 due primarily to net recoveries of $1.2 million primarily due to the payoff of a nonaccrual loan. Future assessments of the expected credit losses will not only be impacted by changes in the composition of and amount of loans and to the reasonable and supportable forecast, but will also include an updated assessment of qualitative factors, as well as consideration of any required changes in the reasonable and supportable forecast reversion period. The reversal of provision for credit losses on unfunded commitments recognized during the three months ended September 30, 2023 was due primarily to an increase in loan utilization rates in commercial and industrial loans which reduced the unfunded exposure.

The $1.9 million provision for credit losses on loans recognized during the three months ended September 30, 2022 was due primarily to growth in loans receivable offset partially by a reduction to the ACL on loans individually evaluated for losses.

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Comparison of the nine months ended September 30, 2023 to the comparable period in the prior year

The following table presents the provision for (reversal of) credit losses for the periods indicated:


	Nine Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Provision for (reversal of) credit losses on loans	$	3,066	$	(1,252)	$	4,318	(344.9)	%
Reversal of provision for credit losses on unfunded commitments	(210)		(1,584)		1,374		(86.7)
Provision for (reversal of) credit losses	$	2,856	$	(2,836)	$	5,692	(200.7)	%

The $3.1 million provision for credit losses on loans during the nine months ended September 30, 2023 was due primarily to an increase in loans receivable as well as a change in mix of loans offset partially by net recoveries of 895,000. The $210,000 reversal of provision for credit losses on unfunded commitments recorded during the nine months ended September 30, 2023 was due primarily to an increase in loan utilization rates in commercial and industrial loans which reduced the unfunded exposure.

The $1.3 million reversal of provision for credit losses on loans recognized during the nine months ended September 30, 2022 was due primarily to a reduction of loans individually evaluated for losses and their related ACL. The $1.6 million reversal of provision for credit losses on unfunded commitments recognized during the nine months ended September 30, 2022 was due primarily to higher loan utilization rates.

Noninterest Income Overview

Comparison of the three months ended September 30, 2023 to the comparable period in the prior year

The following table presents the change in the key components of noninterest income for the periods indicated:


	Three Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Service charges and other fees	$	2,856	$	2,688	$	168	6.3	%
Card revenue	2,273		2,365		(92)		(3.9)
Loss on sale of investment securities, net	(1,940)		—		(1,940)		100.0
Gain on sale of loans, net	157		133		24		18.0
Interest rate swap fees	62		78		(16)		(20.5)
Bank owned life insurance income	734		723		11		1.5
Gain on sale of other assets, net	—		265		(265)		(100.0)
Other income	2,129		1,201		928		77.3
Total noninterest income	$	6,271	$	7,453	$	(1,182)	(15.9)	%

Noninterest income decreased $1.2 million, or 15.9%, during the three months ended September 30, 2023 compared to the same period in 2022 due primarily to a $1.9 million loss on sale of investment securities available for sale partially offset by a $610,000 gain on sale of the Ellensburg branch and related deposits included in other income.

Comparison of nine months ended September 30, 2023 to the comparable period in the prior year

The following table presents the change in the key components of noninterest income for the periods indicated:


	Nine Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Service charges and other fees	$	8,162	$	7,739	$	423	5.5	%
Card revenue	6,396		6,774		(378)		(5.6)
Loss on sale of investment securities, net	(2,226)		—		(2,226)		(100.0)
Gain on sale of loans, net	307		593		(286)		(48.2)

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	Nine Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Interest rate swap fees	230		383		(153)		(39.9)
Bank owned life insurance income	2,280		3,182		(902)		(28.3)
Gain on sale of other assets, net	2		469		(467)		(99.6)
Other income	6,659		3,867		2,792		72.2
Total noninterest income	$	21,810	$	23,007	$	(1,197)	(5.2)	%

Noninterest income decreased $1.2 million, or 5.2%, during the nine months ended September 30, 2023 compared to the same period in 2022. A loss on sale of investment securities of $2.2 million was recognized during the nine months ended September 30, 2023 as a result of the sale of $67.9 million of investment securities available for sale. Other income increased due primarily to a one-time $1.6 million gain on sale of Visa Inc. Class B common stock recognized and a $610,000 gain on sale of the Ellensburg branch and related deposits during the nine months ended September 30, 2023. Bank owned life insurance income decreased due primarily to a $1.0 million death benefit recognized during the nine months ended September 30, 2022.

Noninterest Expense Overview

Comparison of three months ended September 30, 2023 to the comparable period in the prior year

The following table presents changes in the key components of noninterest expense for the periods indicated:


	Three Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Compensation and employee benefits	$	25,008	$	24,206	$	802	3.3	%
Occupancy and equipment	4,814		4,422		392		8.9
Data processing	4,366		4,185		181		4.3
Marketing	389		358		31		8.7
Professional services	582		639		(57)		(8.9)
State/municipal business and use tax	1,088		963		125		13.0
Federal deposit insurance premium	818		500		318		63.6

Amortization of intangible assets	595		671		(76)		(11.3)
Other expense	3,310		3,203		107		3.3
Total noninterest expense	$	40,970	$	39,147	$	1,823	4.7	%

Noninterest expense increased $1.8 million, or 4.7%, during the three months ended September 30, 2023 compared to the same period in 2022 due primarily to an increase in compensation and employee benefits resulting from an increase in the number of full-time equivalent employees including the addition of commercial and relationship banking teams in 2023 and an increase in salaries and wages due to annual salary increases. Occupancy and equipment expense increased due to our recent expansion into Eugene, Oregon and Boise, Idaho. Data processing costs increased due primarily to the expansion of digital services including the addition of the ability to open consumer deposit accounts online. Federal deposit insurance premiums increased due to the increase in the assessment rate starting in January 2023.

Comparison of the nine months ended September 30, 2023 to the comparable period in the prior year

The following table presents changes in the key components of noninterest expense for the periods indicated:


	Nine Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Compensation and employee benefits	$	75,325	$	67,236	$	8,089	12.0	%
Occupancy and equipment	14,372		12,924		1,448		11.2
Data processing	13,208		12,431		777		6.3
Marketing	1,232		968		264		27.3

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	Nine Months Ended September 30,				Change
	2023		2022		$		%
	(Dollars in thousands)
Professional services	1,961		1,867		94		5.0
State/municipal business and use tax	3,150		2,626		524		20.0
Federal deposit insurance premium	2,465		1,525		940		61.6

Amortization of intangible assets	1,841		2,079		(238)		(11.4)
Other expense	10,346		8,918		1,428		16.0
Total noninterest expense	$	123,900	$	110,574	$	13,326	12.1	%

Noninterest expense increased $13.3 million, or 12.1%, during the nine months ended September 30, 2023 compared to the same period in 2022 due primarily to an increase in compensation and employee benefits resulting from a 5.9% increase in the average number of full-time equivalent employees including the addition of commercial and relationship banking teams in 2023 and an increase in salaries and wages due to annual salary increases. Occupancy and equipment expense increased due to our recent expansion into Eugene, Oregon and Boise, Idaho. Data processing costs increased due primarily to the expansion of digital services including the addition of the ability to open consumer deposit accounts online. Federal deposit insurance premiums increased due to the increase in the assessment rate starting in January 2023. Other expense increased due to an increase in customer deposit loss expense and employee related expenses, which included additional expenses related to calling efforts for the newly added teams, as well as a general increase in operating costs.

Income Tax Expense Overview

Comparison of the three months ended September 30, 2023 to the comparable period in the prior year

The following table presents the income tax expense, related metrics and their changes for the periods indicated:


	Three Months Ended September 30,						Change
	2023			2022			$			%
	(Dollars in thousands)
Income before income taxes	$	21,797		$	25,647		$	(3,850)		(15.0)	%
Income tax expense	$	3,578		$	4,657		$	(1,079)		(23.2)	%
Effective income tax rate	16.4		%	18.2		%	(1.8)		%	(9.9)	%

Income tax expense and the effective income tax rate both decreased due primarily to lower estimated pre-tax income which increased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and investments in low-income housing tax credits during the three months ended September 30, 2023 compared to the same period in 2022.

Comparison of the nine months ended September 30, 2023 to the comparable period in the prior year.

The following table presents the income tax expense and related metrics and the change for the periods indicated:


	Nine Months Ended September 30,
	2023			2022			Change			% Change
	(Dollars in thousands)
Income before income taxes	$	66,338		$	71,547		$	(5,209)		(7.3)	%
Income tax expense	$	10,816		$	12,216		$	(1,400)		(11.5)	%
Effective income tax rate	16.3		%	17.1		%	(0.8)		%	(4.7)	%

Income tax expense and the effective income rate both decreased due primarily to lower estimated pre-tax income during the nine months ended September 30, 2023 compared to the same period in 2022 which increased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and investments in low-income housing tax credits.

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Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition at the periods indicated:


	September 30, 2023		December 31, 2022		Change
					$		%
	(Dollars in thousands)
Assets
Cash and cash equivalents	$	220,503	$	103,590	$	116,913	112.9	%
Investment securities available for sale, at fair value, net	1,147,547		1,331,443		(183,896)		(13.8)
Investment securities held to maturity, at amortized cost, net	746,845		766,396		(19,551)		(2.6)
Loans held for sale	263		—		263		100.0
Loans receivable, net	4,219,911		4,007,872		212,039		5.3

Premises and equipment, net	76,436		76,930		(494)		(0.6)
Federal Home Loan Bank stock, at cost	8,373		8,916		(543)		(6.1)
Bank owned life insurance	123,639		122,059		1,580		1.3
Accrued interest receivable	18,794		18,547		247		1.3
Prepaid expenses and other assets	341,952		296,181		45,771		15.5
Other intangible assets, net	5,386		7,227		(1,841)		(25.5)
Goodwill	240,939		240,939		—		—
Total assets	$	7,150,588	$	6,980,100	$	170,488	2.4	%

Liabilities and Stockholders' Equity
Deposits	$	5,635,187	$	5,907,420	$	(272,233)	(4.6)	%
Deposits held for sale	—		17,420		(17,420)		(100.0)
Total deposits	5,635,187		5,924,840		(289,653)		(4.9)
Borrowings	450,000		—		450,000		100.0
Junior subordinated debentures	21,692		21,473		219		1.0
Securities sold under agreement to repurchase	23,158		46,597		(23,439)		(50.3)
Accrued expenses and other liabilities	207,005		189,297		17,708		9.4
Total liabilities	6,337,042		6,182,207		154,835		2.5
Common stock	548,652		552,397		(3,745)		(0.7)
Retained earnings	377,522		345,346		32,176		9.3
Accumulated other comprehensive loss, net	(112,628)		(99,850)		(12,778)		(12.8)
Total stockholders' equity	813,546		797,893		15,653		2.0
Total liabilities and stockholders' equity	$	7,150,588	$	6,980,100	$	170,488	2.4	%

Total assets increased due primarily to an increase in loans receivable, net due to loan growth and an increase in cash and cash equivalents, offset partially by a decrease in investment securities. Total liabilities and stockholders' equity increased due primarily to an increase in borrowings offset partially by a decrease in deposits.

Investment Activities Overview

Our investment policy is established by the Company's Board of Directors and monitored by the Risk Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complements the Company's lending activities. The policy permits investment in various types of liquid assets permissible under applicable regulations. Investments in non-investment grade bonds and stripped mortgage-backed securities are not permitted under the policy.

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The following table provides information regarding our investment securities at the dates indicated:


	September 30, 2023				December 31, 2022				Change
	Balance		% of Total		Balance		% of Total		$		%
	(Dollars in thousands)
Investment securities available for sale, at fair value:
U.S. government and agency securities	$	20,424	1.1	%	$	63,859	3.0	%	$	(43,435)	(68.0)	%
Municipal securities	106,805		5.6		153,026		7.3		(46,221)		(30.2)
Residential CMO and MBS(1)	401,181		21.2		424,386		20.2		(23,205)		(5.5)
Commercial CMO and MBS(1)	597,213		31.5		664,421		31.8		(67,208)		(10.1)
Corporate obligations	3,780		0.2		3,834		0.2		(54)		(1.4)
Other asset-backed securities	18,144		1.0		21,917		1.0		(3,773)		(17.2)
Total	$	1,147,547	60.6	%	$	1,331,443	63.5	%	$	(183,896)	(13.8)	%

Investment securities held to maturity, at amortized cost:
U.S. government and agency securities	$	151,040	8.0	%	$	150,936	7.2	%	$	104	0.07	%

Residential CMO and MBS(1)	273,609		14.4		290,318		13.8		(16,709)		(5.8)
Commercial CMO and MBS(1)	322,196		17.0		325,142		15.5		(2,946)		(0.9)


Total	$	746,845	39.4	%	$	766,396	36.5	%	$	(19,551)	(2.6)	%

Total investment securities	$	1,894,392	100.0	%	$	2,097,839	100.0	%	$	(203,447)	(9.7)	%

(1) U.S. government agency and government-sponsored enterprise CMO and MBS obligations.

Total investment securities decreased $203.4 million, or 9.7%, to $1.89 billion at September 30, 2023 from $2.10 billion at December 31, 2022 due primarily to maturities and prepayments of $154.0 million and sales of $67.9 million, partially offset by purchases of $37.7 million.

Loan Portfolio Overview

Changes by loan type

The Company originates a wide variety of loans with a focus on commercial business loans. In addition to originating loans, the Company may also acquire loans through pool purchases, participation purchases and syndicated loan purchases. The following table provides information about our loan portfolio by type of loan at the dates indicated:


	September 30, 2023				December 31, 2022				Change
	Amortized Cost		% of Loans Receivable		Amortized Cost		% of Loans Receivable		$		%
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	691,318	16.2	%	$	693,568	17.1	%	$	(2,250)	(0.3)	%
Owner-occupied CRE	953,779		22.4		937,040		23.1		16,739		1.8
Non-owner occupied CRE	1,690,099		39.5		1,586,632		39.2		103,467		6.5
Total commercial business	3,335,196		78.1		3,217,240		79.4		117,956		3.7
Residential real estate	377,448		8.8		343,631		8.5		33,817		9.8
Real estate construction and land development:
Residential	70,804		1.7		80,074		2.0		(9,270)		(11.6)
Commercial and multifamily	310,024		7.3		214,038		5.3		95,986		44.8
Total real estate construction and land development	380,828		9.0		294,112		7.3		86,716		29.5
Consumer	173,386		4.1		195,875		4.8		(22,489)		(11.5)
Total	$	4,266,858	100.0	%	$	4,050,858	100.0	%	$	216,000	5.3	%

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Loans receivable increased $216.0 million, or 5.3%, to $4.27 billion at September 30, 2023 from $4.05 billion at December 31, 2022 primarily due to new loan growth. New loans funded during the nine months ended September 30, 2023 were $370.2 million.

Owner-occupied CRE and non-owner occupied CRE loans increased by $120.2 million to $2.64 billion at September 30, 2023, compared to $2.52 billion at December 31, 2022. The following table provides information about owner occupied CRE and non-owner occupied CRE loans by collateral type at the dates indicated:


	September 30, 2023				December 31, 2022				Change
	Amortized Cost		% of CRE Loans		Amortized Cost		% of CRE Loans		$		%
	(Dollars in thousands)
Owner occupied and non-owner occupied CRE loans by collateral type:
Office	$	566,916	21.4	%	$	579,762	22.9	%	$	(12,846)	(2.2)	%
Industrial	415,243		15.7		366,947		14.6		48,296		13.2
Retail store / shopping center	287,746		10.9		291,799		11.6		(4,053)		(1.4)
Multi-family	286,091		10.8		256,661		10.2		29,430		11.5
Mini-storage	158,475		6.0		148,580		5.9		9,895		6.7
Mixed use property	152,979		5.8		154,793		6.1		(1,814)		(1.2)
Warehouse	152,055		5.8		147,443		5.8		4,612		3.1
Motel / hotel	141,731		5.4		129,352		5.1		12,379		9.6
Single purpose	122,819		4.6		112,924		4.5		9,895		8.8
Recreational / school	68,469		2.6		70,565		2.8		(2,096)		(3.0)
Other	291,354		11.0		264,846		10.5		26,508		10.0
Total	$	2,643,878	100.0	%	$	2,523,672	100.0	%	$	120,206	4.8	%

Office loans represented the largest segment of owner-occupied and non-owner occupied CRE loans totaling $566.9 million, or 21.4% of the total owner-occupied CRE and non-owner occupied CRE, at September 30, 2023. Of this total, $283.7 million, or 50.0%, were owner-occupied CRE loans. Owner-occupied CRE loans have a lower risk profile as there is less tenant rollover risk and generally have guarantees from the company occupying the space as well as the owners of the company. The average loan balance of owner-occupied CRE and non-owner occupied CRE was $1.2 million at September 30, 2023.

Commercial and multifamily construction loans increased $96.0 million or 44.8% due to new loan originations and advances on outstanding loans. New commitments for commercial and multifamily construction loans were $209.5 million during the nine months ended September 30, 2023.

Consumer loans decreased $22.5 million primarily due to a $33.1 million decline in indirect loans outstanding as the Bank ceased originating indirect auto loan originations in 2020.

Loans classified as nonaccrual and performing modified loans and nonperforming assets

The following table provides information about our nonaccrual loans, performing modified loans and nonperforming assets for the dates indicated:


	September 30, 2023			December 31, 2022			Change
							$			%
	(Dollars in thousands)
Nonaccrual loans: (1)
Commercial business	$	3,065		$	5,869		$	(2,804)		(47.8)	%

Real estate construction and land development	—			37			(37)			(100.0)

Total nonaccrual loans	3,065			5,906			(2,841)			(48.1)
Other real estate owned	—			—			—			—
Accruing loans past due 90 days or more	$	2,158		$	1,615		$	543		33.6	%
Total nonperforming assets	$	5,223		$	7,521		$	(2,298)		(30.6)	%

Credit quality ratios:
Nonaccrual loans to loans receivable	0.07		%	0.15		%	(0.08)		%	(53.3)	%
Nonperforming loans to loans receivable	0.12			0.19			(0.07)			(36.8)
Nonperforming assets to total assets	0.07			0.11			(0.04)			(36.4)

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	September 30, 2023		December 31, 2022	Change
				$	%
Modified loans:(2)
Commercial business	$	9,471

Real estate construction and land development	3,452
Consumer	45
Total performing modified loans	$	12,968

(1) At both September 30, 2023 and December 31, 2022, $1.5 million of nonaccrual loans, were guaranteed by government agencies.

(2) The Company adopted ASU 2022-02 on a prospective basis January 1, 2023.

The following table provides the changes in nonaccrual loans during the nine months ended September 30, 2023:




(Dollars in thousands)
Balance, beginning of period	$	5,906
Additions	908
Net principal payments, sales and transfers to accruing status	(1,175)
Payoffs	(2,574)


Balance, end of period	$	3,065

Nonaccrual loans decreased $2.8 million, or 48.1%, due primarily to ongoing collection efforts including the payoff of a commercial business loan for $1.6 million which also included a recovery of $1.1 million recognized during the three months ended September 30, 2023.

Allowance for Credit Losses on Loans Overview

The following table provides information regarding our ACL on loans for the periods indicated:


	At or For the Nine Months Ended September 30,						Change
	2023			2022			$			%
	(Dollars in thousands)
ACL on loans at the end of period	$	46,947		$	42,089		$	4,858		11.5	%

Credit quality ratios:
ACL on loans to loans receivable	1.10		%	1.05		%	0.05			4.8
ACL on loans to nonaccrual loans	1,531.71			675.15			856.56			126.9

Net recoveries	$	(895)		$	(980)		$	85		(8.7)
Average balance of loans receivable, net during the period(1)	4,129,429			3,815,387			314,042			8.2
Net recoveries on loans to average loans receivable, net(2)	(0.03)		%	(0.03)		%	—		%	—	%

(1) Average balance of loans receivable, net includes loans held for sale.

(2) Annualized.

The ACL on loans increased $4.0 million, or 9.2%, to $46.9 million at September 30, 2023 from $43.0 million at December 31, 2022 due primarily to an increase in loans receivable, net as well as a change in mix of loans.

The following table presents the ACL on loans by loan portfolio segment at the indicated dates:


	September 30, 2023						December 31, 2022
	ACL on Loans		ACL as a % of Loans in Loan Category		% of Loans in Loan Category to Total Loans		ACL on Loans		ACL as a % of Loans in Loan Category		% of Loans in Loan Category to Total Loans
	(Dollars in thousands)
Commercial business	$	31,105	0.93	%	78.1	%	$	30,718	0.95	%	79.4	%
Residential real estate	3,549		0.94		8.8		2,872		0.84		8.5
Real estate construction and land development	9,959		2.62		9.0		7,063		2.40		7.3

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	September 30, 2023						December 31, 2022
	ACL on Loans		ACL as a % of Loans in Loan Category		% of Loans in Loan Category to Total Loans		ACL on Loans		ACL as a % of Loans in Loan Category		% of Loans in Loan Category to Total Loans
	(Dollars in thousands)
Consumer	2,334		1.35		4.1		2,333		1.19		4.8
Total ACL on loans	$	46,947	1.10	%	100.0	%	$	42,986	1.06	%	100.0	%

Deposits Overview

The following table summarizes the Company's deposits at the dates indicated:


	September 30, 2023				December 31, 2022				Change
	Balance (1)		% of Total Deposits		Balance (1)		% of Total Deposits		$		%
	(Dollars in thousands)
Noninterest demand deposits	$	1,789,293	31.7	%	$	2,099,464	35.5	%	$	(310,171)	(14.8)	%
Interest bearing demand deposits	1,630,007		28.9		1,830,727		30.9		(200,720)		(11.0)
Money market accounts	1,081,253		19.2		1,063,243		17.9		18,010		1.7
Savings accounts	506,028		9.0		623,833		10.5		(117,805)		(18.9)
Total non-maturity deposits	5,006,581		88.8		5,617,267		94.8		(610,686)		(10.9)
Certificates of deposit	628,606		11.2		307,573		5.2		321,033		104.4
Total deposits	$	5,635,187	100.0	%	$	5,924,840	100.0	%	$	(289,653)	(4.9)	%

(1) Deposit balances at December 31, 2022 include deposits held for sale of $17.4 million, respectively.

Total deposits decreased $289.7 million, or 4.9%, to $5.64 billion at September 30, 2023, compared to $5.92 billion at December 31, 2022 due primarily to an overall reduction in market liquidity, as well as interest rate sensitive clients moving a portion of their non-operating deposits to higher yielding accounts. Certificate of deposits increased due to increasing rates which, attracted customers to this deposit type as well as the addition of $107.5 million in brokered deposits.

The Bank entered into a purchase and sale agreement with a third party to sell and transfer certain assets, deposits and other liabilities of its branch in Ellensburg, WA in September 2022. During the three months ended September 30, 2023, $13.8 million in deposits were sold as part of the closing of the Ellensburg branch sale, which included $13.6 million of non-maturity deposits. At December 31, 2022, $17.4 million in deposits were classified as held for sale.

Borrowings Overview

The FHLB functions as a member-owned cooperative providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At September 30, 2023, the Bank maintained a credit facility with the FHLB with available borrowing capacity of $1.20 billion. The Bank had no FHLB advances outstanding at both September 30, 2023 and December 31, 2022. Advances from the FHLB may be collateralized by FHLB stock owned by the Bank, deposits at the FHLB, certain commercial and residential real estate loans, investment securities or other assets.

The Bank maintains a credit facility with the FRB through both the Discount Window and BTFP with available borrowing capacity of $823.1 million as of September 30, 2023. The Bank had $450.0 million in BTFP borrowings outstanding at September 30, 2023. The BTFP offers loans of up to one year in length to institutions pledging eligible investment securities. The advance rate on the collateral is at par value. The average rate on borrowings from the BTFP was 4.74%. The Bank had no FRB borrowings outstanding at December 31, 2022. All advances are secured by investment securities.

The Company utilizes securities sold under agreement to repurchase with one day maturities as a supplement to funding sources. Securities sold under agreement to repurchase are secured by pledged investment securities. Under the securities sold under agreement to repurchase, the Company is required to maintain an aggregate market value of securities pledged greater than the balance of the securities sold under agreement to repurchase. At September 30, 2023 and December 31, 2022, the Company had securities sold under agreements to repurchase of $23.2 million and $46.6 million, respectively.

In addition to funds obtained in the ordinary course of business, the Company assumed trust preferred securities and junior subordinated debentures as part of a prior acquisition. For regulatory capital purposes, the trust preferred securities are included in Tier 2 capital. The junior subordinated debentures outstanding as of September 30, 2023 and December 31, 2022 were $21.7 million and $21.5 million, respectively, net of unaccreted discount.

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The Bank maintains available unsecured federal funds lines with five correspondent banks totaling $145.0 million, with no outstanding borrowings at September 30, 2023.

Stockholders' Equity Overview

The Company’s stockholders' equity to assets ratio was 11.4% at September 30, 2023 and December 31, 2022. Total stockholders' equity increased $15.7 million, or 2.0%, to $813.5 million at September 30, 2023 from $797.9 million at December 31, 2022. The increase was due primarily to $55.5 million in net income recognized, offset partially by $23.3 million in cash dividends declared, an increase of $12.8 million in accumulated other comprehensive loss as a result of declining fair values of investment securities available for sale, and $6.9 million for the repurchase of the Company's common stock during the nine months ended September 30, 2023.

The Company has historically paid cash dividends to its common shareholders. Payments of future cash dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On October 18, 2023, the Company’s board of directors declared a regular quarterly dividend of $0.22 per common share payable on November 15, 2023 to shareholders of record on November 1, 2023.

Regulatory Requirements Overview

The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. The Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve capital requirements generally parallel the FDIC requirements. 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 unaudited Condensed Consolidated Financial Statements. Additionally, the Company and the Bank are required to maintain a capital conservation buffer of common equity Tier 1 capital above 2.5% to avoid restrictions on certain activities including payment of dividends, stock repurchases and discretionary bonuses to executive officers. Management believes that as of September 30, 2023, the Company and the Bank met all capital adequacy requirements to which they are subject.

As of September 30, 2023 and December 31, 2022, the most recent regulatory notifications categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories. The following table presents the actual capital ratios of the Company and the Bank at the periods indicated:


	Company				Bank
	September 30, 2023		December 31, 2022		September 30, 2023		December 31, 2022
Common equity Tier 1 capital ratio	12.9	%	12.8	%	12.9	%	12.9	%
Leverage ratio	9.9		9.7		9.7		9.4
Tier 1 capital ratio	13.3		13.2		12.9		12.9
Total capital ratio	14.1		14.0		13.8		13.7
Capital conservation buffer	6.1		6.0		5.8		5.7

As of both September 30, 2023 and December 31, 2022, the capital measures reflect the revised CECL capital transition provisions adopted by the Federal Reserve and the FDIC that allowed the Bank the option to delay for two years until December 31, 2021 an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s effect on regulatory capital, followed by a three-year transition period.

Liquidity and Capital Resources

We maintain sufficient cash and cash equivalents and investment securities to meet short-term liquidity needs and actively monitor our long-term liquidity position to ensure the availability of capital resources for contractual obligations, strategic loan growth objectives and to fund operations. Our funding strategy has been to acquire non-maturity deposits from our retail accounts, and noninterest bearing demand deposits from our commercial customers and to use our borrowing availability to fund growth in assets. Our liquidity policy permits the purchase of brokered deposits in an amount not to exceed 15% of the Bank's total deposits as a secondary source for funding. At September 30, 2023, we had $107.5 million in brokered deposits, which constituted 1.91% of total deposits. Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition so we adhere to internal management targets assigned to the loan to deposit ratio,

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liquidity ratio, net short-term non-core funding ratio and non-core liabilities to total assets ratio to ensure an appropriate liquidity position. The Company regularly monitors liquidity, models liquidity stress scenarios to ensure that adequate liquidity is available, and has contingency funding plans in place, which are reviewed and tested on a regular, recurring basis.

The following table summarizes the Company's available liquidity as of the dates indicated:


	September 30, 2023		December 31 2022
	(Dollars in thousands)
FRB borrowing availability	$	823,117	$	46,827
FHLB borrowing availability(1)	1,202,172		1,226,234
Unencumbered investment securities available for sale(2)	779,871		1,323,947
Cash and cash equivalents	220,503		103,590
Fed funds line borrowing availability with correspondent banks	145,000		215,000
Total sources of liquidity	3,170,663		2,915,598
Less: Borrowings outstanding	(450,000)		—
Total available liquidity	$	2,720,663	$	2,915,598

(1) Includes FHLB borrowing availability of $1.20 billion at September 30, 2023 based on pledged assets, however, maximum credit capacity is 45% of the Bank's total assets one quarter in arrears or $3.10 billion.

(2) Investment securities available for sale at fair value.

Management believes the capital sources are adequate to meet all reasonably foreseeable short-term and long-term cash requirements and there has not been a material change in our capital resources since the information disclosed in our 2022 Annual Form 10-K. We are not aware of any reasonably likely material changes in the mix and relative cost of such resources.

Critical Accounting Estimates

Our critical accounting estimates are described in detail in the "Critical Accounting Estimates" section within Item 7 of our 2022 Annual Form the Form 10-K. The SEC defines "critical accounting estimates" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. The Company's critical accounting estimates include estimates of the ACL on loans, the ACL on unfunded commitments and goodwill. There have been no material changes in these estimates during the nine months ended September 30, 2023.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk represents the risk of loss due to changes in market values of assets and liabilities. We incur market risk in the normal course of business through our exposure to market interest rates, equity prices and credit spreads. Our primary market risk is interest rate risk, which is the risk of loss of net interest income or net interest margin resulting from changes in market interest rates. Interest rate risk results primarily from the traditional banking activities in which the Bank engages, such as gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences, affect the difference between the interest earned on our assets and the interest paid on our liabilities. 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 risk committee of the Board of Directors oversees market risk management, including the monitoring of risk measures and limits and policy guidelines, for the amount of interest rate risk and its effect on net interest income and capital.

Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.

Net interest income simulation

An income simulation model is the primary tool we use to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Modeling the sensitivity of net interest income is highly dependent on numerous assumptions incorporated into the modeling process. Key assumptions in the model include prepayment speeds on loans and investment securities, repricing betas on non-maturity deposits, and pricing on investment securities, loans, and borrowings. In order to measure the interest rate risk sensitivity, this simulation model uses a “no balance sheet growth” assumption and assumes an instantaneous and sustained uniform change in market interest rates at all maturities. These assumptions are inherently uncertain and, as a result, the net interest income projections should be viewed as an estimate of the net interest income sensitivity at the time of the analysis. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors.

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Based on the results of the simulation model, the following table presents the change in our net interest income as a result of parallel rate shock scenarios for the presented periods after the dates shown:


	September 30, 2023				December 31, 2022
	Amount		% Change in Net Interest Income		Amount		% Change in Net Interest Income
	(Dollars in thousands)
Modeled increase in market interest rates of 100 basis points
Increase in net interest income in Year 1	$	2,420	1.1	%	$	5,113	2.0	%
Increase in net interest income in Year 2	4,104		1.6		11,147		4.1
Modeled increase in market interest rates of 200 basis points
Increase in net interest income in Year 1	3,184		1.4		8,181		3.2
Increase in net interest income in Year 2	6,266		2.4		19,889		7.3
Modeled decrease in market interest rates of 100 basis points
Increase (decrease) in net interest income in Year 1	3,125		1.4		(5,433)		(2.1)
Decrease in net interest income in Year 2	318		0.1		(10,534)		(3.9)
Modeled decrease in market interest rates of 200 basis points
Increase (decrease) in net interest income in Year 1	2,812		1.2		(16,840)		(6.6)
Decrease in net interest income in Year 2	$	(4,113)	(1.6)	%	$	(29,942)	(11.0)	%

These scenarios are based on market interest rates as of the last day of a reporting period published by independent sources that are actively traded in the open market. The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of reprice characteristics, future cash flows and customer behavior. These assumptions are inherently uncertain and actual results will differ, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower net interest income.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and procedures (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of September 30, 2023 were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act was (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the three months ended September 30, 2023, 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

Neither the Company nor the Bank is a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors set forth in Item 1A of the Company’s 2022 Annual Form 10-K.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES, USE OF PROCEEDS, AND ISSUER PURCHASES OF EQUITY SECURITIES

(a) Not applicable.

(b) Not applicable.

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The following table provides information about repurchases of common stock by the Company during the three months ended September 30, 2023:


Period	Total Number of Shares Purchased (1)	Average Price Paid Per Share (1)		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (2)
July 1, 2023—July 31, 2023	—	$	—	10,169,168	455,909
August 1, 2023— August 31, 2023	—	—		10,169,168	455,909
September 1, 2023—September 30, 2023	148,454	17.08		10,317,287	307,790
Total	148,454	$	17.08

(1)Of the common shares repurchased by the Company between July 1, 2023 and September 30, 2023, a total of 335 shares represented the cancellation of stock to pay withholding taxes on vested restricted stock units and were not repurchased pursuant to the publicly announced stock repurchase program.

(2)On March 12, 2020 the Company's Board of Directors announced the repurchase of up to 5% of the Company's outstanding common shares, or 1,799,054 shares, under the twelfth stock repurchase plan. The repurchase program does not have a set expiration date and will expire upon repurchase of the full amount of authorized shares, unless terminated sooner by the board of directors. The repurchase program may be suspended or discontinued at any time by the Company’s board of directors.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

(a) None

(b) None

(c) During the three and nine months ended September 30, 2023, there were no Rule 10b5‑1 trading arrangements (as defined in Item 408(a) of Regulation S-K) or non-Rule 10b5-1 trading arrangements (as defined in Item 408(c) of Regulation S-K) adopted or terminated by any director or officer (as defined in Rule 16a‑1(f) under the Exchange Act) of the Company.

ITEM 6. EXHIBITS

Incorporated by Reference

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

10.1*

Heritage Financial Corporation 2023 Omnibus Equity Plan

DEF 14A

4.4

03/22/2023

10.2*

Form of Restricted Stock Unit Award Agreement under the Heritage Financial Corporation 2023 Omnibus Equity Plan

S-8

4.5

05/08/23

10.3*

Form of Performance-Based Restricted Stock Unit Award Agreement under the Heritage Financial Corporation 2023 Omnibus Equity Plan

S-8

4.6

05/08/23

31.1

Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (1)

31.2

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (1)

32.1

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1)

101.INS

XBRL Instance Document (1)

101.SCH

XBRL Taxonomy Extension Schema Document (1)

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document (1)

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document (1)

101.LAB

XBRL Taxonomy Extension Label Linkbase Document (1)

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Incorporated by Reference

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document (1)

104

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

* Indicates management contract or compensatory plan or arrangement.

(1) Filed herewith.

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.


						HERITAGE FINANCIAL CORPORATION
Date:
November 8, 2023						/S/ JEFFREY J. DEUEL
						Jeffrey J. Deuel
						President and Chief Executive Officer
Date:
November 8, 2023						/S/ DONALD J. HINSON
						Donald J. Hinson
						Executive Vice President and Chief Financial Officer