Human Capital Resources
As of December 31, 2022, we employed 374 full-time-equivalent employees. The Company believes that its employee relations are satisfactory. For the year ended December 31, 2022, salaries and employee benefits expense totaled $64 million, representing 69% of our total non-interest expense. Expenses related to education, training, recruiting and placement exceeded $500,000 for the period ended December 31, 2022.
We are led by an experienced management team with substantial experience in the markets we serve and the financial products we offer. Our business strategy focuses on providing products and services through long-term relationship managers. As a result, our success depends heavily on the performance of our employees, as well as on our ability to attract, motivate and retain highly qualified employees at all levels of the Company. We believe that our work environment contributes to employee satisfaction and retention.
We are committed to maintaining a work environment where every employee is treated with dignity and respect, free from the threat of discrimination and harassment. As stated in our Board approved (i) Code of Conduct and (ii) Prohibited Harassment Policy, we expect these same standards to apply to all stakeholders, and to our interactions with customers, vendors and independent contractors.
We are firmly committed to providing equal employment and advancement opportunities to all qualified individuals and will not tolerate any discrimination or harassment of any kind. Team members are encouraged to immediately report any discrimination or harassment to their supervisor and human resources.
Policies and Planning
We are proud to be an Equal Opportunity Employer and enforce those values throughout all of our operations. We prohibit discrimination in hiring or advancement against any individual on the basis of race, color, religion, gender, sex, national origin, age, marital status, pregnancy, physical or mental disability, genetics, veteran status, sexual orientation, or any other characteristic protected by applicable law.
We strive to ensure our team members have access to working conditions that provide a safe and healthy environment, free from work-related injuries and illnesses. Many of our locations employ badges and keypads to enter or to enter restricted areas of locations that have a public presence.
Each year our annual planning and budgeting process involves an assessment of staffing levels and skills and results in the development of targets for recruitment and training. In addition, our Board of Directors reviews all succession plans in place for key personnel.
Recruitment
We strive to recruit talent from both local educational institutions and the banking industry. The Company has full-time staff dedicated to our recruitment efforts and we utilize many of the major recruitment firms and websites. Annually we visit local colleges and universities for job fairs and other recruitment events, which we believe allows us to identify those students who have the skills and aptitudes we need in the Company. The results of these efforts has been a consistent flow of candidates to fill our staffing needs as we grow.
Compensation
Salary and Bonuses
We have job descriptions and salary grade ranges for all of our positions. Annually, we use outside survey firms to provide information on market pay. We also pay performance-based bonuses to our employees. During 2022, total bonus compensation amounted to over 30% of base salaries. We believe that this “pay-for-performance” approach allows us to effectively recruit and retain key employees.
Retirement Plans
All employees are eligible to participate in our Profit Sharing Plan after one year of service and having worked at least 1,000 hours. The Company makes contributions equal to 5% of the employee’s eligible compensation and discretionary contributions determined annually by the Board of Directors. This is not a matching based program; employees receive these contributions regardless of whether they make individual contributions to our 401(K) program. During 2022 total expenses for the Profit Sharing Plan amounted to over 10% of base salaries, a level that we believe helps us in recruitment and retention.
Medical and Other Benefits
In addition to competitive salaries, incentives and retirement benefits, we provide comprehensive medical, dental, and vision plans, health savings accounts, paid sick time, long-term disability, basic life and AD&D insurance, flexible spending accounts, and employee assistance and wellness programs.
Training
Job Related
We support team members, should they wish to continue their education in subjects and fields that are directly related to our operations, activities, and objectives. We encourage our team members to pursue educational opportunities that will help improve job performance and professional development. To further this goal, we reimburse tuition and certain fees for satisfactory completion of approved educational courses and certain certifications. Included are college credit courses at accredited colleges and universities, continuing education courses and certification exams.
Diversity and Inclusion
To foster a deeper understanding regarding diversity and inclusion, the Company assigns all employees diversity and inclusion training - Diversity Made Simple. The diversity course is mandatory for all staff. As of December 31, 2022, all employees had met their diversity and inclusion training obligations.
Harassment Prevention
The Company assigns all employees prohibitive harassment training. Every two years non-supervisory employees receive one hour of harassment prevention training while supervisors receive two hours of harassment prevention training. Newly hired employees are assigned harassment prevention and must complete the training within six months of hire or promotion. Following the initial training, all employees must complete training every two years, at minimum. As of December 31, 2022, all employees had met their harassment prevention training requirements for 2022.
Performance Evaluation
The Company has implemented a Performance Planning, Coaching and Evaluation (“PPC&E”) system that requires each year that employees and their managers establish detailed goals and objectives. Annually, employees are reviewed relative to their progress in achieving those goals, with the objective of reducing performance surprises and encouraging behavior that is consistent with Company objectives. We believe that this PPC&E discipline is important in retaining and growing our employees.
Government Policies
The Company’s profitability, like that of most financial institutions, is significantly dependent on interest rate differentials. The difference between the interest rates paid by the Company on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by the Company on its interest-earning assets, such as loans and leases extended to its customers and securities held in its investment portfolio, comprise the major portion of the Company’s earnings. These rates are highly sensitive to many factors that are beyond the control of the Company and the Bank, such as inflation, recession, unemployment, and the monetary policy of the FRB. The impact that changes in economic conditions might have on the Company and the Bank cannot be predicted.
The business of the Company is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the FRB. The FRB implements national monetary policies (with objectives such as curbing inflation and maximum employment, stable prices, and moderate long-term interest rates) through its open-market operations in U.S. Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions.
The actions of the FRB in these areas influence the growth of bank loans and leases, investments, and deposits and affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact on the Company of any future changes in monetary and fiscal policies cannot be predicted.
From time to time, legislative acts, as well as regulations, are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions and financial services providers are frequently made in the U.S. Congress, in the state legislatures, and before various regulatory agencies. This legislation may change banking statutes and the operating environment of the Company and the Bank in substantial and unpredictable ways. If enacted, such legislation or regulations could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings institutions, credit unions, and other financial institutions. The Company cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implemented regulations, would have on the financial condition or results of operations of the Company or any of its subsidiaries.
Supervision and Regulation
General
Bank holding companies and banks are extensively regulated under both federal and state law. The regulation is intended primarily for the protection of the banking system and the Deposit Insurance Fund and clients of insured depository institutions and not for the benefit of stockholders of the Company. This supervisory and regulatory framework subjects banks and bank holding companies to regular examination by their respective regulatory agencies, which results in examination reports and ratings that, while not publicly available, can affect the conduct and growth of their businesses. These examinations consider not only compliance with applicable laws and regulations, but also capital levels, asset quality and risk, management ability and performance, earnings, liquidity, and various other factors. The regulatory agencies generally have broad discretion to impose restrictions and limitations on the operations of a regulated entity where the agencies determine, among other things, that such operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies.
Set forth below is a summary description of the material laws and regulations, which relate to the operations of the Company and the Bank. This description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
The Company
The Company is a registered bank holding company and is subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHCA”). Accordingly, the Company’s operations are subject to extensive regulation and examination by the FRB. The Company is required to file with the FRB quarterly and annual reports and such additional information as the FRB may require pursuant to the BHCA. The FRB conducts periodic examinations of the Company.
The FRB may require that the Company terminate an activity, terminate control of, liquidate, or divest certain subsidiaries or affiliates when the FRB believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The FRB also has the authority to regulate provisions of certain bank holding company debt. Under certain circumstances, the Company must file written notice with, and obtain approval from, the FRB prior to purchasing or redeeming its equity securities.
Under the BHCA and regulations adopted by the FRB, a bank holding company and its non-banking subsidiaries are prohibited from requiring certain tie-in arrangements in connection with an extension of credit, lease or sale of property, or furnishing of services. For example, with certain exceptions, a bank may not condition an extension of credit on a promise by its customer to obtain other services provided by it, its holding company or other subsidiaries, or on a promise by its customer not to obtain other services from a competitor. In addition, federal law imposes certain restrictions on transactions between Farmers & Merchants Bancorp and its subsidiaries. Further, the Company is required by the FRB to maintain certain levels of capital. See “Capital Standards.”
The Company is prohibited by the BHCA, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or furnishing services to its subsidiaries. However, the Company, subject to the prior notice to, and/or approval of, the FRB, may engage in any, or acquire shares of companies engaged in, any activities that are deemed by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
A bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the FRB’s policy, that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. This support may be required at times when a bank holding company may not be able to provide such support. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of the FRB’s regulations or both.
The Company is not a financial holding company for purposes of the BHCA.
The Company is also a bank holding company within the meaning of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the DFPI.
The Company’s common stock is registered with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As such, the Company is subject to the reporting, proxy solicitation and other requirements and restrictions of the Exchange Act.
The Bank
The Bank, as a California-chartered non-FRB member bank, is subject to primary supervision, periodic examination and regulation by the DFPI and the FDIC. If, as a result of an examination of the Bank, the FDIC should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory, or that the Bank or its management is violating or has violated any law or regulation, various remedies are available to the FDIC.
Such remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of the Bank, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate the Bank’s deposit insurance, which for a California-chartered bank would result in a revocation of the Bank’s charter. The DFPI has many of the same remedial powers.
Various requirements and restrictions under the laws of the State of California and the United States affect the operations of the Bank. State and federal statutes and regulations relate to many aspects of the Bank’s operations, including reserves against deposits, ownership of deposit accounts, interest rates payable on deposits, loans and leases, investments, mergers and acquisitions, borrowings, dividends, locations of branch offices, and capital requirements. Further, the Bank is required to maintain certain levels of capital. See “Capital Standards.”
The Dodd Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) - The Dodd-Frank Act implemented sweeping reform across the U.S. financial regulatory framework, including, among other changes:
| | • | creating a Financial Stability Oversight Council tasked with identifying and monitoring systemic risks in the financial system; |
| • | creating the Consumer Financial Protection Bureau (“CFPB”), which is responsible for implementing, examining and enforcing compliance with federal consumer financial protection laws; |
| • | requiring the FDIC to make its capital requirements for insured depository institutions countercyclical, so that capital requirements increase in times of economic expansion and decrease in times of economic contraction; |
| • | imposing more stringent capital requirements on bank holding companies and subjecting certain activities, including interstate mergers and acquisitions, to heightened capital conditions; |
| • | changing the assessment base for federal deposit insurance from the amount of the insured deposits held by the depository institution to the depository institution’s average total consolidated assets less tangible equity, eliminating the ceiling on the size of the FDIC’s Deposit Insurance Fund and increasing the floor on the size of the FDIC’s Deposit Insurance Fund; |
| • | eliminating all remaining restrictions on interstate banking by authorizing state banks to establish de novo banking offices in any state that would permit a bank chartered in that state to open a banking office at that location; |
| • | repealing the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts; and |
| • | in the so-called “Volcker Rule,” subject to numerous exceptions, prohibiting depository institutions and affiliates from certain investments in, and sponsorship of, hedge funds and private equity funds and from engaging in proprietary trading. |
On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (“Economic Growth Act”), which repealed or modified certain provisions of the Dodd-Frank Act and eased regulations on all but the largest banks.
The Economic Growth Act’s highlights include improving consumer access to mortgage credit that, among other things: (i) exempt banks with less than $10 billion in assets from the ability-to-repay requirements for certain qualified residential mortgage loans; (ii) do not require appraisals for certain transactions valued at less than $400,000 in rural areas; (iii) exempt banks and credit unions that originate fewer than 500 open-end and 500 closed-end mortgages from the Home Mortgage Disclosure Act’s (“HMDA”) expanded data disclosures (the provision would not apply to nonbanks and would not exempt institutions from HMDA reporting altogether); (iv) amend the SAFE Mortgage Licensing Act by providing registered mortgage loan originators in good standing with 120 days of transitional authority to originate loans when moving from a federal depository institution to a non-depository institution or across state lines; (v) require the CFPB to clarify how Truth in Lending Disclosure (“TRID”) rules apply to mortgage assumption transactions and construction-to-permanent home loans as well as outline certain liabilities related to model disclosure use; and (vi) provide that federal banking regulators may not impose higher capital standards on High Volatility Commercial Real Estate exposures unless they are for acquisition, development or construction (“ADC”), and clarifies ADC status. In addition, the Economic Growth Act’s highlights also include regulatory relief for certain institutions, including among other things, simplifying capital calculations by requiring regulators to adopt a threshold for a community bank leverage ratio of between 8% to 10%.
Institutions under $10 billion in assets that meet such community bank leverage ratio will automatically be deemed to be “well-capitalized”, although regulators retain the flexibility to determine that a depository institution may not qualify for the community bank leverage ratio test based on the institution’s risk profile. The Economic Growth Act also exempts community banks from Section 13 of the BHCA if they have less than $10 billion in total consolidated assets; and exempts banks with less than $10 billion in assets, and total trading assets and liabilities not exceeding more than five percent of their total assets, from the Volcker Rule restrictions on trading with their own capital.
The Economic Growth Act also added certain protections for consumers, including veterans and active duty military personnel, expanded credit freezes and created an identity theft protection database. The Economic Growth Act also made changes applicable to bank holding companies, as it raises the threshold for automatic designation as a systemically important financial institution from $50 billion to $250 billion in assets, subjects banks with $100 billion to $250 billion in total assets to periodic stress tests, exempts from stress test requirements entirely banks with under $100 billion in assets, and required the federal banking regulators , within 180 days of passage, to raise the asset threshold under the Small Bank Holding Company Policy Statement from $1 billion to $3 billion. The Economic Growth Act also added certain protections for student borrowers.
Some aspects of the Dodd-Frank Act remain subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us. In addition, the Economic Growth Act modified several provisions in the Dodd-Frank Act, but these remain subject to implementing regulations. Although the reforms primarily target systemically important financial service providers (which the Bank is not), the Dodd-Frank Act’s influence has and is expected to continue to filter down in varying degrees to smaller institutions over time. We will continue to evaluate the effect of the Dodd-Frank Act; however, in many respects, the ultimate impact of the Dodd-Frank Act will not be fully known for years, and no current assurance may be given that the Dodd-Frank Act, or any other new legislative changes, will not have a negative impact on the results of operations and financial condition of the Company and the Bank.
Capital Standards
The federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization’s operations, both for transactions reported on the balance sheet as assets and for transactions, such as letters of credit and recourse arrangements, that are recorded as off-balance sheet items. In 2013, the FRB, FDIC, and Office of the Comptroller of the Currency issued final rules (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations.
The rules implement the Basel Committee’s December 2010 framework, commonly referred to as Basel III, for strengthening international capital standards, as well as implementing certain provisions of the Dodd-Frank Act.
The Basel III Capital Rules became effective for the Company and the Bank on January 1, 2015 (subject to phase-in periods for some of their components). The Basel III Capital Rules: (i) introduce a new capital measure called Common Equity Tier 1 (“CET1”), and a related regulatory capital ratio of CET1 to risk-weighted assets; (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments, which are instruments treated as Tier 1 instruments under the prior capital rules that meet certain revised requirements; (iii) mandate that most deductions or adjustments to regulatory capital measures be made to CET1 and not to the other components of capital; and (iv) expand the scope of the deductions from and adjustments to capital, as compared to existing regulations. Under the Basel III Capital Rules, for most banking organizations, the most common form of additional Tier 1 capital is non-cumulative perpetual preferred stock and the most common form of Tier 2 capital is subordinated notes and a portion of the allowance for credit losses, in each case, subject to the Basel III Capital Rules’ specific requirements.
Under the Basel III Capital Rules, the following are the minimum capital ratios applicable to the Company and the Bank:
| • | 4.0% Tier 1 leverage ratio; |
| • | 4.5% CET1 to risk-weighted assets, plus the capital conservation buffer, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%; |
| • | 6.0% Tier 1 capital to risk-weighted assets, plus the capital conservation buffer, effectively resulting in a minimum Tier 1 capital ratio of at least 8.5%; and |
| • | 8.0% total capital to risk-weighted assets, plus the capital conservation buffer, effectively resulting in a minimum total capital ratio of at least 10.5%. |
The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that: (i) mortgage servicing rights, (ii) deferred tax assets arising from temporary differences that could not be realized through net operating loss carrybacks, and (iii) significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such items, in the aggregate, exceed 15% of CET1. Under the Basel III Capital Rules, the effects of certain accumulated other comprehensive income or loss items are not excluded for the purposes of determining regulatory capital ratios; however, non-advanced approaches banking organizations (i.e., banking organizations with less than $250 billion in total consolidated assets or with less than $10 billion of on-balance sheet foreign exposures), including the Company and the Bank, may make a one-time permanent election to exclude these items. The Company and the Bank made this election in 2015 in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of its available-for-sale investment securities portfolio, changes of which are included in accumulated other comprehensive income or loss.
The Basel III Capital Rules prescribe a standardized approach for risk weightings that expands the risk weighting categories from the previous four Basel I-derived categories (0%, 20%, 50% and 100%) to a larger and more risk-sensitive number of categories, generally ranging from 0% for U.S. Government and agency securities, to 600% for certain equity exposures, depending on the nature of the assets. The Basel III capital rules generally result in higher risk weights for a variety of asset classes. Additional aspects of the Basel III Capital Rules that are relevant to the Company and the Bank include:
| • | consistent with the Basel I risk-based capital rules, assigning exposures secured by single-family residential properties to either a 50% risk weight for first-lien mortgages that meet prudent underwriting standards or a 100% risk weight category for all other mortgages; |
| • | providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (set at 0% under the Basel I risk-based capital rules); |
| • | assigning a 150% risk weight to all exposures that are nonaccrual or 90 days or more past due (set at 100% under the Basel I risk-based capital rules), except for those secured by single-family residential properties, which will be assigned a 100% risk weight, consistent with the Basel I risk-based capital rules; |
| • | applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans; and |
| • | applying a 250% risk weight to the portion of mortgage servicing rights and deferred tax assets arising from temporary differences that could not be realized through net operating loss carrybacks that are not deducted from CET1 capital (set at 100% under the Basel I risk-based capital rules). |
As of December 31, 2022, the Company’s and the Bank’s capital ratios exceeded the minimum capital adequacy guideline percentage requirements of the federal banking agencies for a “well capitalized” institution under the Basel III capital rules on a fully phased-in basis. With respect to the Bank, the Basel III capital rules also revise the prompt corrective action regulations pursuant to Section 38 of the FDIA.
In December 2017, the Basel Committee published standards that it described as the finalization of the Basel III post-crisis regulatory reforms, which standards are commonly referred to as Basel IV. Among other things, these standards revise the Basel Committee’s standardized approach for credit risk (including the recalibration of the risk weights and the introduction of new capital requirements for certain “unconditionally cancellable commitments,” such as unused credit card lines of credit) and provides a new standardized approach for operational risk capital.
Under the Basel framework, these standards were generally effective on January 1, 2022, with an aggregate output floor phasing in through January 1, 2027. Under the current U.S. capital rules, operational risk capital requirements and a capital floor apply only to advanced approaches institutions, and not to the Bank. The impact of Basel IV on us will depend on how it is implemented by the federal bank regulators.
Prompt Corrective Action (“PCA”)
The FDIA requires federal banking agencies to take PCA in respect of depository institutions that do not meet minimum capital requirements. The FDIA includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The Basel III Capital Rules revised the PCA requirements effective January 1, 2015. Under the revised PCA provisions of the FDIA, an insured depository institution generally will be classified in the following categories based on the capital measures indicated:
| | | Minimum to be Categorized as "Well Capitalized" | | | Minimum to be Categorized as "Adequately Capitalized" | | | Under- capitalized | | | Significantly Under- capitalized | | | Critically Under- capitalized | |
| Risk-based capital to risk-weighted assets | | | 10.00 | %+ | | | 8.00 | %+ | | < 8.00% | | | < 6.00% | | | | N/A | |
| Tier 1 capital to risk-weighted assets | | | 8.00 | %+ | | | 6.00 | %+ | | < 6.00% | | | < 4.00% | | | | N/A | |
| CET1 capital to risk-weighted assets | | | 6.50 | %+ | | | 4.50 | %+ | | < 4.50% | | | < 3.00% | | | | N/A | |
| Tier 1 leverage capital ratio | | | 5.00 | %+ | | | 4.00 | %+ | | < 4.00% | | | < 3.00% | | | | N/A | |
| Tangible equity to assets | | | N/A | | | | N/A | | | | N/A | | | | N/A | | | < 2.00% | |
| Supplemental leverage ratio | | | N/A | | | | 3.00 | %+ | | < 3.00% | | | | N/A | | | | N/A | |
An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios, if it is determined to be operating in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying PCA regulations and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.
The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company, if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” “Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator by the bank regulators.
The capital classification of a bank holding company and a bank affects the frequency of regulatory examinations, the bank holding company’s and the bank’s ability to engage in certain activities and the deposit insurance premium paid by the bank to the FDIC. As of December 31, 2022, we met the requirements to be classified as “well-capitalized” based upon the aforementioned ratios for purposes of the PCA regulations, as currently in effect.
The Community Bank Leverage Ratio
On November 4, 2019, the federal banking agencies jointly issued a final rule that provides for an optional, simplified measure of capital adequacy, known as the community bank leverage ratio (“CBLR”) framework, for qualifying community banking organizations consistent with Section 201 of the Economic Growth, Regulatory Relief, and Consumer Protection Act. The CBLR framework is designed to reduce the capital burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community-banking organizations that opt into the framework. The final rule was effective on January 1, 2020.
In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9%, less than $10 billion in total consolidated assets, off-balance-sheet exposures of 25% or less of total consolidated assets, and trading assets and liabilities of 5% or less of total consolidated assets. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the “well-capitalized” ratio requirements under the PCA regulations. Such a community banking organization would not be subject to other risk-based and leverage capital requirements (including the Basel III and Basel IV requirements). The CBLR is determined by dividing a financial institution’s tangible equity capital by its average total consolidated assets. The rule describes what is included in tangible equity capital and average total consolidated assets. The CBLR framework was available for banks to use in their March 31, 2020, call report. A CBLR bank that ceases to meet any of the qualifying criteria in a future period but maintains a leverage ratio greater than 8% will be allowed a grace period of two reporting periods to satisfy the CBLR qualifying criteria or to otherwise comply with the generally applicable capital requirements. Further, a CBLR bank may opt out of the framework at any time, without restriction, by reverting to the generally applicable capital requirements. The Company and Bank did not opt into the CBLR framework.
Anti-Money Laundering and Office of Foreign Assets Control Regulation
Title III of the United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”), is designed to deny terrorists and criminals the ability to obtain access to the U.S. financial system and has significant implications for depository institutions, brokers, dealers and other businesses involved in the transfer of money.
The Patriot Act mandates financial services companies to have policies and procedures with respect to measures designed to address any or all of the following matters: (i) customer identification programs; (ii) money laundering; (iii) terrorist financing; (iv) identifying and reporting suspicious activities and currency transactions; (v) currency crimes; and (vi) cooperation between financial institutions and law enforcement authorities. Regulatory authorities routinely examine financial institutions for compliance with these obligations, and failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required. Regulatory authorities have imposed cease and desist orders and civil money penalties against institutions found to be violating these obligations.
The U.S. Treasury’s Office of Foreign Assets Control (“OFAC”) administers and enforces economic and trade sanctions against targeted foreign countries and regimes under authority of various laws, including designated foreign countries, nationals and others. OFAC publishes lists of specially designated targets and countries. Financial institutions are responsible for, among other things, blocking accounts of and transactions with such targets and countries, prohibiting unlicensed trade and financial transactions with them and reporting blocked transactions after their occurrence. Banking regulators examine banks for compliance with the economic sanctions regulations administered by OFAC, and failure of a financial institution to maintain and implement adequate OFAC programs, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.
Privacy Restrictions
The Gramm-Leach-Bliley Act (“GLBA”) requires financial institutions in the U.S. to provide certain privacy disclosures to customers and consumers, to comply with certain restrictions on the sharing and usage of personally identifiable information, and to implement and maintain commercially reasonable customer information safeguarding standards.
The Company believes that it complies with all provisions of the GLBA and all implementing regulations and that the Bank has developed appropriate policies and procedures to meet its responsibilities in connection with the privacy provisions of the GLBA.
Dividends and Other Transfer of Funds
Dividends from the Bank constitute the principal source of cash to the Company. The Company is a legal entity separate and distinct from the Bank. The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Company. Under such restrictions, the amount available for payment of dividends to the Company by the Bank totaled $141.2 million at December 31, 2022. During 2022, the Bank paid $34.7 million in dividends to the Company.
The FDIC and the DFPI also have authority to prohibit the Bank from engaging in activities that, in their opinion, constitute unsafe or unsound practices in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the FDIC or the DFPI could assert that the payment of dividends or other payments might, under some circumstances, be an unsafe or unsound practice. Further, the FRB and the FDIC have established guidelines with respect to the maintenance of appropriate levels of capital by banks and bank holding companies under their jurisdiction. Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the PCA provisions of federal law could limit the amount of dividends that the Bank or the Company may pay. An insured depository institution is prohibited from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions if after such transaction the institution would be undercapitalized. The DFPI may impose similar limitations on the Bank. See “Prompt Corrective Action” and “Capital Standards”, above, for a discussion of these additional restrictions on capital distributions.
Transactions with Affiliates
The Bank is subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of the Company or other affiliates, the purchase of, or investments in, stock or other securities of the Company or other affiliates, the taking of such securities as collateral for loans and leases, and the purchase of assets of the Company or other affiliates. Such restrictions prevent the Company and other affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by the Bank to or in the Company or to or in any other affiliates are limited, individually, to 10% of the Bank’s capital and surplus (as defined by federal regulations), and such secured loans and investments are limited, in the aggregate as to all affiliates, to 20% of the Bank’s capital and surplus (as defined by federal regulations).
In addition, the Company and its operating subsidiaries generally may not purchase a low-quality asset from an affiliate, and other specified transactions between the Company or its operating subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices.
Also, the Bank and its operating subsidiaries may engage in transactions with affiliates only on terms and under conditions that are substantially the same, or at least as favorable to the Bank or its subsidiaries, as those prevailing at the time for comparable transactions with (or that in good faith would be offered to) non-affiliated companies. California law also imposes certain restrictions with respect to transactions with affiliates. Additionally, limitations involving the transactions with affiliates may be imposed on the Bank under the PCA provisions of federal law. See “Prompt Corrective Action.”
Safety and Soundness Standards
The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation; credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.
In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the financial institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If a financial institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the financial institution’s rate of growth, require the financial institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal bank regulatory agencies, including cease and desist orders and civil money penalty assessments.
Since the financial crisis of 2008-2009, the bank regulatory agencies have increasingly emphasized the importance of sound risk management processes and strong internal controls when evaluating the activities of the financial institutions they supervise. Properly managing risks has been identified as critical to the conduct of safe and sound banking activities and has become even more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking markets. The agencies have identified a spectrum of risks facing a banking institution including, but not limited to, credit, market, liquidity, operational, legal, and reputational risk.
In particular, regulatory pronouncements in the past few years have focused on operational risk, which arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses. New products and services, third-party risk management and cyber-security are critical sources of operational risk that financial institutions are expected to address in the current environment. The Bank is expected to have active board and senior management oversight; adequate policies, procedures, and limits; adequate risk measurement, monitoring, and management information systems; and comprehensive internal controls.
Deposit Insurance
As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The premiums fund the Deposit Insurance Fund (“DIF”). The FDIC assesses a quarterly deposit insurance premium on each insured institution based on risk characteristics of the institution and may also impose special assessments in emergency situations. Effective July 1, 2016, the FDIC changed the deposit insurance assessment system for banks, such as the Bank, with less than $10 billion in assets that have been federally insured for at least five years. Among other changes, the FDIC eliminated risk categories for such banks and now uses the “financial ratios method” to determine assessment rates for all such banks. Under the financial ratios method, the FDIC determines assessment rates based on a combination of financial data and supervisory ratings that estimate a bank’s probability of failure within three years. The assessment rate determined by considering such information is then applied to the amount of the institution’s average assets minus average tangible equity to determine the institution’s insurance premium.
On October 18, 2022, the FDIC adopted a final rule, applicable to all insured depository institutions to increase the initial base deposit insurance assessment rate schedules uniformly by two basis points consistent with the Amended Restoration Plan approved by the FDIC on June 21, 2022. The FDIC indicated that it was taking this action in order to restore the Deposit Insurance Fund (DIF) reserve ratio to the required statutory minimum of 1.35% by the statutory deadline of September 30, 2028. The FDIC said that the reserve ratio had declined below this level because of the increase in insured deposits since the start of the COVID-19 pandemic and other factors that affect the level of the DIF. Under the final rule, the increase in rates will begin with the first quarterly assessment period of 2023 and will remain in effect unless and until the reserve ratio meets or exceeds 2% in order to support growth in the DIF in progressing toward the FDIC’s long-term goal of a 2% reserve ratio. The increase in assessment rates will apply to F&M Bank and is projected to have an insignificant effect on the Company’s capital levels and net income.
The Bank’s FDIC premiums were $1.4 million, $1.2 million, and $517,000 for the three years ended December 31, 2022, 2021, and 2020, respectively. In 2020, the Bank’s FDIC premiums were reduced by a one-time small bank assessment credit applied by the FDIC. This assessment credit was not available in 2021 or 2022. Future increases in insurance premiums could have adverse effects on the operating expenses and results of operations of the Company. Management cannot predict what the FDIC insurance assessment rates will be in the future.
Insurance of a bank’s deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC or the Bank’s primary regulator. Management of the Company is not aware of any practice, condition or violation that might lead to termination of the Company’s deposit insurance.
Community Reinvestment Act (“CRA”) and Fair Lending
The Bank is subject to certain fair lending requirements involving lending, investing, and other CRA activities. CRA requires each insured depository institution to identify the communities served by the institution’s offices and to identify the types of credit and investments the institution is prepared to extend within such communities including low and moderate-income neighborhoods. It also requires the institution’s regulators to assess the institution’s performance in meeting the credit needs of its community and to consider such assessment in reviewing applications for mergers, acquisitions, relocation of existing branches, opening of new branches, and other transactions. A bank may be subject to substantial penalties and corrective measures for a violation of certain fair lending laws.
A bank’s compliance with the Community Reinvestment Act is assessed using an evaluation system, which bases CRA ratings on an institution’s lending, service and investment performance. An unsatisfactory rating may be the basis for denying a merger application. The Bank’s latest CRA examination was completed by the FDIC in August 2022 and the Bank received an overall Outstanding rating in complying with its CRA obligations. On May 5, 2022, the FDIC, Board of Governors of the Federal Reserve System (“FRB”) and the Office of the Comptroller of the Currency (“OCC”) announced a proposal to modernize the agencies’ regulations under the CRA that have not been substantively updated for over 25 years. As of the date hereof, a final rule has not been issued.
Consumer Protection Regulations
Banks and other financial institutions are subject to numerous laws and regulations intended to protect consumers in their transactions with banks. These laws include, among others, laws regarding unfair and deceptive acts and practices and usury laws, as well as the following consumer protection statutes: Truth in Lending Act, Truth in Savings Act, Electronic Fund Transfer Act, Expedited Funds Availability Act, Equal Credit Opportunity Act, Fair and Accurate Credit Transactions Act, Fair Housing Act, Fair Credit Reporting Act, Fair Debt Collection Practices Act, Gramm-Leach-Bliley Act, Home Mortgage Disclosure Act, Right to Financial Privacy Act, Servicemembers Civil Relief Act, Military Lending Act and Real Estate Settlement Procedures Act.
Many states and local jurisdictions have consumer protection laws analogous, and in addition, to those listed above. These federal, state and local laws regulate the manner in which financial institutions deal with customers when taking deposits, making loans or conducting other types of transactions. Failure to comply with these laws and regulations could give rise to regulatory sanctions, customer rescission rights, action by state and local attorneys general and civil or criminal liability. Failure to comply with consumer protection requirements may also result in our failure to obtain any required bank regulatory approval for merger or acquisition transactions we may wish to pursue or our prohibition from engaging in such transactions even if approval is not required.
The structure of federal consumer protection regulation applicable to all providers of consumer financial products and services changed significantly on July 21, 2011, when the CFPB commenced operations to supervise and enforce federal consumer protection laws. The consumer protection provisions of the Dodd-Frank Act and the examination, supervision and enforcement of those laws and implementing regulations by the CFPB have created a more intense and complex environment for consumer finance regulation. The CFPB has significant authority to implement and enforce federal consumer protection laws and new requirements for financial services products provided for in the Dodd-Frank Act, as well as the authority to identify and prohibit unfair, deceptive or abusive acts and practices. The review of products and practices to prevent such acts and practices is a continuing focus of the CFPB, and of banking regulators more broadly. The ultimate impact of this heightened scrutiny is uncertain but could result in changes to pricing, practices, products and procedures. It could also result in increased costs related to regulatory oversight, supervision and examination, additional remediation efforts and possible penalties. In addition, the Dodd-Frank Act provides the CFPB with broad supervisory, examination and enforcement authority over various consumer financial products and services, including the ability to require reimbursements and other payments to customers for alleged legal violations and to impose significant penalties, as well as injunctive relief that prohibits lenders from engaging in allegedly unlawful practices. The CFPB also has the authority to obtain cease and desist orders providing for affirmative relief or monetary penalties. The Dodd-Frank Act does not prevent states from adopting stricter consumer protection standards. State regulation of financial products and potential enforcement actions could also adversely affect our business, financial condition or results of operations.
The CFPB is authorized to issue rules for both bank and non-bank companies that offer consumer financial products and services, subject to consultation with the prudential banking regulators. In general, however, banks with assets of $10 billion or less, such as the Bank, will continue to be examined for consumer compliance by their primary bank regulator.
Notice and Approval Requirements Related to Control
Banking laws impose notice, approval and ongoing regulatory requirements on any stockholder or other party that seeks to acquire direct or indirect "control" of an FDIC-insured depository institution. These laws include the BHCA and the Change in Bank Control Act. Among other things, these laws require regulatory filings by a stockholder or other party that seeks to acquire direct or indirect "control" of an FDIC-insured depository institution or bank holding company. The determination whether an investor "controls" a depository institution is based on all of the facts and circumstances surrounding the investment. As a general matter, a party is deemed to control a depository institution or other company if the party owns or controls 25% or more of any class of voting stock. Subject to rebuttal, a party may be presumed to control a depository institution or other company if the investor owns or controls 10% or more of any class of voting stock. Ownership by family members, affiliated parties, or parties acting in concert, is typically aggregated for these purposes. If a party's ownership of the Company were to exceed certain thresholds, the investor could be deemed to "control" the Company for regulatory purposes. This could subject the investor to regulatory filings or other regulatory consequences.
In addition, except under limited circumstances, bank holding companies are prohibited from acquiring, without prior approval:
| • | control of any other bank or bank holding company or all or substantially all the assets thereof; or |
| • | more than 5% of the voting shares of a bank or bank holding company which is not already a subsidiary. |
Incentive Compensation
In 2010, the federal bank regulatory agencies issued comprehensive guidance intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of those organizations by encouraging excessive risk-taking. The incentive compensation guidance sets expectations for banking organizations concerning their incentive compensation arrangements and related risk-management, control and governance processes. The incentive compensation guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon three primary principles: (1) balanced risk-taking incentives; (2) compatibility with effective controls and risk management; and (3) strong corporate governance. Any deficiencies in compensation practices that are identified may be incorporated into the organization’s supervisory ratings, which can affect its ability to make acquisitions or take other actions. In addition, under the incentive compensation guidance, a banking organization’s federal supervisor may initiate enforcement action if the organization’s incentive compensation arrangements pose a risk to the safety and soundness of the organization.
In 2016, several federal financial agencies (including the FRB and FDIC) re-proposed restrictions on incentive-based compensation pursuant to Section 956 of the Dodd-Frank Act for financial institutions with $1 billion or more in total consolidated assets.
For institutions with at least $1 billion but less than $50 billion in total consolidated assets, the proposal would impose principles-based restrictions that are broadly consistent with existing interagency guidance on incentive-based compensation. Such institutions would be prohibited from entering into incentive compensation arrangements that encourage inappropriate risks by the institution: (i) by providing an executive officer, employee, director, or principal shareholder with excessive compensation, fees, or benefits; or (ii) that could lead to material financial loss to the institution. The comment period for these proposed regulations has closed, but a final rule has not been published. Depending upon the outcome of the rule making process, the application of this rule to us could require us to revise our compensation strategy, increase our administrative costs and adversely affect our ability to recruit and retain qualified employees. Further, as discussed above, the Basel III Capital Rules limit discretionary bonus payments to bank executives if the institution’s regulatory capital ratios fail to exceed certain thresholds that started being phased in on January 1, 2016.
Available Information
Company reports filed with the SEC including the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and ownership reports filed by directors, executive officers and principal stockholders can be accessed through the Company’s website at http://www.fmbonline.com. The link to the SEC is on the About Us page. The Company’s reports may also be accessed at the SEC’s Internet website (http://www.sec.gov).
An investment in our common stock is subject to risks inherent in our business. The material risks and uncertainties that management believes may affect our business are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this 10-K Report. The risks and uncertainties described below are not the only ones facing our business. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.
Risks Related to COVID-19 Pandemic
The outbreak of the COVID-19 pandemic in early 2020 caused a significant global economic downturn which adversely affected our business and results of operations.
In late 2021 and early 2022, as vaccination rates increased across the markets we serve and governmental restrictions were eased, economic activity began to improve, and at the current time COVID-19 is not having any material adverse impact on our business activities and financial results. However, the COVID-19 virus continues to develop new strains and no assurances can be given that these or other variants of the virus will not lead to future governmental restrictions on economic activity or have other materially adverse effects on the local and national economy and our business.
Even if the COVID-19 outbreak continues to subside locally and nationally, we may experience material adverse impacts to our business as a result of the continuing global economic impact of the virus.
For additional information regarding the COVID-19 pandemic and its consequences for our business, see “COVID-19 (Coronavirus) Disclosure” above in this Annual Report on Form 10-K.
Risks Relating to the Industry and Geographic Area in Which We Operate and the U.S. Economy
As a financial services company, our business and operations may be adversely affected by weak economic conditions. Our business operations, which primarily consist of lending money to clients in the form of loans, borrowing money from clients in the form of deposits and investing in securities, are sensitive to general business and economic conditions in the United States. If the U.S. economy weakens, our growth and profitability from our lending, deposit and investment operations could be constrained. In addition, economic conditions in foreign countries could affect the stability of global financial markets, which could hinder U.S. economic growth. Our business is also significantly affected by monetary and related policies of the U.S. federal government and its agencies. Changes in any of these policies are influenced by macroeconomic conditions and other factors that are beyond our control. Adverse economic conditions and government policy responses to such conditions could have a material adverse effect on our financial condition and operations.
A large portion of our loan portfolio is tied to the real estate market where we operate and we may be negatively impacted by downturns in that market. A significant percentage of our loans are real estate related, consisting of loans for construction and land development projects, and for the purchase, improvement or refinancing of residential and commercial real estate. A downturn in the real estate market could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Real estate collateral provides an alternate source of repayment in the event of default by the client and may deteriorate in value during the time the credit is extended. If values decline, it is also more likely that we would be required to increase our allowance for credit losses. If during a period of reduced real estate values we are required to liquidate the property collateralizing a loan to satisfy the debt or to increase our allowance for credit losses, it could materially reduce our profitability and adversely affect our financial condition.
Although only 4.7% of our loan portfolio consisted of real estate construction, and acquisition and land development loans as of December 31, 2022, such loans generally have a higher degree of risk than long-term financing of existing properties because repayment depends on the completion of the project and usually on the sale or long term financing of the property. The COVID-19 pandemic has had, and may continue to have, an impact on the ability of our clients to complete these projects on time and within budget, particularly with respect to access to materials and labor and costs of the same. In addition, these loans are often “interest-only loans,” which normally require only the payment of interest accrued prior to maturity. Interest-only loans carry greater risk than other loans because no principal is paid prior to maturity. This risk is particularly apparent during periods of rising interest rates and declining real estate values. If there is a significant decline in the real estate market due to a material increase in interest rates or for other reasons, many of these loans could default and result in foreclosure. If we are forced to foreclose on a project prior to completion, we may not be able to recover the entire unpaid portion of the loan or we may be required to fund additional money to complete the project or hold the property for an indeterminate period. In addition, real estate exposes us to incurring costs and liabilities for environmental contamination and remediation. Any of these outcomes may result in losses and reduce our earnings.
The FDIC has given guidance recommending that if the sum of (i) certain categories of CRE loans and (ii) acquisition, development and construction loans (“ADC loans”) exceeds 300% of total risk-based capital, or if ADC loans exceed 100% of total risk- based capital, heightened risk management practices should be employed to mitigate risk. As of December 31, 2022, our ratio for the sum of CRE and ADC loans was 190% and our ratio for ADC loans was 32.27%. Our concentration in ADC loans is cyclical and tends to increase in the second and third quarters of each year as demand for ADC loans increases. An increase in ADC loan concentration could cause our ratio for ADC loans to increase and even exceed the FDIC’s guideline. We have exceeded these guidance ratios at times in the past and may do so in the future. We actively monitor and believe that we effectively manage our CRE and ADC loan concentrations. If we exceed the FDIC’s guidelines and do not effectively manage the risk of our CRE and ADC loans, we may be subject to regulatory scrutiny, including a requirement to raise additional capital, reduce our loan concentrations, or undertake other remedial actions.
We could suffer material credit losses if we do not appropriately manage our credit risk. There are risks inherent in making any loan, including risks in dealing with individual clients, risks of non-payment, risks resulting from uncertainties as to the future value of collateral and risks resulting from changes in economic and industry conditions. Changes in the economy may cause the assumptions that we made at origination to change and may cause clients to be unable to make payments on their loans. There is no assurance that our credit risk monitoring and loan approval procedures are or will be adequate to address the inherent risks associated with lending. Any failure to manage such risks may materially adversely affect our financial condition and results of operations.
The small to medium-sized businesses that we lend to may have fewer resources to weather adverse business and economic developments, which may impair their ability to repay a loan, and such impairment could adversely affect our operations and financial condition. Our business strategy targets primarily small to medium-sized businesses, which frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete, and may experience substantial volatility in operating results, any of which may impair a client’s ability to repay a loan.
The success of a small to medium-sized business often depends on the management skills, talents and efforts of one or a small number of people, and the death, disability or resignation of one or more of these people could have a material adverse impact on the business and its ability to repay its loan. If general economic conditions negatively affect California and small to medium-sized businesses are adversely affected or our clients are otherwise affected by adverse business conditions or developments, our business, financial condition and operations could be adversely affected.
Our profitability depends on interest rates generally, and we may be adversely affected by changes in market interest rates. Our profitability depends in substantial part on our net interest income. Our net interest income depends on many factors that are partly or completely outside of our control, including competition, monetary and fiscal policies, and economic conditions generally. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. In addition, an increase in interest rates could adversely affect clients’ ability to pay the principal or interest on existing loans or reduce their borrowings. This may lead to an increase in our non-performing assets, a decrease in loan originations, or a reduction in the value of and income from our loans, any of which could have a material and negative effect on our operations. Fluctuations in market rates and other market disruptions are neither predictable nor controllable and may adversely affect our financial condition and earnings.
During 2022, inflationary pressures began to affect many aspects of the U.S. economy, including gasoline and fuel prices, and global and domestic supply-chain issues have also had a disruptive effect on many industries, including the agricultural industry. In response, the FRB increased short-term interest rates by 4.25% in 2022, and further increases are generally expected in 2023. The impact of these developments on the business of our clients and on our business cannot be predicted with certainty but could present challenges in 2023 and beyond.
Beginning in 2021, the U.S. economy began to reflect relatively rapid rates of increase in the consumer price index and other economic indices; a prolonged elevated rate of inflation could present risks for the U.S. banking industry and our business. During the latter part of 2021 and into 2022, the U.S. economy exhibited relatively rapid rates of increase in the consumer price index and other economic indices. Pandemic-related supply chain disruptions may be contributing to this development. If the U.S. economy encounters a significant, prolonged rate of inflation, this could pose higher relative risks to the banking industry and our business. Such inflationary periods have historically corresponded with relatively weaker earnings and higher loan losses for banks.
In the past, inflationary environments have caused financing conditions to tighten and have increased borrowing costs for some marginal borrowers, which, in turn, has impacted bank credit quality and loan growth.
Additionally, a sustained period of inflation could prompt broad-based selling of longer-duration, fixed-rate debt, which could have negative implications for equity and real estate markets. Small businesses and leveraged loan borrowers can be challenged in a materially higher-rate environment. Higher interest rates can also present challenges for commercial real estate projects, pressuring valuations and loan-to-value ratios.
In addition, the outbreak of hostilities between Russia and Ukraine and global reactions thereto have increased U.S. domestic and global energy prices. Oil supply disruptions related to the Russia-Ukraine conflict, and sanctions and other measures taken by the U.S. or its allies, have led to higher costs for gas, food and goods in the U.S. and exacerbated the inflationary pressures on the economy, with potentially adverse impacts on our customers and on our business, results of operations and financial condition.
We face strong competition from banks, credit unions and other financial services providers that offer banking services, which may limit our ability to attract and retain banking clients. Competition in the banking industry generally, and in our geographic market specifically, is strong. Competitors include banks, as well as other financial services providers, such as savings and loan institutions, consumer finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. Our competitors include several larger national and regional financial institutions whose greater resources may afford them a marketplace advantage inasmuch as they may offer a wider array of banking services at better rates and be able to target a broader client base through more extensive promotional and advertising campaigns. Moreover, larger competitors may not be as vulnerable as we are to downturns in the local economy and real estate market since they have a broader geographic area and their loan portfolio is more diversified. While our deposit base has increased, several banks have grown their deposit market share in our markets faster than we have resulting in a declining relative deposit market share for us in our existing markets. We believe our declining relative market share in deposits has resulted primarily from aggressive marketing and advertising, in-migration of more competitors, expanded delivery channels and more attractive rates offered by larger bank competitors. We also compete against community banks, credit unions and non-bank financial services companies that have strong local ties. These smaller institutions are likely to cater to the same small to medium-sized businesses that we target. Additionally, financial technology companies allow clients to obtain loans via the Internet in an expeditious manner and have become competitors. If we are unable to attract and retain customers, we may be unable to continue to grow our loan and deposit portfolios and our operations and financial condition may otherwise be adversely affected. Ultimately, we may be unable to compete successfully against current and future competitors.
Our financial results may be impacted by the cyclicality and seasonality of our agricultural lending business. The Company has provided financing to agricultural customers in the mid Central Valley of California throughout its history. We recognize the cyclical nature of the industry, often caused by fluctuating commodity prices, changing climatic conditions and the availability of seasonal labor, and manage these risks accordingly. The Company remains committed to providing credit to agricultural customers and will always have a material exposure to this industry. Although the Company’s loan portfolio is believed to be well diversified, at various times during 2022 a significant portion of the Company’s loans (as much as 29.8%) were outstanding to agricultural borrowers. Commitments are well diversified across various commodities, including dairy, grapes, walnuts, almonds, cherries, apples, pears, and various row crops. Additionally, many individual borrowers are themselves diversified across commodity types, reducing their exposure, and therefore the Company’s, to cyclical downturns in any one commodity.
The Company’s service areas can also be significantly impacted by the seasonal operations of the agricultural industry. As a result, the Company’s financial results can be influenced by the banking needs of its agricultural customers. Generally speaking, during the spring and summer customers draw down their deposit balances and increase loan borrowings to fund the purchase of equipment and the planting of crops. Deposit balances are replenished and loans repaid in late fall and winter as crops are harvested and sold. Disruptions in the global supply chain arising from the COVID-19 pandemic may adversely affect the ability of some of our agricultural customers to efficiently export their agricultural products and in turn may adversely affect their results of operations or financial condition and their ability to repay loans we have made to them.
The impact of climate change and governmental and societal responses to climate change, including on the availability of water and the transition to a low-carbon economy, could adversely affect our business and our clients’ businesses. Despite the fact that 2023 began with significant levels of precipitation in California, the State has experienced severe drought conditions at times over the past several years. These weather patterns reinforce the fact that the long-term risks associated with the availability of water are significant. The farming belt of the Central Valley is often cited as an example of an area that experienced extreme drought. However, not all areas of the state are impacted equally, and this is particularly true in the Central Valley, which stretches some 450 miles from Bakersfield in the south to Redding in the north. The vast majority of the Company’s agricultural customers are located in the mid Central Valley, an area that benefits from the drainage of the Sacramento, American, Mokelumne and Stanislaus rivers.
In addition to the impact of climate has on the availability of water, State and Federal regulators ultimately manage this resource, which may also impact that access of our customers’ water. For example, in 2014, the State of California passed the Sustainable Groundwater Management Act. All Water Districts must develop plans to comply with the Act, including groundwater recharge programs. Although the exact impact of compliance is not currently known, and even prior to 2014 most of the water districts in the Bank’s service area had been developing and implementing management plans, it is possible that some water districts will have to ultimately fallow some ground to achieve compliance with the Act.
Additional legislation and regulatory requirements and changes in consumer preferences, including those associated with the transition to a low-carbon economy, could increase expenses of, or otherwise adversely impact, the Company, its businesses or its customers. We and our customers may face cost increases, asset value reductions, operating process changes, reduced availability of insurance, and the like, as a result of governmental actions or societal responses to climate change. New and/or more stringent regulatory requirements relating to climate change or environmental sustainability could materially affect the Company’s results of operations by increasing our compliance costs. Regulatory changes or market shifts to low-carbon products could also impact the creditworthiness of some of our customers or reduce the value of assets securing loans, which may require the Company to adjust our lending portfolios and business strategies.
Changes to LIBOR may adversely affect the value of, and the return on, our financial instruments that are indexed to LIBOR. In July 2017, the United Kingdom’s Financial Conduct Authority (the “FCA”) which regulates LIBOR announced that it would stop compelling banks to submit rates for the calculation of LIBOR after 2021. In March 2021, the FCA and LIBOR’s administrator, ICE Benchmarks Administration, announced that LIBOR would no longer be provided (i) for the one-week and two-month U.S. dollar settings and for various foreign currency settings after December 31, 2021, and (ii) for the remaining U.S. dollar settings after June 30, 2023. In addition, the FRB issued guidance urging market participants in the U.S. to cease using LIBOR as a reference rate for new contracts entered into after December 31, 2021. There are on-going efforts to establish an alternative reference rate to LIBOR. The Secured Overnight Financing Rate (or SOFR) published by the Federal Reserve Bank of New York (the “FRBNY”) is considered a likely alternative reference rate suitable for replacing LIBOR. SOFR is a broad measure of the cost of overnight borrowings collateralized by U.S. Treasury securities. The Alternative Reference Rates Committee, a group of private-market participants convened by the FRBNY to help ensure a successful transition from U.S. dollar LIBOR to a new reference rate, has recommended adoption of SOFR as the alternative reference rate. The scope of the acceptance of SOFR and the consequent impact on rates, pricing, the value and liquidity of our financial instruments and liquidity of such instruments and the ability to manage risk, including through derivatives, remain uncertain at this time. While some of our existing products or contracts include fallback provisions to alternative reference rates, other products or contracts may not include adequate fallback provisions and may require consent of all parties to any modification. The market transition from LIBOR and similar benchmarks could adversely affect the return on and pricing, liquidity and value of our outstanding products and contracts, cause market dislocations, increase the cost of and access to capital and increase the risk of disputes and litigation in connection with the interpretation and enforceability of our outstanding products and contracts.
Failure of the U.S. Congress to increase the federal government’s debt limit could have material and adverse impacts on the U.S. and global economies and our business. Discussions are occurring between the Administration and the Republican-controlled House of Representatives regarding the increase in the federal government’s statutory debt limit that is expected to be required later in 2023 in order to allow the U.S. to meet its outstanding obligations, including on its borrowings. If the debt limit were not raised and the U.S. were to default on its obligations, there could be material and adverse impacts on the U.S. and global economies with consequent impacts on the business of our customers and our business. Reductions of the ratings on U.S. sovereign debt as a result of issues over the debt ceiling could also have material and adverse impacts on the U.S. economy.
Risks Related to Our Growth
If we are not able to maintain our past levels of growth, our future prospects and competitive position could be diminished and our profitability could be reduced. We may not be able to sustain our deposit, loan, and asset growth at the rate we have attained during the past several years, including the significant deposit growth experienced since the onset of the COVID-19 pandemic. Our growth over the past several years has been driven primarily by agricultural and commercial real estate growth in our market areas, growth in non-real estate agricultural and commercial loans, commercial leasing, and residential real estate. A failure to attract and retain high performing employees, heightened competition from other financial services providers, and an inability to attract additional core deposits and lending clients, among other factors, could limit our ability to grow as rapidly as we have in the past and as such could have a negative effect on our financial condition and operations.
If we are unable to manage our growth effectively, we may incur higher than anticipated costs, and our ability to execute our growth strategy could be impaired. It is our objective to continue to grow our assets and deposits by increasing our product and service offerings and expanding our operations organically. Our ability to manage growth successfully will depend on our ability to (i) identify suitable markets for expansion; (ii) attract and retain qualified management; (iii) attract funding to support additional growth; (iv) maintain asset quality and cost controls; (v) maintain adequate regulatory capital and profitability to support our lending activities; and (vi) may include finding attractive acquisition targets and successfully acquire and integrate the acquisitions in an efficient manner. If we do not manage our growth effectively, we may be unable to realize the benefit from our investments in technology, infrastructure, and personnel that we have made to support our expansion. In addition, we may incur higher costs and realize less revenue growth, which would reduce our earnings and diminish our future prospects. Failing to maintain effective financial and operational controls, as we grow, such as appropriate loan underwriting procedures, adequate allowances for credit losses and compliance with regulatory requirements could have a negative effect on our financial condition and operations, such as increased credit losses, reduced earnings and potential regulatory restrictions on growth.
Entering new market areas, new lines of business, or new products and services may subject us to additional risks. A failure to successfully manage these risks may have a material adverse effect on our business. As part of our growth strategy, we have implemented and may continue to enter new market areas and new lines of business. We have expanded into the East Bay area of San Francisco and Napa, which are relatively new market areas for us. We introduced commercial equipment leasing as a new product line a few years ago. There are risks and uncertainties associated with these efforts, particularly in instances where such product lines are not fully mature. In developing and marketing new lines of business and/or new products and services and/or shifting the focus of our asset mix and/or expanding into new markets, we may invest significant time and resources. Initial timetables may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives in these markets and shifting market preferences, may also affect the successful implementation. Failure to successfully manage these risks could have an adverse effect on our business, financial condition and results of operations.
Risks Related to Our Personnel
We may have difficulty attracting additional necessary personnel, which may divert resources and limit our ability to successfully expand our operations. Our business plan includes, and is dependent upon, our hiring and retaining highly qualified and motivated associates at every level. We have experienced, and expect to continue to experience, substantial competition in identifying, hiring and retaining top-quality associates due to low unemployment rate and new financial institutions entering our markets. If we are unable to hire and retain qualified personnel, we may be unable to successfully execute our business strategy and manage our growth.
The unexpected loss of key officers would materially and adversely affect our ability to execute our business strategy, and diminish our future prospects. Our success to date and our prospects for success in the future depend substantially on our senior management team. The loss of key members of our senior management team could materially and adversely affect our ability to successfully implement our business plan and, as a result, our future prospects. The loss of senior management without qualified successors who can execute our strategy would also have an adverse impact on us.
As a community bank, our ability to maintain our positive reputation is critical to the success of our business. The failure to maintain that reputation may materially and adversely affect our financial performance. Our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our clients. If our reputation is negatively affected by the actions of our employees or otherwise, our business and, therefore, our operating results may be materially and adversely affected.
Risks Related to Our Financial Practices
Our allowance for credit losses may not be adequate to cover actual losses. A significant source of risk arises from the possibility that we could sustain losses due to loan defaults and non-performance on loans. We maintain an allowance for credit losses in accordance with U.S. generally accepted accounting principles to provide for such defaults and other non-performance. The determination of the appropriate level of this allowance is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control. In addition, our underwriting policies, adherence to credit monitoring processes, and risk management systems and controls may not prevent unexpected losses. Our allowance for credit losses may not be adequate to cover actual credit losses. Moreover, any increase in our allowance for credit losses will adversely affect our earnings.
In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13, Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 became effective January 1, 2020, and substantially changed the accounting for credit losses on loans and other financial assets held by banks, financial institutions and other organizations. The standard replaced existing incurred loss impairment guidance and established a single allowance framework for financial assets carried at amortized cost. Upon adoption of ASU 2016-13, companies must recognize credit losses on these assets equal to management’s estimate of credit losses over the full remaining expected life. Companies must consider all relevant information when estimating expected credit losses, including details about past events, current conditions, and reasonable and supportable forecasts. We adopted and implemented this accounting standard fully effective January 1, 2022. The adoption of ASU 2016-13 did not have a material negative effect on the level of allowance for credit loss held by us or on our reported earnings. The potential negative effect that the adoption of this new accounting pronouncement may have on future lending by us or the banking industry in general is still not well known. We believe that our allowance for credit losses as of December 31, 2022 was adequate to absorb expected credit losses inherent in our loan portfolio; however, we cannot assure that such levels will be sufficient to cover actual or future losses.
Our financial and accounting estimates and risk management framework rely on analytical forecasting and models. The processes we use to estimate our inherent credit losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on our financial condition and operations, depend upon the use of analytical and forecasting models. Some of our tools and metrics for managing risk are based upon our use of observed historical market behavior. We rely on quantitative models to measure risks and to estimate certain financial values. Models may be used in such processes as determining the pricing of various products, grading loans and extending credit, measuring interest rate and other market risks, predicting losses, assessing capital adequacy and calculating regulatory capital levels, as well as estimating the value of financial instruments and balance sheet items.
Poorly designed or implemented models present the risk that our business decisions based on information incorporating such models will be adversely affected due to the inadequacy of that information. Moreover, our models may fail to predict future risk exposures if the information used in the model is incorrect, obsolete or not sufficiently comparable to actual events as they occur.
We seek to incorporate appropriate historical data in our models, but the range of market values and behaviors reflected in any period of historical data is not at all times predictive of future developments in any particular period and the period of data we incorporate into our models may prove to be inappropriate for the period being modeled. In such case, our ability to manage risk would be limited and our risk exposure and losses could be significantly greater than our models indicated. This could harm our reputation as well as our revenues and profits. Finally, information we provide to our regulators based on poorly designed or implemented models could also be inaccurate or misleading. Some of the decisions that our regulators make, including those related to capital distributions to our stockholders, could be affected adversely due to their perception that the quality of the models used to generate the relevant information is insufficient.
Impairment of investment securities could require charges to earnings, which would negatively affect our operations. We maintain a significant amount of our assets in investment securities, and must periodically evaluate investment securities for impairment under previously adopted accounting guidance during 2021 or for current expected credit losses after the adoption of ASU 2016-13. We evaluate our investment securities portfolio for impairment as of each reporting date. At December 31, 2022, we had no investment securities that were impaired.
Changes in accounting standards could materially affect our financial statements. The Company’s consolidated financial statements are presented in accordance with accounting principles generally accepted in the United States of America, called GAAP. The financial information contained within our consolidated financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. Other estimates that we use are fair value of our securities and expected useful lives of our depreciable assets. From time to time, the FASB and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements or new interpretations of existing standards emerge. These changes can be difficult to predict and operationally complex to implement and can materially affect how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retrospectively, resulting in our restating prior period financial statements.
Risks Related to Our Access to Capital
We may be unable to, or choose not to, pay dividends on our common shares. We have consistently declared an annual cash dividend for over 87 years. Our ability to continue to pay dividends depends on various factors. FMCB is a legal entity separate and distinct from the Bank, and does not conduct stand-alone operations, which means that the Bank must first pay dividend(s) to the Company. The FDIC, the DFPI and California corporate and banking laws may, under certain circumstances, prohibit the Bank’s payment of dividends to FMCB. FRB policy requires bank holding companies to pay cash dividends on common shares only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. FMCB’s Board of Directors may determine that, even though funds are available for dividend payments, retaining the funds for other internal uses, such as expansion of our operations, is necessary or appropriate in light of our business plan and objectives. A failure to pay dividends may negatively affect your investment.
The price of our common shares may fluctuate significantly and our stock may have low trading volumes, which may make it difficult for you to resell common shares owned by you at times or prices you find attractive. The stock market and, in particular, the market for financial institution stocks, has experienced significant volatility. The markets may produce downward pressure on stock prices for certain issuers without regard to those issuers’ underlying financial strength. As a result, the trading volume in our common shares may fluctuate and cause significant price variations to occur. This may make it difficult for you to resell common shares owned by you at times or at prices you find attractive.
The low trading volume in our common shares on the OTCQX means that our shares may have less liquidity than other companies, who shares are more broadly traded. We cannot ensure that the volume of trading in our common shares or the price of our common shares will be maintained or will increase in the future. Our stock price can fluctuate significantly in response to a variety of factors discussed in this section, including, among other things: actual or anticipated variations in quarterly results of operations; operating and stock price performance of other companies that investors deem comparable to our Company; news reports relating to trends, concerns and other issues in the financial services industry; available investment liquidity in our market area since our stock is not listed on any exchange; and perceptions in the marketplace regarding our Company and/or its competitors.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. We may need to raise additional capital in the future to support our continued growth and to maintain our capital levels. Our ability to raise capital through the sale of additional securities will depend primarily upon our financial condition and the condition of financial markets at that time. Accordingly, we may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to generate or raise additional capital as needed.
Our funding sources may prove insufficient to provide liquidity, replace deposits and support our future growth. We rely on customer deposits, advances from the Federal Home Loan Bank of San Francisco (“FHLB”), lines of credit at other financial institutions and the Federal Reserve Bank to fund our operations. Although we have historically been able to replace maturing deposits and advances if desired, we may not be able to replace such funds in the future if our financial condition, the financial condition of the FHLB or market conditions were to change. Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our profitability would be adversely affected. FHLB borrowings and other current sources of liquidity may not be available or, if available, not sufficient to provide adequate funding for operations. Furthermore, our own actions could result in a loss of adequate funding. For example, our borrowing capacity at the FHLB could be reduced if we are deemed to have poor documentation or processes. Accordingly, we may be required to seek additional higher-cost debt in the future to achieve our long-term business objectives. Additional borrowings, if sought, may not be available to us or, if available, may not be available on favorable terms. If additional financing sources are unavailable or are not available on reasonable terms, our growth and future prospects could be adversely affected.
We may be adversely affected by the lack of soundness of other financial institutions or financial market utilities. Our ability to engage in routine funding and other transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial institutions are interrelated because of trading, clearing, counterparty or other relationships. Defaults by, or even rumors or questions about, one or more financial institutions or financial market utilities, or the financial services industry generally, may lead to market-wide liquidity problems and losses of client, creditor and counterparty confidence and could lead to losses or defaults by us or by other financial institutions.
Risks Related to Cyber-security and Information Technology
Cyber-attacks or other security breaches could have a material adverse effect on our business. In the normal course of business, we collect, process, and retain sensitive and confidential information regarding our clients. We also have arrangements in place with other third parties through which we share and receive information about their clients who are or may become our clients. Although we devote significant resources and management focus to ensuring the integrity of our systems through information security and business continuity programs, our facilities and systems, and those of third-party service providers, are vulnerable to external or internal security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming or human errors or other similar events.
Information security risks for financial institutions have increased recently in part because of new technologies, the use of the Internet and telecommunications technologies (including mobile devices) to conduct financial and other business transactions, and the increased sophistication and activities of organized crime, perpetrators of fraud, hackers, terrorists and others. In addition to cyber-attacks or other security breaches involving the theft of sensitive and confidential information, hackers recently have engaged in attacks against large financial institutions, particularly denial of service attacks that are designed to disrupt key business services, such as client-facing websites. We are not able to anticipate or implement effective preventive measures against all potential security breaches, because the techniques used change frequently and because attacks can originate from a wide variety of sources. We employ detection and response mechanisms designed to contain and mitigate security incidents, but early detection may be thwarted by sophisticated attacks and malware designed to avoid detection.
We also face risks related to cyber-attacks and other security breaches in connection with credit and debit card transactions that typically involve the transmission of sensitive information regarding our clients through various third parties, including merchant acquiring banks, payment processors, payment card networks and our core processors. Some of these parties have in the past been the target of security breaches and cyber-attacks, and because the transactions involve third parties and environments such as the point of sale that we do not control or secure, future security breaches or cyber-attacks affecting any of these third parties could impact us through no fault of our own, and in some cases we may have exposure and suffer losses for breaches or attacks relating to them. We also rely on numerous other third-party service providers to conduct other aspects of our business operations and face similar risks relating to them. While we regularly conduct security assessments on these third parties, we cannot be sure that their information security protocols are sufficient at all times to withstand a cyber-attack or other security breach.
The access by unauthorized persons to, or the improper disclosure by us of, confidential information regarding our clients or our own proprietary information, software, methodologies, and business secrets could result in significant legal and financial exposure, supervisory liability, damage to our reputation or a loss of confidence in the security of our systems, products and services, which could have a material adverse effect on our financial condition or operations. In the past several years, there have been a number of well-publicized attacks or breaches affecting others in our industry that have heightened concern by consumers and have resulted in increased regulatory focus. Furthermore, cyber-attacks or other breaches in the future, whether affecting others or us, could intensify consumer concern and regulatory focus and result in reduced use of our cards and increased costs, all of which could have a material adverse effect on our business. To the extent we are involved in any future cyber-attacks or other breaches, our brand and reputation could be affected, and this could have a material adverse effect on our financial condition and operations. If we experience a cyber-attack, our insurance coverage may not cover all losses, and furthermore, we may experience a loss of reputation.
We rely on our information technology and telecommunications systems and third-party servicers, and the failure of these systems could adversely affect our business. Our business is highly dependent on the successful and uninterrupted functioning of our information technology and telecommunications systems and third-party servicers. We rely on these systems to process new and renewal loans, provide client service, facilitate collections and share data across our organization. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to process new and renewal loans and provide client service or compromise our ability to collect loan payments in a timely manner. Our ability to adopt new information technology and technological products needed to meet our clients’ banking needs may be limited if our third-party servicers are slow to adopt or choose not to adopt such new technology and products. Such a failure to provide this technology and products to our clients could result in a loss of clients, which would negatively affect our financial condition and operations.
Other Operational Risks
Our risk management framework may not be effective in mitigating risks and losses to us. Our risk management framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance. Our framework also includes financial or other modeling methodologies that involve management assumptions and judgment. Our risk management framework may not be effective under all circumstances and may not adequately mitigate any risk of loss to us. If our framework is not effective, we could suffer unexpected losses and our financial condition, operations or business prospects could be materially and adversely affected. We may also be subject to potentially adverse regulatory consequences.
We are subject to certain operating risks, related to client or employee fraud, which could harm our reputation and business. Employee error, or employee or client misconduct, could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our clients or improper use of confidential information. It is not always possible to prevent employee error and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee error could also subject us to financial claims for negligence. If our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured, excess insurance coverage is denied or not available, it could have a material adverse effect on our financial condition and operations.
We depend on the accuracy and completeness of information about clients and counterparties. In deciding whether to extend credit or enter into other transactions with clients and counterparties, we may rely on information furnished to us by or on behalf of clients and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. In deciding whether to extend credit, we may rely upon our clients’ representations that their financial statements conform to U.S. generally accepted accounting principles, or GAAP, and present fairly, in all material respects, the financial condition, operations and cash flows of the client. We also may rely on client representations and certifications, or other auditors’ reports, with respect to the business and financial condition of our clients. Our financial condition, operations, financial reporting and reputation could be negatively affected if we rely on materially misleading, false, inaccurate or fraudulent information provided by or about clients and counterparties.
Catastrophic events including, but not limited to, hurricanes, tornadoes, earthquakes, fires, floods, prolonged drought, and pandemics may adversely affect the general economy, financial and capital markets, specific industries, and the Bank. The Bank has significant operations and a significant customer base in regions where natural and other disasters may occur. These regions are known for being vulnerable to natural disasters and other risks, such as earthquakes, fires, floods, and prolonged drought. These types of natural catastrophic events at times have disrupted the local economy, the Bank’s business and clients, and could pose physical risks to the Bank’s property. In addition, catastrophic events, such as natural disasters or global pandemics, occurring in other regions of the world may have an impact on the Bank’s clients and in turn on the Bank. Although we have business continuity and disaster recovery programs in place, a significant catastrophic event could materially adversely affect the Bank’s operating results.
The physical effects of climate change, as well as governmental and societal responses to climate change could materially adversely affect our operations, businesses and customers. There is increasing concern over the risks of climate change and related environmental sustainability matters. The physical effects of climate change include rising average global temperatures, rising sea levels and an increase in the frequency and severity of extreme weather events and natural disasters, including droughts, wildfires, floods, hurricanes and tornados. Most of the Company’s operations and customers are located in California, which could be adversely impacted by severe weather events. Agriculture is especially dependent on climate, and climate impacts could include shifting average growing conditions, increased climate and weather variability, decreases in available water sources, and more uncertainty in predicting climate and weather conditions, any or all of which could have a particularly adverse impact on our agricultural customers.
Additional legislation and regulatory requirements and changes in consumer preferences, including those associated with the transition to a low-carbon economy, could increase expenses of, or otherwise adversely affect, the Company, its businesses or its customers. Our customers and we may face cost increases, asset value reductions, operating process changes, reduced availability of insurance, and the like, because of governmental actions or societal responses to climate change.
New and/or more stringent regulatory requirements relating to climate change or environmental sustainability could materially affect the Company’s results of operations by increasing our compliance costs. Regulatory changes or market shifts to low-carbon products could also affect the creditworthiness of some of our customers or reduce the value of assets securing loans, which may require the Company to adjust our lending portfolios and business strategies.
Risks Related to Our Regulatory Environment
We are subject to regulation, which increases the cost and expense of regulatory compliance, and may restrict our growth and our ability to acquire other financial institutions. Supervision, regulation, and examination of the Company and the Bank by the bank regulatory agencies are intended primarily for the protection of consumers, bank clients and the Deposit Insurance Fund of the FDIC, rather than holders of our common shares. As a bank holding company under federal law, we are subject to regulation under the BHCA, and the examination and reporting requirements of the FRB. In addition to supervising and examining us, the FRB, through its adoption of regulations implementing the BHCA, places certain restrictions on the permissible activities for bank holding companies. Changes in the number or scope of permissible activities could have an adverse effect on our ability to realize our strategic goals. As a California state-chartered bank that is not a member of the Federal Reserve System, the Bank is separately subject to regulation by both the FDIC and the DFPI. The FDIC and DFPI regulate numerous aspects of the Bank’s operations, including adequate capital and financial condition, permissible types and amounts of extensions of credit and investments, permissible non-banking activities and restrictions on dividend payments. We may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with applicable laws and regulations. This allocation of resources, as well as any failure to comply with applicable requirements, may negatively affect our operations and financial condition.
Banking agencies periodically conduct examinations of our business, including compliance with laws and regulations, and our failure to comply with any regulatory actions to which we become subject because such examinations could materially and adversely affect us. The DFPI, the FDIC, and the FRB periodically conduct examinations of our business, including compliance with laws and regulations. Accommodating such examinations may require management to reallocate resources that would otherwise be used in the day-to-day operation of other aspects of our business. If, as a result of an examination, the DFPI or a federal banking agency were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of our operations had become unsatisfactory, or that we or our management were in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate. These actions could include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to assess civil monetary penalties against us, our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to clients, to terminate our deposit insurance. FDIC deposit insurance is critical to the continued operation of the Bank. If we become subject to such regulatory actions, our business operations could be materially and adversely affected.
Changes in laws, government regulation and monetary policy may have a material adverse effect on our operations. Financial institutions have been the subject of significant legislative and regulatory changes (including the Dodd-Frank Act) and may be the subject of further significant legislation or regulation in the future, none of which is within our control. This may result in repeals of or amendments to, existing laws, treaties, regulations, guidance, reporting, recordkeeping requirements, and other government policies. Significant new laws or regulations or changes in, or repeals of, existing laws or regulations, including those with respect to federal and state taxation, may cause our results of operations to differ materially. In addition, the costs and burden of compliance could adversely affect our ability to operate profitably. Further, federal monetary policy significantly affects the Bank’s credit conditions, as well as the Bank’s clients, particularly as implemented through the FRB, primarily through open market operations in U.S. government securities, the discount rate for bank borrowings and reserve requirements. A material change in any of these conditions could have a material impact on us, the Bank and the Bank’s clients, and therefore on our financial condition and operations.
New and future rulemaking by the CFPB and other regulators, as well as enforcement of existing consumer protection laws, may have a material effect on our operations and operating costs. The CFPB has the authority to implement and enforce a variety of existing federal consumer protection statutes and to issue new regulations. However, with respect to institutions of our size, it does not have primary examination and enforcement authority. The authority to examine depository institutions with $10 billion or less in assets, such as the Bank, for compliance with federal consumer laws remains largely with our primary federal regulator, the FDIC. However, the CFPB may participate in examinations of smaller institutions on a “sampling basis” and may refer potential enforcement actions against such institutions to their primary regulators. In some cases, regulators such as the Federal Trade Commission, or FTC, and the Department of Justice also retain certain rulemaking or enforcement authority, and we remain subject to certain state consumer protection laws. The CFPB has placed significant emphasis on consumer complaint management and has established a public consumer complaint database to encourage consumers to file complaints they may have against financial institutions. We are expected to monitor and respond to these complaints, including those that we deem frivolous, and doing so may require management to reallocate resources away from more profitable endeavors.
The CFPB has adopted a number of significant rules that affect nearly every aspect of the lifecycle of a residential mortgage. These rules implement the Dodd-Frank Act amendments to the Equal Credit Opportunity Act, the Truth in Lending Act and the Real Estate Settlement Procedures Act. The rules require banks to, among other things: (i) develop and implement procedures to ensure compliance with a new “reasonable ability to repay” test and identify whether a loan meets a new definition for a “qualified mortgage”; (ii) implement new or revised disclosures, policies and procedures for servicing mortgages including, but not limited to, early intervention with delinquent clients and specific loss mitigation procedures for loans secured by a client’s principal residence; (iii) comply with additional restrictions on mortgage loan originator compensation; and (iv) comply with new disclosure requirements and standards for appraisals and escrow accounts maintained for “higher priced mortgage loans.” These rules create operational and strategic challenges for us, as we are both a mortgage originator and a servicer.
We are subject to stringent capital requirements.
Pursuant to the Dodd-Frank Act, the federal banking agencies adopted final rules, or the U.S. Basel III Capital Rules, to update their general risk-based capital and leverage capital requirements to incorporate agreements reflected in the Third Basel Accord adopted by the Basel Committee on Banking Supervision, or Basel III Capital Standards, as well as the requirements of the Dodd-Frank Act. The U.S. Basel III Capital Rules are described in more detail in “Supervision and Regulation — Capital Standards” in this report on Form 10-K.
The failure to meet the established capital requirements could result in one or more of our regulators placing limitations or conditions on our activities or restricting the commencement of new activities. Such failure could subject us to a variety of enforcement remedies available to the federal regulatory authorities, including limiting our ability to pay dividends, issuing a directive to increase our capital and terminating our FDIC deposit insurance. FDIC deposit insurance is critical to the continued operation of the Bank. Our failure to meet applicable regulatory capital requirements, or to maintain appropriate capital levels in general, could affect client and investor confidence, our ability to grow, our costs of funds and FDIC insurance costs, our ability to pay dividends on common shares, our ability to make acquisitions, and our operations and financial condition, generally.
We may be required to contribute capital or assets to the Bank that could otherwise be invested or deployed more profitably elsewhere. Federal law and regulatory policy impose a number of obligations on bank holding companies designed to reduce potential loss exposure to the clients of insured depository subsidiaries and to the FDIC’s DIF. For example, a bank holding company is required to serve as a source of financial strength to its FDIC-insured depository subsidiaries and to commit financial resources to support such institutions where it might not do so otherwise. These situations include guaranteeing the compliance of an “undercapitalized” bank with its obligations under a capital restoration plan.
A capital injection into the Bank may be required at times when we do not have the resources to provide it at the holding company level; therefore, we may be required to issue common shares or debt to obtain the required capital. Issuing additional common shares would dilute our current stockholders’ percentage of ownership and could cause the price of our common shares to decline. Any debt would be entitled to a priority of payment over the claims of the Company’s general unsecured creditors or equity holdings. Thus, any Company borrowing to make the required capital injection may be expensive and adversely affect our cash flows, financial condition, operations, and business prospects.
We face a risk of non-compliance and enforcement actions with respect to the Bank Secrecy Act (“BSA”) and other anti-money laundering statutes and regulations. Like all U.S. financial institutions, we are subject to monitoring requirements under federal law, including anti-money laundering, or AML, and BSA matters. Since September 11, 2001, banking regulators have intensified their focus on AML and BSA compliance requirements, particularly the AML provisions of the USA PATRIOT Act. There is also increased scrutiny of compliance with the rules enforced by the U.S. Treasury Department’s OFAC, which involve sanctions for dealing with certain persons or countries. While the Bank has adopted policies, procedures and controls to comply with the BSA, other AML statutes and regulations and OFAC regulations, this aggressive supervision and examination and increased likelihood of enforcement actions may increase our operating costs, which could negatively affect our operations and reputation.
We are subject to federal and state fair lending laws, and failure to comply with these laws could lead to material penalties. Federal and state fair lending laws and regulations, such as the Equal Credit Opportunity Act and the Fair Housing Act, impose non-discrimination lending requirements on financial institutions. The FDIC, the Department of Justice, the CFPB and other federal and state agencies are responsible for enforcing these laws and regulations. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. A successful challenge to our performance under the fair lending laws and regulations could adversely impact our rating under the CRA, and result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on merger and acquisition activity and restrictions on expansion activity, which could negatively impact our reputation, financial condition and operations.
Regulations relating to privacy, information security and data protection could increase our costs, affect or limit how we collect and use personal information and adversely affect our business opportunities. We are subject to various privacy, information security and data protection laws, including requirements concerning security breach notification, and these laws could negatively affect us. Federal law imposes requirements for the safeguarding of certain client information. Various state and federal banking regulators and states have also enacted data security breach notification requirements with varying levels of individual, consumer, regulatory or law enforcement notification in certain circumstances in the event of a security breach. Moreover, legislators and regulators in the United States are increasingly adopting or revising privacy, information security and data protection laws that potentially could have a significant impact on our current and planned privacy, data protection and information security-related practices, our collection, use, sharing, retention and safeguarding of consumer or employee information, and some of our current or planned business activities. This could also increase our costs of compliance and business operations and could reduce income from certain business initiatives.
Compliance with current or future privacy, data protection and information security laws (including those regarding security breach notification) affecting client or employee data to which we are subject could result in higher compliance and technology costs and could restrict our ability to provide certain products and services, which could have a material adverse effect on our financial conditions or operations.
Our failure to comply with privacy, data protection and information security laws could result in potentially significant regulatory or governmental investigations or actions, litigation, fines, sanctions and damage to our reputation, which could have a material adverse effect on our financial condition or operations.
Possible changes in the U.S. tax laws could adversely affect our business and result of operations in a variety of ways.
The Tax Cuts and Jobs Act (“TCJA”), signed into law on December 22, 2017, enacted sweeping changes to the U.S. federal tax laws generally, effective January 1, 2018. The TCJA reduced the corporate tax rate to 21% from 35%, which resulted in a net reduction in our annual income tax expense and which benefitted many of our corporate and other small business borrowers. However, our ability to utilize tax credits, such as those arising from low-income housing and alternative energy investments, was constrained by the lower tax rate. There are presently ongoing discussions in the U.S. Congress and the White House which could result in changes in the tax laws that would substantially increase the U.S. corporate tax rate. If enacted, such measures could adversely affect our profitability and that of our customers.
| Item 1B. | Unresolved Staff Comments |
None.
Farmers & Merchants Bancorp and its subsidiaries are headquartered in Lodi, California. Executive offices are located at 111 W. Pine Street. Banking services are provided in 29 branch locations in the Company's service area. Of the 29 branches, 20 are owned and 9 are leased. The expiration of these leases occurs between the years 2023 and 2030. See Note 14, located in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
Certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against the Company or its subsidiaries. Based upon information available to the Company, its review of such lawsuits and claims and consultation with its counsel, the Company believes the liability relating to these actions, if any, would not have a material adverse effect on its consolidated financial statements.
There are no material proceedings adverse to the Company to which any director, officer or affiliate of the Company is a party.
| Item 4. | Mine Safety Disclosures |
Not Applicable
PART II
| Item 5. | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
The common stock of Farmers & Merchants Bancorp is not widely held or listed on any exchange. However, trades are reported on the OTCQX under the symbol “FMCB.”
The following tables summarize the actual high, low, and close sale prices for the Company's common stock since the first quarter of 2021. These figures are based on activity posted on the OTCQX:
| | | Year Ended December 31, 2022 | |
| | | High | | | Low | | | Close | | | Dividend Declared | |
| First quarter | | $ | 960 | | | $ | 913 | | | $ | 950 | | | $ | - | |
| Second quarter | | | 960 | | | | 914 | | | | 927 | | | | 7.85 | |
| Third quarter | | | 975 | | | | 922 | | | | 956 | | | | - | |
| Fourth quarter | | | 1,088 | | | | 952 | | | | 1,050 | | | | 8.30 | |
| | | Year Ended December 31, 2021 | |
| | | High | | | Low | | | Close | | | Dividend Declared | |
| First quarter | | $ | 788 | | | $ | 731 | | | $ | 778 | | | $ | - | |
| Second quarter | | | 925 | | | | 773 | | | | 862 | | | | 7.50 | |
| Third quarter | | | 920 | | | | 862 | | | | 897 | | | | - | |
| Fourth quarter | | | 1,156 | | | | 897 | | | | 960 | | | | 7.80 | |
As of February 28, 2023, there were approximately 1,315 stockholders of record of the Company’s common stock. The Company and, before the Company was formed, the Bank, has paid cash dividends for the past 87 consecutive years. There are limitations under Delaware corporate law as to the amounts of cash dividends that may be paid by the Company. Additionally, if we decided to defer interest on our 2003 subordinated debentures, we would be prohibited from paying cash dividends on the Company’s common stock. The Company is dependent on cash dividends paid by the Bank to fund its cash dividend payments to its stockholders. There are regulatory limitations on cash dividends that may be paid by the Bank. See “Item 1. Business – Supervision and Regulation.”
On November 8, 2022, the Board of Directors authorized an extension to its share repurchase program through December 31, 2024 for an additional $20.0 million of the Company’s common stock (“Repurchase Plan”), which represents approximately 3% of outstanding shareholders’ equity. Repurchases by the Company under the Repurchase Plan may be made from time to time through open market purchases, trading plans established in accordance with SEC rules, privately negotiated transactions, or by other means. Beginning in 2023 under the Inflation Reduction Act of 2022 (IRA), a 1% excise tax will be imposed on certain public company stock repurchases.
The actual means and timing of any repurchases, the quantity of purchased shares and prices will be subject to certain limitations, including, without limitation, market prices of the Company’s common shares, general market and economic conditions, the Company’s financial performance, capital position, and applicable legal and regulatory requirements, and at the discretion of the Chief Executive Officer and Chief Financial Officer.
Repurchases under the Repurchase Plan may be initiated, discontinued, suspended, or restarted at any time in the Company’s discretion. The Company is not obligated to repurchase any shares under the Repurchase Plan. No shares may be repurchased pursuant to the authority granted in the Repurchase Plan after December 31, 2024. Repurchased shares are to be used to fund the Company’s non-qualified retirement plans or may be returned to the status of authorized but unissued common shares of the Company.
On May 24, 2018, stockholders approved a proposal to increase our authorized shares of common stock from 7,500,000 to 40,000,000. In approving this proposal the stockholders also granted the Board discretionary authority (i.e., without further stockholder action) to determine whether to delay the proposed amendment. The Company has no immediate plans to effect the increase in the authorized shares of common stock.
On August 5, 2008, the Board of Directors approved a Share Purchase Rights Plan (the “Rights Plan”), pursuant to which the Company entered into a Rights Agreement dated August 5, 2008, with Computershare as Rights Agent, and the Company declared a dividend of a right to acquire one preferred share purchase right (a “Right”) for each outstanding share of the Company’s common stock, $0.01 par value per share, to stockholders of record at the close of business on August 15, 2008. Generally, the Rights are only triggered and become exercisable if a person or group (the “Acquiring Person”) acquires beneficial ownership of 10 percent or more of the Company’s common stock or announces a tender offer for 10 percent or more of the Company’s common stock.
The Rights Plan is similar to plans adopted by many other publicly traded companies. The effect of the Rights Plan is to discourage any potential acquirer from triggering the Rights without first convincing the Company’s Board of Directors that the proposed acquisition is fair to, and in the best interest of, all of the stockholders of the Company. The provisions of the Plan, if triggered by the Acquiring Person, will substantially dilute the equity and voting interest of any potential acquirer unless the Board of Directors approves of the proposed acquisition (under Article XV of the Company’s Certificate of Incorporation, the Board of Directors has the authority to consider any and all factors in determining whether an acquisition is in the best interests of the Company and its stockholders). Each Right, if and when exercisable, will entitle the registered holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, no par value, at a purchase price of $1,600 for each one one-hundredth of a share, subject to adjustment.
Each holder of a Right (except for the Acquiring Person, whose Rights will be null and void upon such event) shall thereafter have the right to receive, upon exercise, that number of Common Shares of the Company having a market value of two times the exercise price of the Right. At any time before a person becomes an Acquiring Person, the Rights can be redeemed, in whole, but not in part, by the Company’s Board of Directors at a price of $0.001 per Right.
The Rights Plan was set to expire on August 5, 2018. On November 19, 2015, the Board of Directors approved a seven-year extension of the term of the Rights Plan. Pursuant to an Amendment to the Rights Agreement dated February 18, 2016, the term of the Rights Plan was extended from August 5, 2018 to August 5, 2025. The extension of the term of the Rights Plan was intended as a means to continue to guard against abusive takeover tactics and was not in response to any particular proposal. The Board also increased the purchase price under the Rights Plan to $1,600 per one one-hundredth of a preferred share from $1,200, to reflect the increase in the market price of the Company’s common stock over the past several years.
During 2022, the Company repurchased 21,309 shares under the Repurchase Plan, for a total of $20.31 million. All of these shares were purchased at prices ranging from $925.00 to $990.00 per share, based upon the then current price on the OTCQX. The Company did not issue any shares of common stock during 2022.
The following table reports information regarding repurchases of our common stock during the year ended December 31, 2022:
| Period | | Total number of shares purchased | | | Average price paid per share | | | Total number of shares purchased as part of publicly announced plans or programs | | | Maximum number (or approximate dollar value) of shares that may yet purchased under the plans or programs (In thousands) (1) | |
| Total 1st Quarter 2022 | | | 4,500 | | | $ | 945.00 | | | | 4,500 | | | $ | 15,748 | |
| Total 2nd Quarter 2022 | | | 7,956 | | | | 954.32 | | | | 7,956 | | | | 8,155 | |
| Total 3rd Quarter 2022 | | | 6,368 | | | | 951.68 | | | | 6,368 | | | | 2,095 | |
| | | | | | | | | | | | | | | | | |
| October 1, 2022 to October 31, 2022 | | | 1,465 | | | $ | 962.22 | | | | 1,465 | | | $ | 685 | |
| November 1, 2022 to November 30, 2022 | | | 709 | | | | 973.47 | | | | 709 | | | | 19,995 | |
| December 1, 2022 to December 31, 2022 | | | 311 | | | | 979.84 | | | | 311 | | | | 19,690 | |
| Total 4th Quarter 2022 | | | 2,485 | | | $ | 967.64 | | | | 2,485 | | | $ | 19,690 | |
| | | | | | | �� | | | | | | | | | | |
| Total 2022 | | | 21,309 | | | $ | 953.12 | | | | 21,309 | | | $ | 19,690 | |
| | | | | | | | | | | | | | | | | |
(1)As of November 8, 2022 the Board approved an extension to the repurchase program through December 31, 2024 and for an additional $20 million of the Company's common stock.
The Company did not issue or purchase any shares of common stock during 2021.
Performance Graphs
The following graph compares the Company’s cumulative total stockholder return on common stock from December 31, 2017 to December 31, 2022 to that of: (i) the S&P 600 Regional Banks (Sub Ind) (TR) Index (which replaces the Morningstar Banks Index - Regional (US) Industry Group going forward through 2020, since the data is no longer accessible); and (ii) the cumulative total return of the New York Stock Exchange market index. The graph assumes an initial investment of $100 on December 31, 2017 and reinvestment of dividends. The stock price performance set forth in the following graph is not necessarily indicative of future price performance. The Company’s stock price data is based on activity posted on the OTCQX and on private transactions between individual stockholders that are reported to the Company. This data was furnished by Zacks SEC Compliance Services Group.
This graph shall not be deemed filed or incorporated by reference into any filing under the Securities Act.
| Item 7. | Management's Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion and analysis is intended to provide a comprehensive review of the Company’s operating results and financial condition. The information contained in this section should be read in conjunction with the Audited Consolidated Financial Statements and accompanying Notes to Consolidated Financial Statements in this Annual Report on Form 10-K. Information related to the comparison of the results of operations for the years December 31, 2021 to 2020 is found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the 2021 Annual Report on Form 10-K filed with the SEC on March 15, 2022.
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act, as amended, and Section 21E of the Exchange Act. These forward-looking statements reflect our current views and are not historical facts. These statements may include statements regarding projected performance for periods following the date of this report. These statements can generally be identified by use of phrases such as “believe,” “expect,” “will,” “seek,” “should,” “anticipate,” “estimate,” “intend,” “plan,” “target,” “project,” “commit” or other words of similar import. Similarly, statements that describe our future financial condition, results of operations, objectives, strategies, plans, goals or future performance and business are also forward-looking statements. Statements that project future financial conditions, results of operations and shareholder value are not guarantees of performance and many of the factors that will determine these results and values are beyond our ability to control or predict. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties and other factors, including, but not limited to, those described in the “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sections and other parts of this Annual Report on Form 10-K that could cause our actual results to differ materially from those anticipated in these forward-looking statements. The following is a non-exclusive list of factors, that could cause our actual results to differ materially from our forward-looking statements in this Annual Report on Form 10-K:
| ◾ | changes in general economic conditions, either nationally, in California, or in our local markets; |
| ◾ | inflation, changes in interest rates, securities market volatility and monetary fluctuations; |
| ◾ | increases in competitive pressures among financial institutions and businesses offering similar products and services; |
| ◾ | the future impact of the COVID-19 virus; |
| ◾ | higher defaults in our loan portfolio than we expect; |
| ◾ | changes in management’s estimate of the adequacy of the allowance for credit losses; |
| ◾ | risks associated with our growth and expansion strategy and related costs; |
| ◾ | increased lending risks associated with our high concentration of real estate loans; |
| ◾ | legislative or regulatory changes or changes in accounting principles, policies or guidelines; |
| ◾ | failure to raise the debt limit on U.S. debt; |
| ◾ | regulatory or judicial proceedings; and |
| ◾ | other factors and risks including those described under “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. |
Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, expected, projected, intended, committed or believed. Additional factors that could cause actual results to differ materially from those expressed in the forward-looking statements are discussed in “Item 1A. Risk Factors” in this Annual Report on Form 10-K. Please take into account that forward-looking statements speak only as of the date of this Annual Report on Form 10-K (or documents incorporated by reference, if applicable).
The Company does not undertake any obligation to publicly correct or update any forward-looking statement if it later becomes aware that actual results are likely to differ materially from those expressed in such forward-looking statement, except as required by law.
Overview
Farmers & Merchants Bancorp (the “Company”, “FMCB”, or “we”) is the holding company for Farmers & Merchants Bank of Central California (the “Bank” or “FMB). The Bank is a full-service community bank providing loans, deposit and cash management services to individuals and businesses. Our primary clients are small to medium-sized businesses that require highly personalized commercial banking products and services. The Bank has 29 branch locations and 3 ATMs that have been serving communities in the mid-Central Valley and East Bay of California for over 100 years.
The primary source of funding for our asset growth has been the generation of core deposits, which we raise through our existing branch locations, newly opened branch locations, or through acquisitions. Our recent loan growth is primarily the result of organic growth generated by our seasoned relationship managers and supporting associates who provide outstanding service and responsiveness to our clients or through acquisitions.
Our results of operations are largely dependent on net interest income. Net interest income is the difference between interest income we earn on interest earning assets, which are comprised of loans, investment securities and short-term investments, and the interest we pay on our interest bearing liabilities, which are primarily deposits, and, to a lesser extent, other borrowings. Management strives to match the re-pricing characteristics of the interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve.
We measure our performance by calculating our net interest margin, return on average assets, and return on average equity. Net interest margin is calculated by dividing net interest income, which is the difference between interest income on interest earning assets and interest expense on interest bearing liabilities, by average interest earning assets. Net interest income is our largest source of revenue. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. We also measure our performance by our efficiency ratio, which is calculated by dividing non-interest expense by the sum of net interest income and non-interest income.
Selected Financial Data
The following condensed consolidated statements of financial condition and operations and selected performance ratios as of December 31, 2022, 2021, and 2020 and for the years then ended have been derived from our audited consolidated financial statements. The information below is qualified in its entirety by the detailed information included elsewhere herein and should be read along with this “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8, Financial Statement and Supplementary Data.”
| | | Years Ended December 31 | |
| (Dollars in thousands, except per share data) | | 2022 | | | 2021 | | | 2020 | |
| Selected Income Statement Information: | | | | | | | | | |
| Interest income | | $ | 198,413 | | | $ | 165,268 | | | $ | 159,294 | |
| Interest expense | | | 4,840 | | | | 4,332 | | | | 9,491 | |
| Net interest income | | | 193,573 | | | | 160,936 | | | | 149,803 | |
| Provision for credit losses | | | 6,450 | | | | 1,910 | | | | 4,500 | |
| Net interest income after provision for credit losses | | | 187,123 | | | | 159,026 | | | | 145,303 | |
| Non-interest income | | | 6,178 | | | | 21,056 | | | | 15,054 | |
| Non-interest expense | | | 93,560 | | | | 91,761 | | | | 82,406 | |
| Income before income tax expense | | | 99,741 | | | | 88,321 | | | | 77,951 | |
| Income tax expense | | | 24,651 | | | | 21,985 | | | | 19,217 | |
| Net income | | $ | 75,090 | | | $ | 66,336 | | | $ | 58,734 | |
| | | | | | | | | | | | | |
| Selected financial ratios: | | | | | | | | | | | | |
| Basic and diluted earnings per share | | $ | 96.55 | | | $ | 84.01 | | | $ | 74.03 | |
| Cash dividends per common share | | | 16.15 | | | | 15.30 | | | | 14.75 | |
| Dividend ratio | | | 16.73 | % | | | 18.21 | % | | | 19.92 | % |
| Net interest margin | | | 3.80 | % | | | 3.46 | % | | | 3.88 | % |
| Non-interest income to average assets | | | 0.12 | % | | | 0.43 | % | | | 0.37 | % |
| Non-interest expense to average assets | | | 1.75 | % | | | 1.87 | % | | | 2.00 | % |
| Efficiency ratio | | | 46.84 | % | | | 50.42 | % | | | 49.99 | % |
| Return on average assets | | | 1.41 | % | | | 1.35 | % | | | 1.43 | % |
| Return on average equity | | | 16.04 | % | | | 15.00 | % | | | 14.60 | % |
| Net charge-offs (recoveries) to average loans | | | 0.01 | % | | | (0.01 | %) | | | 0.02 | % |
| | | As of December 31, | |
| (Dollars in thousands, except per share data) | | 2022 | | | 2021 | | | 2020 | |
| Selected Balance Sheet Information: | |
| Cash and cash equivalents | | $ | 588,257 | | | $ | 715,460 | | | $ | 383,837 | |
| Investment securities | | | 997,817 | | | | 1,007,506 | | | | 876,665 | |
| Gross loans held for investment | | | 3,512,361 | | | | 3,237,177 | | | | 3,099,592 | |
| Total assets | | | 5,327,399 | | | | 5,177,720 | | | | 4,550,453 | |
| Total deposits | | | 4,759,269 | | | | 4,640,152 | | | | 4,060,267 | |
| Shareholders' equity | | | 485,308 | | | | 463,136 | | | | 423,665 | |
| | | | | | | | | | | | | |
| Average Balances: | | | | | | | | | | | | |
| Average earning assets | | | 5,091,684 | | | | 4,656,337 | | | | 3,861,070 | |
| Average assets | | | 5,341,901 | | | | 4,913,999 | | | | 4,112,537 | |
| Average shareholders' equity | | | 468,001 | | | | 442,246 | | | | 402,329 | |
| | | | | | | | | | | | | |
| Selected financial ratios: | | | | | | | | | |
| Book value per share | | $ | 631.63 | | | $ | 586.51 | | | $ | 536.53 | |
| Tangible book value per share | | $ | 613.42 | | | $ | 568.04 | | | $ | 517.28 | |
| Allowance for credit losses to total loans | | | 1.90 | % | | | 1.88 | % | | | 1.89 | % |
| Non-performing assets to total assets | | | 0.03 | % | | | 0.03 | % | | | 0.03 | % |
| Loans held for investment to deposits | | | 73.80 | % | | | 69.76 | % | | | 76.34 | % |
| | | | | | | | | | | | | |
| Capital ratios: | | | | | | | | | | | | |
| Tier 1 leverage capital | | | 9.36 | % | | | 8.92 | % | | | 9.13 | % |
| Total risk-based capital | | | 13.06 | % | | | 13.19 | % | | | 12.59 | % |
| Average equity to average assets | | | 8.76 | % | | | 9.00 | % | | | 9.78 | % |
| Tangible common equity to tangible assets | | | 8.87 | % | | | 8.69 | % | | | 9.01 | % |
Summary of Critical Accounting Policies and Estimates
In the opinion of management, the accompanying Consolidated Statements of Financial Condition and related Consolidated Statements of Operations, Comprehensive Income, Changes in Shareholders’ Equity and Cash Flows reflect all adjustments (which include reclassification and normal recurring adjustments) that are necessary for a fair presentation in conformity with GAAP. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements.
Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, management has identified certain accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our financial statements. Management believes the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the factual circumstances at the time. However, given the sensitivity of the financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition. Further, subsequent changes in economic or market conditions could have a material impact on these estimates and our financial condition and operating results in future periods. For additional information concerning critical accounting policies, see the Selected Notes to the Consolidated Financial Statements and the following:
Use of Estimates — The preparation of our financial statements requires management to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. On an ongoing basis, management evaluates the estimates used. Estimates are based upon historical experience, current economic conditions and other factors that management considers reasonable under the circumstances and the actual results may differ from these estimates under different assumptions. The allowance for credit losses, deferred income taxes, and fair values of financial instruments are estimates, which are particularly subject to change.
Allowance for Credit Losses — The Company recognizes there is risk of credit losses with financial instruments, to include loans, and unfunded loan commitments, where the Company advances funds to a counterparty. The risk of credit losses varies with, among other things, the type of financial instrument, the creditworthiness and cash flows of the counterparty, any guarantees from government agencies, and the collateral, if any, used to secure the financial instrument. The Company maintains an allowance for credit losses on loans and unfunded commitments held in accordance with GAAP. The allowance for credit losses represents our estimate of probable losses inherent in our existing loan portfolio. The allowance for credit losses is increased by charging a provision for credit losses against income and reduced by charge-offs, net of recoveries.
Under the guidance of Financial Accounting Standards Board Accounting Standards Update 2016-13, Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (“CECL”), we evaluate our allowance for credit losses quarterly based on a number of quantitative and qualitative factors, including levels and trends of past due and non-accrual loans, asset classifications, loan grades and internal loan reviews, change in volume and mix of loans, collateral value, historical loss experience, size and complexity of individual credits, loan concentrations and economic conditions. Allowance for credit losses is provided on both a specific and general basis. Specific allowances are provided for impaired credits for which the expected/anticipated loss is measurable. General valuation allowances are based on a portfolio segmentation based on risk grading, with a further evaluation of various quantitative and qualitative factors.
The Company begins its determination of credit losses by evaluating historical credit loss experience by loan segment. Historical loss information may be adjusted based on specific risk characteristics by loan segment. Such risk characteristics may include, but are not necessarily limited to, changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses; changes in national and local economic conditions and forecasts; changes in the nature and volume of the loans and in the terms of such instruments; changes in the experience, ability, and depth of lending management and other relevant staff; changes in the volume and severity of past due status, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans; changes in the quality of the institution’s loan review system; changes in the value of underlying collateral for collateral-dependent loans; the existence and effect of any concentrations of credit, and changes in the level of such concentrations; and the effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses.
While the Company utilizes a systematic methodology in determining its allowance, the allowance is based on estimates, and ultimate losses may vary from current estimates. The estimates are reviewed periodically and, as adjustments become necessary, are reported in earnings in the periods in which they become known. For additional information, see Note 4, located in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
The allowance for credit losses on unfunded loan commitments is classified in other liabilities on the Consolidated Statements of Financial Condition. The allowance for credit losses on unfunded loan commitments is increased by charging a provision for credit losses on unfunded commitments, which was reported in other non-interest expenses for 2022 and prior.
We believe that our allowance for credit losses was adequate to absorb probable losses inherent in the loan portfolio as of December 31, 2022 and 2021.
Investment Securities — Investment securities are classified as held-to-maturity (“HTM”) when the Company has the positive intent and ability to hold the securities to maturity. Investment securities are classified as available-for-sale (“AFS”) when the Company has the intent of holding the security for an indefinite period of time, but not necessarily to maturity. The Company determines the appropriate classification at the time of purchase, and periodically thereafter. Investment securities classified at HTM are carried at amortized cost. Investment securities classified at AFS are reported at fair value. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Debt securities classified as held-to-maturity are carried at cost, net of the allowance for credit losses - securities, adjusted for amortization of premiums and discounts to the earliest callable date. Debt securities classified as available-for-sale are measured at fair value. Unrealized holding gains and losses on debt securities classified as available-for-sale are excluded from earnings and are reported net of tax as accumulated other comprehensive income (AOCI), a component of shareholders’ equity, until realized. When AFS securities, specifically identified, are sold, the unrealized gain or loss is reclassified from AOCI to non-interest income.
Management measures expected credit losses on held-to-maturity debt securities on a collective basis by major security type. The Company’s HTM portfolio contains securities issued by U.S. government entities and agencies and municipalities. The Company uses industry historical credit loss information adjusted for current conditions to establish the allowance for credit losses on its HTM municipal bond portfolio.
For available-for-sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. If the Company intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings. If the Company does not intend to sell the security, and it is not more likely than not that the Company will be required to sell the security, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized costs, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. Projected cash flows are discounted by the current effective interest rate. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to AOCI.
Changes in the allowance for credit losses-securities are recorded as provision for (or reversal of) credit losses. Losses are charged against the allowance when management believes the non-collectability of an available-for-sale security is confirmed or when either criteria regarding intent of requirement to sell is met.
At December 31, 2022, we had no investment securities that were impaired.
Goodwill — Goodwill represents the excess of the purchase considerations paid over the fair value of the assets acquired, net of the fair values of liabilities assumed in a business combination it is not amortized but is reviewed annually, or more frequently as current circumstances and conditions warrant, for impairment. An assessment of qualitative factors is completed to determine if it is more likely than not that, the fair value of a reporting unit is less than its carrying amount. If the qualitative analysis concludes that further analysis is required, then a quantitative impairment test would be completed. The quantitative goodwill impairment compares the reporting unit's estimated fair values, including goodwill, to its carrying amount. If the carrying amount exceeds its reporting unit’s fair value, then an impairment loss would be recognized as a charge to earnings, but is limited by the amount of goodwill allocated to that reporting unit.
Other Intangible Assets — Other intangible assets consists primarily of core deposit intangibles (“CDI”), which are amounts recorded in business combinations or deposit purchase transactions related to the value of transaction-related deposits and the value of the client relationships associated with the deposits. Core deposit intangibles are amortized over the estimated useful lives of such deposits. These assets are reviewed at least annually for events or circumstances that could affect their recoverability. These events could include loss of the underlying core deposits, increased competition or adverse changes in the economy. The amortization of our CDI is recorded in other non-interest expense. To the extent other identifiable intangible assets are deemed unrecoverable; impairment losses are recorded in other non-interest expense to reduce the carrying amount of the assets.
Fair Value Measurements — The Company discloses the fair value of financial instruments and the methods and significant assumptions used to estimate those fair values. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. The use of assumptions and various valuation techniques, as well as the absence of secondary markets for certain financial instruments, will likely reduce the comparability of fair value disclosures between financial institutions. In some cases, book value is a reasonable estimate of fair value due to the relatively short period between origination of the instrument and its expected realization.
For additional information, see “Item 7A. Quantitative and Qualitative Disclosures about Market Risk” and Note 12 located in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
Income Taxes — Income taxes are filed on a consolidated basis with our subsidiaries and allocate income tax expense (benefit) based on each entity’s proportionate share of the consolidated provision for income taxes. Deferred income tax assets and liabilities are recognized for the tax consequences of temporary differences between the reported amounts of assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The determination of the amount of deferred income tax assets, that are more likely than not to be realized is primarily dependent on projections of future earnings, which are subject to uncertainty and estimates that may change given economic conditions and other factors. The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred income tax asset will not be realized. “More likely than not” is defined as greater than a 50% probability. All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed.
Only tax positions that meet the more likely than not recognition threshold are recognized. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more likely than not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated statements of financial condition along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest expense and penalties associated with unrecognized tax benefits are classified as income tax expense in the consolidated statements of income.
Impact of Recently Issued Accounting Standards
See Note 1. “Summary of Significant Accounting Policies” to the Consolidated Financial Statements in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
Results of Operations
The following discussion and analysis is intended to provide a better understanding of Farmers & Merchants Bancorp and its subsidiaries’ performance during each of the years in the two-year period ended December 31, 2022 and the material changes in financial condition, operating income, and expense of the Company and its subsidiaries as shown in the accompanying consolidated financial statements. Information related to the comparison of the results of operations for the years December 31, 2021 and 2020 can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the 2021 Annual Report on Form 10-K filed with the SEC on March 15, 2022.
Factors that determine the level of net income include the volume of earning assets and interest bearing liabilities, yields earned and rates paid, fee income, non-interest expense, the level of non-performing loans and other non-earning assets, and the amount of non-interest bearing liabilities supporting earning assets. Non-interest income includes card processing fees, service charges on deposit accounts, bank-owned life insurance income, gains/losses on the sale of investment securities, and gains/losses on deferred compensation investments. Non-interest expense consists primarily of salaries and employee benefits, cost of deferred compensation benefits, occupancy, data processing, FDIC insurance, marketing, legal and other expenses.
Average Balance and Yields. The following table sets forth a summary of average balances with corresponding interest income and interest expense as well as average yield, cost and net interest margin information for the periods presented. Average balances are derived from daily balances.
| | | Year ended December 31, |
| | 2022 | | | 2021 | |
| (Dollars in thousands) | | Average Balance | | | Interest Income / Expense | | | Average Yield / Rate | | | Average Balance | | | Interest Income / Expense | | | Average Yield / Rate | |
| ASSETS | | | | | | | | | | | | | | | | | | |
Interest earnings deposits in other banks and federal funds sold | | $ | 704,082 | | | $ | 12,102 | | | | 1.72 | % | | $ | 666,167 | | | $ | 902 | | | | 0.14 | % |
Investment securities:(1) | | | | | | | | | | | | | | | | | | | | | | | | |
| Taxable securities | | | 1,044,954 | | | | 19,678 | | | | 1.88 | % | | | 838,710 | | | | 14,646 | | | | 1.75 | % |
Non-taxable securities(2) | | | 48,168 | | | | 1,569 | | | | 3.26 | % | | | 52,384 | | | | 1,648 | | | | 3.15 | % |
| Total investment securities | | | 1,093,122 | | | | 21,247 | | | | 1.94 | % | | | 891,094 | | | | 16,294 | | | | 1.83 | % |
Loans:(3) | | | | | | | | | | | | | | | | | | | | | | | | |
| Real estate: | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | | 1,202,548 | | | | 58,966 | | | | 4.90 | % | | | 1,037,554 | | | | 53,298 | | | | 5.14 | % |
| Agricultural | | | 705,222 | | | | 35,010 | | | | 4.96 | % | | | 641,086 | | | | 29,544 | | | | 4.61 | % |
| Residential and home equity | | | 369,619 | | | | 14,551 | | | | 3.94 | % | | | 339,345 | | | | 12,717 | | | | 3.75 | % |
| Construction | | | 182,523 | | | | 9,788 | | | | 5.36 | % | | | 182,722 | | | | 7,965 | | | | 4.36 | % |
| Total real estate | | | 2,459,912 | | | | 118,315 | | | | 4.81 | % | | | 2,200,707 | | | | 103,524 | | | | 4.70 | % |
| Commercial & industrial | | | 440,510 | | | | 22,452 | | | | 5.10 | % | | | 373,497 | | | | 16,935 | | | | 4.53 | % |
| Agricultural | | | 262,461 | | | | 14,084 | | | | 5.37 | % | | | 233,544 | | | | 10,385 | | | | 4.45 | % |
| Commercial leases | | | 94,040 | | | | 5,702 | | | | 6.06 | % | | | 98,056 | | | | 5,485 | | | | 5.59 | % |
| Consumer and other | | | 22,008 | | | | 3,469 | | | | 15.76 | % | | | 178,535 | | | | 10,879 | | | | 6.09 | % |
| Total loans and leases | | | 3,278,931 | | | | 164,022 | | | | 5.00 | % | | | 3,084,339 | | | | 147,208 | | | | 4.77 | % |
| Non-marketable securities | | | 15,549 | | | | 1,042 | | | | 6.70 | % | | | 14,737 | | | | 864 | | | | 5.86 | % |
| Total interest earning assets | | | 5,091,684 | | | | 198,413 | | | | 3.90 | % | | | 4,656,337 | | | | 165,268 | | | | 3.55 | % |
| Allowance for credit losses | | | (62,588 | ) | | | | | | | | | | | (60,059 | ) | | | | | | | | |
| Non-interest earning assets | | | 312,805 | | | | | | | | | | | | 317,721 | | | | | | | | | |
| Total average assets | | $ | 5,341,901 | | | | | | | | | | | $ | 4,913,999 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | |
| LIABILITIES AND SHAREHOLDERS' EQUITY | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest bearing deposits: | | | | | | | | | | | | | | | | | | | | | | | | |
| Demand | | $ | 1,120,198 | | | | 1,497 | | | | 0.13 | % | | $ | 1,024,009 | | | | 1,128 | | | | 0.11 | % |
| Savings and money market accounts | | | 1,542,310 | | | | 1,981 | | | | 0.13 | % | | | 1,352,258 | | | | 1,458 | | | | 0.11 | % |
| Certificates of deposit greater than $250,000 | | | 157,623 | | | | 460 | | | | 0.29 | % | | | 170,040 | | | | 701 | | | | 0.41 | % |
| Certificates of deposit less than $250,000 | | | 215,044 | | | | 411 | | | | 0.19 | % | | | 235,746 | | | | 730 | | | | 0.31 | % |
| Total interest bearing deposits | | | 3,035,175 | | | | 4,349 | | | | 0.14 | % | | | 2,782,053 | | | | 4,017 | | | | 0.14 | % |
| Short-term borrowings | | | 1 | | | | - | | | | 0.00 | % | | | 1 | | | | - | | | | 0.00 | % |
| Subordinated debentures | | | 10,310 | | | | 491 | | | | 4.76 | % | | | 10,310 | | | | 315 | | | | 3.06 | % |
| Total interest bearing liabilities | | | 3,045,486 | | | | 4,840 | | | | 0.16 | % | | | 2,792,364 | | | | 4,332 | | | | 0.16 | % |
| Non-interest bearing deposits | | | 1,751,797 | | | | | | | | | | | | 1,610,611 | | | | | | | | | |
| Total funding | | | 4,797,283 | | | | 4,840 | | | | 0.10 | % | | | 4,402,975 | | | | 4,332 | | | | 0.10 | % |
| Other non-interest bearing liabilities | | | 76,617 | | | | | | | | | | | | 68,778 | | | | | | | | | |
| Shareholders' equity | | | 468,001 | | | | | | | | | | | | 442,246 | | | | | | | | | |
| Total average liabilities and shareholders' equity | | $ | 5,341,901 | | | | | | | | | | | $ | 4,913,999 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net interest income | | | | | | $ | 193,573 | | | | | | | | | | | $ | 160,936 | | | | | |
| Interest rate spread | | | | | | | | | | | 3.74 | % | | | | | | | | | | | 3.39 | % |
Net interest margin(4) | | | | | | | | | | | 3.80 | % | | | | | | | | | | | 3.46 | % |
| | | | | | | | | | | | | | | | | | | | | | | | |
| (1) | Excludes average unrealized (losses) gains of ($24.5) million and $3.4 million for the years ended December 31, 2022, and 2021, respectively, which are included in non-interest earning assets. |
| (2) | The average yield does not include the federal tax benefits at an assumed effective yield of 26% related to income earned on tax-exempt municipal securities totaling $415,000 and $436,000 for the years ended December 31, 2022, and 2021, respectively. |
| (3) | Loan interest income includes loan fees of $11.6 million and $17.0 million for the years ended December 31, 2022 and 2021, respectively. |
| (4) | Net interest margin is computed by dividing net interest income by average interest earning assets. |
Interest-bearing deposits with banks and Federal Reserve balances are additional earning assets available to the Company. Average interest-bearing deposits with banks consisted primarily of FRB deposits. Balances with the FRB earned an average interest rate of 1.72% and 0.14% for the years ended December 31, 2022 and 2021, respectively. The increase was primarily the result of the FRB increasing rates by 425 basis points during 2022. Average interest-bearing deposits was $704 million and $666 million for the years ended December 31, 2022 and 2021, respectively. Interest income on interest-bearing deposits with banks was $12.1 million and $902,000 for the years ended December 31, 2022 and 2021, respectively.
The investment portfolio is another main component of the Company’s earning assets. Historically, the Company invested primarily in: (1) mortgage-backed securities issued by government-sponsored entities; (2) debt securities issued by the U.S. Treasury, government agencies and government-sponsored entities; and (3) investment grade bank-qualified municipal bonds. However, at certain times the Company selectively added investment grade corporate securities (floating rate and fixed rate with maturities less than 5 years) to the portfolio in order to obtain yields that exceed government agency securities of equivalent maturity. Since the risk factor for these types of investments is generally lower than that of loans and leases, the yield earned on investments is generally less than that of loans and leases.
Average total investment securities were $1.1 billion and $891 million for the years ended December 31, 2022 and 2021, respectively. The average yield on total investment securities were 1.94% and 1.83 % for the years ended December 31, 2022 and 2021, respectively. See “Investment Securities and Federal Reserve balances” for a discussion of the Company’s investment strategy in 2022.
Average loans and leases held for investment were $3.3 billion and $3.1 billion for the years ended December 31, 2022 and 2021, respectively. The yield on the loan & lease portfolio was 5.00% and 4.77% for the years ended December 31, 2022 and 2021, respectively. The Company continues to experience aggressive competitor pricing for loans and leases to which it may need to respond in order to retain key customers. This could continue to place negative pressure on future loan & lease yields and net interest margin.
Average interest-bearing liabilities was $3.0 billion and $2.8 billion for the years ended December 31, 2022 and 2021, respectively. Total interest expense on interest-bearing liabilities was $4.8 million, $4.3 million for the years ended December 31, 2022 and 2021, respectively. The average rate paid on interest-bearing liabilities was 0.16% and 0.16% for the years ended December 31, 2022 and 2021, respectively.
Rate/Volume Analysis. The following table shows the change in interest income and interest expense and the amount of change attributable to variances in volume, rates and the combination of volume and rates based on the relative changes of volume and rates. For purposes of this table, the change in interest due to both volume and rate has been allocated to change due to volume and rate in proportion to the relationship of absolute dollar amounts of change in each.
| | Year Ended December 31, 2022 compared with 2021 |
|
| | | | Increase (Decrease) Due to: | | | | |
| (Dollars in thousands) | | Volume | | | Rate | | | Net | |
| Interest income: | | | | | | | | | |
| Interest earnings deposits in other banks and federal funds sold | | $ | 54 | | | $ | 11,146 | | | $ | 11,200 | |
| Investment securities: | | | | | | | | | | | | |
| Taxable securities | | | 3,816 | | | | 1,216 | | | | 5,032 | |
| Non-taxable securities | | | (136 | ) | | | 57 | | | | (79 | ) |
| Total investment securities | | | 3,680 | | | | 1,273 | | | | 4,953 | |
| Loans: | | | | | | | | | | | | |
| Real estate: | | | | | | | | | | | | |
| Commercial | | | 7,805 | | | | (2,137 | ) | | | 5,668 | |
| Agricultural | | | 3,081 | | | | 2,385 | | | | 5,466 | |
| Residential and home equity | | | 1,168 | | | | 666 | | | | 1,834 | |
| Construction | | | (9 | ) | | | 1,832 | | | | 1,823 | |
| Total real estate | | | 12,045 | | | | 2,746 | | | | 14,791 | |
| Commercial & industrial | | | 3,261 | | | | 2,256 | | | | 5,517 | |
| Agricultural | | | 1,385 | | | | 2,314 | | | | 3,699 | |
| Commercial leases | | | (231 | ) | | | 448 | | | | 217 | |
Consumer and other(1) | | | (14,475 | ) | | | 7,065 | | | | (7,410 | ) |
| Total loans and leases | | | 1,986 | | | | 14,828 | | | | 16,814 | |
| Non-marketable securities | | | 49 | | | | 129 | | | | 178 | |
| Total interest income | | | 5,769 | | | | 27,376 | | | | 33,145 | |
| | | | | | | | | | | | |
| Interest expense: | | | | | | | | | | | | |
| Interest bearing deposits: | | | | | | | | | | | | |
| Demand | | | 113 | | | | 256 | | | | 369 | |
| Savings and money market accounts | | | 222 | | | | 301 | | | | 523 | |
| Certificates of deposit greater than $250,000 | | | (48 | ) | | | (193 | ) | | | (241 | ) |
| Certificates of deposit less than $250,000 | | | (60 | ) | | | (259 | ) | | | (319 | ) |
| Total interest bearing deposits | | | 227 | | | | 105 | | | | 332 | |
| Subordinated debentures | | | 8 | | | | 168 | | | | 176 | |
| Total interest expense | | | 235 | | | | 273 | | | | 508 | |
| Net interest income | | $ | 5,534 | | | $ | 27,103 | | | $ | 32,637 | |
(1) Consumer and other - These decreases respresent the end of the PPP loans which were $0 and $70,765 as of December 31, 2022 and 2021 respectively.
Net interest income was $193.6 million and $160.9 million for the two years ended December 31, 2022 and 2021, respectively. The increase in net interest income was driven primarily by increased interest rates and deposit growth, which we were able to partially deploy into growing our loan portfolio. The remaining increase in interest was held in interest earning deposits and investment securities.
Comparison of Results of Operations for the Years Ended December 31, 2022 and 2021
| | | Years Ended
December 31 | | | | | | | |
| (Dollars in thousands) | | 2022 | | | 2021 | | | $ Better / (Worse) | | | % Better / (Worse) | |
| Selected Income Statement Information: | | | | | | | | | | | | |
| Interest income | | $ | 198,413 | | | $ | 165,268 | | | $ | 33,145 | | | | 20.06 | % |
| Interest expense | | | 4,840 | | | | 4,332 | | | | (508 | ) | | | -11.73 | % |
| Net interest income | | | 193,573 | | | | 160,936 | | | | 32,637 | | | | 20.28 | % |
| Provision for credit losses | | | 6,450 | | | | 1,910 | | | | (4,540 | ) | | | -237.70 | % |
| Net interest income after provision for credit losses | | | 187,123 | | | | 159,026 | | | | 28,097 | | | | 17.67 | % |
| Non-interest income | | | 6,178 | | | | 21,056 | | | | (14,878 | ) | | | -70.66 | % |
| Non-interest expense | | | 93,560 | | | | 91,761 | | | | (1,799 | ) | | | -1.96 | % |
| Income before income tax expense | | | 99,741 | | | | 88,321 | | | | 11,420 | | | | 12.93 | % |
| Income tax expense | | | 24,651 | | | | 21,985 | | | | (2,666 | ) | | | -12.13 | % |
| Net income | | $ | 75,090 | | | $ | 66,336 | | | $ | 8,754 | | | | 13.20 | % |
Net Income. For the years ended December 31, 2022 and 2021, net income was $75.1 million compared with $66.3 million, respectively. The increase in net income was primarily the result of higher net interest income of $32.6 million. This increase was offset by a decrease in non-interest income of $14.9 million, higher provision for credit losses of $4.5 million, higher income tax expense of $2.7 million and an increase in non-interest expense of $1.8 million.
Net Interest Income and Net Interest Margin. For the year ended December 31, 2022, net interest income increased $32.6 million, or 20.28%, to $193.6 million compared with $160.9 million for the same period a year earlier. The increase is the result of: (1) average interest earning assets increasing $435.4 million, or 9.35%, to $5.1 billion compared with $4.7 billion for the same period a year earlier; and (2) the net interest margin increasing 34 basis points to 3.80% for all of 2022 compared with 3.46% for the same period a year earlier. The increase in the net interest margin was primarily the result of the FRB increasing the federal funds rate over the past year.
Provision for Credit Losses. The provision for credit losses in each period is a charge against earnings in that period. The provision is the amount required to maintain the allowance for credit losses at a level that, in management’s judgment, is adequate to absorb expected losses over the life of the loan and HTM securities portfolios.
The provision for credit losses for the year ended December 31, 2022, was $6.5 million compared with $1.9 million for the same period a year ago. For the year ended December 31, 2022, the Company incurred net charge-offs of $0.2 million compared with net recoveries of $0.2 million for the same period a year earlier.
Non-interest Income. Non-interest income decreased $14.9 million, or 70.66%, to $6.2 million for 2022 compared with $21.1 million for the same period a year earlier. The year-over-year decrease in non-interest income was primarily due to: (1) a $10.7 million loss on the sale of investment securities versus a $2.6 gain for the same period a year earlier; and (2) $2.2 million decline in gains/(losses) on deferred compensation plan investments.
The Company recorded net gains on deferred compensation plan investments of $0.45 million in 2022 compared to net gains of $2.6 million in 2021. See Note 11, located in “Item 8. Financial Statements and Supplementary Data” for a description of these plans. Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although GAAP requires these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no net-effect on the Company’s net income.
Non-interest Expense. Non-interest expense increased $1.8 million, or 1.96%, to $93.6 million for 2022 compared with $91.8 million for the same period a year ago. The year-over-year increase was primarily comprised of: (1) a $0.4 million increase in salaries and employee benefits; (2) a $0.6 million increase in legal expenses; (3) a $0.2 million increase in FDIC insurance; (4) a $0.2 million increase in marketing expenses; and (5) an increase of $2.5 million in other miscellaneous expenses ($1.0 million of which was a provision for unused commitments). These increases were partially off-set by a $2.2 million decline in gain/(losses) on deferred compensation plan investments. For the year ended December 31, 2022, the Company’s efficiency ratio was 46.84% compared with 50.42% for the same period a year ago.
Net gains on deferred compensation plan obligations were $0.4 million in 2022 compared to net gains of $2.6 million in 2021. See Note 11, located in “Item 8. Financial Statements and Supplementary Data” for a description of these plans. Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although GAAP requires these gains on obligations to be recorded in non-interest expense, an offsetting entry is also required to be made to non-interest income resulting in no net-effect on the Company’s net income.
Income Tax Expense. For the year ended December 31, 2022, income tax expense was $24.7 million, compared with $22.0 million for the same period a year earlier. For the year ended December 31, 2022, the effective tax rate was 24.72% compared with 24.89% for the same period a year ago.
Financial Condition
Total assets grew $149.7 million, or 2.89%, to $5.3 billion at December 31, 2022 compared with $5.2 billion at December 31, 2021. Loans held for investment grew $275.2 million or 8.5% to $3.5 billion at December 31, 2022, compared with $3.2 billion at December 31, 2021. Exclusive of SBA PPP loans, the loan portfolio grew $346 million, or 10.69%, over December 31, 2021. This data constitutes non-GAAP financial data. The Company believes that excluding the temporary effect of the PPP loans furnishes useful information regarding the Company’s growth. Total deposits increased $119.1 million, or 2.57%, to $4.8 billion at December 31, 2022 compared with $4.6 billion at December 31, 2021. The increase in total assets and deposits was primarily the result of continued strong organic deposit growth.
Investment Securities and Federal Reserve Balances
The Company’s investment portfolio decreased by less than 1.0%, to $1.0 billion at December 31, 2022. This decrease is net of the impact of $47.7 million that the Company sold for interest rate risk management purposes. The Company uses its investment portfolio to manage interest rate and liquidity risks. The Company's total investment portfolio as of December 31, 2022 represents 18.72% of the Company’s total assets as compared to 19.45% at December 31, 2021. Not included in the investment portfolio are interest bearing deposits with banks and overnight investments in Federal Reserve balances. Interest bearing deposits with banks consisted primarily of FRB deposits.
The FRB currently pays interest on the deposits that banks maintain in their FRB accounts, whereas historically banks had to sell these Federal Funds to other banks in order to earn interest. Since balances at the FRB are effectively risk free, the Company elected to maintain its excess cash at the FRB. Interest bearing deposits with banks totaled $515 million at December 31, 2022 and $663 million at December 31, 2021.
The Company classifies its investment securities as either held-to-maturity (“HTM”) or available-for-sale (“AFS”). Securities are classified as held-to-maturity and are carried at amortized cost, net of an allowance for credit losses, when the Company has the intent and ability to hold the securities to maturity. See Note 2 “Investment Securities” to the Consolidated Financial Statements in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. Securities classified as AFS include securities, which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demands and other factors. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders’ equity, net of related income taxes. As of December 31, 2022, the Company held no investment securities from any issuer (other than the U.S. Treasury or an agency of the U.S. government or a government-sponsored entity) that totaled over 10% of our shareholders’ equity.
The carrying value of our portfolio of investment securities was as follows:
| | | As of December 31, | |
| (Dollars in thousands) | | 2022 | | | 2021 | |
| Available-for-Sale Securities | | | | | | |
| U.S. Treasury notes | | $ | 4,964 | | | $ | 10,089 | |
| U.S. Government-sponsored securities | | | 4,427 | | | | 6,374 | |
Mortgage-backed securities(1) | | | 132,528 | | | | 251,120 | |
Collateralized mortgage obligations(1) | | | 1,054 | | | | 2,436 | |
| Corporate securities | | | 9,581 | | | | - | |
| Other | | | 310 | | | | 435 | |
| Total available-for-sale securities | | $ | 152,864 | | | $ | 270,454 | |
(1) All mortgage-backed securities and collateralized mortgage obligations were issued by an agency or government sponsored entity of the U.S. Government.
| | | As of December 31, | |
| (Dollars in thousands) | | 2022 | | | 2021 | |
| Held-to-Maturity Securities | | | | | | |
Mortgage-backed securities(1) | | $ | 702,858 | | | $ | 596,775 | |
Collateralized mortgage obligations(1) | | | 80,186 | | | | 73,781 | |
Municipal securities(2) | | | 61,909 | | | | 66,496 | |
| Total held-to-maturity securities | | $ | 844,953 | | | $ | 737,052 | |
(1) All mortgage-backed securities and collateralized mortgage obligations were issued by an agency or government sponsored entity of the U.S. Government.
(2) Municipal securities are net of allowance for credit losses of $393 and $0, respectively.
The following table shows the carrying value for contractual maturities of investment securities and the weighted average yields of such securities, including the benefit of tax-exempt securities:
| Investment Securities | | As of December 31, 2022 | |
| | Within One Year | | | After One but Within Five Years | | | After Five but Within Ten Years | | | After Ten Years | | | Total | |
| (Dollars in thousands) | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | |
| Debt securities available-for-sale | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Treasury notes | | $ | 4,964 | | | | 2.37 | % | | $ | - | | | | 0.00 | % | | $ | - | | | | 0.00 | % | | $ | - | | | | 0.00 | % | | $ | 4,964 | | | | 2.37 | % |
| U.S. Government-sponsored securities | | | 3 | | | | 2.17 | % | | | 53 | | | | 2.29 | % | | | 380 | | | | 4.52 | % | | | 3,991 | | | | 4.52 | % | | | 4,427 | | | | 4.29 | % |
Mortgage-backed securities(1) | | | 13 | | | | 2.82 | % | | | 16,460 | | | | 2.31 | % | | | 15,156 | | | | 2.41 | % | | | 100,899 | | | | 1.82 | % | | | 132,528 | | | | 1.95 | % |
Collateralized mortgage obligations(1) | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 1,054 | | | | 2.35 | % | | | 1,054 | | | | 2.35 | % |
| Corporate securities | | | - | | | | 0.00 | % | | | 9,581 | | | | 3.13 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 9,581 | | | | 3.13 | % |
| Other | | | 310 | | | | 4.60 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 310 | | | | 4.60 | % |
| Total debt securities available-for-sale | | $ | 5,290 | | | | 2.50 | % | | $ | 26,094 | | | | 2.61 | % | | $ | 15,536 | | | | 2.46 | % | | $ | 105,944 | | | | 1.93 | % | | $ | 152,864 | | | | 2.11 | % |
(1) All mortgage-backed securities and collateralized mortgage obligations were issued by an agency or government sponsored entity of the U.S. Government.
| | As of December 31, 2022 | |
| | | Within One Year | | | After One but Within Five Years | | | After Five but Within Ten Years | | | After Ten Years | | | Total | |
| (Dollars in thousands) | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | |
| Securities held-to-maturity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Mortgage-backed securities(1) | | $ | - | | | | 0.00 | % | | $ | - | | | | 0.00 | % | | $ | 18,197 | | | | 1.22 | % | | $ | 684,661 | | | | 1.90 | % | | $ | 702,858 | | | | 1.88 | % |
Collateralized mortgage obligations(1) | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 80,186 | | | | 1.80 | % | | | 80,186 | | | | 1.80 | % |
| Municipal securities | | | 883 | | | | 5.92 | % | | | 8,058 | | | | 3.98 | % | | | 15,670 | | | | 3.70 | % | | | 37,691 | | | | 4.83 | % | | | 62,302 | | | | 4.45 | % |
| Total securities held-to-maturity | | $ | 883 | | | | 5.92 | % | | $ | 8,058 | | | | 3.98 | % | | $ | 33,867 | | | | 2.37 | % | | $ | 802,538 | | | | 2.03 | % | | $ | 845,346 | | | | 2.07 | % |
(1) All mortgage-backed securities and collateralized mortgage obligations were issued by an agency or government sponsored entity of the U.S. Government.
| Investment Securities | | As of December 31, 2021 | |
| | | Within One Year | | | After One but Within Five Years | | | After Five but Within Ten Years | | | After Ten Years | | | Total | |
| (Dollars in thousands) | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | |
| Securities available-for-sale | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Treasury notes | | $ | 5,028 | | | | 2.33 | % | | $ | 5,061 | | | | 2.38 | % | | $ | - | | | | 0.00 | % | | $ | - | | | | 0.00 | % | | $ | 10,089 | | | | 2.36 | % |
| U.S. Government-sponsored securities | | | 2 | | | | 1.80 | % | | | 148 | | | | 2.29 | % | | | 512 | | | | 1.55 | % | | | 5,712 | | | | 1.26 | % | | | 6,374 | | | | 1.30 | % |
Mortgage-backed securities(1) | | | 13 | | | | 1.50 | % | | | 21,155 | | | | 2.36 | % | | | 50,554 | | | | 2.36 | % | | | 179,398 | | | | 1.61 | % | | | 251,120 | | | | 1.83 | % |
Collateralized mortgage obligations(1) | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 2,436 | | | | 2.30 | % | | | 2,436 | | | | 2.30 | % |
| Other | | | 435 | | | | 3.31 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 435 | | | | 3.31 | % |
| Total securities available-for-sale | | $ | 5,478 | | | | 2.41 | % | | $ | 26,364 | | | | 2.36 | % | | $ | 51,066 | | | | 2.35 | % | | $ | 187,546 | | | | 1.61 | % | | $ | 270,454 | | | | 1.84 | % |
(1) All mortgage-backed securities and collateralized mortgage obligations were issued by an agency or government sponsored entity of the U.S. Government.
| | As of December 31, 2021 | |
| | | Within One Year | | | After One but Within Five Years | | | After Five but Within Ten Years | | | After Ten Years | | | Total | |
| (Dollars in thousands) | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | |
| Securities held-to-maturity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Mortgage-backed securities(1) | | $ | - | | | | 0.00 | % | | $ | - | | | | 0.00 | % | | $ | 10,641 | | | | 0.41 | % | | $ | 586,134 | | | | 1.72 | % | | $ | 596,775 | | | | 1.70 | % |
Collateralized mortgage obligations(1) | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % | | | 73,781 | | | | 1.71 | % | | | 73,781 | | | | 1.71 | % |
| Municipal securities | | | 308 | | | | 1.10 | % | | | 8,487 | | | | 2.19 | % | | | 18,433 | | | | 3.42 | % | | | 39,268 | | | | 4.52 | % | | | 66,496 | | | | 3.90 | % |
| Total securities held-to-maturity | | $ | 308 | | | | 1.10 | % | | $ | 8,487 | | | | 2.19 | % | | $ | 29,074 | | | | 2.32 | % | | $ | 699,183 | | | | 1.88 | % | | $ | 737,052 | | | | 1.90 | % |
(1) All mortgage-backed securities and collateralized mortgage obligations were issued by an agency or government sponsored entity of the U.S. Government.
Expected maturities may differ from contractual maturities because issuers may have the right to call obligations with or without penalties including prepayments on mortgage-backed securities. The Company evaluates securities for expected credit losses at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.
Loans and Leases
Loans and leases can be categorized by borrowing purpose and use of funds. Common examples of loans and leases made by the Company include:
Commercial and Agricultural Real Estate – These are loans secured by owner-occupied real estate, non-owner-occupied real estate, owner-occupied farmland, and multifamily residential properties. Commercial mortgage term loans can be made if the property is either income producing or scheduled to become income producing based upon acceptable pre-leasing, or the income will be the Bank's primary source of repayment for the loan. Loans are made both on owner occupied and investor properties; maturities generally do not exceed 15 years (and may have pricing adjustments on a shorter timeframe) amortizations of up to 25 years (30 years for multifamily residential properties); have debt service coverage ratios of 1.00 or better with a target of 1.25 or greater; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan.
Real Estate Construction – These are loans for acquisition, development and construction and are secured by commercial or residential real estate. These loans are generally made only to experienced local developers with a successful track record; for projects in our service area; with Loan to Value (LTV) below 75%; and where the property can be developed and sold within 2 years. Commercial construction loans are made only when there is an approved take-out commitment from the Bank or an acceptable financial institution or government agency. Most acquisition, development and construction loans are tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan.
Single Family Residential Real Estate – These are loans primarily made on owner occupied residences; generally underwritten to income and LTV guidelines similar to those used by FNMA and FHLMC. However, the Company will make loans on rural residential properties up to 41 acres. Most residential loans have terms from ten to thirty years and carry fixed or variable rates priced to treasury rates. The Company has always underwritten mortgage loans based upon traditional underwriting criteria and does not make loans that are known in the industry as “subprime,” “no or low doc,” or “stated income” loans.
Home Equity Lines and Loans – These are loans made to individuals for home improvements and other personal needs. Generally, amounts do not exceed $500,000; but can be made for up to $1,000,000 in high cost counties. Combined Loan To Value (CLTV) does not exceed 75%; FICO scores are at or above 670; Total Debt Ratios do not exceed 43%; and in some situations the Company is in a 1st lien position
Agricultural – These are non-real estate loans and lines of credit made to farmers to finance agricultural production. Lines of credit are extended to finance the seasonal needs of farmers during peak growing periods; are usually established for periods no longer than 12 to 36 months; are often secured by general filing liens on livestock, crops, crop proceeds and equipment; and are most often tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Term loans are primarily made for the financing of equipment, expansion or modernization of a processing plant, or orchard/vineyard development; have maturities from five to seven years; and fixed rates that are most often tied to treasury indices or variable rates tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan.
Commercial – These are non-real estate loans and lines of credit to businesses that are sole proprietorships, partnerships, LLC’s and corporations. Lines of credit are extended to finance the seasonal working capital needs of customers during peak business periods; are usually established for periods no longer than 12 to 36 months; are often secured by general filing liens on accounts receivable, inventory and equipment; and are most often tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Term loans are primarily made for the financing of equipment, expansion or modernization of a plant or purchase of a business; have maturities from five to seven years; and fixed rates that are most often tied to treasury indices or variable rates tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan.
Consumer – These are loans to individuals for personal use, and primarily include loans to purchase automobiles or recreational vehicles, and unsecured lines of credit. The Company has a minimal consumer loan portfolio.
Commercial Leases – These are leases primarily to businesses and farmers for financing the acquisition of equipment. They can be either “finance leases” where the lessee retains the tax benefits of ownership but obtains 100% financing on their equipment purchases; or “true tax leases” where the Company, as lessor, places reliance on equipment residual value and in doing so obtains the tax benefits of ownership. Leases typically have a maturity of three to ten years, and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk. Credit risks are underwritten using the same credit criteria the Company would use when making an equipment term loan. Residual value risk is managed with qualified, independent appraisers that establish the residual values the Company uses in structuring a lease.
The Company accounts for leases with Investment Tax Credits (“ITC”) under the deferred method as established in ASC 740-10. ITCs are viewed and accounted for as a reduction of the cost of the related assets and presented as deferred income on the Company’s financial statement.
Each loan or lease type involves risks specific to the: (1) borrower; (2) collateral; and (3) loan & lease structure. See “Results of Operations - Provision and Allowance for Credit Losses” for a more detailed discussion of risks by loan & lease type. The Company’s current underwriting policies and standards are designed to mitigate the risks involved in each loan & lease type. The Company’s policies require that loans and leases be approved only to those borrowers exhibiting a clear source of repayment and the ability to service existing and proposed debt. The Company’s underwriting procedures for all loan & lease types require careful consideration of the borrower, the borrower’s financial condition, the borrower’s management capability, the borrower’s industry, and the economic environment affecting the loan or lease.
Most loans and leases made by the Company are secured, but collateral is the secondary or tertiary source of repayment; cash flow is our primary source of repayment. The quality and liquidity of collateral are important and must be confirmed before the loan is made.
In order to be responsive to borrower needs, the Company prices loans and leases: (1) on both a fixed rate and adjustable rate basis; (2) over different terms; and (3) based upon different rate indices as long as these structures are consistent with the Company’s interest rate risk management policies and procedures. See “Item 7A. Quantitative and Qualitative Disclosures about Market Risk” in this Annual Report on Form 10-K for further details.
Overall, the Company's loan & lease portfolio at December 31, 2022 totaled $3.5 billion, an increase of $275.2 million or 8.50% over December 31, 2021. Exclusive of SBA PPP loans, the loan portfolio grew $346.0 million, or 10.69%, over December 31, 2021. This increase in the non-PPP loans occurred as a result of: (1) the Company’s business development efforts directed toward credit-qualified borrowers; and (2) expansion of our service area into the East Bay of San Francisco and Napa County. This data constitutes non-GAAP financial data. The Company believes that excluding the temporary effect of the PPP loans furnishes useful information regarding the Company’s growth.
The following table sets forth the distribution of the loan & lease portfolio by type and percent at the end of each period presented:
| | | December 31, | |
| | | 2022 | | | 2021 | |
| (Dollars in thousands) | | Dollars | | | Percent of Total | | | Dollars | | | Percent of Total | |
| Gross Loans and Leases | | | | | | | | | | | | |
| Real estate: | | | | | | | | | | | | |
| Commercial | | $ | 1,328,691 | | | | 37.73 | % | | $ | 1,167,516 | | | | 35.95 | % |
| Agricultural | | | 726,938 | | | | 20.64 | % | | | 672,830 | | | | 20.72 | % |
| Residential and home equity | | | 387,753 | | | | 11.01 | % | | | 350,581 | | | | 10.79 | % |
| Construction | | | 166,538 | | | | 4.73 | % | | | 177,163 | | | | 5.45 | % |
| Total real estate | | | 2,609,920 | | | | 74.11 | % | | | 2,368,090 | | | | 72.91 | % |
| Commercial & industrial | | | 478,758 | | | | 13.59 | % | | | 427,799 | | | | 13.17 | % |
| Agricultural | | | 314,525 | | | | 8.93 | % | | | 276,684 | | | | 8.52 | % |
| Commercial leases | | | 112,629 | | | | 3.20 | % | | | 96,971 | | | | 2.99 | % |
Consumer and other(1) | | | 5,886 | | | | 0.17 | % | | | 78,367 | | | | 2.41 | % |
| Total gross loans and leases | | $ | 3,521,718 | | | | 100.00 | % | | $ | 3,247,911 | | | | 100.00 | % |
(1) Includes SBA PPP loans of $0 and $70,765 as of December 31, 2022 and December 31, 2021, respectively.
The following table shows the maturity distribution and interest rate sensitivity of the loan portfolio of the Company as of December 31, 2022.
| | | Loan Contractual Maturity | |
| (Dollars in thousands) | | One Year or Less | | | After One But Within Five Years | | | After Five But Within Fifteen Years | | | After Fifteen Years | | | Total | |
| Gross loan and leases: | | | | | | | | | | | | | | | |
| Real estate: | | | | | | | | | | | | | | | |
| Commercial | | $ | 61,340 | | | $ | 326,671 | | | $ | 889,041 | | | $ | 51,639 | | | $ | 1,328,691 | |
| Agricultural | | | 26,588 | | | | 172,766 | | | | 452,249 | | | | 75,335 | | | | 726,938 | |
| Residential and home equity | | | 384 | | | | 4,143 | | | | 117,421 | | | | 265,805 | | | | 387,753 | |
| Construction | | | 94,238 | | | | 72,300 | | | | - | | | | - | | | | 166,538 | |
| Total real estate | | | 182,550 | | | | 575,880 | | | | 1,458,711 | | | | 392,779 | | | | 2,609,920 | |
| Commercial & industrial | | | 216,019 | | | | 181,520 | | | | 75,093 | | | | 6,126 | | | | 478,758 | |
| Agricultural | | | 197,010 | | | | 98,898 | | | | 18,617 | | | | - | | | | 314,525 | |
| Commercial leases | | | 45,503 | | | | 61,377 | | | | 5,749 | | | | - | | | | 112,629 | |
| Consumer and other | | | 753 | | | | 3,989 | | | | 1,144 | | | | - | | | | 5,886 | |
| Total gross loans and leases | | $ | 641,835 | | | $ | 921,664 | | | $ | 1,559,314 | | | $ | 398,905 | | | $ | 3,521,718 | |
| Rate Structure for Loans | | | | | | | | | | | | | | | | | | | | |
| Fixed Rate | | $ | 116,749 | | | $ | 475,248 | | | $ | 1,158,859 | | | $ | 255,628 | | | $ | 2,006,484 | |
| Adjustable Rate | | | 525,086 | | | | 446,416 | | | | 400,455 | | | | 143,277 | | | | 1,515,234 | |
| Total gross loans and leases | | $ | 641,835 | | | $ | 921,664 | | | $ | 1,559,314 | | | $ | 398,905 | | | $ | 3,521,718 | |
Non-Accrual Loans and Leases - Accrual of interest on loans and leases is generally discontinued when a loan or lease becomes contractually past due by 90 days or more with respect to interest or principal. When loans and leases are 90 days past due, but in management's judgment are well secured and in the process of collection, they may not be classified as nonaccrual. When a loan or lease is placed on non-accrual status, all interest previously accrued but not collected is reversed. Income on such loans and leases is then recognized only to the extent that cash is received and where the future collection of principal is probable. Non-accrual loans and leases totaled $571,000 and $516,000 for the years ended December 31, 2022 and 2021, respectively.
Restructured Loans and Leases - A restructuring of a loan or lease constitutes a TDR under ASC 310-40, if the Company for economic or legal reasons related to the debtor's financial difficulties grants a concession to the borrower that it would not otherwise consider, except when subject to the CARES Act and H.R. 133, as discussed below. Restructured loans or leases typically present an elevated level of credit risk, as the borrowers are not able to perform according to the original contractual terms. If the restructured loan or lease was current on all payments at the time of restructure and management reasonably expects the borrower will continue to perform after the restructure, management may keep the loan or lease on accrual. Loans and leases that are on non-accrual status at the time they become TDR loans or leases, remain on non-accrual status until the borrower demonstrates a sustained period of performance, which the Company generally believes to be six consecutive months of payments, or equivalent. A loan or lease can be removed from TDR status if it was restructured at a market rate in a prior calendar year and is currently in compliance with its modified terms. However, these loans or leases continue to be classified as collateral dependent and are individually evaluated for impairment.
At December 31, 2022, restructured loans totaled $1.3 million compared with $2.3 million at December 31, 2021, all of which were performing. See Note 4 “Loans and Leases” to the Consolidated Financial Statements in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
Other Real Estate Owned – OREO represents real property taken either through foreclosure or through a deed in lieu thereof from the borrower. The Company records all OREO properties at amounts equal to or less than the fair market value of the properties based on current independent appraisals reduced by estimated selling costs. The Company reported $873,000 of foreclosed OREO at December 31, 2022, and at December 31, 2021.
Not included in the table below, but relevant to a discussion of asset quality are loans that were granted some form of relief because of COVID-19 but were not considered TDRs because of the CARES Act and H.R. 133. Since April 2020, we have restructured $304.0 million of loans under the CARES Act and H.R. 133 guidelines (see “Part I, Introduction - COVID-19 (Coronavirus) Disclosure”). At December 31, 2022, all loans that were restructured as part of the CARES Act, have returned to the contractual terms and conditions of the loans, without exception.
The following table summarizes the loans for which the accrual of interest has been discontinued and loans more than 90 days past due and still accruing interest, including those non-accrual loans that are troubled debt restructured loans, and OREO (as hereinafter defined):
| | | December 31, | |
| (Dollars in thousands) | | 2022 | | | 2021 | |
| Non-performing assets: | | | | | | |
| Non-accrual loans and leases, not TDRs | | | | | | |
| Real estate: | | | | | | |
| Commercial | | $ | 403 | | | $ | - | |
| Agricultural | | | - | | | | 18 | |
| Residential and home equity | | | - | | | | - | |
| Construction | | | 168 | | | | - | |
| Total real estate | | | 571 | | | | 18 | |
| Commercial & industrial | | | - | | | | - | |
| Agricultural | | | - | | | | - | |
| Commercial leases | | | - | | | | - | |
| Consumer and other | | | - | | | | - | |
| Subtotal | | | 571 | | | | 18 | |
| Non-accrual loans and leases, are TDRs | | | | | | | | |
| Real estate: | | | | | | | | |
| Commercial | | | - | | | | - | |
| Agricultural | | | - | | | | - | |
| Residential and home equity | | | - | | | | - | |
| Construction | | | - | | | | - | |
| Total real estate | | | - | | | | - | |
| Commercial & industrial | | | - | | | | - | |
| Agricultural | | | - | | | | 498 | |
| Commercial leases | | | - | | | | - | |
| Consumer and other | | | - | | | | - | |
| Subtotal | | | - | | | | 498 | |
| Total non-performing loans and leases | | $ | 571 | | | $ | 516 | |
| Other real estate owned ("OREO") | | $ | 873 | | | $ | 873 | |
| Total non-performing assets | | $ | 1,444 | | | $ | 1,389 | |
| Performing TDRs | | $ | 1,311 | | | $ | 1,824 | |
| | | | | | | | | |
| Selected ratios: | | | | | | | | |
| Non-performing loans to total loans and leases | | | 0.02 | % | | | 0.02 | % |
| Non-performing assets to total assets | | | 0.03 | % | | | 0.03 | % |
| | | | | | | | | |
Although management believes that non-performing loans and leases are generally well-secured and that potential losses are provided for in the Company’s allowance for credit losses, there can be no assurance that future deterioration in economic conditions and/or collateral values will not result in future credit losses. See Note 4. “Loans and Leases”, located in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for an allocation of the allowance classified to collateral dependent loans and leases.
Except for non-performing loans and leases discussed above, the Company’s management is not aware of any loans and leases as of December 31, 2022, for which known financial problems of the borrower would cause serious doubts as to the ability of these borrowers to materially comply with their present loan or lease repayment terms, or any known events that would result in the loan or lease being designated as non-performing at some future date. However:
| • | The State of California experienced drought conditions from 2013 through most of 2016. After 2016, reasonable levels of rain and snow alleviated drought conditions in our primary service area, but the winter of 2020-2021 and 2021-2022 were once again dry (although 2023 has begun with significant levels of rain and snow). Despite this, the availability of water in our primary service area was not an issue for the 2022 growing season. However, the weather patterns over the past nine years further reinforce the fact that the long-term risks associated with the availability of water are significant. |
| • | While significant progress has been made in fighting the COVID-19 virus, particularly with the development of vaccines, the effects of COVID-19 are still with us, and it is impossible to predict the ultimate impact on classified and non-performing loans and leases (see Part I. “Introduction - COVID-19 (Coronavirus) Disclosure”). |
Allowance for Credit Losses—Loans and Leases
The Company maintains an allowance for credit losses (“ACL”) under the guidance of Financial Accounting Standards Board Accounting Standards Update 2016-13, Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (“CECL”). The allowance is established through a provision for credit losses, which is charged to expense. Additions to the allowance are expected to maintain the adequacy of the total allowance after credit losses and loan & lease growth. Credit exposures determined to be uncollectible are charged against the allowance. Cash received on previously charged off amounts is recorded as a recovery to the allowance. The overall allowance consists of three primary components: specific reserves related to collateral dependent loans and leases; general reserves for current expected credit losses related to loans and leases that are not collateral dependent; and an unallocated component that takes into account the imprecision in estimating and allocating allowance balances associated with macro factors. See Note 1, located in “Item 8. Financial Statements and Supplementary Data” for a detailed discussion on the Company’s allowance for credit losses.
The following table sets forth the activity in our ACL for the periods indicated:
| | | Year Ended December 31, | |
| (Dollars in thousands) | | 2022 | | | 2021 | |
| Allowance for credit losses: | | | | | | |
| Balance at beginning of year | | $ | 61,007 | | | $ | 58,862 | |
| Provision / (recapture) for credit losses | | | 6,057 | | | | 1,910 | |
| Charge-offs: | | | | | | | | |
| Real estate: | | | | | | | | |
| Commercial | | | (170 | ) | | | - | |
| Agricultural | | | - | | | | - | |
| Residential and home equity | | | (25 | ) | | | - | |
| Construction | | | - | | | | - | |
| Total real estate | | | (195 | ) | | | - | |
| Commercial & industrial | | | (324 | ) | | | - | |
| Agricultural | | | - | | | | - | |
| Commercial leases | | | - | | | | - | |
| Consumer and other | | | (62 | ) | | | (44 | ) |
| Total charge-offs | | | (581 | ) | | | (44 | ) |
| Recoveries: | | | | | | | | |
| Real estate: | | | | | | | | |
| Commercial | | | - | | | | - | |
| Agricultural | | | - | | | | - | |
| Residential and home equity | | | 131 | | | | 98 | |
| Construction | | | - | | | | - | |
| Total real estate | | | 131 | | | | 98 | |
| Commercial & industrial | | | 195 | | | | 99 | |
| Agricultural | | | 53 | | | | 55 | |
| Commercial leases | | | - | | | | - | |
| Consumer and other | | | 23 | | | | 27 | |
| Total recoveries | | | 402 | | | | 279 | |
| Net charge-offs / recoveries | | | (179 | ) | | | 235 | |
| | | | | | | | | |
| Balance at end of year | | $ | 66,885 | | | $ | 61,007 | |
| | | | | | | | | |
| Selected financial information: | | | | | | | | |
| Gross loans and leases held for investment | | $ | 3,512,361 | | | $ | 3,237,177 | |
| Average loans and leases | | | 3,278,931 | | | | 3,084,339 | |
| Non-performing loans and leases | | | 571 | | | | 516 | |
| Allowance for credit losses to non-performing loans and leases | | | 11713.66 | % | | | 11823.06 | % |
| Net charge-offs / (recoveries) to average loans and leases | | | 0.01 | % | | | (0.01 | %) |
| Provision for credit losses to average loans and leases | | | 0.18 | % | | | 0.06 | % |
| Allowance for credit losses to loans and leases held for investment | | | 1.90 | % | | | 1.88 | % |
The increase in ACL in both 2021 and 2022 was primarily related to higher expected probable losses inherent in the loan portfolio that was directly related to quantitative and qualitative factors associated with the current economic environment and overall growth in the loan portfolio.
The following table indicates management’s allocation of the ACL by loan type as of each of the following dates:
| | | December 31, | |
| | | 2022 | | | 2021 | |
| (Dollars in thousands) | | Dollars | | | Percent of Each Loan Type to Total Loans | | | Dollars | | | Percent of Each Loan Type to Total Loans | |
| Allowance for credit losses: | | | | | | | | | | | | |
| Real estate: | | | | | | | | | | | | |
| Commercial | | $ | 18,055 | | | | 37.73 | % | | $ | 28,536 | | | | 35.95 | % |
| Agricultural | | | 14,496 | | | | 20.64 | % | | | 9,613 | | | | 20.72 | % |
| Residential and home equity | | | 7,508 | | | | 11.01 | % | | | 2,847 | | | | 10.79 | % |
| Construction | | | 3,026 | | | | 4.73 | % | | | 1,456 | | | | 5.45 | % |
| Total real estate | | | 43,085 | | | | 74.11 | % | | | 42,452 | | | | 72.91 | % |
| Commercial & industrial | | | 11,503 | | | | 13.59 | % | | | 11,489 | | | | 13.17 | % |
| Agricultural | | | 10,202 | | | | 8.93 | % | | | 5,465 | | | | 8.52 | % |
| Commercial leases | | | 1,924 | | | | 3.20 | % | | | 938 | | | | 2.99 | % |
| Consumer and other | | | 171 | | | | 0.17 | % | | | 663 | | | | 2.41 | % |
| Total allowance for credit losses | | $ | 66,885 | | | | 100.00 | % | | $ | 61,007 | | | | 100.00 | % |
Deposits
Total deposits were $4.76 billion and $4.64 billion as of December 31, 2022 and 2021, respectively. In addition to the Company’s ongoing business development activities for deposits, in management’s opinion the following factors positively impacted year-over-year deposit growth: (1) the Company’s strong financial results and position and F&M Bank’s reputation as one of the most safe and sound banks in its market area; and (2) the Company’s expansion of its service area into Walnut Creek, Oakland, Concord and Napa.
Non-interest bearing demand deposits increased to $1.76 billion, or 36.96% of total deposits, as of December 31, 2022 from $1.75 billion, or 37.72% of total deposits, as of December 31, 2021. Interest bearing deposits are comprised of interest-bearing transaction accounts, money market accounts, regular savings accounts, and certificates of deposit.
Total deposits have increased 2.57% since December 31, 2021:
• | Demand and interest-bearing transaction accounts totaled $2.88 billion at December 31, 2022, an increase of $36.1 million, or 1.27% from $2.85 billion held at December 31, 2021. |
• | Savings and money market accounts increased $144.1 million, or 10.29%, to $1.54 billion at December 31, 2022 compared with $1.40 billion at December 31, 2021. |
• | Certificates of deposit accounts decreased $61.1 million, or 15.56%, to $331.4 million at December 31, 2022 compared with $392.5 million at December 31, 2021. |
The following table shows the average amount and average rate paid on the categories of deposits for each of the periods presented:
| | | As of December 31, | |
| | 2022 | | | 2021 | | | 2020 | |
| (Dollars in thousands) | | Average Balance | | | Interest Expense | | | Average Rate | | | Average Balance | | | Interest Expense | | | Average Rate | | | Average Balance | | | Interest Expense | | | Average Rate | |
| Total deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest bearing deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Demand | | $ | 1,120,198 | | | | 1,497 | | | | 0.13 | % | | $ | 1,024,009 | | | | 1,128 | | | | 0.11 | % | | $ | 787,306 | | | | 1,618 | | | | 0.21 | % |
| Savings and money market | | | 1,542,310 | | | | 1,981 | | | | 0.13 | % | | | 1,352,258 | | | | 1,458 | | | | 0.11 | % | | | 1,128,623 | | | | 2,724 | | | | 0.24 | % |
| Certificates of deposit greater than $250,000 | | | 157,623 | | | | 460 | | | | 0.29 | % | | | 170,040 | | | | 701 | | | | 0.41 | % | | | 220,952 | | | | 2,535 | | | | 1.15 | % |
| Certificates of deposit less than $250,000 | | | 215,044 | | | | 411 | | | | 0.19 | % | | | 235,746 | | | | 730 | | | | 0.31 | % | | | 268,294 | | | | 2,236 | | | | 0.83 | % |
| Total interest bearing deposits | | | 3,035,175 | | | | 4,349 | | | | 0.14 | % | | | 2,782,053 | | | | 4,017 | | | | 0.14 | % | | | 2,405,175 | | | | 9,113 | | | | 0.38 | % |
| Non-interest bearing deposits | | | 1,751,797 | | | | | | | | | | | | 1,610,611 | | | | | | | | | | | | 1,232,874 | | | | | | | | | |
| Total deposits | | $ | 4,786,972 | | | $ | 4,349 | | | | 0.09 | % | | $ | 4,392,664 | | | $ | 4,017 | | | | 0.09 | % | | $ | 3,638,049 | | | $ | 9,113 | | | | 0.25 | % |
Deposits are gathered from individuals and businesses in our market areas. The interest rates paid are competitively priced for each particular deposit product and structured to meet our funding requirements. The significant increase in short-term interest rates during 2022 has placed pressure on deposit pricing, and we will continue to manage this ongoing impact through careful deposit pricing. The average cost of deposits, including non-interest bearing deposits was 0.09% for all of 2022 and all of 2021.
The following table shows deposits with a balance greater than $250,000 at December 31, 2022 and 2021:
| | | December 31 | |
| (Dollars in thousands) | | 2022 | | | 2021 | |
| Non-Maturity Deposits greater than $250,000 | | $ | 2,872,754 | | | $ | 2,708,576 | |
| Certificates of deposit greater than $250,000, by maturity: | | | | | | | | |
| Less than 3 months | | | 45,078 | | | | 59,591 | |
| 3 months to 6 months | | | 30,426 | | | | 37,182 | |
| 6 months to 12 months | | | 44,189 | | | | 59,945 | |
| More than 12 months | | | 9,153 | | | | 12,147 | |
| Total certificates of deposit greater than $250,000 | | $ | 128,846 | | | $ | 168,865 | |
| Total deposits greater than $250,000 | | $ | 3,001,600 | | | $ | 2,877,441 | |
Refer to the Year-To-Date Average Balances and Rate Schedules located in this "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for information on separate deposit categories.
The Bank participates in a program wherein the State of California places time deposits with the Bank at the Bank’s option. At December 31, 2022 and 2021, the Bank had $3.0 million, of these deposits.
Federal Home Loan Bank Advances and Federal Reserve Bank Borrowings
Lines of Credit with the Federal Reserve Bank and Federal Home Loan Bank are other key sources of funds to support earning assets. These sources of funds are also used to manage the Company’s interest rate risk exposure; and, as opportunities arise, to borrow and invest the proceeds at a positive spread through the investment portfolio. There were no FHLB advances at December 31, 2022 or 2021. There were no Federal Funds purchased or advances from the FRB at December 31, 2022 or 2021.
Long-Term Subordinated Debentures
On December 17, 2003, the Company raised $10.0 million through the sale of subordinated debentures to an off-balance sheet trust and its sale of trust-preferred securities. See Note 9. “Long-Term Subordinated Debentures” located in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. Although this amount is reflected as subordinated debt on the Company’s balance sheet, under current regulatory guidelines, our Trust Preferred Securities will continue to qualify as regulatory capital.
These securities accrue interest at a variable rate based upon 3-month LIBOR plus 2.85%. Interest rates reset quarterly (the next reset is March 17, 2023) and the rate was 7.59% as of December 31, 2022. The average rate paid for these securities was 4.76% in 2022 and 3.06% in 2021. Additionally, if the Company decided to defer interest on the subordinated debentures, the Company would be prohibited from paying cash dividends on the Company’s common stock.
Capital Resources
The Company relies primarily on capital generated through the retention of earnings to satisfy its capital requirements. The Company engages in an ongoing assessment of its capital needs in order to support business growth and to insure depositor protection. Shareholders’ Equity totaled $485.3 million at December 31, 2022, and $463.1 million at the end of 2021.
The Company and the Bank are subject to various regulatory capital adequacy guidelines as outlined under Part 324 of the FDIC Rules and Regulations. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Company and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
The Company believes that it is currently in compliance with all of these capital requirements and that they will not result in any restrictions on the Company’s business activity.
Management believes that the Bank meets the requirements to be categorized as “well capitalized” under the FDIC regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables as of December 31, 2022 and 2021.
The following table sets forth our capital ratios:
| | Minimum to be Categorized as "Well Capitalized" under Prompt Corrective Action Regulations | | | As of
December 31, | |
| (Dollars in thousands) | | 2022 | | | 2021 | |
| Farmers & Merchants Bancorp | | | | | | | | | |
| CET1 capital to risk-weighted assets | | N/A | | | | 11.57 | % | | | 11.68 | % |
| Tier 1 capital to risk-weighted assets | | N/A | | | | 11.80 | % | | | 11.94 | % |
| Risk-based capital to risk-weighted assets | | N/A | | | | 13.06 | % | | | 13.19 | % |
| Tier 1 leverage capital ratio | | N/A | | | | 9.36 | % | | | 8.92 | % |
| | | | | | | | | | | | |
| Farmers & Merchants Bank | | | | | | | | | | | |
| CET1 capital to risk-weighted assets | | 6.50% |
| | | 11.79 | % | | | 11.91 | % |
| Tier 1 capital to risk-weighted assets | | 8.00% |
| | | 11.79 | % | | | 11.91 | % |
| Risk-based capital to risk-weighted assets | | 10.00% |
| | | 13.04 | % | | | 13.17 | % |
| Tier 1 leverage capital ratio | | 5.00% |
| | | 9.35 | % | | | 8.91 | % |
On November 15, 2021, the Board of Directors reauthorized the Company’s share repurchase program for up to $20.0 million of the Company’s common stock (“Repurchase Plan”), representing approximately 4% of outstanding shareholders’ equity. Repurchases by the Company under the Repurchase Plan may be made from time to time through open market purchases, trading plans established in accordance with SEC rules, privately negotiated transactions, or by other means. On November 8, 2022, the Board of Directors authorized an extension to its share repurchase program through December 31, 2024 for an additional $20.0 million of the Company’s common stock (“Repurchase Plan”), which represents approximately 4% of outstanding shareholders’ equity.
During 2022, the Company repurchased 21,309 shares under the Repurchase Plan, for a total of $20.3 million.
Off-Balance-Sheet Arrangements
Off-balance-sheet arrangements are any contractual arrangement to which an unconsolidated entity is a party, under which the Company has: (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; (3) any obligation under certain derivative instruments; or (4) any obligation under a material variable interest held by us in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company, or engages in leasing, hedging, or research and development services with the Company. The Company had the following off balance sheet commitments as of the dates indicated.
The following table sets forth our off-balance sheet lending commitments as of December 31, 2022:
| | | | | | Amount of Commitment Expiration per Period | |
| (Dollars in thousands) | | Total Committed Amount | | | Less than One Year | | | One to Three Years | | | Three to Five Years | | | After Five Years | |
| Off-balance sheet commitments | | | | | | | | | | | | | | | |
| Commitments to extend credit | | $ | 1,141,036 | | | $ | 423,956 | | | $ | 203,186 | | | $ | 476,671 | | | $ | 37,223 | |
| Standby letters of credit | | | 17,138 | | | | 10,770 | | | | 4,468 | | | | 1,470 | | | | 430 | |
| Total off-balance sheet commitments | | $ | 1,158,174 | | | $ | 434,726 | | | $ | 207,654 | | | $ | 478,141 | | | $ | 37,653 | |
The Company's exposure to credit loss in the event of nonperformance by the other party with regard to standby letters of credit, undisbursed loan commitments, and financial guarantees is represented by the contractual notional amount of those instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The Company uses the same credit policies in making commitments and conditional obligations as it does for recorded balance sheet items. The Company may or may not require collateral or other security to support financial instruments with credit risk. Evaluations of each customer's creditworthiness are performed on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Company to guarantee performance of or payment for a customer to a third-party. Most standby letters of credit have maturity dates ranging from 1 to 60 months with final expiration in January 2027. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Additionally, the Company maintains a reserve for off balance sheet commitments, which totaled $ 2.1 million and $315,000 at December 31, 2022 and 2021, respectively.
The allowance for credit losses - unfunded loan commitments was $2.1 million at December 31, 2022 compared to $0.3 million at December 31, 2021. The increase in ACL in 2022 was primarily related to higher expected probable losses inherent in the loan portfolio that was directly related to quantitative and qualitative factors associated with the current economic environment and overall growth in the loan portfolio.
Liquidity
The ability to have readily available funds sufficient to repay maturing liabilities is of primary importance to depositors, creditors and regulators. Our liquidity, represented by cash borrowing lines, federal funds and available-for-sale securities, is a result of our operating, investing and financing activities and related cash flows. In order to ensure funds are available at all times, we devote resources to projecting the amount of funds that will be required and we maintain relationships with a diversified client base so funds are accessible. Liquidity requirements can also be met through short-term borrowings or the disposition of short-term assets. We had the following borrowing lines available at December 31, 2022:
| | | As of December 31, 2022 | |
| (Dollars in thousands) | | Total Credit Line Limit | | | Current Credit Line Available | | | Outstanding Amount | | | Remaining Credit Line Available | | | Value of Collateral Pledged | |
| Additional liquidity sources: | | | | | | | | | | | | | | | |
| Federal Home Loan Bank | | $ | 757,866 | | | $ | 757,866 | | | $ | - | | | $ | 757,866 | | | $ | 1,225,175 | |
| Federal Reserve BIC | | | 650,925 | | | | 650,925 | | | | - | | | | 650,925 | | | | 883,754 | |
| FHLB Fed Funds | | | 18,000 | | | | 18,000 | | | | - | | | | 18,000 | | | | - | |
| US Bank Fed Funds | | | 35,000 | | | | 35,000 | | | | - | | | | 35,000 | | | | - | |
| PCBB Fed Funds | | | 50,000 | | | | 50,000 | | | | - | | | | 50,000 | | | | - | |
| Total additional liquidity sources | | $ | 1,511,791 | | | $ | 1,511,791 | | | $ | - | | | $ | 1,511,791 | | | $ | 2,108,929 | |
We believe our liquid assets and short-term borrowing credit lines are adequate to meet our cash flow needs for loan funding and deposit cash withdrawal for the foreseeable future. As of December 31, 2022, we had $958 million in cash and unencumbered investment securities; $2.1 million in investment securities and $2.1 billion in loans pledged as collateral on short-term borrowing credit lines. We have the option of either borrowing on our credit lines or selling these investment securities for cash flow needs.
On a long-term basis, our liquidity will be met by changing the relative distribution of our asset portfolios by reducing our investment or loan volumes, or selling or encumbering assets. Further, we will increase liquidity by soliciting higher levels of deposit accounts through promotional activities and/or borrowing from our correspondent banks as well as the FHLB. At the current time, our long-term liquidity needs primarily relate to funds required to support loan originations and commitments and deposit withdrawals.
We believe we can meet all of these needs from existing liquidity sources.
Our liquidity is comprised of three primary classifications: cash flows from or used in operating activities; cash flows from or used in investing activities; and cash flows from or used in financing activities. Net cash provided by or used in operating activities has consisted primarily of net income adjusted for certain non-cash income and expense items such as the credit loss provision, investment and other amortization and depreciation.
Our primary investing activities are the origination of loans, and purchases and sales of investment securities. As of December 31, 2022, we had unfunded loan commitments of $1.1 billion and unfunded letters of credit of $17.1 million. We anticipate that we will have sufficient funds available to meet current loan commitments.
| Item 7A. | Quantitative and Qualitative Disclosures about Market Risk |
Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices and equity prices. Our market risk arises primarily from interest rate risk inherent in our lending and deposit taking activities. Management actively monitors and manages our interest rate risk exposure. We do not have any market-risk sensitive instruments entered into for trading purposes. We manage our interest-rate sensitivity by matching the re-pricing opportunities on our earning assets to those on our funding liabilities.
Management uses various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans and deposits, and managing the deployment of our securities, are used to reduce mismatches in interest rate re-pricing opportunities of portfolio assets and their funding sources.
Our Asset Liability Management Committee (“ALCO”), which is comprised of members of the Board of Directors and executive officers, manages market risk. ALCO monitors interest rate risk by analyzing the potential impact on net interest income from potential changes in interest rates, and considers the impact of alternative strategies or changes in balance sheet structure. ALCO manages our balance sheet in part to maintain the potential impact of changes in interest rates on net interest income within acceptable ranges despite changes in interest rates.
Our exposure to interest rate risk is reviewed on at least a quarterly basis by ALCO. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine our change in net interest income in the event of hypothetical changes in interest rates. If potential changes to net interest income resulting from hypothetical interest rate changes are not within risk tolerances determined by ALCO, and approved by the full Board of Directors, Management may make adjustments to the Company’s asset and liability mix to bring interest rate risk levels within the Board approved limits.
Net Interest Income Simulation. In order to measure interest rate risk, we used a simulation model to project changes in net interest income that result from forecasted changes in interest rates. This analysis calculates the difference between net interest income forecasted using a rising and a falling interest rate scenario and a net interest income forecast using a base market interest rate derived from the current treasury yield curve. The income simulation model includes various assumptions regarding the re-pricing relationships for each of our products. Many of our assets are floating rate loans, which are assumed to re-price immediately, and to the same extent as the change in market rates according to their contracted index.
Some loans and investment vehicles include the opportunity of prepayment (embedded options), and accordingly the simulation model uses national indexes to estimate these prepayments and assumes the reinvestment of the proceeds at current yields. Our non-term deposit products re-price more slowly, usually changing less than the change in market rates and at our discretion.
This analysis indicates the impact of changes in net interest income for the given set of rate changes and assumptions. It assumes the balance sheet grows modestly, but that its structure will remain similar to the structure as of the period presented. It does not account for all factors that affect this analysis, including changes by management to mitigate the effect of interest rate changes or secondary impacts such as changes to our credit risk profile as interest rates change.
Furthermore, loan prepayment-rate estimates and spread relationships change regularly. Interest rate changes create changes in actual loan prepayment rates that will differ from the market estimates incorporated in this analysis. Changes that vary significantly from the assumptions may have significant effects on our net interest income.
For the rising and falling interest rate scenarios, the base market interest rate forecast was increased or decreased, on an instantaneous and sustained basis, by 200 basis points. As of the periods presented, our net interest margin exposure related to these hypothetical changes in market interest rates was within the current guidelines established by us. Our simulation model highlights the fact that our balance sheet is asset sensitive, which means that our net interest income rises in a rising interest rate environment.
The ratio of variable to fixed-rate loans in our loan portfolio, the ratio of short-term (maturing at a given time within 12 months) to long-term loans, and the ratio of our demand, money market and savings deposits to CDs (and their time periods), are the primary factors affecting the sensitivity of our net interest income to changes in market interest rates. Our short-term loans are typically priced at prime plus a margin, and our long-term loans are typically priced based on a FHLB index for comparable maturities, plus a margin. The composition of our rate-sensitive assets or liabilities is subject to change and could result in a more unbalanced position that would cause market rate changes to have a greater impact on our net interest margin.
Gap Analysis. Another way to measure the impact that future changes in interest rates will have on net interest income is through a cumulative gap measure. The gap represents the net position of assets and liabilities subject to re-pricing in specified periods. A gap analysis highlights the distribution of re-pricing opportunities of our interest earning assets and interest-bearing liabilities, the interest rate sensitivity gap (that is, interest rate sensitive assets less interest rate sensitive liabilities), cumulative interest earning assets and interest bearing liabilities, the cumulative interest rate sensitivity gap, the ratio of cumulative interest earning assets to cumulative interest-bearing liabilities and the cumulative gap as a percentage of total assets and total interest earning assets as of the periods presented. The analysis also sets forth the time periods during which interest earning assets and interest bearing liabilities will mature or may re-price in accordance with their contractual terms. The interest rate relationships between the re-priceable assets and re-priceable liabilities are not necessarily constant and may be affected by many factors, including the behavior of clients in response to changes in interest rates.
Gap analysis has certain limitations. Measuring the volume of re-pricing or maturing assets and liabilities does not always measure the full impact on the portfolio value of equity or net interest income. Gap analysis does not account for rate caps on products, dynamic changes such as increasing prepayment speeds as interest rates decrease, basis risk, embedded options or the benefit of no-rate funding sources. The relation between product rate re-pricing and market rate changes (basis risk) is not the same for all products. The majority of interest earning assets generally re-price along with a movement in market rates, while non-term deposit rates in general move more slowly and usually incorporate only a fraction of the change in market rates.
Products categorized as non-rate sensitive, such as our non-interest bearing demand deposits, in the gap analysis behave like long-term fixed rate funding sources. Management uses income simulation, net interest income rate shocks and market value of portfolio equity as its primary interest rate risk management tools.
