Table of Contents
I
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 transition period from to
Commission File Number 000-10537
(Exact name of Registrant as specified in its charter)
Delaware
36-3143493
(State or other jurisdiction
(I.R.S. Employer Identification Number)
of incorporation or organization)
37 South River Street, Aurora, Illinois 60507
(Address of principal executive offices) (Zip Code)
(630) 892-0202
(Registrant’s telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock
OSBC
The Nasdaq Stock Market
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 and post 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 Exchange Act Rule 12b-2).
Yes ☐ No ☒
As of November 3, 2023, the Registrant has 44,697,917 shares of common stock outstanding at $1.00 par value per share.
OLD SECOND BANCORP, INC.
Form 10-Q Quarterly Report
Cautionary Note Regarding Forward-Looking Statements
PART I
Page Number
Item 1.
Financial Statements
4
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
37
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
62
Item 4.
Controls and Procedures
63
PART II
Legal Proceedings
64
Item 1.A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosure
Item 5.
Other Information
Item 6.
Exhibits
65
Signatures
66
2
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report and other publicly available documents of the Company contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including, but not limited to, management’s expectations regarding future plans, strategies and financial performance, including regulatory developments, industry and economic trends and estimates and assumptions underlying accounting policies. Forward-looking statements are based on our current beliefs, expectations and assumptions and on information currently available and, can be identified by the use of words such as “should,” “anticipate,” “expect,” “estimate,” “intend,” “believe,” “may,” “likely,” “will,” “forecast,” “project,” “looking forward,” “optimistic,” “hopeful,” “potential,” “progress,” “prospect,” “remain,” “continue,” “trend,” “momentum” or the negative thereof as well as other similar words and expressions of the future. Forward-looking statements are subject to risks, uncertainties and assumptions that are difficult to predict as to timing, extent, likelihood and degree of occurrence, which could cause our actual results to differ materially from those anticipated in or by such statements. Potential risks and uncertainties include, but are not limited to, the following:
Because the Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain, there can be no assurances that future actual results will correspond to any forward-looking statements and you should not rely on any forward-looking statements. Additionally, all statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events, except as required by applicable law.
3
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share data)
(unaudited)
September 30,
December 31,
2023
2022
Assets
Cash and due from banks
$
55,548
56,632
Interest earning deposits with financial institutions
53,485
58,545
Cash and cash equivalents
109,033
115,177
Securities available-for-sale, at fair value
1,229,618
1,539,359
Federal Home Loan Bank Chicago (“FHLBC”) and Federal Reserve Bank Chicago (“FRBC”) stock
35,830
20,530
Loans held-for-sale
2,297
491
Loans
4,029,543
3,869,609
Less: allowance for credit losses on loans
51,729
49,480
Net loans
3,977,814
3,820,129
Premises and equipment, net
76,472
72,355
Other real estate owned
407
1,561
Mortgage servicing rights, at fair value
11,461
11,189
Goodwill
86,478
Core deposit intangible
11,820
13,678
Bank-owned life insurance (“BOLI”)
108,187
106,608
Deferred tax assets, net
44,051
44,750
Other assets
64,688
56,012
Total assets
5,758,156
5,888,317
Liabilities
Deposits:
Noninterest bearing demand
1,862,659
2,051,702
Interest bearing:
Savings, NOW, and money market
2,273,671
2,617,100
Time
477,990
441,921
Total deposits
4,614,320
5,110,723
Securities sold under repurchase agreements
25,894
32,156
Other short-term borrowings
435,000
90,000
Junior subordinated debentures
25,773
Subordinated debentures
59,361
59,297
Senior notes
-
44,585
Notes payable and other borrowings
9,000
Other liabilities
65,250
55,642
Total liabilities
5,225,598
5,427,176
Stockholders’ Equity
Common stock
44,705
Additional paid-in capital
201,553
202,276
Retained earnings
377,320
310,512
Accumulated other comprehensive loss
(90,619)
(93,124)
Treasury stock
(401)
(3,228)
Total stockholders’ equity
532,558
461,141
Total liabilities and stockholders’ equity
September 30, 2023
December 31, 2022
Common
Stock
Par value
1.00
Shares authorized
60,000,000
Shares issued
44,705,150
Shares outstanding
44,684,987
44,582,311
Treasury shares
20,163
122,839
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income
(In thousands, except per share data)
Three Months Ended September 30,
Nine Months Ended September 30,
Interest and dividend income
Loans, including fees
62,665
46,614
181,436
121,209
29
22
60
111
Securities:
Taxable
8,946
9,116
29,611
21,071
Tax exempt
1,333
1,332
4,007
3,946
Dividends from FHLBC and FRBC stock
597
261
1,273
677
Interest bearing deposits with financial institutions
659
663
1,887
1,714
Total interest and dividend income
74,229
58,008
218,274
148,728
Interest expense
Savings, NOW, and money market deposits
2,558
380
5,449
1,124
Time deposits
1,982
335
3,802
877
27
10
43
30
5,840
44
13,345
245
285
805
849
547
546
1,639
728
2,408
1,791
87
309
Total interest expense
11,199
2,439
27,578
6,663
Net interest and dividend income
63,030
55,569
190,696
142,065
Provision for credit losses
3,000
4,500
8,501
5,050
Net interest and dividend income after provision for credit losses
60,030
51,069
182,195
137,015
Noninterest income
Wealth management
2,475
2,280
7,203
7,484
Service charges on deposits
2,504
2,661
7,290
7,063
Secondary mortgage fees
81
201
270
Mortgage servicing rights mark to market gain (loss)
281
548
(148)
3,608
Mortgage servicing income
519
514
1,534
1,612
Net gain on sales of mortgage loans
449
1,111
1,682
Securities losses, net
(924)
(1)
(4,146)
(34)
Change in cash surrender value of BOLI
919
146
1,579
342
Card related income
2,606
2,653
7,540
8,194
Other income
1,024
2,165
3,286
3,949
Total noninterest income
9,877
11,496
25,450
34,170
Noninterest expense
Salaries and employee benefits
23,115
21,011
67,161
62,310
Occupancy, furniture and equipment
3,506
4,119
10,620
10,864
Computer and data processing
1,922
2,543
4,986
12,817
FDIC insurance
744
2,122
1,771
Net teller & bill paying
534
504
1,551
3,245
General bank insurance
300
257
911
923
Amortization of core deposit intangible
616
657
1,858
1,981
Advertising expense
93
83
338
459
Card related expense
1,347
1,453
3,785
3,044
Legal fees
97
212
699
648
Consulting & management fees
549
607
1,859
1,746
Other real estate (income) expense, net
(27)
21
181
96
Other expense
4,627
3,862
12,104
11,585
Total noninterest expense
37,423
35,988
108,175
111,489
Income before income taxes
32,484
26,577
99,470
59,696
Provision for income taxes
8,149
7,054
25,966
15,906
Net income
24,335
19,523
73,504
43,790
Basic earnings per share
0.55
0.43
1.65
0.98
Diluted earnings per share
0.54
1.62
0.97
Dividends declared per share
0.05
0.15
5
Consolidated Statements of Comprehensive Income (Loss)
(In thousands)
Net Income
Unrealized holding losses on available-for-sale securities arising during the period
(9,062)
(41,163)
(1,212)
(146,477)
Related tax benefit
2,538
11,526
344
41,014
Holding losses, after tax, on available-for-sale securities
(6,524)
(29,637)
(868)
(105,463)
Less: Reclassification adjustment for the net losses realized during the period
Net realized losses
260
1
1,165
Net realized losses after tax
(664)
(2,981)
(24)
Other comprehensive (loss) income on available-for-sale securities
(5,860)
2,113
(105,439)
Changes in fair value of derivatives used for cash flow hedges
1,975
(4,868)
560
(2,381)
Related tax (expense) benefit
(548)
1,360
(168)
Other comprehensive income (loss) on cash flow hedges
1,427
(3,508)
392
(1,718)
Total other comprehensive (loss) income
(4,433)
(33,145)
2,505
(107,157)
Total comprehensive income (loss)
19,902
(13,622)
76,009
(63,367)
Accumulated
Total
Unrealized Gain
Accumulated Other
(Loss) on Securities
(Loss) on Derivative
Comprehensive
Available-for -Sale
Instruments
Income/(Loss)
For the Three Months Ended
Balance, July 1, 2022
(64,663)
(581)
(65,244)
Other comprehensive loss, net of tax
Balance, September 30, 2022
(94,300)
(4,089)
(98,389)
Balance, July 1, 2023
(80,919)
(5,267)
(86,186)
Other comprehensive (loss) income, net of tax
Balance, September 30, 2023
(86,779)
(3,840)
For the Nine Months Ended
Balance, January 1, 2022
11,139
(2,371)
8,768
Balance, January 1, 2023
(88,892)
(4,232)
Other comprehensive income, net of tax
6
Consolidated Statements of Cash Flows
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net premium / discount amortization on securities
2,506
4,259
4,146
34
Originations of loans held-for-sale
(39,068)
(65,103)
Proceeds from sales of loans held-for-sale
37,962
69,263
Net gains on sales of mortgage loans
(1,111)
(1,682)
Mortgage servicing rights mark to market loss (gain)
148
(3,608)
Net accretion of discount on loans and unfunded commitments
(2,620)
(5,473)
Net change in cash surrender value of BOLI
(1,579)
(342)
Net gains on sale of other real estate owned
(229)
(163)
Provision for other real estate owned valuation losses
269
104
Depreciation of fixed assets and amortization of leasehold improvements
3,246
3,079
Net gains on disposal and transfer of fixed assets
(636)
(1,872)
Amortization of core deposit intangibles
Change in current income taxes receivable
1,070
7,279
Deferred tax expense
(289)
(1,854)
Change in accrued interest receivable and other assets
(10,053)
1,036
Accretion of purchase accounting adjustment on time deposits
(1,004)
(1,207)
Change in accrued interest payable and other liabilities
7,991
3,314
Stock based compensation
2,709
2,176
Net cash provided by operating activities
87,321
60,061
Cash flows from investing activities
Proceeds from maturities and calls, including pay down of securities available-for-sale
104,471
231,483
Proceeds from sales of securities available-for-sale
205,738
3,303
Purchases of securities available-for-sale
(4,186)
(301,649)
Net purchases of FHLBC/FRBC stock
(15,300)
(6,156)
Net change in loans
(164,252)
(443,628)
Proceeds from sales of other real estate owned, net of participations and improvements
1,800
941
Proceeds from disposition of premises and equipment
4,460
12,167
Net purchases of premises and equipment
(8,217)
(2,670)
Cash paid for acquisition, net of cash and cash equivalents acquired
(146)
Net cash provided by (used in) investing activities
124,514
(506,355)
Cash flows from financing activities
Net change in deposits
(495,399)
(183,666)
Net change in securities sold under repurchase agreements
(6,262)
(14,840)
Net change in other short-term borrowings
345,000
25,000
Repayment of term note
(9,000)
(3,000)
Net change in notes payable and other borrowings, excluding term note
(6,056)
Repayment of senior notes
(45,000)
Dividends paid on common stock
(6,713)
(6,650)
Purchase of treasury stock
(605)
(447)
Net cash used in financing activities
(217,979)
(189,659)
Net change in cash and cash equivalents
(6,144)
(635,953)
Cash and cash equivalents at beginning of period
752,107
Cash and cash equivalents at end of period
116,154
7
Consolidated Statements of Changes in
Additional
Other
Paid-In
Retained
Treasury
Stockholders’
Capital
Earnings
Income (Loss)
Equity
201,282
271,831
(3,670)
448,904
Dividends declared on common stock, ($0.05 per share)
(2,228)
Vesting of restricted stock
(304)
304
722
Purchase of treasury stock from taxes withheld on stock awards
(62)
201,700
289,126
(3,428)
433,714
200,963
355,219
(746)
513,955
(2,234)
(345)
345
935
202,443
252,011
(5,900)
502,027
Dividends declared on common stock, ($0.15 per share)
(6,675)
(2,919)
2,919
(6,696)
(3,432)
3,432
8
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share data, unaudited)
Note 1 – Basis of Presentation and Changes in Significant Accounting Policies
The accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended September 30, 2023 are not necessarily indicative of the results that may be expected for the year ending December 31, 2023. These interim consolidated financial statements and accompanying notes are unaudited and should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) annual report on Form 10-K for the year ended December 31, 2022. Unless otherwise indicated, dollar amounts in the tables contained in the notes to the consolidated financial statements are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.
The Company’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.
Recent Accounting Pronouncements
The following is a summary of recent accounting pronouncements that have impacted or could potentially affect the Company:
ASU 2018-16, ASU 2020-04, ASU 2021-01, and ASU 2022-06 – In October 2018, the Financial Standards Board, or FASB, issued ASU No. 2018-16 “Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting.” ASU 2018-16 adds the SOFR overnight index swap rate to the list of United States (U.S.) benchmark rates eligible for hedge accounting purposes, which is the fourth rate permissible to be used as a U.S. benchmark rate. This guidance was effective for annual and interim periods beginning after December 15, 2018, and did not have a material impact on the financial condition or liquidity of the Company. ASU 2020-04 and ASU 2021-01 Reference Rate Reform (Topic 848) were issued on March 12, 2020 and January 7, 2021, respectively, and each provide further guidance on optional expedients and exceptions for applying GAAP to contract modifications and hedging relationships due to the discontinuation of LIBOR. In addition, on March 5, 2021, the International Swaps and Derivatives Association (“ISDA”) issued a statement with an “Index Cessation Event Announcement,” which confirmed the extension of the cessation of LIBOR-referenced rates from December 31, 2021, to June 30, 2023, for certain rate tenors. ASU 2022-06 further defers the sunset date of Topic 848 from December 31, 2022, to December 31, 2024, after which entities will no longer be permitted to apply the relief in Topic 848.
The Company formed a LIBOR transition team in 2019 and developed a project plan to assess the use of alternative indexes and to seek to ensure all financial instruments that reference LIBOR are identified, quantified, and researched for the LIBOR fallback language available or needed. The Company completed the ISDA protocol adherence for LIBOR fallback language for all commercial swaps, met with its commercial loan clients to also guide their swap fallback language adherence, and worked to revise all credit documents being issued by Old Second National Bank (the “Bank”) for new loans to ensure appropriate fallback language was included. We discontinued the use of LIBOR as a reference rate for all consumer loans issued after July 31, 2021, and all commercial loans issued after December 31, 2021, with certain exceptions for those loans that were in the process of funding at the end of 2021. The Company’s systems were updated to handle multiple SOFR-based indexes and we planned accordingly for the transition of existing LIBOR exposures as the final LIBOR cessation date was June 30, 2023. As of September 30, 2023, the Company’s LIBOR transition processes were determined to be completed and alternative index rates are in place.
9
ASU 2022-01 – On March 28, 2022, the FASB issued ASU 2022-01 “Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method.” The goal of this new hedging standard is to better align the economic results of risk management activities with hedge accounting, by allowing multiple layers of a single closed portfolio to be hedged, as compared to the single-layer, or last of layer method, allowed with the adoption of ASU 2017-12. ASU 2022-01 is effective for public business entities for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and was adopted by the Company as of January 1, 2023. There was no material impact of the pronouncement to the financial statements of the Company.
ASU 2022-02 – On March 31, 2022, the FASB issued ASU 2022-02 “Financial Instruments-Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures.” The amendments eliminate certain troubled debt restructuring (“TDR”) recognition and measurement guidance previously in effect, and consideration of the TDRs similar to other modified loans under CECL is now required. ASU 2022-02 also requires enhancements to vintage loan disclosures, requiring detail be provided on current-period gross write-offs and disclosure of the amortized cost basis of financing receivables by credit quality indicators and by loan portfolio class of the gross charge-off based on year of origination. ASU 2022-02 was effective for fiscal years beginning after December 15, 2022, including interim periods within those years, and was adopted prospectively by the Company as of January 1, 2023. There was no material impact of the pronouncement to the financial statements of the Company.
Change in Significant Accounting Policies
Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. During the third quarter of 2023, the Company had no changes to significant accounting policies or estimates.
Subsequent Events
On October 17, 2023, our Board of Directors declared a cash dividend of $0.05 per share payable on November 6, 2023, to stockholders of record as of October 27, 2023; dividends of $2.2 million are scheduled to be paid to stockholders on November 6, 2023.
Note 2 – Acquisition
On December 1, 2021, the Company completed its acquisition of West Suburban Bancorp, Inc. (“West Suburban”), a bank holding company, and its wholly owned subsidiary, West Suburban Bank, based in Lombard, Illinois, with operations throughout our existing market footprint. At closing, the Company acquired $2.94 billion of assets, $1.50 billion of loans, $1.07 billion of securities, and $2.69 billion of deposits, net of fair value adjustments. Under the terms of the merger agreement, each outstanding share of West Suburban common stock was exchanged for 42.413 shares of Company common stock, plus $271.15 of cash. This resulted in merger consideration of $295.2 million, based on the closing price of the Company’s common stock on the date of acquisition, which consisted of 15.7 million shares of the Company’s common stock and $100.7 million of cash. Goodwill of $67.9 million associated with the acquisition was recorded by the Company, which was the result of expected synergies, operational efficiencies and other factors. The acquisition of West Suburban was accounted for as a business combination, and none of the $67.9 million of goodwill recorded is expected to be deductible for income tax purposes.
Note 3 – Securities
Investment Portfolio Management
Our investment portfolio serves the liquidity needs and income objectives of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets. The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives. Portfolio size and composition will be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.
Investments are comprised of debt securities and non-marketable equity investments. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.
Federal Home Loan Bank of Chicago (“FHLBC”) and Federal Reserve Bank of Chicago (“FRBC”) stock are considered nonmarketable equity investments. FHLBC stock was recorded at $20.9 million at September 30, 2023, and $5.6 million at December 31, 2022. FRBC stock was recorded at $14.9 million at September 30, 2023 and December 31, 2022.
The following tables summarize the amortized cost and fair value of the securities portfolio at September 30, 2023, and December 31, 2022, and the corresponding amounts of gross unrealized gains and losses:
Gross
Amortized
Unrealized
Fair
Cost1
Gains
Losses
Value
Securities available-for-sale
U.S. Treasury
224,481
(7,704)
216,777
U.S. government agencies
60,197
(4,376)
55,821
U.S. government agencies mortgage-backed
122,653
(18,084)
104,569
States and political subdivisions
240,107
142
(20,149)
220,100
Corporate bonds
5,000
(39)
4,961
Collateralized mortgage obligations
450,470
54
(63,845)
386,679
Asset-backed securities
71,241
(4,325)
66,916
Collateralized loan obligations
175,995
(2,210)
173,795
Total securities available-for-sale
1,350,144
206
(120,732)
224,054
(11,925)
212,129
61,178
(5,130)
56,048
140,588
(15,598)
124,990
239,999
363
(14,234)
226,128
10,000
(378)
9,622
596,336
(62,569)
533,768
210,388
(8,466)
201,928
180,276
(5,530)
174,746
1,662,819
370
(123,830)
1 Excludes accrued interest receivable of $6.7 million and $6.8 million at September 30, 2023 and December 31, 2022, respectively, that is recorded in other assets on the consolidated balance sheets.
11
The fair value, amortized cost and weighted average yield of debt securities at September 30, 2023, by contractual maturity, are listed in the table below. Securities not due at a single maturity date are shown separately.
Weighted
Average
Cost
Yield
Due in one year or less
49,989
0.64
%
49,804
Due after one year through five years
253,955
1.17
241,430
Due after five years through ten years
60,975
2.92
53,882
Due after ten years
164,866
3.11
152,543
529,785
1.92
497,659
Mortgage-backed and collateralized mortgage obligations
573,123
2.29
491,248
4.24
7.21
3.00
At September 30, 2023, the Company had no securities issued from any one originator, other than the U.S. Government and its agencies, which individually amounted to over 10% of the Company’s stockholders’ equity.
Securities with unrealized losses with no corresponding allowance for credit losses at September 30, 2023 and December 31, 2022, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands except for number of securities):
Less than 12 months
12 months or more
in an unrealized loss position
Number of
Securities
U.S. Treasuries
7,704
4,376
128
18,084
3,232
110,511
16,917
104,582
74
20,149
215,093
39
14
756
63,831
379,159
63,845
379,915
19
4,325
33
2,210
170,803
46
111,267
371
117,486
1,103,588
417
120,732
1,214,855
1,025
24,121
10,900
188,008
11,925
5,130
15
975
11,369
117
14,623
113,621
132
15,598
45
5,800
128,770
8,434
48,877
14,234
177,647
378
80
12,895
180,624
120
49,674
348,880
200
62,569
529,504
3,030
121,915
5,436
79,659
51
8,466
201,574
23
3,579
112,772
1,951
61,974
5,530
194
27,304
579,571
299
96,526
906,689
493
123,830
1,486,260
Each quarter, we perform an analysis to determine if any of the unrealized losses on securities available-for-sale are comprised of credit losses as compared to unrealized losses due to market interest rate adjustments. Our assessment includes a review of the unrealized loss for each security issuance held; the financial condition and near-term prospects of the issuer, including external credit ratings and recent downgrades; and our ability and intent to hold the security for a period of time sufficient for a recovery in value. We also consider the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies. The portfolio continues to consist of a mix of fixed and floating-rate, high quality securities, largely rated AA (or better), displaying an overall effective duration of approximately 3.0 years. No credit losses were determined to be present as of September 30, 2023, as there was no credit quality deterioration noted. Therefore, no provision for credit losses on securities was recognized for the third quarter of 2023.
12
The following table presents net realized losses on securities available-for-sale for three and nine months ended:
Three Months Ended
Nine Months Ended
Proceeds from sales of securities
65,572
Gross realized losses on securities
Income tax benefit on net realized losses
Effective tax rate applied
28.1
N/M
29.4
N/M - Not meaningful
As of September 30, 2023, securities valued at $808.7 million were pledged for borrowings, and for other purposes, an increase from $547.8 million of securities pledged at year-end 2022.
Note 4 – Loans and Allowance for Credit Losses on Loans
Major segments of loans were as follows:
Commercial
834,877
840,964
Leases
354,827
277,385
Commercial real estate – investor
1,047,122
987,635
Commercial real estate – owner occupied
809,050
854,879
Construction
202,546
180,535
Residential real estate – investor
53,762
57,353
Residential real estate – owner occupied
227,446
219,718
Multifamily
372,020
323,691
HELOC
102,055
109,202
Other 1
25,838
18,247
Total loans
Allowance for credit losses on loans
(51,729)
(49,480)
Net loans 2
1 The “Other” segment includes consumer loans and overdrafts in this table and in subsequent tables within Note 4 – Loans and Allowance for Credit Losses on Loans.
2 Excludes accrued interest receivable of $19.2 million and $15.9 million at September 30, 2023 and December 31, 2022, respectively, that is recorded in other assets on the consolidated balance sheets.
It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained. The type of collateral, when required, will vary from liquid assets to real estate. The Company seeks to assure access to collateral, in the event of borrower default, through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. Although the Bank makes loans primarily within its market area, there are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector. The real estate related categories listed above represent 69.8% and 70.6% of the portfolio at September 30, 2023, and December 31, 2022, respectively, and include a mix of owner occupied and non-owner occupied commercial real estate, residential, construction and multifamily loans.
13
The following tables represent the activity in the allowance for credit losses for loans, or the ACL, for the three and nine months ended September 30, 2023 and 2022:
Provision for
Beginning
(Release of)
Ending
Allowance for credit losses
Balance
Credit Losses
Charge-offs
Recoveries
Three months ended September 30, 2023
11,532
(1,025)
20
10,499
2,690
(193)
95
2,592
20,031
4,726
6,774
18,003
12,562
(154)
35
12,385
1,179
100
1,240
743
(55)
691
1,868
(36)
25
1,857
2,737
(165)
2,572
1,694
(77)
1,652
278
107
238
55,314
3,012
6,936
339
Nine months ended September 30, 2023
11,968
(1,287)
427
2,865
498
882
10,674
14,117
6,845
57
15,001
(2,397)
236
17
1,546
(406)
768
(104)
2,046
(260)
71
2,453
119
1,806
(242)
88
353
53
301
133
10,091
8,691
Three months ended September 30, 2022
14,114
(919)
67
47
13,175
1,736
178
9,436
256
124
9,587
11,478
3,618
15,171
1,535
1,544
661
147
816
1,869
149
113
2,131
2,434
2,530
1,542
386
1,963
583
(128)
103
396
45,388
3,527
484
416
48,847
Nine months ended September 30, 2022
11,751
1,488
85
3,480
(1,768)
10,795
604
4,913
10,289
102
3,373
(1,829)
760
2,832
218
3,675
(1,208)
2,510
(649)
192
404
320
44,281
5,177
1,384
773
At September 30, 2023, our allowance for credit losses (“ACL”) on loans totaled $51.7 million, and our ACL on unfunded commitments, included in other liabilities, totaled $2.9 million including related purchase accounting adjustments. During the first nine months of 2023, we recorded net provision expense of $8.5 million based on historical loss rate updates driven by higher charge offs in commercial real estate-investor, loan growth of approximately $160.0 million, downward risk rating migration including an increased reserve on loans individually analyzed, and our assessment of estimated future credit losses. The ACL on loans excludes $2.7 million, $4.3 million and $4.4 million of allowance for unfunded commitments as of September 30, 2023, December 31, 2022 and September 30, 2022, respectively, recorded within Other Liabilities. The total ACL on unfunded commitments listed as of September 30, 2023, December 31, 2022, and September 30, 2022 excludes the purchase accounting adjustment of $149,000, $819,000, and $1.0 million, respectively, recorded due to our acquisition of West Suburban, which is also recorded within Other Liabilities, and is being accreted in interest income over the estimated life of the unused commitments.
Generally, the Bank considers a loan to be collateral dependent when, based on current information and events, it is probable that foreclosure will be initiated. Additionally, the Bank will review all loans meeting the criteria for individual analysis, to determine if repayment or satisfaction of the loan is expected through the sale of collateral. This will generally be the case for credits with high loan-to-values. Exceptions to this policy would include loans with guarantors that have the means and willingness to support the obligation. Non-accruing loans with an outstanding balance of $500,000 or more are assessed on an individual loan level basis. When a financial asset is deemed collateral-dependent, the level of credit loss is measured by the difference between amortized cost of the financial asset and the fair value of collateral adjusted for estimated cost to sell. The Company had $55.8 million and $50.5 million of collateral dependent loans secured by real estate or business assets as of September 30, 2023, and December 31, 2022, respectively.
The following tables present the collateral dependent loans and the related ACL allocated by segment of loans as of September 30, 2023 and December 31, 2022:
Accounts
ACL
Real Estate
Receivable
Equipment
Allocation
679
1,528
26,724
4,848
17,636
4,201
7,206
32
1,679
568
54,733
55,751
9,390
883
5,915
364
7,162
569
1,248
16,576
2,875
19,188
2,310
21,498
5,808
675
1,817
244
1,322
180
40,641
2,674
50,478
10,744
Aged analysis of past due loans by segments of loans was as follows:
90 days or
90 Days or
Greater Past
30-59 Days
60-89 Days
Total Past
Due and
Past Due
Due
Current
Total Loans
Accruing
1,829
1,874
1,052
4,755
830,122
979
2,502
157
2,659
352,168
2,205
16,728
16,116
35,049
1,012,073
15,232
1,879
17,231
791,819
118
7,524
195,022
252
277
529
53,233
140
735
419
1,820
2,974
224,472
713
127
840
371,180
646
259
993
101,062
90
24,232
19,556
28,766
72,554
3,956,989
1,209
1,012
825
1,840
839,124
460
447
614
1,083
276,302
3,276
1,276
4,315
8,867
978,768
373
2,211
2,697
852,182
173
116
130
180,405
445
987
1,432
55,921
144
1,191
2,232
3,423
216,295
485
267
361
1,950
321,741
291
108,429
18,228
6,326
2,874
13,014
22,214
3,847,395
1,262
16
The table presents all nonaccrual loans as of September 30, 2023, and December 31, 2022:
Nonaccrual loan detail
With no ACL
2,167
7,189
6,598
377
38
1,876
11,786
4,346
4,244
18,290
3,833
8,050
3,813
251
1,362
3,627
3,713
1,572
1,141
1,222
2,109
62,116
32,382
31,602
18,404
The Company recognized $189,000 and $304,000 of interest on nonaccrual loans during the three months and nine months ended September 30, 2023, respectively.
Credit Quality Indicators
The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison to industry averages, historical payment experience, and current economic trends. This analysis includes loans with outstanding balances or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages. Loans with a classified risk rating are reviewed quarterly regardless of size or loan type. The Company uses the following definitions for classified risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated.
Credit quality indicators by loan segment and loan origination date at September 30, 2023 were as follows:
2021
2020
2019
Prior
RevolvingLoans
RevolvingLoansConvertedTo TermLoans
Pass
215,492
187,682
41,464
13,359
10,676
311,562
1,379
785,929
Special Mention
500
29,855
30,650
Substandard
79
1,381
2,735
9,689
4,414
18,298
Total commercial
188,261
43,089
16,094
20,416
345,831
151,691
125,092
47,808
17,522
9,545
2,595
354,253
235
574
Total leases
125,431
9,780
176,779
341,597
203,972
111,333
59,770
67,264
8,148
968,863
12,866
11,267
24,133
10,964
11,787
7,748
9,278
12,399
54,126
Total commercial real estate – investor
187,743
366,250
217,189
119,081
69,048
20,547
105,963
139,223
181,543
78,750
54,909
101,396
33,258
695,042
1,758
11,722
18,180
26,480
222
354
58,716
14,994
19,926
1,142
18,811
55,292
Total commercial real estate – owner occupied
107,721
165,939
219,649
106,372
73,942
102,169
26,529
75,698
56,217
19,531
1,837
1,155
3,699
184,666
305
312
617
10,057
17,263
Total construction
26,834
83,216
29,588
3,310
14,560
8,954
6,317
7,116
10,519
1,417
52,193
398
418
686
1,502
Total residential real estate – investor
14,958
9,021
7,534
11,205
26,371
41,915
41,439
26,544
15,147
71,637
766
223,819
122
2,729
Total residential real estate – owner occupied
42,037
26,634
15,833
74,366
69,947
79,689
101,878
57,792
12,391
42,603
382
364,682
170
3,505
326
1,656
540
6,197
887
254
Total multifamily
80,746
105,383
58,118
14,047
43,397
1,765
2,760
211
1,443
1,631
2,494
90,317
100,621
106
1,260
1,434
Total HELOC
1,804
2,787
1,444
2,600
91,577
4,461
2,068
1,415
223
151
17,432
Total other
782,308
1,010,284
684,901
332,814
173,173
304,066
466,981
3,755,906
2,063
25,570
33,263
26,806
1,929
894
120,380
11,003
35,839
23,258
21,773
39,117
4,194
18,073
153,257
795,374
1,071,693
741,422
381,393
214,219
309,154
514,909
18
Credit quality indicators by loan segment and loan origination date at December 31, 2022, were as follows:
2018
225,056
70,608
21,597
12,742
6,957
2,651
447,821
787,432
1,875
272
1,182
2,432
21,286
27,047
4,958
2,447
2,981
12,176
3,916
26,485
231,889
73,327
25,760
27,350
6,964
473,023
161,379
64,203
26,995
17,653
4,449
830
275,509
1,606
162,985
17,923
416,094
228,686
118,491
46,935
46,406
7,113
927,570
5,349
5,490
10,206
9,123
32,655
12,332
2,018
10,763
27,410
433,775
232,121
123,981
84,814
48,005
57,826
169,703
223,731
105,669
47,351
49,367
86,660
33,745
716,226
8,430
22,242
48,184
17,668
231
1,008
97,763
2,546
17,129
16,962
3,062
40,890
180,679
263,102
155,044
81,981
49,598
90,730
53,058
65,758
39,542
2,390
226
1,408
1,523
163,905
15,297
1,217
54,275
54,839
14,737
9,910
6,945
8,585
4,853
9,548
991
70
621
499
186
408
15,358
9,980
9,084
5,039
9,956
41,885
44,884
28,418
16,146
12,152
70,741
1,638
215,864
131
237
723
2,365
3,854
42,016
45,151
28,655
16,869
12,283
73,106
76,877
126,257
52,262
13,125
39,703
6,098
329
314,651
3,683
1,684
6,086
2,100
587
2,954
79,354
129,940
52,604
14,809
40,290
6,365
517
1,497
1,703
2,288
97,258
106,680
1,972
2,411
2,822
518
724
2,597
99,341
4,195
2,835
432
167
69
10,436
18,245
433
10,437
1,165,744
837,389
401,848
183,707
165,368
226,741
600,854
3,581,651
16,031
27,684
70,495
31,990
1,301
10,131
21,397
179,029
25,573
21,862
4,410
41,509
978
8,708
5,889
108,929
1,207,348
886,935
476,753
257,206
167,647
245,580
628,140
The gross charge-offs activity by loan type and year of origination for the nine months ended September 30, 2023 were as follows:
Current period gross charge-offs
RevolvingLoansConverted to TermLoans
870
4,121
26
265
5,016
292
3,028
343
The Company had $176,000 and $600,000 in residential real estate loans in the process of foreclosure as of September 30, 2023 and December 31, 2022, respectively.
As of January 1, 2023, the Company prospectively adopted ASU 2022-02, Topic 326 “Troubled Debt Restructuring (“TDRs”) and Vintage Disclosures”, see Note 1. Fifteen loans, totaling $43.0 million in aggregate, were modified which were experiencing financial difficulty during the nine-month period ending September 30, 2023. There were no TDR loan modifications for the three months ended September 30, 2022, and there were two TDR loan modifications for an aggregate of $39,000 for the nine months ended September 30, 2022. TDRs were classified as being in default on a case-by-case basis when they failed to be in compliance with the modified terms. There were no financial difficulty loans modified in payment default as of September 30, 2023 and was no TDR default activity for the period ended September 30, 2023, for loans that were restructured within the prior 12-month period.
The following table presents the amortized costs basis of loans at September 30, 2023 that were both experiencing financial difficulty and modified during the period ended September 30, 2023 by class and by type of modification. The percentage of the amortized cost basis of loans that were modified to borrowers in financial distress as compared to amortized costs basis of each class of financing receivable is also presented below.
Term Extension
Combination - Term Extension and Interest Rate Reduction
Combination - Term Extension and Payment Delay
Total Loans Modified
% of Total Loan Segment Modified to Total Loan Segment
1,713
2,692
0.3%
12,755
10,608
23,363
2.2%
16,218
2.0%
437
0.2%
0.1%
0.0%
31,416
43,003
1.1%
The Company closely monitors the performance of loan modifications to borrowers experiencing financial difficulty. The following table presents the performance of loans that have been modified as of September 30, 2023.
30-59 days past due
60-89 Days Past Due
90 Days or Greater Past Due
Total Past Due
Total Loan Modified
42,024
The following table summarizes the financial effect of the loan modifications presented above to borrowers experiencing financial difficulty for the period ended September 30, 2023. The Company had two Commercial real estate – investor loans that had a payment modification, one changed to a single payment at maturity and the other changed from principal and interest to interest only until maturity.
Weighted-Average Term Extension (In Months)
Weighted-Average Interest Rate Change
Weighted-Average Delay of Payment (In Months)
6.74
5.00
9.81
7.17
14.00
2.00
16.00
24.00
11.17
Note 5 – Deposits
Major classifications of deposits were as follows:
Savings
1,003,498
1,145,592
NOW accounts
567,997
609,338
Money market accounts
702,176
862,170
Certificates of deposit of less than $100,000
248,272
244,017
Certificates of deposit of $100,000 through $250,000
162,901
157,438
Certificates of deposit of more than $250,000
66,817
40,466
Note 6 – Borrowings
The following table is a summary of borrowings as of September 30, 2023 and December 31, 2022. Junior subordinated debentures are discussed in more detail in Note 7.
Junior subordinated debentures1
Total borrowings
546,028
260,811
1 See Note 7: Junior Subordinated Debentures
The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities, and had a carrying amount of $25.9 million at September 30, 2023, and $32.2 million at December 31, 2022. The fair value of the pledged collateral was $43.8 million at September 30, 2023, and $71.4 million at December 31, 2022. At September 30, 2023, there were no customers with secured balances exceeding 10% of stockholders’ equity.
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of September 30, 2023, the Bank had $435.0 million in short-term advances outstanding under the FHLBC. There were $90.0 million in short-term advances as of December 31, 2022. FHLBC stock held at September 30, 2023 was valued at $20.9 million, and any potential FHLBC advances were collateralized by loans and securities with a principal balance of $1.47 billion, which carried a FHLBC-calculated combined collateral value of $1.02 billion. The Company had excess collateral of $581.7 million available to secure borrowings at September 30, 2023.
In the second quarter of 2021, we issued $60.0 million in aggregate principal amount of our 3.50% Fixed-to-Floating Rate Subordinated Notes due April 15, 2031 (the “Notes”). The Company used the net proceeds from the offering for general corporate purposes. The Notes bear interest at a fixed annual rate of 3.50%, from and including the date of issuance to but excluding April 15, 2026, payable semi-annually in arrears. From and including April 15, 2026 to, but excluding the maturity date or early redemption date, the interest rate will reset quarterly to an interest rate per annum equal to three-month Term SOFR (as defined by the Note) plus 273 basis points, payable quarterly in arrears. As of September 30, 2023 and December 31, 2022, we had $59.4 million and $59.3 million of subordinated debentures outstanding, net of deferred issuance costs, respectively.
The Company issued senior notes in December 2016 with a ten-year maturity, and terms included interest payable semiannually at 5.75% for five years. Beginning December 31, 2021, the senior debt began to pay interest at a floating rate, with interest payable quarterly at three month LIBOR plus 385 basis points. The interest rate at June 30, 2023 and December 31, 2022 was 9.39% and 8.62%, respectively. The notes were redeemable, in whole or in part, at the option of the Company, beginning with the interest payment date on December 31, 2021, and on any floating rate interest payment date thereafter, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. On June 30, 2023, we redeemed all of the $45.0 million senior notes. Upon redemption, the related deferred debt issuance costs of $362,000 was also recorded as interest expense, resulting in an effective cost of this debt issuance of 12.85% for the second quarter of 2023.
On February 24, 2020, the Company originated a $20.0 million three-year term note with a correspondent bank. The term note was issued at one-month LIBOR plus 175 basis points, and required principal payments quarterly and interest payments monthly. This note was included within Notes payable and other borrowings on the Consolidated Balance Sheets, and the remaining $9.0 million balance of the note was paid off on February 24, 2023. The Company also has an undrawn line of credit of $30.0 million with a correspondent bank to be used for short-term funding needs; advances under this line can be outstanding up to 360 days from the date of issuance. This line of credit has not been utilized since early 2019.
Note 7 – Junior Subordinated Debentures
The Company issued $25.0 million of cumulative trust preferred securities through a private placement completed by an unconsolidated subsidiary, Old Second Capital Trust II, in April 2007. These trust preferred securities mature in 30 years, but subject to regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017. The quarterly cash distributions on the securities were fixed at 6.77% through June 15, 2017, and now have a floating rate of 150 basis points over three-month SOFR. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 3.77% and 4.39% for the quarters ended September 30, 2023 and September 30, 2022, respectively. The Company issued a $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
The junior subordinated debentures issued by the Company are disclosed on the Consolidated Balance Sheets, and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of September 30, 2023 and December 31, 2022, the remaining unamortized debt issuance costs related to the junior subordinated debentures were $1,000 and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheets. The remaining deferred issuance costs on the junior subordinated debentures related to the issuance of Old Second Capital Trust II will be amortized to interest expense over the remainder of the 30-year term of the notes and are included in the Consolidated Statements of Income.
Note 8 – Equity Compensation Plans
Stock-based awards are outstanding under the Company’s 2019 Equity Incentive Plan, as amended and restated (the “2019 Plan”). The 2019 Plan was originally approved at the May 2019 annual stockholders’ meeting and authorized 600,000 shares, and at the May 2021 annual stockholders’ meeting, the Company obtained stockholder approval to increase the number of shares of common stock authorized for issuance under the 2019 Plan by 1,200,000 shares, from 600,000 shares to 1,800,000 shares. Following the approval of the 2019 Plan, no further awards will be granted under any other prior plan.
The 2019 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights (“SARs”). Awards may be granted to selected directors, officers, employees or eligible service providers under the 2019 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors. As of September 30, 2023, 975,712 shares remained available for issuance under the 2019 Plan. The Company has granted only restricted stock units under the 2019 Equity Plan.
Generally, restricted stock units granted under the 2019 Plan vest three years from the grant date, but the Compensation Committee of the Company’s Board of Directors has discretionary authority to change the terms of particular awards including the vesting schedule.
Under the 2019 Plan, unless otherwise provided in an award agreement, upon the occurrence of a change in control, all equity awards then held by the participant will become fully exercisable immediately if, and all stock awards and cash incentive awards will become fully earned and vested immediately if, (i) the 2019 Plan is not an obligation of the successor entity following a change in control or (ii) the 2019 Plan is an obligation of the successor entity following a change in control and the participant incurs a termination of service without cause or for good reason following the change in control. Notwithstanding the immediately preceding sentence, if the vesting of an award is conditioned upon the achievement of performance measures, then such vesting will generally be subject to the following: if, at the time of the change in control, the performance measures are less than 50% attained (pro rata based upon the time of the period through the change in control), the award will become vested and exercisable on a fractional basis with the numerator being equal to the percentage of attainment and the denominator being 50%; and if, at the time of the change in control, the performance measures are at least 50% attained (pro rata based upon the time of the period through the change in control), the award will become fully earned and vested immediately upon the change in control.
Awards of restricted stock under the 2019 Plan generally entitle holders to voting and dividend rights upon grant and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. Awards of restricted stock units under the 2019 Plan are also subject to forfeiture until certain restrictions have lapsed including employment for a specific period, but do not entitle holders to voting rights until the restricted period ends and shares are transferred in connection with the units.
There were 240,149 and 268,160 restricted stock units issued under the 2019 Plan during the nine months ended September 30, 2023 and September 30, 2022, respectively. Compensation expense is recognized over the vesting period of the restricted stock units based on the market value of the award on the issue date. Total compensation cost that has been recorded for the 2019 Plan was $2.7 million for the nine months ended September 30, 2023 and $2.3 million for the nine months ended September 30, 2022.
A summary of changes in the Company’s unvested restricted awards for the nine months ended September 30, 2023, is as follows:
Restricted
Stock Shares
Grant Date
and Units
Fair Value
Unvested at January 1
649,210
12.84
Granted
240,149
17.02
Vested
(137,534)
12.53
Forfeited
(15,191)
14.25
Unvested at September 30
736,634
14.23
Total unrecognized compensation cost of restricted awards was $5.0 million as of September 30, 2023, which is expected to be recognized over a weighted-average period of 1.87 years.
Note 9 – Earnings Per Share
The earnings per share, both basic and diluted, are as follows:
Basic earnings per share:
Weighted-average common shares outstanding
44,675,489
44,565,626
44,653,451
44,509,072
Diluted earnings per share:
Dilutive effect of unvested restricted awards 1
752,920
655,915
736,767
698,920
Diluted average common shares outstanding
45,428,409
45,221,541
45,390,218
45,207,992
1 Includes the common stock equivalents for restricted share rights that are dilutive.
24
Note 10 – Regulatory & Capital Matters
The Bank is subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighted Bank assets, developed by the Office of the Comptroller of the Currency (the “OCC”) and the other bank regulatory agencies. In connection with the current risk-based capital regulatory guidelines, the Bank’s Board of Directors has established an internal guideline requiring the Bank to maintain a Tier 1 leverage capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%). At September 30, 2023, the Bank exceeded those thresholds.
At September 30, 2023, the Bank’s Tier 1 capital leverage ratio was 10.43%, an increase of 111 basis points from December 31, 2022, and is above the 8.00% objective. The Bank’s total capital ratio was 13.57%, an increase of 82 basis points from December 31, 2022, and also above the objective of 12.00%.
Bank holding companies are generally required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System. The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of September 30, 2023 and December 31, 2022.
The Basel III Rules are applicable to all banking organizations that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies, other than “small bank holding companies”, which are generally holding companies with consolidated assets of less than $3.0 billion. A detailed discussion of the Basel III Rules is included in Part I, Item 1 of the Company’s Form 10-K for the year ended December 31, 2022, under the heading “Supervision and Regulation.”
At September 30, 2023 and December 31, 2022, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.
Capital levels and industry defined regulatory minimum required levels are as follows:
Minimum Capital
Well Capitalized
Adequacy with Capital
Under Prompt Corrective
Actual
Conservation Buffer, if applicable1
Action Provisions2
Amount
Ratio
Common equity tier 1 capital to risk weighted assets
Consolidated
530,368
11.00
337,507
7.00
N/A
Old Second Bank
601,999
12.49
337,389
313,290
6.50
Total capital to risk weighted assets
667,182
13.84
506,171
10.50
653,813
13.57
505,898
481,808
10.00
Tier 1 capital to risk weighted assets
555,368
11.52
409,777
8.50
409,687
385,588
8.00
Tier 1 capital to average assets
9.62
230,922
4.00
10.43
230,872
288,590
457,206
9.67
330,966
552,404
11.70
330,498
306,891
592,039
12.52
496,518
602,237
12.75
495,960
472,343
482,206
10.20
401,838
401,319
377,712
8.14
236,956
9.32
237,083
296,354
1 Amounts are shown inclusive of a capital conservation buffer of 2.50%.
2 The prompt corrective action provisions are only applicable at the Bank level. The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”
As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. As of September 30, 2023, the capital measures of the Company exclude $1.9 million, which is the modified CECL transition adjustment.
Dividend Restrictions
In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above. As of September 30, 2023, the Bank had capacity to pay dividends of $70.4 million to the Company without prior regulatory approval. Pursuant to the Basel III rules, the Bank must keep a capital conservation buffer of 2.50% above the regulatory minimum capital requirements, which must consist entirely of Common Equity Tier 1 capital in order to avoid additional limitations on capital distributions and certain other payments.
Note 11 – Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy established by the Company also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs that may be used to measure fair value are:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.
During the nine-month period ended September 30, 2023, $14.9 million of asset-backed securities and $6.8 million of collateralized mortgage obligations were transferred to Level 2 from Level 3. There were no transfers between levels at September 30, 2022.
The majority of securities available-for-sale are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy. Both market and income valuation approaches are utilized. Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value. The Company uses the following methods and significant assumptions to estimate fair value:
Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The tables below present the balance of assets and liabilities at September 30, 2023 and December 31, 2022, respectively, measured by the Company at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
206,034
14,066
Mortgage servicing rights
Interest rate swap agreements, including risk participation agreement
9,028
Mortgage banking derivatives
1,010,137
25,527
1,252,441
Liabilities:
Interest rate swap agreements, including risk participation agreements
14,293
28
211,899
14,229
526,998
6,770
186,916
15,012
Interest rate swap agreements
6,516
76
1,298,302
47,200
1,557,631
12,265
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:
Nine Months Ended September 30, 2023
Collateralized
States and
Mortgage
Asset-backed
Political
Servicing
Obligations
Subdivisions
Rights
Beginning balance January 1, 2023
Transfers out of Level 3
(14,885)
(6,764)
Total gains or losses
Included in earnings
(11)
(99)
232
Included in other comprehensive income
(6)
(132)
Purchases, issuances, sales, and settlements
Purchases
406
Issuances
420
Settlements
(338)
(380)
Ending balance September 30, 2023
Nine Months Ended September 30, 2022
Beginning balance January 1, 2022
15,236
7,097
(98)
4,384
(1,333)
(1,015)
(776)
Ending balance September 30, 2022
13,309
The following table and commentary present quantitative and qualitative information about Level 3 fair value measurements as of September 30, 2023:
Measured at fair value
Significant Unobservable
on a recurring basis:
Valuation Methodology
Inputs
Range of Input
of Inputs
Discounted Cash Flow
Discount Rate
3.5 – 5.9%
4.3
Liquidity Premium
0.3 – 0.5%
0.5
9.0 – 11.0%
9.0
Prepayment Speed
0.0 – 16.4%
6.2
The following table and commentary present quantitative and qualitative information about Level 3 fair value measurements as December 31, 2022:
2.3 – 5.8%
4.4
7.0 – 7.0%
7.0
6.2 – 6.5%
6.3
3.6 – 27.3%
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:
The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of individually evaluated loans and OREO. For assets measured at fair value on a nonrecurring basis at
September 30, 2023 and December 31, 2022, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:
Individually evaluated loans1
63,322
Other real estate owned, net2
63,729
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans, which had a carrying amount of $82.0 million and a valuation allowance of $18.7 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $1.0 million for the nine months ended September 30, 2023.
2 OREO is measured at fair value, less costs to sell, and had a net carrying amount of $407,000 at September 30, 2023, which is made up of the outstanding balance of $525,000, and a valuation allowance of $118,000.
47,700
49,261
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans, which had a carrying amount of $65.3 million and a valuation allowance of $17.6 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $12.2 million for the year December 31, 2022.
2 OREO is measured at fair value, less costs to sell, and had a net carrying amount of $1.6 million at December 31, 2022, which is made up of the outstanding balance of $2.5 million, net of a purchase accounting adjustment of $131,000 and a valuation allowance of $856,000.
The Company has estimated the fair values of these assets based primarily on Level 3 inputs. OREO and individually evaluated loans are generally valued using the fair value of collateral provided by third party appraisals. These valuations include assumptions related to cash flow projections, discount rates, and recent comparable sales. The numerical ranges of unobservable inputs for these valuation assumptions are not meaningful.
Note 12 – Fair Values of Financial Instruments
The estimated fair values approximate carrying amount for all items except those described in the following table. Securities available-for-sale fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security. The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable and can only be sold to the FHLBC or another member institution at par. At September 30, 2023 and December 31, 2022, the fair values of loans are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors. The fair value of time deposits was estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off balance sheet volume was not considered material.
31
The carrying amount and estimated fair values of financial instruments were as follows:
Carrying
Financial assets:
998,775
FHLBC and FRBC stock
3,855,774
11,641
8,980
Interest rate lock commitments and forward contracts
Interest receivable on securities and loans
25,921
Financial liabilities:
Noninterest bearing deposits
Interest bearing deposits
2,751,661
2,738,632
19,072
46,161
Note payable and other borrowings
Interest payable on deposits and borrowings
3,066
1,291,219
36,011
3,681,387
6,391
22,661
3,059,021
3,042,740
21,907
52,322
44,248
8,984
12,264
1,657
Note 13 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk
Risk Management Objective of Using Derivatives
The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.
Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. The aggregate fair value of the swaps is recorded in other assets or other liabilities with changes in fair value recorded in other comprehensive income, net of tax. The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective. For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in accumulated other comprehensive income and subsequently reclassified into interest income or interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts
reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received on the variable rate loan pools or paid on the Company’s fixed-rate borrowings.
Interest rate swaps with notional amounts totaling $300.0 million and $250.0 million as of September 30, 2023 and December 31, 2022, respectively, were designated as cash flow hedges of certain variable rate commercial and commercial real estate loan pools. Each of these hedges were executed to pay variable and receive fixed rate cash flows. Each of these hedges was determined to be effective during all periods presented and the Company expects the hedges to remain effective during the remaining terms of the swaps.
An interest rate swap with a notional amount of $25.8 million as of September 30, 2023 and December 31, 2022, is designated as a cash flow hedge of junior subordinated debentures and was executed to pay fixed and receive variable rate cash flows. The hedge was determined to be effective during all periods presented and the Company expects the hedge to remain effective during the remaining terms of the swap.
During the next twelve months, the Company estimates that an additional $7.0 million will be reclassified as an increase to interest income and an additional $708,000 will be reclassified as an increase to interest expense.
Non-designated Hedges
Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. The notional amounts of interest rate swaps with its loan customers as of September 30, 2023 and December 31, 2022 were $105.6 million and $110.6 million, respectively. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.
At September 30, 2023 and December 31, 2022, the Company had $9.2 million and $11.2 million of cash collateral pledged with two correspondent financial institutions, respectively. The Company held $8.1 million and $5.3 million of cash pledged from one correspondent financial institution to support the interest rate swap activity during the years presented, respectively. No investment securities were required to be pledged to any correspondent financial institution during 2023 through September 30, 2023, or during 2022. The Company offsets derivative assets and liabilities that are subject to a master netting arrangement.
The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The notional amount of these commitments at September 30, 2023 and December 31, 2022 was $7.6 million and $5.3 million, respectively. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.
The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheets as of September 30, 2023 and December 31, 2022.
Fair Value of Derivative Instruments
No. of Trans.
Notional Amount $
Balance Sheet Location
Fair Value $
Derivatives designated as hedging instruments
325,774
Other Assets
4,517
Other Liabilities
9,830
Total derivatives designated as hedging instruments
Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers
105,558
4,463
7,613
Other contracts
44,892
48
Total derivatives not designated as hedging instruments
4,548
275,774
8,610
110,647
3,654
5,298
43,699
125
3,855
3,655
Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting
The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement. The loss recognized in AOCI on derivatives totaled $3.8 million as of September 30, 2023, and $4.1 million as of September 30, 2022. The amount of the loss reclassified from AOCI to net interest income on the income statement was $3.9 million for the nine months ended September 30, 2023 and $15,000 of gain for the nine months ended September 30, 2022.
Credit-risk-related Contingent Features
For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties. Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.
Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties. Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain. This is monitored by the Company and procedures are in place to minimize this exposure. Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.
Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):
The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2023, and December 31, 2022.
The following table is a summary of letter of credit commitments:
Fixed
Variable
Letters of credit:
Borrower:
Financial standby
16,543
16,716
3,514
15,365
18,879
Performance standby
15,733
16,086
3,161
13,989
17,150
526
32,276
32,802
6,675
29,354
36,029
Non-borrower:
Total letters of credit
32,343
32,869
29,421
36,096
Unused loan commitments:
146,201
710,271
856,472
139,070
860,255
999,325
As of September 30, 2023, the Company evaluated current market conditions, including any impacts related to market interest rate changes and unused line of credit utilization trends during the second quarter of 2023, and based on that analysis under the CECL methodology, the Company determined credit losses related to unfunded commitments totaled $2.7 million, excluding a $149,000 purchase accounting adjustment on unfunded commitments recorded from our West Suburban acquisition, which is being accreted to interest income over the estimated life of the unused commitments. The resultant decrease in the ACL for unfunded commitments of $235,000 for the third quarter of 2023, compared to the prior quarter end, is primarily related to a $223,000 decrease by accretion to interest income of the purchase accounting adjustment, as well as adjustments to historical benchmark assumptions, such as the funding rates and the period used to forecast those rates within the ACL calculation, resulting in a $12,000 reduction. The Company will continue to assess the credit risk at least quarterly, and adjust the allowance for unfunded commitments, which is carried within other liabilities on our Consolidated Balance Sheets, as needed, with the appropriate offsetting entry to the provision for credit losses on our Consolidated Statements of Income.
36
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion provides additional information regarding our operations for the three and nine months ended September 30, 2023, compared to the three and nine months ended September 30, 2022, and our financial condition at September 30, 2023, compared to December 31, 2022. This discussion should be read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2022. The results of operations for the three and nine months ended September 30, 2023, are not necessarily indicative of future results. Dollar amounts presented in the following tables are in thousands, except per share data, and September 30, 2023 and 2022 amounts are unaudited.
In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).
We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.
Business Overview
The Company is a bank holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 48 banking centers located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.
Our results of operations depend generally on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Net interest income is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. In addition, we are subject to interest rate risk to the degree that our interest-earning assets mature or reprice at different times, or at different speeds, than our interest-bearing liabilities. Our results of operations are also affected by noninterest income, such as service charges, wealth management fees, loan fees, gains from the sale of newly originated loans, gains or losses on investments and certain other noninterest related items. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, professional fees, data processing expenses and provision for credit losses.
We are significantly impacted by prevailing economic conditions, including federal monetary and fiscal policies, and federal regulations of financial institutions. Deposit balances are influenced by numerous factors such as competing investments, the level of income and the personal rate of savings within our market areas. Factors influencing lending activities include the demand for housing and the interest rate pricing competition from other lending institutions.
As of September 30, 2023, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession, our reported and regulatory capital ratios could be adversely impacted by credit losses.
Merger with West Suburban Bancorp, Inc.
On December 1, 2021, we completed our merger with West Suburban Bancorp, Inc. (“West Suburban”), the holding company for West Suburban Bank. Under the terms of the merger agreement, each share of West Suburban common stock was converted into 42.413 shares of our common stock and $271.15 in cash. Total cash and stock consideration paid was approximately $295.2 million. With the acquisition of West Suburban, we acquired 34 branches in DuPage, Kane, Kendall and Will counties in Illinois. The transaction is discussed in more detail in Note 2 to our Consolidated Financial Statements included in this report and in Note 2 of our Annual Report in Form 10-K.
Recent Banking Events
There were three significant bank failures in the first five months of 2023, primarily due to the failed banks’ lack of liquidity as depositors sought to withdraw their deposits. Due to rising interest rates, the failed banks were unable to sell investment securities held to meet liquidity needs without realizing substantial losses. As a result of the bank closures during 2023 and in an effort to strengthen public confidence in the banking system and protect depositors, regulators announced that any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law, which could increase the cost of our FDIC insurance assessment. Additionally, the Federal Reserve announced the creation of a new Bank Term Funding Program in an effort to minimize the need for banks to sell securities at a loss in times of stress. We have access but have not received or requested funds from this Program and, though we do have access to the Federal Reserve Discount Window, we have not accessed these funds and have an unused capacity of $18.7 million at September 30, 2023. The future impact of these failures on the economy, financial institutions and their depositors, as well as any governmental regulatory responses or actions resulting from the same, is difficult to predict at this time.
Financial Overview
Net income for the third quarter of 2023 was $24.3 million, or $0.54 per diluted share, compared to $19.5 million, or $0.43 per diluted share, for the third quarter of 2022. The increase was primarily due to growth in our loan portfolio and higher loan and security yields, partially offset by increased funding costs and increased other short-term borrowing, which resulted in growth in net interest income. Noninterest income decreased in the third quarter of 2023, compared to the like quarter of 2022, as a result of net losses on security sales and a reduction in mortgage banking revenues. An increase was also noted in noninterest expense for the current quarter, primarily due to higher salaries and employee benefits and $629,000 of liquidation and deconversion costs incurred in the third quarter of 2023 related to the 2022 sale of our Visa credit card portfolio. Also contributing to the increase in net income in the third quarter of 2023, compared to the third quarter of 2022, were acquisition costs, net of gains on branch sales, of $2.0 million incurred in the prior year like quarter, compared to no acquisition related costs or branch sales in the third quarter of 2023. Adjusted net income, a non-GAAP financial measure that excludes Visa portfolio and land trust portfolio gains on sale, Visa portfolio liquidation and deconversion costs, and any merger related costs, as applicable, was $24.8 million for the third quarter of 2023, compared to $25.6 million for the second quarter of 2023, and $19.6 million for the third quarter of 2022. Adjusted net income was $73.8 million for the nine months ended September 30, 2023, compared to $49.4 million for the nine months ended September 30, 2022. See the discussion entitled “Non-GAAP Financial Measures” on page 40, as well as the table below, which provides a reconciliation of this non-GAAP measure to the most comparable GAAP equivalents.
Quarters Ended
June 30,
Income before income taxes (GAAP)
34,973
Pre-tax income adjustments:
Merger-related costs, net of losses/(gains) on branch sales
1,061
(277)
8,527
Liquidation and deconversion costs on Visa credit card portfolio
629
Gains on the sale of Visa credit card and land trust portfolios
(923)
Adjusted net income before taxes
33,113
35,002
26,715
99,822
67,300
Taxes on adjusted net income
8,307
9,419
7,091
26,051
17,944
Adjusted net income (non-GAAP)
24,806
25,583
19,624
73,771
49,356
Basic earnings per share (GAAP)
0.57
Diluted earnings per share (GAAP)
0.56
Adjusted basic earnings per share excluding acquisition-related costs (non-GAAP)
0.58
0.44
1.11
Adjusted diluted earnings per share excluding acquisition-related costs (non-GAAP)
1.63
1.09
The following provides an overview of some of the factors impacting our financial performance for the three month period ended September 30, 2023, compared to the like period ended September 30, 2022:
Critical Accounting Estimates
Our consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations.
Of the significant accounting policies used in the preparation of our consolidated financial statements, we have identified certain items as critical accounting policies based on the associated estimates, assumptions, judgments and complexity. See “Management’s Discussion
and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2022. There have been no material changes to our critical accounting policies or the estimates made pursuant to those policies during the most recent quarter from those disclosed in our 2022 Annual Report in Form 10-K.
Non-GAAP Financial Measures
This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest margin on a tax equivalent (“TE”) basis, adjusted net income, adjusted basic and diluted earnings per share, our adjusted efficiency ratio, and our tangible common equity to tangible assets ratio. Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation of our performance to investors. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These measures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.
Results of Operations
Three months ended September 30, 2023 and 2022
Our income before taxes was $32.5 million in the third quarter of 2023 compared to $26.6 million in the third quarter of 2022. This increase in pretax income was primarily due to a $7.5 million increase in net interest and dividend income, and a $1.5 million decrease in provision for credit losses. Income before taxes was negatively impacted by a $1.6 million decrease in noninterest income, primarily due to $924,000 of security losses and a $1.1 million decrease in other income in the third quarter of 2023, as well as a $1.4 million increase in noninterest expense. Our net income was $24.3 million, or $0.54 per diluted share, for the third quarter of 2023, compared to net income of $19.5 million, or $0.43 per diluted share, for the third quarter of 2022. The Bank remains well positioned to navigate uncertain macroeconomics; we have mitigated interest rate risk, controlled expenses in an inflationary environment, and actively managed daily liquidity. Furthermore, we continue to possess strong liquidity metrics and an outsized securities portfolio for funding needs.
Net interest and dividend income was $63.0 million in the third quarter of 2023, compared to $55.6 million in the third quarter of 2022. The $7.4 million increase was primarily driven by significant growth in our loan portfolio as well as the effect of higher market interest rates on our loan portfolios. Higher interest income was partially offset by an increase in interest expense in the third quarter of 2023, compared to the third quarter of 2022, primarily due to a rise in deposit interest rates, and an increase in other short-term borrowing expense due to additional FHLB advances. As of June 30, 2023, we redeemed the $45.0 million senior debt issuance that was due in 2026, which resulted in no senior debt interest expense recorded for the third quarter of 2023.
Nine months ended September 30, 2023 and 2022
Our income before taxes was $99.5 million for the nine months ended September 30, 2023 compared to $59.7 million for the nine months ended September 30, 2022. This increase in pretax income was primarily due to a $48.6 million increase in net interest and dividend income and a $3.3 million decrease in noninterest expenses. These changes were partially offset by a $3.5 million increase in provision for credit losses, and a $8.7 million decrease in noninterest income, mainly due to $4.1 million of security losses recorded in the first nine months of 2023 and a $4.5 million decrease in mortgage banking revenues. Our net income was $73.5 million, or $1.62 per diluted share, for the nine months ended September 30, 2023, compared to net income of $43.8 million, or $0.97 per diluted share, for the same period of 2022.
Net interest and dividend income was $190.7 million for the nine months ended September 30, 2023, compared to $142.1 million for the same period of 2022. The $48.6 million increase was primarily driven by significant growth in our loan portfolio as well as the effect of higher market interest rates on our loan and securities portfolios. Higher interest and dividend income was partially offset by an increase in interest expense in the first nine months of 2023, compared to the first nine months of 2022, primarily due to a rise in deposit interest rates, an increase in other short-term borrowing expense due to FHLB advances, and an increase in the rate paid on our senior notes. The senior notes redeemed on June 30, 2023 had an effective cost of 10.95% for the nine months ending September 30, 2023.
40
Net Interest Income
Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.
The increased yield of 10 basis points on interest earning assets compared to the linked period was driven by higher yields on loan originations than those in the previous period as well as repricing within the existing variable rate portfolios for securities available-for-sale and loans. Changes in the market interest rate environment impact earning assets at varying intervals depending on the repricing timeline of loans, as well as the securities maturity, paydown and purchase activities.
The year over year increase of 136 basis points on interest earning assets was driven by significant increases to benchmark interest rates as well as strong loan growth throughout the period, specifically within the leases, commercial real estate and multifamily portfolios, as these loan segments generally produce the greatest yield. The increases in benchmark interest rates impacted yields on the securities portfolio through the inverse relationship between interest rates and market value coupled with maturities and strategic sales of lower yielding assets, as we work to increase the weighted average yield in the portfolio.
Average balances of interest-bearing deposit accounts have decreased steadily since the third quarter of 2022 through the third quarter of 2023, from $3.23 billion to $2.79 billion, with decreases reflected in all deposit categories excluding time deposits. We have continued to control the cost of funds over the periods reflected, with the rate of overall interest-bearing deposits increasing to 65 basis points for the quarter ended September 30, 2023, from 40 basis points for the quarter ended June 30, 2023, and from nine basis points for the quarter ended September 30, 2022. A 32 basis point increase in the cost of money market funds for the quarter ended September 30, 2023 compared to prior linked quarter, and a 91 basis point increase compared to the prior year like quarter were both due to select deposit account exception pricing, and drove a significant portion of the overall increase. Average rates paid on time deposits for the quarter ended September 30, 2023 increased by 63 basis points and 140 basis points in the quarter over linked quarter and year over year quarters, respectively, primarily due to CD rate specials we offered.
Borrowing costs decreased in the third quarter of 2023 compared to the second quarter of 2023, primarily due to the redemption of the senior notes as of June 30, 2023, partially offset by an increase in average short-term borrowings of $24.6 million stemming from increased average FHLB advances over the prior quarter. The increase of $421.7 million year over year of average FHLB advances was based on daily liquidity needs. Subordinated and junior subordinated debt interest expense were essentially flat over each of the periods presented. We redeemed all of the $45.0 million senior notes, net of deferred issuance costs, on June 30, 2023, resulting in senior notes having no balance or related interest expense in the third quarter of 2023. In February 2023, we paid off the remaining balance of $9.0 million on the original $20.0 million term note issued in 2020, resulting in notes payable and other borrowings having no balance after that time.
Our net interest margin (GAAP) increased three basis points to 4.64% for the third quarter of 2023 compared to 4.61% for the second quarter of 2023, and increased 71 basis points compared to 3.93% for the third quarter of 2022. Our net interest margin (TE) increased two basis points to 4.66% for the third quarter of 2023, compared to 4.64% for the second quarter of 2023, and increased 70 basis points compared to 3.96% for the third quarter of 2022. The increase in the current quarter, compared to the prior quarter, is primarily due to the growth in loan interest income due to the rising interest rate environment, and a decrease in borrowing interest expense due to the redemption of the senior notes in June 2023. The increase in the current quarter, compared to the prior year like quarter, is primarily due to an increase in market interest rates, and the related rate resets on loans and securities during the past year, as well as continuing loan growth relative to a more modest increase in costs of interest-bearing liabilities. See the discussion entitled “Non-GAAP Financial Measures” and the tables on page 45 that provide a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent.
41
The year over year increase of 187 basis points on interest earning assets was driven by significant increases to benchmark interest rates as well as strong loan growth throughout the period, specifically within the leases, commercial real estate-investor, construction and multi-family portfolios. The increases in benchmark interest rates impacted yields on the securities portfolio through the inverse relationship between interest rates and market value coupled with maturities and strategic sales of lower yielding assets and timely purchase of higher yielding securities as we work to increase the weighted average yield in the portfolio. Average securities available-for-sale decreased $367.0 million for the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022, due to paydowns, changes in market value, and strategic sales. Due to market interest rate increases year over year, securities available-for-sale interest income was $34.7 million for the nine months ended September 30, 2023, compared to $26.1 million for the like 2022 period, reflecting an increase in yield of 134 basis points. Average loans, including loans held for sale, increased $438.0 million in the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022, primarily driven by the growth in leases, commercial real estate-investor, construction, and multi-family portfolios. Growth in the loan portfolio, as well as the rising interest rate environment, resulted in $181.5 million of loan interest income in the nine months ended September 30, 2023, compared to $121.3 million in the like 2022 period, reflecting an increase in yield of 152 basis points.
Average balances of interest-bearing deposit accounts have decreased steadily since September 30, 2022 through the nine months ended September 30, 2023, from $3.32 billion to $2.89 billion, with such decreases reflected in all categories. We have continued to control the cost of funds over the periods reflected, with the rate of overall interest-bearing deposits increasing by 35 basis points to 43 basis points from eight basis points as of September 30, 2022. A 61 basis point increase in the cost of money market funds as of September 30, 2023, compared to September 30, 2022, was due to select deposit account exception pricing and drove a significant portion of the overall increase. Interest expense paid on time deposits also contributed to the increased cost of deposits year over year, as the cost of average time deposits increased 89 basis points to 114 basis points for the nine months ended September 30, 2023, compared to 25 basis points for the nine months ended September 30, 2022, primarily due to CD rate specials we offered.
Borrowing costs increased in the nine months ended September 30, 2023 primarily due to the increase in short term borrowings from higher average FHLB advance growth of $342.5 million since the nine months ended September 30, 2022, based on daily liquidity needs. Subordinated and junior subordinated debt interest expense remained flat over the periods presented. Senior notes interest expense had the most significant interest expense increase, as this issuance referenced three-month LIBOR, and rising market interest rates resulted in a 557 basis point increase to 10.95%, from 5.38% for the nine months ended September 30, 2022. We redeemed these notes on June 30, 2023, which contributed to the significant basis point increase due to the $362,000 in deferred issuance costs that were recognized as interest expense due to the early redemption. In the first quarter of 2023, we paid off the remaining balance of $9.0 million on the original $20.0 million term note issued in 2020, recorded within notes payable and other borrowings.
Our net interest margin (GAAP) increased 135 basis points to 4.66% for the nine months ended September 30, 2023, compared to 3.31% for the nine months ended September 30, 2022. Our net interest margin (TE) increased 135 basis points to 4.68% for the nine months ended September 30, 2023, compared to 3.33% for the nine months ended September 30, 2022. The increase in the current period, compared to the prior year like period, is primarily due to an increase in market interest rates, and the related rate resets on loans and securities during the past year, as well as continuing loan growth relative to a more modest increase in the cost of interest-bearing liabilities.
We continue to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While our loan prices are targeted to achieve certain returns on equity, significant competition for commercial and industrial loans as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.
The following tables set forth certain information relating to our average consolidated balance sheets and reflect the yield on average earning assets and cost of average interest-bearing liabilities for the periods indicated. These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period. Average balances are derived from daily balances. For purposes of discussion, net interest income and net interest income to total earning assets in the following tables have been adjusted to a non-GAAP TE basis using a marginal rate of 21% in 2023 and 2022 to compare returns more appropriately on tax-exempt loans and securities to other earning assets.
42
Analysis of Average Balances,
Tax Equivalent Income / Expense and Rates
(Dollars in thousands - unaudited)
June 30, 2023
September 30, 2022
Income /
Rate
Expense
49,737
5.26
50,309
643
5.13
131,260
1,125,688
3.15
1,231,994
9,930
3.23
1,525,258
2.37
Non-taxable (TE)1
169,523
1,687
3.95
172,670
1,692
3.93
178,090
1,686
3.76
Total securities (TE)1
1,295,211
10,633
3.26
1,404,664
11,622
3.32
1,703,348
10,802
2.52
FHLBC and FRBC Stock
35,954
6.59
34,029
4.67
19,565
5.29
Loans and loans held-for-sale1, 2
4,010,859
62,705
6.20
4,040,202
61,591
6.11
3,753,117
46,642
4.93
Total interest earning assets
5,391,761
74,594
5.49
5,529,204
74,252
5.39
5,607,290
58,368
4.13
57,279
56,191
56,265
(54,581)
(53,480)
(45,449)
Other noninterest bearing assets
384,059
379,576
377,850
5,778,518
5,911,491
5,995,956
Liabilities and Stockholders' Equity
576,138
440
0.30
600,957
0.21
612,174
0.10
720,488
1,767
762,967
1,245
0.65
967,106
0.06
Savings accounts
1,027,987
351
0.14
1,073,172
185
0.07
1,186,001
75
0.03
466,250
1.69
436,524
1,156
1.06
459,925
0.29
2,790,863
4,540
2,873,620
2,898
0.40
3,225,206
715
0.09
24,945
25,575
0.11
33,733
0.12
427,174
5.42
402,527
5,160
5.14
5,435
3.21
3.77
4.37
4.39
59,350
3.66
59,329
3.69
59,265
44,134
1,414
12.85
44,546
6.48
10,989
4.01
Total interest bearing liabilities
3,328,105
1.34
3,430,958
10,306
1.20
3,404,947
0.28
1,867,201
1,920,448
2,092,301
53,164
48,434
34,949
Stockholders' equity
530,048
511,651
463,759
Total liabilities and stockholders' equity
Net interest income (GAAP)
63,580
Net interest margin (GAAP)
4.64
4.61
Net interest income (TE)1
63,395
63,946
55,929
Net interest margin (TE)1
4.66
3.96
Interest bearing liabilities to earning assets
61.73
62.05
60.72
1 Represents a non-GAAP financial measure. See the discussion entitled “Reconciliation of Tax-Equivalent Non-GAAP Financial Measures” below that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2023 and 2022.
2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes loan fee expense of $780,000 for the third quarter of 2023, $242,000 for the second quarter of 2023, and $750,000 of loan fee income for the third quarter of 2022. Nonaccrual loans are included in the above-stated average balances.
49,787
5.07
395,948
1,228,576
3.22
1,582,549
1.78
171,825
5,072
184,842
4,995
3.61
1,400,401
34,683
3.31
1,767,391
26,066
1.97
Dividends from FHLBC and FRBC
31,670
5.37
18,888
4.79
Loans and loans held-for-sale 1 , 2
3,994,804
181,524
6.08
3,556,798
121,337
4.56
5,476,662
219,367
5.36
5,739,025
149,794
3.49
56,211
50,918
(52,505)
(44,719)
382,077
374,388
5,862,445
6,119,612
592,617
995
0.22
605,578
772,011
3,840
0.67
1,039,717
482
1,075,374
0.08
1,200,014
303
445,926
1.14
474,665
0.25
2,885,928
9,251
3,319,974
2,001
27,178
35,791
344,341
5.18
1,832
4.18
4.40
59,244
3.70
Senior note
29,414
10.95
44,520
5.38
1,780
6.53
14,338
2.88
3,373,743
3,501,472
1,929,653
2,101,749
50,965
42,706
508,084
473,685
191,789
143,131
4.68
3.33
61.60
61.01
2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes fee expense of $1.8 million and $2.1 million for the nine months ended September 30, 2023 and 2022, respectively. Nonaccrual loans are included in the above-stated average balances.
Reconciliation of Tax-Equivalent Non-GAAP Financial Measures
Net interest and dividend income (TE) and net interest income (TE) to average interest earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2023 and 2022 to compare returns more appropriately on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent for the periods indicated:
Net Interest Margin
Interest income (GAAP)
73,886
Taxable-equivalent adjustment:
355
1,065
1,049
Interest and dividend income (TE)
Interest expense (GAAP)
Net interest income (TE)
Average interest earning assets
Net interest margin (TE)
Noninterest Income
The following table details the major components of noninterest income for the periods presented:
3rd Quarter 2023
Percent Change From
(Dollars in thousands)
2,458
0.7
8.6
2,362
6.0
(5.9)
Residential mortgage banking revenue
(13.2)
(18.5)
MSRs mark to market gain
192.7
(48.7)
4.0
1.0
2.3
(9.4)
Total residential mortgage banking revenue
1,069
1,592
19.1
(20.0)
(1,547)
40.3
119.9
529.5
(3.1)
(1.8)
32.5
(52.7)
8,223
20.1
(14.1)
Noninterest income increased $1.7 million, or 20.1%, in the third quarter of 2023, compared to the second quarter of 2023, and decreased $1.6 million, or 14.1%, compared to the third quarter of 2022. The increase from the second quarter of 2023 was primarily driven by a $204,000 increase in residential mortgage banking revenue, a $623,000 decrease in securities losses, net, based on strategic sales, a $501,000 increase in the cash surrender value of BOLI, and a $251,000 increase in other income primarily due to contract incentives achieved on brokerage activities, as well as various recoveries on prior year sold mortgage claims.
The decrease in noninterest income of $1.6 million in the third quarter of 2023, compared to the third quarter of 2022, is primarily due to an increase in security losses, net, of $923,000 on strategic sales for the quarter ended September 30, 2023, a decrease of $267,000 on mortgage servicing rights mark to market gains, and a $1.1 million decrease in other income due to a $743,000 pretax gain on a Visa credit card portfolio sale and a $180,000 pretax gain on the sale of a land trust portfolio recorded in the third quarter of 2022. These decreases were partially offset by a $773,000 increase in the cash surrender value of BOLI due to market interest rate changes.
YTD through September 30, 2023
Percent
Change
(3.8)
3.2
(25.6)
MSRs mark to market (loss) gain
(104.1)
(4.8)
(33.9)
2,698
7,172
(62.4)
361.7
(8.0)
(16.8)
(25.5)
Noninterest income decreased $8.7 million, or 25.5%, for the nine months ended September 30, 2023 compared to the nine months ended September 30, 2022. This decrease was primarily driven by a $4.5 million decline in mortgage banking revenue, comprised mostly of a $3.8 million decrease in MSRs mark to market gains and a $571,000 decrease in net gain on sales of mortgage loans. In addition, the current nine month period decreased due to a $4.1 million increase in net losses on the sale of securities for the year over year period. Partially offsetting these decreases was a $227,000 increase in service charges on deposits and a $1.2 million increase in the cash surrender value of BOLI.
Noninterest Expense
The following table details the major components of noninterest expense for the periods presented:
Salaries
17,279
16,310
14,711
5.9
17.5
Officers incentive
2,773
2,397
15.7
(0.5)
Benefits and other
3,063
3,091
3,513
(0.9)
(12.8)
Total salaries and employee benefits
21,798
10.0
Occupancy, furniture and equipment expense
3,639
(3.7)
(14.9)
1,290
49.0
(24.4)
794
(6.3)
12.9
515
3.7
306
(2.0)
16.7
Amortization of core deposit intangible asset
618
(0.3)
(6.2)
(9.7)
12.0
10.2
(7.3)
283
(65.7)
(54.2)
520
5.6
(9.6)
Other real estate owned expense, net
72.4
(228.6)
20.5
19.8
34,830
7.4
Efficiency ratio (GAAP)1
50.08
46.84
53.08
Adjusted efficiency ratio (non-GAAP)2
48.82
46.49
51.90
1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less net gains or losses on securities, and mark to market gains or losses on MSRs.
2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits, OREO expenses, and acquisition-related costs, net of gains on branch sales, Visa credit card portfolio liquidation and related deconversion costs, as well as any merger related costs, if applicable, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities, mark to market gains or losses on MSRs, gain on the sale of our Visa credit card and land trust portfolios, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI. See the discussion entitled “Non-GAAP Financial Measures” above and the table on page 49 that provides a reconciliation of this non-GAAP financial measure to the most comparable GAAP equivalent.
Noninterest expense for the third quarter of 2023 increased $2.6 million, or 7.4%, compared to the second quarter of 2023, and increased $1.4 million, or 4.0%, compared to the third quarter of 2022. The increase in the third quarter of 2023 compared to the second quarter of 2023 was attributable to a $1.3 million increase in salaries and employee benefits, primarily due to an increase in salaries and the officer incentive accrual. Also contributing to the increase in the third quarter of 2023 was a $632,000 increase in computer and data processing costs as the second quarter reflects software contract incentives, and a $787,000 increase in other expenses primarily due to $629,000 of liquidation costs recorded from the September 2023 Visa credit card portfolio deconversion, which was sold in the third quarter of 2022 and we continued to service through the third quarter of 2023. Partially offsetting the increase in noninterest expense in the third quarter
of 2023 was a $186,000 decrease in legal fees, as the second quarter of 2023 experienced higher legal costs due to senior debt redemption, the proxy filing, and benefit plan reviews.
The year over year increase in noninterest expense is primarily attributable to a $2.1 million increase in salaries and employee benefits, primarily due to an increase in salaries due to higher wage rates and an increase in full-time equivalent employees in the current year. Also contributing to the increase was a $765,000 growth in other expense, which was primarily due to $629,000 of liquidation and deconversion costs recorded on the Visa credit card portfolio liquidation in the third quarter of 2023. Partially offsetting the increase in noninterest expense in the third quarter of 2023, compared to the third quarter of 2022, was a $613,000 decrease in furniture and equipment expenses, a $621,000 decrease in computer and data processing expenses, and a $115,000 decrease in legal fees, all stemming from acquisition related costs that were recorded in the third quarter of 2022.
49,676
46,304
7.3
6,997
5,443
28.6
10,488
10,563
(0.7)
7.8
(2.2)
(61.1)
(52.2)
(1.3)
(26.4)
24.3
7.9
6.5
88.5
4.5
(3.0)
48.15
63.37
47.66
58.35
Noninterest expense for the nine months ended September 30, 2023, decreased $3.3 million, or 3.0%, compared to the nine months ended September 30, 2022, primarily due to a $7.8 million decrease in computer and data processing due to acquisition related costs incurred during the nine months ended September 30, 2022 as the result of our acquisition of West Suburban in December 2021. Salaries and employee benefits increased $4.9 million largely from incentives and merit increases effective during the nine months ended September 30, 2023. Net teller & bill paying decreased $1.7 million largely due to acquisition related costs that were incurred during the nine months ended September 30, 2022. In addition, FDIC insurance increased $351,000 due to growth in our asset size, a scheduled increase in rates
used by the FDIC for assessments, as well as the absence of assessment credits fully utilized in the nine months ended September 30, 2022. Finally, card related expense increased $741,000 due to the growth in customer transactions and related volume changes.
49
Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures
GAAP
Non-GAAP
Efficiency Ratio / Adjusted Efficiency Ratio
Less amortization of core deposit
Less other real estate (income) expense, net
Less acquisition related costs, net of losses/(gains) on branch sales
Less liquidation and deconversion costs on Visa credit card portfolio
Noninterest expense less adjustments
36,834
34,310
35,310
36,205
34,281
34,249
Net interest income
Net interest income including adjustments
Less securities losses
Less MSRs mark to market gains
Less gain on Visa credit card portfolio sale
Less gain on sale of land trust portfolio
Noninterest income (excluding) / including adjustments
10,520
9,674
10,949
10,765
9,785
10,065
Net interest income including adjustments plus noninterest income (excluding) / including adjustments
73,550
73,254
66,518
74,160
73,731
65,994
Efficiency ratio / Adjusted efficiency ratio
N/A - not applicable
Less other real estate expense, net
Less acquisition related costs, net of (gains)/losses on branch sales
106,136
109,412
105,784
100,885
Less securities losses, net
Less MSRs mark to market (losses) gains
50
91
29,744
30,596
30,164
29,764
220,440
172,661
221,953
172,895
Income Taxes
We recorded income tax expense of $8.1 million for the third quarter of 2023 on $32.5 million of pretax income, compared to income tax expense of $9.4 million on $35.0 million of pretax income in the second quarter of 2023, and income tax expense of $7.1 million on $26.6 million of pretax income in the third quarter of 2022. Our effective tax rate was 25.1% in the third quarter of 2023, 26.9% for the second quarter of 2023, and 26.6% for the third quarter of 2022. The slight reduction in the effective tax rate for the third quarter of 2023 reflects the finalization of the 2022 income tax return, and related adjustments due to state apportionment factor changes and deferred tax allocations within the current period.
We recorded income tax expense of $26.0 million on $99.5 million of pretax income for the nine months ended September 30, 2023, compared to income tax expense of $15.9 million on $59.7 million of pretax income in the like 2022 period. The effective tax rate was 26.1% and 26.7% for the nine months ended September 30, 2023 and 2022, respectively.
Income tax expense reflected all relevant statutory tax rates and GAAP accounting. There were no significant changes in our ability to utilize our deferred tax assets during the quarter ended September 30, 2023. We had no valuation reserve on the deferred tax assets as of September 30, 2023.
Financial Condition
Total assets decreased $130.2 million to $5.76 billion at September 30, 2023, from $5.89 billion at December 31, 2022, due primarily to the decrease of $309.7 million in securities available-for-sale. The decrease in securities available-for-sale was primarily due to strategic sales. These decreases were partially offset by increases in net loans of $157.7 million, FHLB and FRB stock held of $15.3 million, and other assets of $8.7 million. We continue to actively assess potential investment opportunities to utilize our excess liquidity. Total deposits were $4.61 billion at September 30, 2023, a decrease of $496.4 million from December 31, 2022, through a combination of seasonal activity as well as leakage from excess savings stemming from COVID-related government payments and opportunities for alternative investments.
As of
211,097
2.2
2.7
55,963
(0.4)
127,626
(16.3)
(18.1)
224,259
(2.7)
(1.9)
9,544
(48.4)
(48.0)
587,846
(27.6)
(34.2)
219,587
(66.9)
(69.5)
173,837
(0.0)
Total securities
1,609,759
(20.1)
(23.6)
Securities available-for-sale decreased $309.7 million as of September 30, 2023 compared to December 31, 2022, and decreased $380.1 million compared to September 30, 2022. The decrease in the portfolio during the third quarter of 2023 was driven by securities sales totaling $65.6 million and paydowns totaling $29.6 million, in addition to growth in unrealized losses of $8.1 million. We continue to
52
seek to position the portfolio in higher credit quality, shorter duration securities with an appropriate mix of fixed- and floating-rate exposures.
888,081
(6.0)
251,603
27.9
41.0
941,910
11.2
876,951
(5.4)
(7.7)
176,700
12.2
14.6
59,580
(9.8)
220,969
3.5
2.9
322,856
14.9
15.2
116,108
(6.5)
(12.1)
14,576
41.6
77.3
3,869,334
4.1
1 The “Other” segment includes consumer loans and overdrafts.
Total loans were $4.03 billion as of September 30, 2023, an increase of $159.9 million from December 31, 2022. The increase in total loans in the first nine months of 2023, compared to December 31, 2022, was due primarily to growth in loan originations, net of paydowns, within leases of $77.4 million, commercial real estate – investor of $59.5 million and multifamily of $48.3 million offset by net reductions in commercial real estate – owner occupied of $45.8 million from December 31, 2022. Total loans increased $160.2 million from September 30, 2022 to September 30, 2023, primarily due to growth in loan originations, net of paydowns, within commercial real estate – investor of $105.2 million, leases of $103.2 million and multifamily of $49.2 million, offset by net reductions in commercial real estate – owner occupied of $67.9 million and commercial of $53.2 million. As required by CECL, the balance (or amortized cost basis) of purchased credit deteriorated loans, or PCD loans (discussed below) is carried on a gross basis (rather than net of the associated credit loss estimate), and the expected credit losses for PCD loans are estimated and separately recognized as part of the allowance for credit losses, or ACL.
The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial real estate, construction, residential, multifamily, and HELOCs) has been and continues to be a sizeable portion of our portfolio. These categories comprised 69.8% of the portfolio as of September 30, 2023, compared to 70.6% of the portfolio as of December 31, 2022. At September 30, 2023, our outstanding commercial real estate loans and undrawn commercial real estate commitments, excluding owner occupied real estate were equal to 288.9% of our Tier 1 capital plus allowance for credit losses, an increase from 304.2% at December 31, 2022. We continue to oversee and seek to manage our loan portfolio in accordance with interagency guidance on risk management.
Asset Quality
Nonperforming loans consist of nonaccrual loans and loans 90 days or greater past due. Prior to January 1, 2023, nonperforming loans also included performing troubled debt restructured loans accruing interest. Nonperforming loans increased by $30.4 million to $63.3 million at September 30, 2023 from $32.9 million at December 31, 2022 and increased $10.4 million from $52.9 million at September 30, 2022. Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, we determined had experienced a more-than-insignificant deterioration in credit quality since origination. PCD loans and their related deferred loan costs are included in our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan. Management continues to carefully monitor loans considered to be in a classified status. Nonperforming loans as a percent of total loans were 1.6% as of September 30, 2023, 0.9% as of December 31, 2022, and 1.4% as of September 30, 2022. The distribution of our nonperforming loans is shown in the following table.
Nonperforming Loans
3,146
7,649
8,821
(58.9)
(64.3)
(79.9)
60.4
17,945
514.9
48.9
9,581
122.4
90.9
7,525
(4.2)
1,672
1,380
(10.2)
8.8
4,198
3,787
(13.6)
1,559
(55.0)
(26.8)
1,312
2,158
2,065
(39.2)
(36.5)
(100.0)
Total nonperforming loans
63,325
32,913
52,900
92.4
19.7
N/M – Not meaningful.
The components of our nonperforming assets are shown in the following table.
Nonperforming Assets
Nonaccrual loans
32,126
96.6
93.4
Performing troubled debt restructured loans accruing interest 1
Loans past due 90 days or more and still accruing interest
20,752
(94.2)
(73.9)
Total nonperforming assets
63,732
34,474
54,461
84.9
17.0
30-89 days past due loans and still accruing interest
28,486
7,508
8,197
Nonaccrual loans to total loans
1.5
0.8
Nonperforming loans to total loans
1.6
0.9
1.4
Nonperforming assets to total loans plus OREO
Allowance for credit losses to total loans
1.3
Allowance for credit losses to nonaccrual loans
83.3
156.6
152.1
N/A – Not applicable
1 As of January 1, 2023, the Company prospectively adopted ASU 2022-02 Topic 326 “Troubled Debt Restructurings (“TDRs”) and Vintage Disclosures”, which eliminated the need for recognition, measurement and disclosure of TDRs going forward. See Note 1 for further details of ASU 2022-02 adoption.
Loan charge-offs, net of recoveries, for the third quarter of 2023, prior linked quarter and year over year quarter are shown in the following table.
Loan Charge–offs, Net of Recoveries
% of
Total1
0.1
298
59.0
(95)
(1.4)
(7)
261.8
6,754
102.4
10.1
105
154.4
0.3
198
39.2
(75)
(110.3)
(100)
(1.5)
(3)
(5)
(1.0)
(8)
(11.8)
(25)
(7.1)
(113)
(166.2)
(63)
(92.6)
(35)
(51.5)
Other 2
59
86.8
Net charge–offs
6,597
100.0
505
68
1 Represents the percentage of net charge-offs attributable to each category of loans.
2 The “Other” segment includes consumer and overdrafts.
Net charge-offs of $6.6 million were recorded for the third quarter of 2023, compared to net charge-offs of $505,000 for the second quarter of 2023, and net charge-offs of $68,000 for the third quarter of 2022, reflecting continuing management attention to credit quality and remediation efforts. The net charge-offs for the third quarter of 2023 were primarily due to charge offs of three commercial real estate-investor loans of $6.8 million in aggregate. These three commercial real estate-investor credits had a reported reserve allocation of $4.7 million prior to the third quarter of 2023 charge-offs. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.
Classified loans include nonaccrual loans and all other loans considered substandard. Classified assets include both classified loans and OREO. Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that we will sustain some loss if deficiencies remain uncorrected.
The following table shows classified assets by segment for the following periods.
Classified Assets
31,722
(30.9)
(42.3)
(69.4)
144.3
28,252
97.5
91.6
42,698
35.2
29.5
1,285
(12.4)
16.9
3,929
(61.4)
(42.4)
2,278
(40.5)
(37.1)
Total classified loans
113,730
40.7
34.8
Total classified assets
153,664
110,490
115,291
39.1
33.3
55
Total classified loans increased $44.3 million and classified assets increased $43.2 million as of September 30, 2023 from December 31, 2022. The increase since December 31, 2022 is due to the addition of $26.7 million of classified loans in commercial real estate – investor, primarily due to four large credits, two of which are office buildings, one is an assisted living facility during the first six months of 2023, and one office building in the third quarter of 2023. The increase is also due to the growth in construction, primarily due to two large credits. The increase from September 30, 2022 is primarily due to the same loan additions to commercial real estate – investor and construction. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the ACL on loans as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 23.51% for the period ended September 30, 2023, compared to 18.36% as of December 31, 2022, and 19.23% as of September 30, 2022.
Allowance for Credit Losses on Loans
The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the allowance for credit losses (“ACL”) at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date.
At September 30, 2023, our ACL on loans totaled $51.7 million, and our ACL on unfunded commitments, included in other liabilities, totaled $2.9 million. In the third quarter of 2023, we recorded provision expense on loans of $3.0 million, based on our assessment of nonperforming loan metrics and trends and estimated future credit losses, and a $12,000 reversal of provision on unfunded commitments, primarily due to an adjustment of historical benchmark assumptions, such as funding rates and the period used to forecast those rates, within the ACL calculation. These adjustments resulted in a $3.0 million net impact to the provision for credit losses for the third quarter of 2023.
Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated credit losses on loans, leases and unfunded commitments. The ACL on loans totaled $51.7 million as of September 30, 2023, $49.5 million as of December 31, 2022, and $48.8 million as of September 30, 2022. Our ACL on loans to total loans was 1.3% as of September 30, 2023, compared to 1.3% as of December 31, 2022 and September 30, 2022. See Item 7 – Critical Accounting Estimates in the Management Discussion and Analysis in our 2022 Annual Report in Form 10-K for discussion of our ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.
56
Below is a reconciliation of the activity in the allowance for credit losses on loans for the periods indicated (dollars in thousands):
Allowance at beginning of period
53,392
Charge–offs:
Total charge–offs
733
Recoveries:
82
Total recoveries
228
Net charge-offs
7,842
611
Provision for credit losses on loans
2,427
Allowance at end of period
Average total loans (exclusive of loans held–for–sale)
4,009,218
4,039,052
3,751,097
3,993,600
3,552,871
Net charge–offs to average loans
0.01
0.26
0.02
Allowance at period end to average loans
1.29
1.37
1.30
The coverage ratio of the ACL on loans to nonperforming loans was 81.3% as of September 30, 2023, which was a decrease from the coverage ratio of 90.3% as of June 30, 2023 and a decrease from 92.3% as of September 30, 2023. When measured as a percentage of average loans, our total ACL on loans was 1.29% at September 30, 2023, 1.37% at June 30, 2023, and 1.30% at September 30, 2022.
In management’s judgment, an adequate ACL has been established to encompass the current lifetime expected credit losses at September 30, 2023, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession. Continued volatility in the economic environment stemming from the impacts of and response to inflation, potential recession, and the war in Ukraine and the conflict in the Middle East, and the associated effects on our customers, or other factors, such as changes in business climates and the condition of collateral at the time of default or repossession, may revise our current expectations of future credit losses in future reporting periods.
Deposits and Borrowings
Deposits
2,098,144
(9.2)
(11.2)
1,164,036
(13.8)
630,747
(6.8)
(9.9)
931,813
(18.6)
(24.6)
258,071
1.7
148,411
9.8
50,137
65.1
5,281,359
(12.6)
Total deposits were $4.61 billion at September 30, 2023, which reflects a $496.4 million decrease from total deposits of $5.11 billion at December 31, 2022, and a decrease of $667.0 million from total deposits of $5.28 billion at September 30, 2022. The decrease in deposits at September 30, 2023, compared to December 31, 2022, was primarily due to decreases in noninterest-bearing deposits of $189.0 million, money market accounts of $160.0 million and savings accounts of $142.1 million. The decrease in deposits at September 30, 2023, compared to September 30, 2022, was primarily due to decreases in noninterest-bearing deposits of $235.5 million, money market accounts of $229.6 million, and savings accounts of $160.5 million. Total quarterly average deposits decreased $659.4 million, or 12.4%, in the year over year period, driven by declines in our average demand deposits of $225.1 million, and savings, NOW and money markets combined of $440.7 million. In general, the bulk of the decline in deposits year over year can be characterized as rate sensitive with significant flows and transfers into investing activities, materially offsetting the significant expansion in those same accounts in the immediate aftermath of the pandemic.
The following table presents estimated insured and uninsured deposits at September 30, 2023 and December 31, 2022 by deposit type, as well as the weighted average rates for each year to date ending period.
Total Deposits
Insured Deposits
Uninsured Deposits
Average Rate Paid
1,202,051
660,608
1,327,379
724,323
935,664
67,834
1,065,153
80,439
409,219
158,778
453,799
155,539
490,539
211,637
588,923
273,247
414,227
63,763
381,980
59,941
0.31
3,451,700
1,162,620
3,817,234
1,293,489
Collateralized public funds
264,322
15,410
248,912
262,318
15,879
246,439
Deposits declined 9.7% for the nine months ended September 30, 2023 due to retail and commercial run off. Total deposit run off year to date has been very granular, and not necessarily attributable to large deposit accounts. Our deposit retention efforts for commercial clients were more effective due to high touch relationships where we had a larger share of wallet. The largest reduction in total deposits was from retail customers due to personal and real estate tax payments, real estate transactions, investments, and consumer spending. In terms of product mix, we observed some migration into time deposits, drawn by CD rate specials. Overall, our deposit level remains stable and we continue to monitor customer relationships and liquidity levels daily.
In addition to deposits, we used other liquidity sources for our funding needs in all periods presented, such as repurchase agreements and other short-term borrowings with the FHLBC. Securities sold under repurchase agreements totaled $25.9 million at September 30, 2023, a $6.3 million, or 19.5%, decrease from $32.2 million at December 31, 2022. Our excess liquidity on hand during much of 2022 allowed us to fund our short-term liquidity needs with cash on hand. During the third quarter of 2022, we began re-utilizing short-term borrowings from the FHLBC. The outstanding balance of our short-term FHLBC borrowings was $435.0 million as of September 30, 2023, $90.0 million as of December 31, 2022, and $25.0 million as of September 30, 2022.
58
We are also indebted on $25.8 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust II (“Trust II”) as of September 30, 2023. The Trust II issuance converted from fixed to floating rate at three month LIBOR, which is now three month Term SOFR, plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.18% as of September 30, 2023, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017 rate reset.
In the second quarter of 2021, we entered into Subordinated Note Purchase Agreements with certain qualified institutional buyers pursuant to which we issued $60.0 million in aggregate principal amount of our 3.50% Fixed-to-Floating Rate Subordinated Notes due April 15, 2031 (the “Notes”). We sold the Notes to eligible purchasers in a private offering, and the proceeds of this issuance were used for general corporate purposes. The Notes bear interest at a fixed annual rate of 3.50% through April 14, 2026, payable semi-annually in arrears. As of April 15, 2026 forward, the interest rate on the Notes will generally reset quarterly to a rate equal to three-month Term SOFR (as defined by the Note) plus 273 basis points, payable quarterly in arrears. The Notes have a stated maturity of April 15, 2031, and are redeemable, in whole are in part, on April 15, 2026, or any interest payment date thereafter, and at any time upon the occurrence of certain events. As of September 30, 2023, we had $59.4 million of subordinated debentures outstanding, net of deferred issuance costs.
In December 2016, we completed a $45.0 million senior note issuance. The notes had a ten-year term, and included interest payable semiannually at 5.75% for five years. Beginning December 31, 2021, the interest became payable quarterly at three month LIBOR plus 385 basis points. On June 30, 2023, the senior notes were redeemed in full. The remaining balance of deferred debt issuance costs of $362,000 related to these senior notes was recognized as interest expense as of June 30, 2023.
On February 24, 2023, we paid off the remaining $9.0 million balance in notes payable and other borrowings, resulting in no balance in this line item as of September 30, 2023, compared to $9.0 million as of December 31, 2022, and $10.0 million as of September 30, 2022. The balance in notes payable was related to a $20.0 million dollar term note originated with a correspondent bank in the first quarter of 2020, to facilitate the redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures, completed on March 2, 2020.
As of September 30, 2023, total stockholders’ equity was $532.6 million, which was an increase of $71.5 million from $461.1 million as of December 31, 2022. This increase is primarily attributable to an increase in retained earnings of $66.8 million due to net income of $73.5 million in the first nine months of 2023, partially offset by $6.7 million of dividends paid to our common stockholders. In addition, total stockholders’ equity as of September 30, 2023 increased over December 31, 2022, due to a reduction in unrealized net losses on available-for-sale securities, which decreased accumulated other comprehensive loss by $2.5 million in the first nine months of 2023, due to changes in market interest rates. Total stockholders’ equity as of September 30, 2023 increased $98.8 million compared to September 30, 2022 due to net income year over year and the increase in accumulated other comprehensive loss of $7.8 million year over year.
The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:
Adequacy with
Under Prompt
Capital Conservation
Corrective Action
Buffer, if applicable1
Provisions2
The Company
Common equity tier 1 capital ratio
9.16
Total risk-based capital ratio
11.99
Tier 1 risk-based capital ratio
9.68
Tier 1 leverage ratio
7.70
The Bank
11.60
12.64
9.24
2 The prompt corrective action provisions are only applicable at the Bank level.
As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. As of September 30, 2023, our capital measures exclude $1.9 million, which is the modified CECL transition adjustment.
As of September 30, 2023, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the capital conservation buffer requirements. In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, increased from 7.83% at December 31, 2022, to 9.25% at September 30, 2023. Our GAAP tangible common equity to tangible assets ratio was 7.67% at September 30, 2023, compared to 6.24% as of December 31, 2022. Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, increased from 6.28% at December 31, 2022, to 7.71% at September 30, 2023, primarily due to an increase in tangible common equity in the third quarter of 2023. The increase in tangible common equity was due to an increase in retained earnings of $66.8 million and an increase in accumulated other comprehensive loss of $2.5 million primarily related to improved unrealized losses on available-for-sale securities stemming from the changes in market interest rates.
Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure
Tangible common equity
Total Equity
Less: Goodwill and intangible assets
98,298
100,156
Add: Limitation of exclusion of core deposit intangible (80%)
2,364
2,736
Adjusted goodwill and intangible assets
95,934
97,420
434,260
436,624
360,985
363,721
Tangible assets
Less: Adjusted goodwill and intangible assets
5,659,858
5,662,222
5,788,161
5,790,897
Common equity to total assets
9.25
7.83
Tangible common equity to tangible assets
7.67
7.71
6.24
6.28
The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for us when reviewing risk based capital ratios and equity performance metrics.
Liquidity
Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds. In the third quarter of 2023, we continued to experience moderate loan growth, while deposits have trended down as clients moved balances to pursue higher yields as well as due to seasonal declines. We managed the change in our funding through borrowing from the Federal Home Loan Bank of Chicago (“FHLBC”) and sales of securities, which resulted in minimal losses and mitigated our interest rate risk profile. The bank failures in the first five months of 2023 exemplify the potentially serious results of the unexpected inability of insured depository institutions to obtain needed liquidity to satisfy deposit withdrawal requests, including how quickly such requests can accelerate once uninsured depositors lose confidence in an institution’s ability to satisfy its obligations to depositors. We seek to ensure our funding needs are met by maintaining a level of liquidity through asset and liability management. We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors. In addition, our senior management team monitors cash balances daily to ensure we have adequate liquidity to meet our operational and financing needs. As of September 30, 2023, our cash on hand liquidity totaled $109.0 million, a decrease of $6.1 million over cash balances held as of December 31, 2022.
Net cash inflows from operating activities were $87.3 million during the first nine months of 2023, compared with net cash inflows of $60.1 million in the same period of 2022. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale, were a source of outflows for the first nine months of 2023 compared to a source of inflows for the like period of 2022. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of outflows for the nine months ended September 30, 2023 and source of inflows for the like period of 2022. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.
Net cash inflows from investing activities were $124.5 million in the nine months ended September 30, 2023, compared to net cash outflows of $506.4 million in the same period in 2022. In the first nine months of 2023, securities transactions accounted for net inflows of $306.0 million, and the principal change on loans accounted for net outflows of $164.3 million. In the first nine months of 2022, securities transactions accounted for net outflows of $66.9 million, and principal on loans funded, net of paydowns, accounted for net outflows of $443.6 million.
Net cash outflows from financing activities in the nine months ended September 30, 2023, were $218.0 million, compared with net cash outflows of $189.7 million in the nine months ended September 30, 2022. Net deposit outflows in the first nine months of 2023 were $495.4 million compared to net deposit outflows of $183.7 million in the first nine months of 2022. Other short-term borrowings had $345.0 million of net cash inflows in the first nine months of 2023, compared to net cash inflows of $25.0 million for other short-term borrowings in the first nine months of 2022. Changes in securities sold under repurchase agreements accounted for outflows of $6.3 million and outflows of $14.8 million for the nine months ended September 30, 2023 and 2022, respectively. Dividends paid on our common stock totaled $6.7 million for both the nine months ended September 30, 2023 and 2022. The purchase of treasury stock in the first nine months of 2023 due to shares acquired with equity award vestings resulted in outflows of $605,000, compared to cash outflows of $447,000 in the first nine months of 2022.
Cash and cash equivalents for the nine months ended September 30, 2023, totaled $109.0 million, as compared to $115.2 million as of December 31, 2022 and $116.2 million as of September 30, 2022. The decrease in cash and cash equivalents for the nine months ended September 30, 2023 was mainly attributable to loan growth and the payoffs of the remaining balance of the term note and senior notes, as well as deposit outflows, partially offset by security sales and FHLB advances during the first nine months of 2023. The year over year decrease is again driven by loan growth, as well as increased customer use of deposits. In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs. These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business. Additional sources of funding include a $30.0 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale.
61
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund (primarily customer deposits and borrowed funds). Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income. Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates. A financial institution’s ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in a volatile rate environment. We mitigate the impact of interest rate volatility to the Bank by managing our rate sensitivity under various scenarios.
During the third quarter of 2023, the Federal Reserve increased rates by 0.25% in July and held rates unchanged at the September FOMC meeting. The current market expectation is for rates to be unchanged for the remainder of 2023. The projected level of rate cuts in 2024 have been reduced and moved to later in the year, framing a “higher rates for a longer period” outcome. The Federal Reserve managed to shrink its balance sheet to $8.0 trillion by September 2023, down from its peak of $8.7 trillion in March 2023.
We manage interest rate risk within guidelines established by policy which are intended to limit the amount of rate exposure. In practice, we seek to manage our interest rate risk exposure within our guidelines so that such exposure does not pose a material risk to our future earnings. We manage various market risks in the normal course of our operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of our business activities and operations. In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities. Our interest rate risk exposures at September 30, 2023 and December 31, 2022 are outlined in the table below.
Our net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as SOFR and Prime), and balance sheet growth or contraction. Our asset-liability committee seeks to manage interest rate risk under a variety of rate environments by structuring our on-balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 19 of our consolidated financial statements found in in our Annual Report on Form 10-K for the year ended December 31, 2022. We seek to monitor and manage interest rate risk within approved policy guidelines and limits. Asset and liability modeling and tracking is performed and presented to the Asset-Liability committee and the Board of Directors no less than quarterly. The presentations discuss our current and historical interest rate risk posture, shifts in the balance sheet composition, and the impact of interest rate movements on earnings and equity. Our current balance sheet is a moderately asset sensitive profile, as our variable rate assets reprice faster than our longer duration, low beta deposit base. Recent market events of failed liquidity management at other banks have been reviewed by the Asset-Liability committee. The committee concluded that we possess a strong liquidity profile and no new liquidity risks were identified. Prudently, we added new measures to assess liquidity risk and enhanced our reports to segment deposits by insured, uninsured, collateralized deposits; and monitor the bank’s funding sources and uses on a regular basis.
We also have a Risk Committee, chaired by our Chief Risk Officer, which reports no less than quarterly to senior management as well as our Board of Directors regarding compliance with risk tolerance limits, key risk factor changes, both internally and externally, due to portfolio changes as well as market conditions. Our enterprise risk management framework is governed by this committee, with input being provided by line of business managers, senior management and the Board.
We use simulation analysis to quantify the impact of various rate scenarios on our net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model. Earnings at risk are calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change. As of September 30, 2023, our net interest income profile remained sensitive to earnings gains (in both dollars and percentage) should interest rates rise. However, we have moved to a less sensitive profile compared to December 31, 2022, due to the impact of interest rate swaps and sales of variable rate securities.
The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1.0%, and 2.0%, with no change in the slope of the yield curve.
Analysis of Net Interest Income Sensitivity
Immediate Changes in Rates
2.0
Dollar change
(37,003)
(18,371)
(9,055)
9,349
18,817
36,942
Percent change
(14.6)
(7.2)
(3.6)
14.5
(46,800)
(22,963)
(11,327)
11,278
22,593
44,482
(18.2)
(8.9)
(4.4)
17.3
The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude, balance sheet composition and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.
Effects of Inflation
In management’s opinion, although changes in interest rates affect our financial condition to a far greater degree than changes in the inflation rate, we monitor both. The annual US inflation rate for September 2023 was 3.7%, a moderate increase quarter-over-quarter, while Core CPI eased to 4.1%. Management believes the inflation rate will continue to come down, albeit at a much slower rate than experienced year-to-date as of September 2023. The downside risks of high inflation put upwards pressure to our expenses, which could impact our profits. Furthermore, higher costs of living weaken the financial condition of our borrowers which could affect our credit profile. Overall, we expect the risk of high inflation has been contained with minimal impact to our results.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of September 30, 2023. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2023, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.
There were no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2023, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.
Item 1.A. Risk Factors
Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as well as cautionary statements contained in this Quarterly Report, on Form 10-Q, including those under the caption “Cautionary Note Regarding Forward-Looking Statements.”
There have been no material changes to the risk factors previously disclosed in the Company’s (i) Annual Report on Form 10-K for the fiscal year ended December 31, 2022; (ii) Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2023; and (iii) Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2023.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
Item 6. Exhibits
Exhibits:
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at September 30, 2023 and December 31, 2022; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2023 and 2022; (iii) Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2023 and 2022; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2023 and 2022; (v) Consolidated Statements of Stockholders’ Equity for the three and nine months ended September 30, 2023 and 2022; and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.
Cover Page Interactive Data File (the cover page XBRL tags are embedded within the Inline XBRL document).
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
BY:
/s/ James L. Eccher
James L. Eccher
Chairman and Chief Executive Officer
(principal executive officer)
/s/ Bradley S. Adams
Bradley S. Adams
Executive Vice President,
Chief Operating Officer and Chief Financial Officer
(principal financial and accounting officer)
DATE: November 8, 2023