| PART I | Page |
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| Item 1 | | 5 |
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| Item 1A | | 15 |
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| Item 1B | | 25 |
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| Item 1C | | 25 |
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| Item 2 | | 26 |
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| Item 3 | | 26 |
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| Item 4 | | 26 |
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| PART II | |
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| Item 5 | | 27 |
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| Item 6 | | 28 |
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| Item 7 | | 29 |
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| Item 7A | | 53 |
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| Item 8 | | 54 |
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| Item 9 | | 113 |
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| Item 9A | | 113 |
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| Item 9B | | 114 |
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| Item 9C | | 114 |
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| PART III | |
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| Item 10 | | 115 |
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| Item 11 | | 115 |
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| Item 12 | | 116 |
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| Item 13 | | 116 |
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| Item 14 | | 116 |
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| PART IV | |
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| Item 15 | | 117 |
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| Item 16 | | 120 |
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| 121 |
NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report includes forward-looking statements, which may include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our forecasts and expectations. See Part I, Item 1A. “Risk Factors,” and the other risks described in this report for factors to be considered when reading any forward-looking statements in this filing.
This report includes forward-looking statements, which are subject to the “safe harbor” created by section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. We may make forward-looking statements in our Securities and Exchange Commission (“SEC”) filings, press releases, news articles and when we are speaking on behalf of the Company. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “target,” “anticipate,” “intend,” “plan,” “seek,” “estimate,” “potential,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” or “may.” These forward-looking statements are intended to provide investors with additional information with which they may assess our future potential. All of these forward-looking statements are based on assumptions about an uncertain future and are based on information available to us at the date of these statements. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made.
In this document, for example, we make forward-looking statements, which discuss our expectations about:
| ● | Our business objectives, strategies and initiatives, our organizational structure, the growth of our business and our competitive position and prospects, and the effect of competition on our business and strategies |
| ● | Our assessment of significant factors and developments that have affected or may affect our results |
| ● | Legal and regulatory actions, and future legislative and regulatory developments, including the effects of the Dodd-Frank Wall Street Reform and Protection Act (the “Dodd-Frank Act”), the Economic Growth, Regulatory Relief and Consumer Protection Act (the “EGRRCPA”), and other legislation and governmental measures introduced in response to the financial crisis which began in 2008 and the ensuing recession affecting the banking system, financial markets and the U.S. economy |
| ● | Regulatory and compliance controls, processes and requirements and their impact on our business |
| ● | The costs and effects of legal or regulatory actions |
| ● | Expectations regarding draws on performance letters of credit and liabilities that may result from recourse provisions in standby letters of credit |
| ● | Our intent to sell or hold, and the likelihood that we would be required to sell, various investment securities |
| ● | Our regulatory capital requirements, including the capital rules established after the 2008 financial crisis by the U.S. federal banking agencies and our current intention not to elect to use the community bank leverage ratio framework |
| ● | Expectations regarding our non-payment of a cash dividend on our common stock in the foreseeable future |
| ● | Credit quality and provision for credit losses and management of asset quality and credit risk, expectations regarding collections and the timing thereof |
| ● | Our allowances for credit losses, including the conditions we consider in determining the unallocated allowance and our portfolio credit quality, the adequacy of the allowance for credit losses, underwriting standards, and risk grading |
| ● | Our assessment of economic conditions and trends and credit cycles and their impact on our business |
| ● | The seasonal nature of our business |
| ● | The impact of changes in interest rates and our strategy to manage our interest rate risk profile and the possible effect of changes in residential mortgage interest rates on new originations and refinancing of existing residential mortgage loans |
| ● | Loan portfolio composition and risk grade trends, expected charge-offs, portfolio credit quality, loan demand, our strategy regarding loan modifications, delinquency rates and our underwriting standards and our expectations regarding our recognition of interest income on loans that were provided payment deferrals upon completion of the payment forbearance period |
| ● | Our deposit base including renewal of time deposits and the outlook for deposit balances |
| ● | The impact on our net interest income and net interest margin of changes in interest rates |
| ● | The effect of possible changes in the initiatives and policies of the federal and state bank regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, the Securities and Exchange Commission and other standard setters |
| ● | Tax rates and the impact of changes in the U.S. tax laws |
| ● | Our pension and retirement plan costs |
| ● | Our liquidity strategies and beliefs concerning the adequacy of our liquidity and ability to satisfactorily manage our liquidity |
| ● | Critical accounting policies and estimates, the impact or anticipated impact of recent accounting pronouncements or changes in accounting principles |
| ● | Expected rates of return, maturities, loss exposure, growth rates, yields, and projected results |
| ● | The possible impact of weather-related or other natural conditions, including drought, fire or flooding, seismic events, and related governmental responses, including related electrical power outages, on economic conditions, especially in the agricultural sector |
| ● | Maintenance of insurance coverages appropriate for our operations |
| ● | Threats to the banking sector and our business due to cybersecurity issues and attacks and regulatory expectations related to cybersecurity |
| ● | Possible changes in the fair values recorded on our financial statements of the assets acquired and liabilities assumed in our business combination completed in January 2023 |
| ● | The possible effects on community banks and our business from the recent failures of other banks |
| ● | The possible adverse impacts on the banking industry and our business from a period of significant, prolonged inflation |
| ● | Descriptions of assumptions underlying or relating to any of the foregoing |
There are numerous risks and uncertainties that could and will cause actual results to differ materially from those discussed in our forward-looking statements. Many of these factors are beyond our ability to control or predict and could have a material adverse effect on our financial condition and results of operations or prospects. Such risks and uncertainties include but are not limited to those listed in this “Note Regarding Forward-Looking Statements,” Part I, Item 1A “Risk Factors,” Part II and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report and in our other reports to the SEC.
Readers of this document should not rely unduly on forward-looking information and should consider all uncertainties and risks disclosed throughout this document and in our other reports to the SEC, including, but not limited to, those discussed below. Any factor described in this report could by itself, or together with one or more other factors, adversely affect our business, future prospects, results of operations, or financial condition. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions, or events that occur after the date the forward-looking statements are made.
PART I
General
First Northern Community Bancorp (the “Company”) is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (“BHCA”). Its legal headquarters and principal administrative offices are located at 195 N. First Street, Dixon, CA 95620 and its telephone number is (707) 678-3041. The Company provides a full range of community banking services to individual and corporate customers throughout the California Counties of Solano, Yolo, Placer, and Sacramento as well as portions of El Dorado and Contra Costa Counties through its wholly-owned subsidiary bank, First Northern Bank of Dixon (“First Northern” or the “Bank”). The Company’s operating policy since inception has emphasized the banking needs of individuals and small- to medium-sized businesses. In addition, the Bank owns 100% of the capital stock of Yolano Realty Corporation, a subsidiary created for the purpose of managing selected other real estate owned properties.
The Bank was established in 1910 under a California state charter as Northern Solano Bank, and opened for business on February 1st of that year. On January 2, 1912, the First National Bank of Dixon was established under a federal charter, and until 1955, the two entities operated side by side under the same roof and with the same management. In an effort to increase efficiency of operation, reduce operating expense, and improve lending capacity, the two banks were consolidated on April 8, 1955, with the First National Bank of Dixon as the surviving entity. On January 1, 1980, the Bank’s federal charter was relinquished in favor of a California state charter, and the Bank’s name was changed to First Northern Bank of Dixon.
In April of 2000, the shareholders of First Northern approved a corporate reorganization, which provided for the creation of the bank holding company. This reorganization, effected May 19, 2000, enabled the Company to better compete and grow in its competitive and rapidly changing marketplace.
On January 20, 2023, the Company completed the acquisition of three branches of Columbia State Bank, a Washington state-chartered commercial bank (“Columbia”), and a wholly-owned subsidiary of Columbia Banking System, Inc., in the California towns of Colusa, Orland and Willows. This acquisition enabled the Company to extend its existing footprint. The Bank acquired these branches for consideration in an amount equal to 3.15% of the average daily closing balance of the deposits for the period commencing thirty calendar days prior to the closing date and concluding on the date preceding the closing date plus the net book values of certain assets of Columbia and accrued interest and fees with respect to the acquired loans. At the closing of the acquisition, and subject to the terms of the purchase agreement, the Bank assumed the deposit liabilities related to certain accounts. The aggregate deposits assumed totaled approximately $116 million, and the aggregate principal balance of the loans acquired totaled approximately $4 million.
The Bank has fourteen full-service branches located in the cities of Auburn, Colusa, Davis, Dixon, Fairfield, Orland, Rancho Cordova, Roseville, Sacramento, Vacaville, West Sacramento, Winters, Willows and Woodland. The Bank has one satellite banking office inside a retirement community in the city of Davis and a residential mortgage loan office in Davis. The Bank engages financial advisors, through Raymond James Financial Services, Inc., who offer non-FDIC insured investment and brokerage services throughout the region from offices strategically located in West Sacramento, Davis and Auburn. The Bank also has a commercial loan office in the Contra Costa County city of Walnut Creek that serves the East Bay Area’s small- to medium-sized business lending needs. The Bank’s operations center is located in Dixon and provides back-office support including information services, central operations, and the central loan department. In 2019, the Bank opened an additional administrative office in Sacramento.
The Bank is in the commercial banking business and generates most of its revenue by providing a wide range of products and services to small- and medium-sized businesses and individuals including accepting demand, interest bearing transaction, savings, and time deposits, and making commercial, consumer, and real estate related loans. It also issues cashier’s checks, rents safe deposit boxes, and provides other customary banking services.
First Northern offers a broad range of alternative investment products, fiduciary and other financial services through Raymond James Financial Services, Inc. First Northern also offers equipment leasing, credit cards, merchant card processing, payroll services, and limited international banking services through third parties.
The Bank’s principal source of revenue is interest income. Interest income is primarily derived from interest and fees on loans and leases, interest on investments, and due from banks interest bearing accounts. For the year ended December 31, 2023, these sources comprised approximately 70%, 16%, and 13%, respectively, of the Company’s interest income.
The Bank is a member of the Federal Deposit Insurance Corporation (“FDIC”) and all deposit accounts are insured by the FDIC to the maximum amount permitted by law, currently $250,000 per depositor. Most of the Bank’s deposits are attracted from the market of northern and central Solano County, southern and central Yolo County and Placer County. The Bank’s deposits are not received from a single depositor or group of affiliated depositors, the loss of any one which would have a materially adverse impact on the business of the Bank. A material portion of the Bank’s deposits are not concentrated within a single industry group of related industries.
As of December 31, 2023, the Company had consolidated assets of approximately $1.87 billion, liabilities of approximately $1.71 billion and stockholders’ equity of approximately $159.2 million. The Company and its subsidiaries employed 203 full-time-equivalent employees as of December 31, 2023. The Company and the Bank consider their relationship with their employees to be good and have not experienced any interruptions of operations due to labor disagreements.
Available Information
The Company makes available free of charge on its website, www.thatsmybank.com, its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC. These filings are also accessible on the SEC’s website at www.sec.gov. The information found on the Company’s website shall not be deemed incorporated by reference by any general statement incorporating by reference this report into any filing under the Securities Act of 1933 or under the Securities Exchange Act of 1934 and shall not otherwise be deemed filed under such Acts.
The Effect of Government Policy on Banking
The earnings and growth of the Bank are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the Board of Governors of the Federal Reserve System (“FRB”) influences the supply of money through its open market operations in U.S. Government securities, adjustments to the discount rates applicable to borrowings by depository institutions and others and establishment of reserve requirements against both member and non-member financial institutions’ deposits. Such actions significantly affect the overall growth and distribution of loans, investments, and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the business and earnings of the Company cannot be predicted. Additionally, state and federal tax policies can impact banking organizations.
Because of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to being affected by the enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities or enhancing the competitive position of other financial institutions. Any change in applicable laws, regulations, or policies may have a material adverse effect on the business, financial condition, or results of operations, or prospects of the Company.
In May 2018, the President signed into law the Economic Growth, Regulatory Relief and Consumer Protection Act (the “EGRRCPA”) which amended various provisions of the Dodd-Frank Act as well as other federal banking statutes, and generally authorized the FRB to tailor regulation to better reflect the character of the different banking firms that the FRB supervises. In August 2018, the FRB began implementing the EGRRCPA with several interim final rules which, among other things, revised the FRB’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement (the “policy statement”) to raise the consolidated assets threshold from $1 billion to $3 billion, allowing the Company to qualify under the policy statement. This policy statement applies to bank holding companies with pro forma consolidated assets of less than $3 billion that (i) are not engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (ii) do not conduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; and (iii) do not have a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the SEC. This policy statement permits qualifying bank holding companies, such as the Company, to operate with higher levels of debt, facilitating the ability of community banks to issue debt and raise capital. Qualifying bank holding companies, such as the Company, also are permitted to be examined by a Federal banking agency every 18 months (as opposed to every 12 months) and are eligible to use shorter call report forms. Whether and to what extent the EGRRCPA or new legislation will result in additional regulatory initiatives and policies, or modifications of existing regulations and policies, which may impact our business, cannot be predicted at this time.
Supervision and Regulation of Bank Holding Companies
The Company is a bank holding company subject to the BHCA. The Company reports to, registers with, and is subject to supervision and examination by, the FRB. The FRB also has the authority to examine the Company’s subsidiaries. The costs of any examination by the FRB are payable by the Company.
The FRB has significant supervisory, regulatory and enforcement authority over the Company and its affiliates. The FRB requires the Company to maintain certain levels of capital. See “Capital Standards” below for more information. The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations, or conditions imposed in writing by the FRB. See “Prompt Corrective Action and Other Enforcement Mechanisms” below for more information. Such enforcement powers include the power to assess civil money penalties against any bank holding company violating any provision of the BHCA or any regulation or order of the FRB under the BHCA. Knowing violations of the BHCA or regulations or orders of the FRB can also result in criminal penalties for the bank holding company and any individuals participating in such conduct. Under long-standing FRB policy and provisions of the Dodd-Frank Act, bank holding companies are required to act as a source of financial and managerial strength to their subsidiary banks, and to commit resources to support their subsidiary banks. This support may be required at times when a bank holding company may not have the resources to provide such support, or may not be inclined to provide such support under the then-existing circumstances.
Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over a bank, or acquires, directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges, or consolidates with any bank or bank holding company. Any company seeking to acquire, merge, or consolidate with the Company also would be required to obtain the prior approval of the FRB.
The Company is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than banking, managing banks, or providing services to affiliates of the holding company. However, a bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged, in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity.
The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. The FRB’s policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality, and overall financial condition. The Company is also subject to restrictions relating to the payment of dividends under California corporate law. See “Restrictions on Dividends and Other Distributions” below for additional restrictions on the ability of the Company and the Bank to pay dividends.
Supervision and Regulation of the Bank
The Bank is subject to regulation, supervision and regular examination by the Financial Institutions Division of the California Department of Financial Protection and Innovation (“DFPI”) and the FDIC. The regulations of and laws administered by these agencies affect most aspects of the Bank’s business and prescribe permissible types of loans and investments, the amount of required reserves, requirements for branch offices, the permissible scope of the Bank’s activities and various other requirements. While the Bank is not a member of the FRB, it is directly subject to certain regulations of the FRB dealing with such matters as check clearing activities, establishment of banking reserves, Truth-in-Lending (“Regulation Z”), and Equal Credit Opportunity (“Regulation B”). The Bank is also subject to regulations of (although not direct supervision and examination by) the Consumer Financial Protection Bureau (“CFPB”), which was created by the Dodd-Frank Act. Among the CFPB’s responsibilities are implementing and enforcing federal consumer financial protection laws, reviewing the business practices of financial services providers for legal compliance, monitoring the marketplace for transparency on behalf of consumers and receiving complaints and questions from consumers about consumer financial products and services. The Dodd-Frank Act added prohibitions on unfair, deceptive or abusive acts and practices to the scope of consumer protection regulations overseen and enforced by the CFPB.
The banking industry is also subject to significantly increased regulatory controls and processes regarding the Bank Secrecy Act and anti-money laundering laws. Over the past decade, a number of banks and bank holding companies announced the imposition of regulatory sanctions, including regulatory agreements and cease and desist orders and, in some cases, fines and penalties, by the bank regulators due to failures to comply with the Bank Secrecy Act and other anti-money laundering legislation. In a number of these cases, the fines and penalties have been significant. Failure to comply with these additional requirements may also adversely affect the Bank’s ability to obtain regulatory approvals for future initiatives requiring regulatory approval, including acquisitions.
Under California law, the Bank is subject to various restrictions on, and requirements regarding, its operations and administration including the maintenance of branch offices and automated teller machines, capital and reserve requirements, deposits and borrowings, and investment and lending activities.
California law permits a state-chartered bank to invest in the stock and securities of other corporations, subject to a state-chartered bank receiving either general authorization or, depending on the amount of the proposed investment, specific authorization from the DFPI. Federal banking laws, however, impose limitations on the activities and equity investments of state-chartered, federally insured banks. The FDIC rules on investments prohibit a state bank from acquiring an equity investment of a type, or in an amount, not permissible for a national bank. FDIC rules also prohibit a state bank from engaging as a principal in any activity that is not permissible for a national bank, unless the bank is adequately capitalized and the FDIC approves the activity after determining that such activity does not pose a significant risk to the deposit insurance fund. The FDIC rules on activities generally permit subsidiaries of banks, without prior specific FDIC authorization, to engage in those activities that have been approved by the FRB for bank holding companies because such activities are so closely related to banking to be a proper incident thereto. Other activities generally require specific FDIC prior approval, and the FDIC may impose additional restrictions on such activities on a case-by-case basis in approving applications to engage in otherwise impermissible activities.
The USA Patriot Act
Title III of the United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA Patriot Act”) includes numerous provisions for fighting international money laundering and blocking terrorism access to the U.S. financial system. The USA Patriot Act requires certain additional due diligence and record keeping practices, including, but not limited to, new customers, correspondent and private banking accounts.
Part of the USA Patriot Act is the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“IMLAFATA”). Among its provisions, IMLAFATA requires each financial institution to: (i) establish an anti-money laundering program; (ii) establish appropriate anti-money laundering policies, procedures, and controls; (iii) appoint a Bank Secrecy Act officer responsible for day-to-day compliance; and (iv) conduct independent audits. In addition, IMLAFATA contains a provision encouraging cooperation among financial institutions, regulatory authorities, and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. IMLAFATA expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours. IMLAFATA also amends the BHCA and the federal Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing an application under these Acts.
Pursuant to IMLAFATA, the Secretary of the Treasury, in consultation with the heads of other government agencies, has adopted measures applicable to banks, bank holding companies, and/or other financial institutions. These measures include enhanced record keeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions.
Privacy Restrictions
The Gramm-Leach-Bliley Act (“GLBA”), which became law in 1999, in addition to the previous described changes in permissible non-banking activities permitted to banks, bank holding companies and financial holding companies, also requires financial institutions in the U.S. to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to non-affiliated third parties. In general, the GLBA requires explanations to consumers on policies and procedures regarding the disclosure of such nonpublic personal information, and, except as otherwise required by law, prohibits disclosing such information except as provided in the banks’ policies and procedures and applicable law. These regulations also allow consumers to opt-out of the sharing of certain information between affiliates, and impose other requirements.
Certain state laws and regulations designed to protect the privacy and security of customer information also apply to us and our subsidiaries, including laws requiring notification to affected individuals and regulators of data security breaches. For additional information, see “Information security breaches or other technological difficulties could adversely affect the Company” in Part I, Item 1A. “Risk Factors” in this report.
The Company believes that it complies with all provisions of 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 GLBA.
California and other state legislatures have adopted privacy laws, including laws prohibiting sharing of customer information without the customer’s prior permission. These laws may make it more difficult for the Company to share information with its marketing partners, reduce the effectiveness of marketing programs, and increase the cost of marketing programs.
In June 2018, the State of California enacted The California Consumer Privacy Act of 2018 (“CCPA”). This new law became effective on January 1, 2020, and provides consumers with expansive rights and controls over their personal information which is obtained by or shared with “covered businesses”, which includes the Bank and most other banking institutions subject to California law. The CCPA gives consumers the right to request disclosure of information collected about them and whether that information has been sold or shared with others, the right to request deletion of personal information subject to certain exceptions, the right to opt out of the sale of the consumer’s personal information and the right not to be discriminated against because of choices regarding the consumer’s personal information. The CCPA provides for certain monetary penalties and for its enforcement by the California Attorney General or consumers whose rights under the law are not observed. It also provides for damages as well as injunctive or declaratory relief if there has been unauthorized access, theft or disclosure of personal information due to failure to implement reasonable security procedures. The CCPA contains several exemptions, including a provision to the effect that the CCPA does not apply where the information is collected, processed, sold or disclosed pursuant to the GLBA if the GLBA is in conflict with the CCPA.
In November 2020, California voters approved state-wide Proposition 24, also known as the California Privacy Rights and Enforcement Act of 2020 (the “CPREA”) which expanded and amended certain provisions of the CCPA and created the California Privacy Protection Agency to enforce privacy rights for Californians and impose fines for violations of such rights. The CPREA requires businesses to not share a consumer’s personal information upon the consumer’s request, provides consumers with an opt-out option for having their sensitive personal information used or disclosed for advertising or marketing, to obtain permission for collecting data on certain minors, and to correct a consumer’s inaccurate information upon the consumer’s request. It also removed the ability of businesses to remedy violations before being penalized for violations and increased the penalties for such violations. Most of the provisions of the CPREA took effect in 2023 but some portions, such as the creation of the new state agency, went into effect immediately.
These laws could adversely impact the business of the Bank by resulting in increased operating expenses as well as additional exposure to the risk of litigation by or on behalf of consumers.
Capital Standards
The FRB and the federal banking agencies have in place risk-based capital standards applicable to U.S. bank holding companies and banks. In July 2013, the FRB and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the guidelines published by the Basel Committee on Banking Supervision (“Basel Committee”) known as the Basel III Global Regulatory Framework for Capital and Liquidity. The Basel Committee is a committee of banking supervisory authorities from major countries in the global financial system which formulates broad supervisory standards and guidelines relating to financial institutions for implementation on a country-by-country basis. These rules adopted by the FRB and the other federal banking agencies (“the U.S. Basel III Capital Rules”) replaced the federal banking agencies’ general risk-based capital rules, advanced approaches rule, market risk rule, and leverage rules, in accordance with certain transition provisions.
Banks, such as First Northern, became subject to these rules on January 1, 2015. The rules implemented higher minimum capital requirements, include a common equity Tier 1 capital requirement, and established criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. The final rules provided for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.5%; (b) a Tier 1 capital ratio of 6%; (c) a total capital ratio of 8%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4%. Under these rules, in order to avoid certain limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk-based capital requirements (equal to 2.5% of total risk-weighted assets). The capital conservation buffer is designed to absorb losses during periods of economic stress. First Northern believes that it was in compliance with these requirements at December 31, 2023.
Pursuant to the EGRRCPA, the FRB adopted a final rule, effective August 31, 2018, amending the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement (the “policy statement”) to increase the consolidated assets threshold to qualify to utilize the provisions of the policy statement from $1 billion to $3 billion. Bank holding companies, such as the Company, are subject to capital adequacy requirements of the FRB; however, bank holding companies which are subject to the policy statement are not subject to compliance with the regulatory capital requirements until they hold $3 billion or more in consolidated total assets. As a consequence, as of December 31, 2023, the Company was not required to comply with the FRB’s regulatory capital requirements until such time that its consolidated total assets equal $3 billion or more or if the FRB determines that the Company is no longer deemed to be a small bank holding company. However, if the Company had been subject to these regulatory capital requirements, it would have exceeded all regulatory requirements.
In August of 2020, the federal banking agencies adopted the final version of the community bank leverage ratio framework rule (the “CBLR”), implementing two interim final rules adopted in April of 2020. The rule provides an optional, simplified measure of capital adequacy. Under the optional CBLR framework, the CBLR was 8.5% through calendar year 2021 and 9% thereafter. The rule is applicable to all non-advanced approaches FDIC-supervised institutions with less than $10 billion in total consolidated assets. Banks not electing the CBLR framework will continue to be subject to the generally applicable risk-based capital rule. At the present time, the Company and the Bank do not intend to elect to use the CBLR framework.
The following table presents the capital ratios for the Bank as of December 31, 2023 (calculated in accordance with the Basel III capital rules):
| | The Bank | |
| | 2023 | | | Adequately Capitalized | | | Well Capitalized | |
| | Capital | | Ratio | | | Ratio* | | | Ratio | |
Tier 1 Leverage Capital (to Average Assets) | | | | | | | | | | | | | | |
Common Equity Tier 1 Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | |
Tier 1 Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | |
Total Risk-Based Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | |
* Ratio for regulatory requirement excludes the capital conservation buffer of 2.50%.
The federal banking agencies must take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution’s ability to manage those risks, when determining the adequacy of an institution’s capital. This evaluation will be made as a part of the institution’s regular safety and soundness examination. The federal banking agencies must also consider interest rate risk (when the interest rate sensitivity of an institution’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluating a Bank’s capital adequacy.
In January 2014, the Basel Committee issued an updated version of its leverage ratio and disclosure guidance (“Basel III leverage ratio”), which were implemented beginning January 1, 2023. The Basel Committee guidance continues to set a minimum Basel III leverage ratio of 3%. The Basel Committee, in December 2017, adopted further revisions to the Basel III capital standards (“Basel IV”) which refined the definition of the leverage ratio “exposure measures” (the Basel III term for non risk-weighted assets). On July 27, 2023, the federal banking agencies issued a proposed rule to implement the final components of the Basel III standards set by the Basel Committee on Banking Supervision in 2017. The proposed rule, which would not apply to the Company and the Bank as proposed, would substantially revise the existing regulatory capital framework for institutions with $100 billion or more of assets.
Prompt Corrective Action and Other Enforcement Mechanisms
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, under-capitalized, significantly undercapitalized, and critically undercapitalized.
Under the prompt corrective action provisions of FDICIA, an insured depository institution generally will be classified in one of five capital categories ranging from “well capitalized” to “critically under-capitalized.”
An institution that, based upon its capital levels, is classified as “well capitalized,” “adequately capitalized” or “under-capitalized” may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to increased restrictions on its operations. Management believes that at December 31, 2023, the Company and the Bank exceeded the required ratios for classification as “well capitalized.” Institutions that are “under-capitalized” or lower are subject to certain mandatory supervisory corrective actions. Failure to meet regulatory capital guidelines can result in a bank being required to raise additional capital. An “under-capitalized” bank must develop a capital restoration plan and its parent holding company must generally guarantee compliance with the plan.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted. Additionally, a holding company’s inability to serve as a source of strength to its subsidiary banking organizations could serve as a further basis for a regulatory action against the holding company.
Safety and Soundness Standards
FDICIA also implemented certain specific restrictions on transactions and required federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder, or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.
The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution’s non-compliance with one or more standards.
Restrictions on Dividends and Other Distributions
The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and liquidity needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.
The federal banking agencies also have authority to prohibit a depository institution from engaging in business practices, which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.
In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank’s net income for its last three fiscal years (less any distributions to shareholders during such period). In the event a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with the prior approval of the DFPI in an amount not exceeding the greatest of the bank’s retained earnings, the bank’s net income for its last fiscal year, or the bank’s net income for its current fiscal year.
Premiums for Deposit Insurance
The Bank is a member of the Deposit Insurance Fund (“DIF”) maintained by the FDIC. Through the DIF, the FDIC insures the deposits of the Bank up to prescribed limits for each depositor. To maintain the DIF, member institutions are assessed an insurance premium based on their deposits and their institutional risk category. The FDIC determines an institution’s risk category by combining its supervisory ratings with its financial ratios and other risk measures. The FDIC also has the authority to impose special assessments at any time it estimates that DIF reserves could fall to a level that would adversely affect public confidence.
In September, 2020, the FDIC board of directors voted to adopt a restoration plan to restore the DIF reserve ratio to at least 1.35% within 8 years as required by the FDIC Act. This action was in response to the reserve ratio dropping to 1.30% primarily due to the inflow of more than $1 trillion in estimated insured deposits in the first six month of 2020 resulting mainly from the pandemic, monetary policy actions, direct government assistance and an overall reduction in business spending. 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 DIF reserve ratio to the required statutory minimum of 1.35% by the statutory deadline of September 30, 2028. Under the final rule, the increase in rates began 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 the Bank and is projected to have an insignificant effect on the Company’s capital levels and net income.
Deposit insurance assessments and assessment rates are subject to change by the FDIC and can be impacted by the overall economy and the stability of the banking industry as a whole. On November 16, 2023, the FDIC issued a final rule to implement a special assessment to recover the loss to the DIF associated with protecting uninsured depositors following the closure of Silicon Valley Bank and Signature Bank. Under the final rule, the assessment base for an insured depository institution will be equal to the institution’s estimated uninsured deposits as of December 31, 2022, adjusted to exclude the first $5 billion in estimated uninsured deposits. Under the final rule, the FDIC will collect the special assessment at an annual rate of 13.4 basis points beginning with the first quarterly assessment period of 2024 and will continue to collect special assessments for an anticipated total of eight quarterly assessment periods. This special assessment did not apply to the Bank; however, there can be no assurance that the FDIC will not impose special assessments on, or increase annual assessments payable by, the Bank in the future. The ultimate effect on our business of legislative, regulatory and economic developments on the DIF cannot be predicted with certainty. 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 and Fair Lending
The Bank is subject to certain fair lending requirements and reporting obligations involving its home mortgage lending operations and is also subject to the Community Reinvestment Act (“CRA”). The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of the Bank’s local communities, including low- and moderate-income neighborhoods. In addition to substantive penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when reviewing other activities by the Bank, particularly applications involving business expansion such as acquisitions or de novo branching.
On October 24, 2023, the federal banking agencies jointly issued a final rule to strengthen and modernize the existing CRA regulations. Under the final rule, the agencies will evaluate a bank’s CRA performance based upon the varied activities that it conducts and the communities in which it operates. CRA evaluations and data collection requirements will be tailored based on bank size and type. Under the final rule, the Bank would be considered an intermediate bank (with assets of at least $600 million and less than $2 billion) and therefore will be evaluated under a new retail lending test and will have the flexibility to remain under the existing CD test under the current rule or opt into a new Community Development Financing Test. The final rule includes CRA assessment areas associated with mobile and online banking, and new metrics and benchmarks to assess retail lending performance. In addition, the final rule emphasizes smaller loans and investments that can have a high impact and be more responsive to the needs of low- and moderate-income communities. The final rule exempts small and intermediate banks from new data requirements that apply to banks with assets of at least $2 billion and limits certain new data collection and reporting requirements to large banks with assets greater than $10 billion. The final rule will take effect on April 1, 2024; however, compliance with the majority of the final rule’s provisions will not be required until January 1, 2026, and the data reporting requirements of the final rule will not take effect until January 1, 2027.
Cybersecurity
The federal banking regulators regularly issue new guidance and standards, and update existing guidance and standards, regarding cybersecurity intended to enhance cyber risk management among financial institutions. Financial institutions are expected to comply with such guidance and standards and to accordingly develop appropriate security controls and risk management processes. If we fail to observe such regulatory guidance or standards, we could be subject to various regulatory sanctions, including financial penalties. In 2023, the SEC issued a final rule that requires disclosure of material cybersecurity incidents, as well as cybersecurity risk management, strategy and governance. Under this rule, banking organizations that are SEC registrants must generally disclose information about a material cybersecurity incident within four business days of determining it is material with periodic updates as to the status of the incident in subsequent filings as necessary.
Under a final rule adopted by federal banking agencies in 2021, banking organizations are required to notify their primary banking regulator within 36 hours of determining that a “computer-security incident” has materially disrupted or degraded, or is reasonably likely to materially disrupt or degrade, the banking organization’s ability to carry out banking operations or deliver banking products and services to a material portion of its customer base, its businesses and operations that would result in material loss, or its operations that would impact the stability of the United States. The federal banking agencies have also adopted guidelines for establishing information security standards and cybersecurity programs for implementing safeguards under the supervision of the board of directors. These guidelines, along with related regulatory materials, increasingly focus on risk management and processes related to information technology and the use of third parties in the provision of financial services. Moreover, recent cyberattacks against banks and other financial institutions that resulted in unauthorized access to confidential customer information have prompted the federal banking regulators to issue more extensive guidance on cybersecurity risk management. Among other things, financial institutions are expected to design multiple layers of security controls to establish lines of defense and ensure that their risk management processes address the risks posed by compromised customer credentials, including security measures to authenticate customers accessing internet-based services. A financial institution also should have a robust business continuity program to recover from a cyberattack and procedures for monitoring the security of third-party service providers that may have access to nonpublic data at the institution.
State regulators have also been increasingly active in implementing privacy and cybersecurity standards and regulations. Recently, several states have adopted regulations requiring certain financial institutions to implement cybersecurity programs and many states, including Texas, have also recently implemented or modified their data breach notification, information security and data privacy requirements. We expect this trend of state-level activity in those areas to continue and are continually monitoring developments in the states in which our customers are located.
Risks and exposures related to cybersecurity attacks, including litigation and enforcement risks, are expected to be elevated for the foreseeable future due to the rapidly evolving nature and sophistication of these threats, as well as due to the expanding use of Internet banking, mobile banking and other technology-based products and services by us and our customers.
See Item 1A. “Risk Factors” for a further discussion of risks related to cybersecurity and Item 1C. “Cybersecurity” for a further discussion of risk management strategies and governance processes related to cybersecurity.
Certain CFPB Rules
The Consumer Financial Protection Bureau (“CFPB”) has adopted an Ability-to-Repay rule that all newly originated residential mortgages must meet. The Ability-to-Repay rule establishes guidelines that the lender must follow when reviewing an applicant’s income, obligations, assets, liabilities, and credit history and requires that the lender make a reasonable and good faith determination of an applicant’s ability to repay the loan according to its terms. Lenders will be presumed to have met the Ability-to-Repay rule by originating loans that meet the criteria for “Qualified Mortgages”, which are set forth in detail in the rule. The mortgage loans originated by the Bank with the intent to sell them to Freddie Mac meet the Qualified Mortgage criteria.
The CFPB has also adopted a rule on simplified and improved mortgage loan disclosures, otherwise known as Know Before You Owe. The rule provides that mortgage borrowers receive a loan estimate three business days after application and a closing disclosure three days before closing. These forms replace disclosure forms previously provided to borrowers under other provisions of federal law. The rule provides for limitations on application fees and increases in closing costs.
Any new regulatory requirements promulgated by the CFPB could have an adverse impact on our residential mortgage lending business as the industry adapts to the additional regulations. Our business strategy, product offerings and profitability may change as the market adjusts to any additional regulations and as these requirements are interpreted by the regulators and courts.
Conservatorship and Receivership of Insured Depository Institutions
If any insured depository institution becomes insolvent and the FDIC is appointed its conservator or receiver, the FDIC may, under federal law, disaffirm or repudiate any contract to which such institution is a party, if the FDIC determines that performance of the contract would be burdensome, and that disaffirmance or repudiation of the contract would promote the orderly administration of the institution’s affairs. Such disaffirmance or repudiation would result in a claim by its holder against the receivership or conservatorship. The amount paid upon such claim would depend upon, among other factors, the amount of receivership assets available for the payment of such claim and its priority relative to the priority of others. In addition, the FDIC as conservator or receiver may enforce most contracts entered into by the institution notwithstanding any provision providing for termination, default, acceleration, or exercise of rights upon or solely by reason of insolvency of the institution, appointment of a conservator or receiver for the institution, or exercise of rights or powers by a conservator or receiver for the institution. The FDIC as conservator or receiver also may transfer any asset or liability of the institution without obtaining any approval or consent of the institution’s shareholders or creditors.
The Dodd-Frank Act
The Dodd-Frank Act, enacted in 2010, has resulted in sweeping changes to the U.S. financial system and financial institutions, including us. Many of the law’s provisions have been implemented by rules and regulations of the federal banking agencies. The law contains many provisions which have particular relevance to our business, including provisions that have resulted in adjustments to our FDIC deposit insurance premiums and that resulted in increased capital and liquidity requirements, increased supervision, increased regulatory and compliance risks and costs and other operational costs and expenses, reduced fee-based revenues and restrictions on some aspects of our operations, and increased interest expense on our demand deposits. In May 2018, the President signed into law the EGRRCPA, which amended various provisions of the Dodd-Frank Act as well as other federal banking statutes. See “The Effect of Government Policy on Banking” above for additional information.
The environment in which financial institutions continue to operate since the U.S. financial crisis, including legislative and regulatory changes affecting capital, liquidity, supervision, permissible activities, corporate governance and compensation, and changes in fiscal policy may have long-term effects on the business model and profitability of financial institutions that cannot now be foreseen.
Overdraft and Interchange Fees
The FRB’s Regulation E imposes restrictions on banks’ abilities to charge overdraft services and fees. The rule prohibits financial institutions from charging fees for paying overdrafts on ATM and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. The Dodd-Frank Act, through a provision known as the Durbin Amendment, required the FRB to establish standards for interchange fees that are “reasonable and proportional” to the cost of processing debit card transactions and imposes other requirements on card networks. Under the rule, the maximum permissible interchange fee that a bank may receive is the sum of $0.21 per transaction and five basis points multiplied by the value of the transaction, with an additional upward adjustment of no more than $0.01 per transaction if a bank develops and implements policies and procedures reasonably designed to achieve fraud-prevention standards set by regulation. This regulation has resulted in decreased revenues and increased compliance costs for the banking industry and the Bank, and there can be no assurance that alternative sources of revenues can be implemented to offset the impact of these developments.
Possible Future Legislation and Regulatory Initiatives
The economic and political environment of the past several years has led to a number of proposed legislative, governmental and regulatory initiatives, at both the federal and state levels, certain of which are described above, that may significantly impact our industry. These and other initiatives could significantly change the competitive and operating environment in which we and our subsidiaries operate. We cannot predict whether these or any other proposals will be enacted or the ultimate impact of any such initiatives on our operations, competitive situation, financial condition or results of operations.
The results of the 2024 national elections and a shift of control in the U.S. Senate could lead to new legislative and regulatory initiatives or the roll-back of initiatives of the previous Administration which could have significant impact on the banking and financial services industry and on our business. We cannot assess at this time the degree to which this may occur.
A change of Administration in Washington, D.C. could also likely result in changes in the leadership and other senior positions at the federal bank regulatory agencies. We cannot assess at this time the impact such changes would have on the banking and financial services industry and on our business.
Competition
In the past, an independent bank’s principal competitors for deposits and loans have been other banks, savings and loan associations, and credit unions. Many of these competitors are large financial institutions that have substantial capital, technology and marketing resources, which are well in excess of ours, although these larger institutions may be required to hold more regulatory capital and as a result, achieve lower returns on equity. For agricultural loans, the Bank also competes with constituent entities with the Federal Farm Credit System. To a lesser extent, competition is also provided by thrift and loans, mortgage brokerage companies and insurance companies. Other institutions, such as brokerage houses, mutual fund companies, credit card companies, and even retail establishments have offered new investment vehicles, which also compete with banks for deposit business. Additionally, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and payment systems. We also experience competition, especially for deposits, from internet-based banking institutions and other financial companies, which do not always have a presence in our market footprint and have grown rapidly in recent years.
Current federal law has made it easier for out-of-state banks to enter and compete in California. Competition in our principal markets has further intensified as a result of the Dodd-Frank Act which, among other things, permitted out-of-state de novo branching by national banks, state banks and foreign banks from other states.
The business of banking in California remains highly competitive. Competition in our industry is likely to further intensify as a result of continued consolidation of financial services companies, including consolidations of significance in our market area. In order to compete with major financial institutions and other competitors in its primary service areas, the Bank relies upon the experience of its executive and senior officers in serving business clients, and upon its specialized services, local promotional activities and the personal contacts made by its officers, directors and employees.
For customers whose loan demand exceeds the Bank’s legal lending limit, the Bank may arrange for such loans on a participation basis with correspondent banks. In the past, the seasonal swings, discussed below in “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Liquidity”, have had some impact on the Bank’s liquidity. The management of investment maturities, sale of loan participations, federal fund borrowings, qualification for funds under the Federal Reserve Bank’s seasonal credit program, and the ability to sell mortgages in the secondary market is intended to allow the Bank to satisfactorily manage its liquidity.
In addition to factors mentioned elsewhere in this Report, the factors contained below, among others, could cause our financial condition and results of operations to be materially and adversely affected. If this were to happen, the value of our common stock could decline, perhaps significantly, and you could lose all or part of your investment.
Recent Negative Developments in the Banking Industry, and any Legislative and/or Bank Regulatory Actions that may Result, Could Adversely Affect our Business Operations, Results of Operations and Financial Condition.
The high-profile bank failures of Silicon Valley Bank, Signature Bank and First Republic Bank last year, and related negative media attention, generated significant market trading volatility among publicly-traded bank holding companies and, in particular, regional and community banks, such as the Company. These developments negatively impacted customer confidence in the safety and soundness of regional and community banks. The FDIC took steps to ensure that depositors of these failed banks would have access to their deposits, including uninsured deposit accounts. U.S. bank regulators have taken action in an effort to further strengthen public confidence in the banking system through the creation of a new Bank Term Funding Program. Defaults by, or even rumors or questions about, one or more financial institutions 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. There can be no assurance that actions will be successful in restoring customer confidence in regional and community banks and the banking system more broadly.
While we currently do not anticipate liquidity constraints of the kind that caused these other financial services institutions to fail or require external support, constraints on our liquidity could occur as a result of customers choosing to maintain their deposits with larger financial institutions or to invest in higher yielding short-term fixed income securities, which could materially adversely impact our liquidity, cost of funding, loan funding capacity, net interest margin, capital and results of operations. If we were required to sell a portion of our securities portfolio to address liquidity needs, we may incur losses, including as a result of the negative impact of rising interest rates on the value of our securities portfolio, which could negatively affect our earnings and our capital. While the Company has taken actions to maintain adequate and diversified sources of funding and management believes that its liquidity measures are reasonable in light of the nature of the Bank’s customer base, there can be no assurance that such actions will be sufficient in the event of a sudden liquidity crisis.
These recent events may also result in potentially adverse changes to laws or regulations governing banks and bank holding companies, enhanced regulatory supervision and examination policies and priorities, and/or the imposition of restrictions through regulatory supervisory or enforcement activities, including higher capital requirements and/or an increase in the Bank’s deposit insurance assessments. Although these legislative and regulatory actions cannot be predicted with certainty, any of these potential legislative or regulatory actions could, among other things, subject us to additional costs, limit the types of financial services and products we may offer, and reduce our profitability, any of which could materially and adversely affect our business, results of operations or financial condition. The FDIC has recently proposed that Congress consider various changes in the FDIC insurance program, including possible increases in the deposit insurance limit for certain types of accounts, such as business payment accounts.
Economic Conditions in the U.S. May Soften or Become Recessionary with Resultant Adverse Consequences for the U.S. Financial Services Industry and for the Bank
Following the financial crisis of 2008, adverse financial and economic developments impacted U.S. and global economies and financial markets and presented challenges for the banking and financial services industry and for us. These developments included a general recession both globally and in the U.S. accompanied by substantial volatility in the financial markets.
In response, various significant economic and monetary stimulus measures were implemented by the U.S. government. The FRB also pursued a highly accommodative monetary policy aimed at keeping interest rates at historically low levels. The more recent tightening of the Federal Reserve’s monetary policies, including repeated and aggressive increases in target range for the federal funds rate as well as the conclusion of the Federal Reserve’s tapering of asset purchases, together with ongoing economic and geopolitical instability, increases the risk of an economic recession. Although forecasts have varied, many economists are projecting that, while indicators of U.S. economic performance, such as income growth, may be strong and levels of inflation may continue to decrease, the U.S. economy may be flat or experience a modest decrease in gross domestic output in 2024 while inflation is expected to remain elevated relative to historic levels in the coming quarters.
We, and other financial services companies, are impacted to a significant degree by current economic conditions. If the U.S. economy weakens, our growth and profitability from our lending, deposit and investment operations could be constrained and our asset quality, deposit levels, loan demand and results of operations may be adversely affected.
The U.S. government continues to face significant fiscal and budgetary challenges which, if not resolved, could result in renewed adverse U.S. economic conditions. These challenges may be intensified over time if federal budget deficits were to increase and Congress and the Administration cannot effectively work to address them. The overall level of the federal government’s debt, the extensive political disagreements regarding the government’s statutory debt limit and the continuing substantial federal budget deficits led to a downgrade from “AAA” to “AA+” of the long-term sovereign credit rating of United States debt by one credit rating agency, although other credit rating agencies did not take such action. This risk could be exacerbated over time.
If substantial federal budget deficits were to continue or increase in the years ahead, further downgrades by the credit rating agencies with respect to the obligations of the U.S. federal government could occur. Any such further downgrades could increase over time the U.S. federal government’s cost of borrowing, which may worsen its fiscal challenges, as well as generate further upward pressure on interest rates generally in the U.S. which could, in turn, have adverse consequences for borrowers and the level of business activity. The long-term impact of this situation, including the impact to the Bank’s investment securities portfolio and other assets, cannot be predicted.
The Bank is Subject to Lending Risks of Loss and Repayment Associated with Commercial Banking Activities
The Bank’s business strategy is to focus on commercial business loans (which includes agricultural loans), construction loans, and commercial and multi-family real estate loans. The principal factors affecting the Bank’s risk of loss in connection with commercial business loans include the borrower’s ability to manage its business affairs and cash flows, general economic conditions, and, with respect to agricultural loans, weather and climate conditions.
For a number of years, California has also experienced severe drought, wildfires or other natural disasters. It can be expected that these events will continue to occur from time to time in the areas served by the Bank, and that the consequences of these natural disasters, including public utility public safety power outages when weather conditions and fire danger warrant, may adversely affect the Bank’s business and that of its commercial loan customers, particularly in the agricultural sector.
Loans secured by commercial real estate are generally larger and involve a greater degree of credit and transaction risk than residential mortgage (one to four family) loans. Because payments on loans secured by commercial and multi-family real estate properties are often dependent on successful operation or management of the underlying properties, repayment of such loans may be dependent on factors other than the prevailing conditions in the real estate market or the economy. Real estate construction financing is generally considered to involve a higher degree of credit risk than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development compared to the estimated cost (including interest) of construction. If the estimate of value proves to be inaccurate, the Bank may be confronted with a project which, when completed, has a value which is insufficient to assure full repayment of the construction loan. For additional information, see “The Bank’s Dependence on Real Estate Lending Increases Our Risk of Losses”, below in these “Risk Factors” in this Annual Report on Form 10-K.
Although the Bank manages lending risks through its underwriting and credit administration policies, no assurance can be given that such risks will not materialize, in which event, the Company’s financial condition, results of operations, cash flows, and business prospects could be materially adversely affected.
Increases in the Allowance for Credit Losses Would Adversely Affect the Bank’s Financial Condition and Results of Operations
The Bank’s allowance for credit losses on loans was approximately $16.6 million, or 1.55% of total loans, at December 31, 2023, compared to $14.8 million, or 1.50% of total loans, at December 31, 2022, and 199.1% of total non-performing loans net of guaranteed portions at December 31, 2023, compared to 172.4% of total non-performing loans, net of guaranteed portions at December 31, 2022. Provision for credit losses totaling $1.1 million and $0.9 million for the years ended December 31, 2023 and 2022, respectively. The provision for credit losses for the years ended December 31, 2023 and 2022 was primarily due to loan growth.
Material future additions to the allowance for estimated losses on loans may be necessary if material adverse changes in economic conditions in our markets were to continue to occur and the performance of the Bank’s loan portfolio were to deteriorate.
An allowance for credit losses on other real estate owned may also be required in order to reflect changes in the markets for real estate in which the Bank’s other real estate owned is located and other factors which may result in adjustments which are necessary to ensure that the Bank’s foreclosed assets are carried at the lower of cost or fair value, less estimated costs to dispose of the properties. Moreover, the FDIC and the California DFPI, as an integral part of their examination process, periodically review the Bank’s allowance for credit losses on loans and the carrying value of its assets. Increases in the provisions for estimated losses on loans and foreclosed assets would adversely affect the Bank’s financial condition and results of operations.
The Bank’s Dependence on Real Estate Lending Increases Our Risk of Losses
The Bank’s primary lending focus has historically been commercial (including agricultural), construction, and real estate mortgage. At December 31, 2023, real estate mortgage (excluding loans held-for-sale) and construction loans (residential and other) comprised approximately 89% and 3%, respectively, of the total loans in the Bank’s portfolio. At December 31, 2023, all of the Bank’s real estate mortgage and construction loans and approximately 1% of its commercial loans were secured fully or in part by deeds of trust on underlying real estate. The Company’s dependence on real estate increases the risk of loss in both the Bank’s loan portfolio and its holdings of other real estate owned if economic conditions in Northern California were to deteriorate. Deterioration of the real estate market in Northern California would have a material adverse effect on the Company’s business, financial condition, and results of operations.
The CFPB has adopted various regulations which have impacted, and will continue to impact, our residential mortgage lending business.
Adverse Economic Factors Affecting Certain Industries the Bank Serves Could Adversely Affect Our Business
The Bank is subject to certain industry-specific economic factors. For example, a portion of the Bank’s total loan portfolio is related to residential and commercial real estate, especially in California. Increases in residential mortgage loan interest rates could have an adverse effect on the Bank’s operations by depressing new mortgage loan originations, which in turn could negatively impact the Bank’s title and escrow deposit levels. Additionally, a downturn in the residential real estate and housing industries in California could have an adverse effect on the Bank’s operations and the quality of its real estate and construction loan portfolio. Although the Bank does not engage in subprime or negative amortization lending, we are not immune to volatility in the real estate market. Real estate valuations are influenced by demand, and demand is driven by economic factors such as employment rates and interest rates, which have been, and may continue to be, affected by the pandemic. These factors could adversely impact the quality of the Bank’s residential construction, residential mortgage and construction related commercial portfolios in various ways, including by decreasing the value of the collateral for our loans, and thereby negatively affecting the Bank’s overall loan portfolio.
The Bank provides financing to, and receives deposits from, businesses in a number of other industries that may be particularly vulnerable to industry-specific economic factors, including the home building, commercial real estate, retail, agricultural, industrial, and commercial industries. Following the financial crisis of 2008, the home building industry in California was especially adversely impacted by the deterioration in residential real estate markets, which lead the Bank to take additional provisions and charge-offs against credit losses in this portfolio. The recessionary economic and market conditions resulting from the COVID-19 pandemic also significantly affected the commercial and residential real estate markets in the U.S. generally, and in California in particular, decreasing property values, increasing the risk of defaults and reducing the value of real estate collateral. Continued volatility in fuel prices and energy costs and drought conditions in California could also adversely affect businesses in several of these industries.
Industry specific risks are beyond the Bank’s control and could adversely affect the Bank’s portfolio of loans, potentially resulting in an increase in non-performing loans or charge-offs and a slowing of growth or reduction in our loan portfolio.
In recent years, wildfires across California and in our market areas resulted in significant damage and destruction of property and equipment. The fire damage caused resulted in adverse economic impacts to those affected markets and beyond and on the Bank’s customers. In addition, the major electric utility company in our region has adopted programs of electrical power shut-offs, often for multiple days, in wide areas of Northern California during periods of high winds and high fire danger. Shut-offs of power by this utility have adversely impacted the business of some of our customers and also have resulted in some of our branches being temporarily closed. It can be expected that these events will continue to occur from time to time in the areas served by the Bank, and that the consequences of these natural disasters, including programs of public utility public safety power outages when weather conditions and fire danger warrant, may adversely affect the Bank’s business and that of its customers. It is also possible that climate change may be increasing the severity or frequency of adverse weather conditions, thus increasing the impact of these types of natural disasters on our business and that of our customers.
The long-term impact of these developments on the markets we serve cannot be predicted at this time.
The Effects of Changes or Increases in, or Supervisory Enforcement of, Banking or Other Laws and Regulations or Governmental Fiscal or Monetary Policies Could Adversely Affect Us
We are subject to significant federal and state banking regulation and supervision, which is primarily for the benefit and protection of our customers and the Deposit Insurance Fund and not for the benefit of investors in our securities. In the past, our business has been materially affected by these regulations. This will continue and likely intensify in the future. Laws, regulations or policies, including accounting standards and interpretations, currently affecting us may change at any time. Regulatory authorities may also change their interpretation of and intensify their examination of compliance with these statutes and regulations. Therefore, our business may be adversely affected by changes in laws, regulations, policies or interpretations or regulatory approaches to compliance and enforcement, as well as by supervisory action or criminal proceedings taken as a result of noncompliance, which could result in the imposition of significant civil money penalties or fines. Changes in laws and regulations may also increase our expenses by imposing additional supervision, fees, taxes or restrictions on our operations. Compliance with laws and regulations, especially new laws and regulations, increases our operating expenses and may divert management attention from our business operations.
Following the imposition in 2008 of a federal government conservatorship on the two government-sponsored enterprises (“GSEs”) in the housing finance industry, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association, various proposals have been advanced from time to time to reform the role of the GSEs in the housing finance market. These proposals, among other things, include reducing or eliminating over time the role of the GSEs in guaranteeing mortgages and providing funding for mortgage loans, as well as the implementation of reforms relating to borrowers, lenders, and investors in the mortgage market, including reducing the maximum size of a loan that the GSEs can guarantee, phasing in a minimum down payment requirement for borrowers, improving underwriting standards, and increasing accountability and transparency in the securitization process.
The GSEs remain in federal government conservatorship at this time and proposals for the reform of their role are not being actively pursued in Congress or by the current Administration. However, this could change at any time and GSE reform could again become a subject under active consideration and if adopted, could well have a substantial impact on the mortgage market and could reduce our income from mortgage originations by increasing mortgage costs or lowering originations. GSE reforms could also reduce real estate prices, which could reduce the value of collateral securing outstanding mortgage loans. This reduction of collateral value could negatively impact the value or perceived collectability of these mortgage loans and may increase our allowance for credit loan losses. Such reforms may also include changes to the Federal Home Loan Bank System, which could adversely affect a significant source of term funding for lending activities by the banking industry, including the Bank. These reforms may also result in higher interest rates on residential mortgage loans, thereby reducing demand, which could have an adverse impact on our residential mortgage lending business.
In July 2013, the FRB and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the Basel III Global Regulatory Framework for Capital and Liquidity. For additional information, see “Business-Capital Standards” in Item 1 of this Form 10-K.
We maintain systems and procedures designed to comply with applicable laws and regulations. However, some legal/regulatory frameworks provide for the imposition of criminal or civil penalties (which can be substantial) for noncompliance. In some cases, liability may attach even if the noncompliance was inadvertent or unintentional and even if compliance systems and procedures were in place at the time. There may be other negative consequences from a finding of noncompliance, including restrictions on certain activities and damage to our reputation.
Additionally, our business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies. We are particularly affected by the policies of the FRB, which regulates the supply of money and credit in the U.S. Under the Dodd-Frank Act and a long-standing policy of the FRB, a bank holding company is expected to act as a source of financial and managerial strength for its subsidiary banks. As a result of that policy, we may be required to commit financial and other resources to our subsidiary bank in circumstances where we might not otherwise do so. Among the instruments of monetary policy available to the FRB are (a) conducting open market operations in U.S. Government securities, (b) changing the discount rates on borrowings by depository institutions and the federal funds rate, and (c) imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. The policies of the FRB can be expected to have a material effect on our business, prospects, results of operations and financial condition.
Refer to “Business – Supervision and Regulation of Bank Holding Companies” and “Business – Supervision and Regulation of the Bank” in Item 1 of this Form 10-K for discussion of certain existing and proposed laws and regulations that may affect our business.
The Bank is Subject to Interest Rate Risk
The income of the Bank depends to a great extent on “interest rate differentials” and the resulting net interest margins (i.e., the difference between the interest rates earned on the Bank’s interest-earning assets such as loans and investment securities, and the interest rates paid on the Bank’s interest-bearing liabilities such as deposits and borrowings). Changes in the relationship between short-term and long-term market interest rates or between different interest rate indices can impact our interest rate differential, possibly resulting in a decrease in our interest income relative to interest expense. Interest rates are highly sensitive to many factors, which are beyond the Bank’s control, including, but not limited to, general economic conditions and the policies of various governmental and regulatory agencies, in particular, the FRB. Changes in monetary policy, including changes in interest rates, influence the origination of loans, the purchase of investments and the generation of deposits and affect the rates received on loans and investment securities and paid on deposits. 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. Starting in 2022 and continuing through 2023, 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 January 2022, due to elevated levels of inflation and corresponding pressure to raise interest rates, the FRB announced after several periods of historically low federal funds rates and yields on Treasury notes that it would be slowing the pace of its bond purchasing and increasing the target range for the federal funds rate over time. The FOMC since has increased the target range 11 times throughout 2022 and 2023. As of December 31, 2023, the target range for the federal funds rate had been increased to 5.25% to 5.50%. It remains uncertain whether the FOMC will further increase the target range for the federal funds rate to attain a monetary policy sufficiently restrictive to return inflation to more normalized levels, begin to reduce the federal funds rate or leave the rate at its current elevated level for a lengthy period of time. 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 2024 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.
Beginning in 2021, the U.S. economy exhibited relatively rapid rates of increase in the consumer price index and other economic indices. 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 credit 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 well above the FRB’s long-term target could prompt broad-based selling of longer-duration, fixed-rate debt, which could have negative implications for equity and real estate markets. Lower interest rates enable less credit-worthy borrowers to more readily meet their debt obligations. 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. The FRB has initiated a series of significant interest rate increases in response to the recent economic developments. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Net Interest Income” below in this Annual Report on Form 10-K.
In addition, the war 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, could lead to higher costs for gas, food and goods in the U.S. and exacerbate the inflationary pressures on the economy, with potentially adverse impacts on our customers and on our business, results of operations and financial condition.
Our Ability to Pay Dividends is Subject to Legal Restrictions
As a bank holding company, our cash flow typically comes from dividends of the Bank. Various statutory and regulatory provisions restrict the amount of dividends the Bank can pay to the Company without regulatory approval. The ability of the Company to pay cash dividends in the future also depends on the Company’s profitability, growth, and capital needs. In addition, California law restricts the ability of the Company to pay dividends. For a number of years, the Company has paid stock dividends, but not cash dividends, to its shareholders. No assurance can be given that the Company will pay any dividends in the future or, if paid, such dividends will not be discontinued. See “Business - Restrictions on Dividends and Other Distributions” above.
Competition Adversely Affects our Profitability
In California generally, and in the Bank’s primary market area specifically, major banks dominate the commercial banking industry. By virtue of their larger capital bases, such institutions have substantially greater lending limits than those of the Bank. Competition is likely to further intensify as a result of the recent and increasing level of consolidation of financial services companies, particularly in our market area resulting from various economic and market conditions. In obtaining deposits and making loans, the Bank competes with these larger commercial banks and other financial institutions, such as savings and loan associations, credit unions and member institutions of the Farm Credit System, which offer many services that traditionally were offered only by banks. Using the financial holding company structure, insurance companies and securities firms may compete more directly with banks and bank holding companies. In addition, the Bank competes with other institutions such as mutual fund companies, brokerage firms, and even retail stores seeking to penetrate the financial services market. Current federal law has also made it easier for out-of-state banks to enter and compete in the states in which we operate. Competition in our principal markets has further intensified as a result of the Dodd-Frank Act which, among other things, permitted out-of-state de novo branching by national banks, state banks and foreign banks from other states. We also experience competition, especially for deposits, from internet-based banking institutions and other financial companies, which do not always have a physical presence in our market footprint and have grown rapidly in recent years. Also, technology and other changes increasingly allow parties to complete financial transactions electronically, and in many cases, without banks. For example, consumers can pay bills and transfer funds over the internet and by telephone without banks. Non-bank financial service providers may have lower overhead costs and are subject to fewer regulatory constraints. If consumers do not use banks to complete their financial transactions, we could potentially lose fee income, deposits and income generated from those deposits. During periods of declining interest rates, competitors with lower costs of capital may solicit the Bank’s customers to refinance their loans. Furthermore, during periods of economic slowdown or recession, the Bank’s borrowers may face financial difficulties and be more receptive to offers from the Bank’s competitors to refinance their loans. No assurance can be given that the Bank will be able to compete with these lenders. See “Business – Competition” above.
Government Regulation and Legislation Could Adversely Affect the Company
The Company and the Bank are subject to extensive state and federal regulation, supervision, and legislation, which govern almost all aspects of the operations of the Company and the Bank. The business of the Bank is particularly susceptible to being affected by the enactment of federal and state legislation, which may have the effect of increasing the cost of doing business, modifying permissible activities, or enhancing the competitive position of other financial institutions. Such laws are subject to change from time to time and are primarily intended for the protection of consumers, depositors and the Deposit Insurance Fund and not for the benefit of shareholders of the Company. Regulatory authorities may also change their interpretation of these laws and regulations. The Company cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on the business and prospects of the Company, but it could be material and adverse. See “Business – Supervision and Regulation of the Bank” and “The effects of changes or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us” above.
We maintain systems and procedures designed to comply with applicable laws and regulations. However, some legal/regulatory frameworks provide for the imposition of criminal or civil penalties (which can be substantial) for non-compliance. In some cases, liability may attach even if the non-compliance was inadvertent or unintentional and even if compliance systems and procedures were in place at the time. There may be other negative consequences from a finding of non-compliance, including restrictions on certain activities and damage to the Company’s reputation.
Our Controls and Procedures May Fail or be Circumvented Which Could Have a Material Adverse Effect on the Company’s Financial Condition or Results of Operations
The Company maintains controls and procedures to mitigate against risks such as processing system failures and errors, and customer or employee fraud, and maintains insurance coverage for certain of these risks. Any system of controls and procedures, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Events could occur which are not prevented or detected by the Company’s internal controls or are not insured against or are in excess of the Company’s insurance limits. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.
Changes in Deposit Insurance Premiums Could Adversely Affect Our Business
As discussed above in Part I under the caption “Business – Premiums for Deposit Insurance,” in September, 2020, the FDIC board of directors voted to adopt a restoration plan for the Deposit Insurance Fund to ensure that the ratio of the fund’s reserves to insured deposits reaches 1.35% within the next 8 years, as required by the Dodd-Frank Act. This action was in response to the reserve ratio dropping to 1.30% primarily due to the inflow of more than $1 trillion in estimated insured deposits in the first six month of 2020 resulting mainly from the pandemic, monetary policy actions, direct government assistance and an overall reduction in business spending. 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 DIF reserve ratio to the required statutory minimum of 1.35% by the statutory deadline of September 30, 2028. Under the final rule, the increase in rates began 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.
On November 16, 2023, the FDIC issued a final rule to implement a special assessment to recover the loss to the DIF associated with protecting uninsured depositors following the closure of Silicon Valley Bank and Signature Bank. This special assessment did not apply to the Bank; however, there can be no assurance that the FDIC will not impose special assessments on, or increase annual assessments payable by, the Bank in the future.
Any further increases in the deposit insurance assessments the Bank pays would further increase our costs.
Negative Public Opinion Could Damage Our Reputation and Adversely Affect Our Earnings
Reputational risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business. Negative public opinion can result from the actual or perceived manner in which we conduct our business activities, management of actual or potential conflicts of interest and ethical issues, lending practices, governmental enforcement actions, corporate governance deficiencies, use of social media, cyber-security breaches and our protection of confidential client information, the implementation of environmental, social and governance (ESG) practices, or from actions taken by regulators or community organizations in response to such actions. Negative public opinion can adversely affect our ability to keep and attract customers and employees and can expose us to claims and litigation and regulatory action and increased liquidity risk and could have a material adverse effect on the price of our stock.
We May Not Be Able to Hire or Retain Additional Qualified Personnel and Recruiting and Compensation Costs May Increase as a Result of Turnover, Both of Which May Increase Costs and Reduce Profitability and May Adversely Impact Our Ability to Implement Our Business Strategy
Our success depends upon the ability to attract and retain highly motivated, well-qualified personnel. We face significant competition in the recruitment and retention of qualified employees. Executive compensation in the financial services sector has been controversial and the subject of regulation. The FDIC has proposed rules which would increase deposit premiums for institutions with compensation practices deemed to increase risk to the institution. Over time, this guidance and the proposed rules, upon their adoption, could have the effect of making it more difficult for banks to attract and retain skilled personnel.
We May Be Adversely Affected by Unpredictable Catastrophic Events or Terrorist Attacks and Our Business Continuity and Disaster Recovery Plans May Not Adequately Protect Us from Serious Disaster
The occurrence of catastrophic events such as wildfires (including programs of public utility public safety power outages when weather conditions and fire danger warrant), earthquakes, flooding or other large-scale catastrophes and terrorist attacks could adversely affect our business, financial condition or results of operations if a catastrophe rendered both our production data center in Sacramento and our recovery data center in Las Vegas unusable. There can be no assurance that our current disaster recovery plans and capabilities will protect us from serious disaster.
Changes in Accounting Standards Could Materially Impact 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. Along with other factors, we use historical loss factors to determine the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical loss factors that we use. Other estimates that we use are fair value of our securities, expected useful lives of our depreciable assets, fair value of stock options, calculation of deferred tax assets and liabilities, and the value of our mortgage servicing rights. We have not entered into derivative contracts for our customers or for ourselves, which relate to interest rate, credit, equity, commodity, energy, or weather-related indices, other than forward commitments related to our loans held for sale portfolio. From time to time, the FASB and SEC change the financial accounting and reporting standards that govern the preparation of our financial statements or new interpretations of existing standards emerge as standard industry practice. These changes can be difficult to predict and operationally complex to implement and can materially impact 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.
On January 1, 2023, the Company adopted ASU 2016-13 Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which replaces the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (CECL) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized costs, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in certain leases. In addition, ASC 326 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities, based on management’s intent to sell the security, or likelihood the Company will be required to sell the security, before recovery of the amortized cost basis.
Upon adoption of ASU 2016-13, the Company made the accounting policy election to not measure an estimate of credit losses on accrued interest receivable as the Company writes off any uncollectible accrued interest receivable in a timely manner.
Results for the reporting periods beginning January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. Upon adoption of CECL, the Company recognized an increase in the ACL for loans and reserve for unfunded commitments totaling $1.3 million as a cumulative effect adjustment from change in accounting policies, with a corresponding decrease in retained earnings of $0.9 million, net of deferred taxes of $0.4 million.
There is a Limited Public Market for the Company’s Common Stock Which May Make It Difficult for Shareholders to Dispose of Their Shares
The Company’s common stock is not listed on any exchange. However, trades may be reported on the OTC Markets under the symbol “FNRN.” The Company is aware that JWTT, Inc., Monroe Securities and Raymond James all currently make a market in the Company’s common stock. Management is aware that there are also private transactions in the Company’s common stock. However, the limited trading market for the Company’s common stock may make it difficult for shareholders to dispose of their shares. Also, the price of the Company’s common stock may be affected by general market price movements as well as developments specifically related to the financial services sector, including interest rate movements, quarterly variations, or changes in financial estimates by securities analysts and a significant reduction in the price of the stock of another participant in the financial services industry.
Advances and Changes in Technology, and the Company’s Ability to Adapt Its Technology, May Strain Our Available Resources and Could Adversely Impact Our Ability to Compete and the Company’s Business and Operations
Advances and changes in technology can significantly impact the business and operations of the Company. The financial services industry is undergoing rapid technological change which regularly involves the introduction of new products and services based on new or enhanced technologies. Examples include cloud computing, artificial intelligence and machine learning, biometric authentication and data protection enhancements, as well as increased online and mobile device interaction with customers and increased demand for providing computer access to Bank accounts and the systems to perform banking transactions electronically. The Company’s merchant processing services require the use of advanced computer hardware and software technology and rapidly changing customer and regulatory requirements. The Company’s ability to compete effectively depends on its ability to continue to adapt its technology on a timely and cost-effective basis to meet these requirements. Our continued success and the maintenance of our competitive position depends, in part, upon our ability to meet the needs of our customers through the application of new technologies. If we fail to maintain or enhance our competitive position with regard to technology, whether because we fail to anticipate customer needs and expectations or because our technological initiatives fail to perform as desired or are not timely implemented, we may lose market share or incur additional expense. Our ability to execute our core operations and to implement technology and other important initiatives may be adversely affected if our resources are insufficient or if we are unable to allocate available resources effectively.
In addition, the Company’s business and operations are susceptible to negative impacts from computer system failures, communication and power disruption, and unethical individuals with the technological ability to cause disruptions or failures of the Company’s data processing systems.
Information Security Breaches or Other Technological Difficulties Could Adversely Affect the Company
Our operations rely on the secure processing, storage, transmission and reporting of personal, confidential and other sensitive information in our computer systems, networks and business applications. Although we take protective measures, our computer systems, as well as the systems of our third-party providers, may be vulnerable to breaches or attacks, unauthorized access, misuse, computer viruses or other malicious code, operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems, and other events that could have significant negative consequences to us. Such events could result in interruptions or malfunctions in our or our customers’ operations, interception, misuse or mishandling of personal or confidential information, or processing of unauthorized transactions or loss of funds. These events could result in litigation, regulatory enforcement actions, and financial losses that are either not insured against or not fully covered by our insurance, or result in regulatory consequences or reputational harm, any of which could harm our competitive position, operating results and financial condition. We maintain cyber insurance, but this insurance may not cover all costs associated with cyber incidents or the consequences of personal or confidential information being compromised. These types of incidents can remain undetected for extended periods of time, thereby increasing the associated risks. We may also be required to expend significant resources to modify our protective measures or to investigate and remediate vulnerabilities or exposures arising from cybersecurity risks.
We depend on the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and our employees in our day-to-day and ongoing operations. Our increasing dependence upon automated systems to record and process transactions may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. With regard to the physical infrastructure that supports our operations, we have taken measures to implement backup systems and other safeguards, but our ability to conduct business may be adversely affected by any disruption to that infrastructure. Failures in our internal control or operational systems, security breaches or service interruptions could impair our ability to operate our business and result in potential liability to customers, reputational damage and regulatory intervention, any of which could harm our operating results and financial condition.
We may also be subject to disruptions of our operating systems arising from other events that are wholly or partially beyond our control, such as outages related to electrical, internet or telecommunications, natural disasters (such as major seismic events), or unexpected difficulties with the implementation of our technology enhancement and replacement projects, which may give rise to disruption of service to customers and to financial loss or liability. Our business recovery plan may not work as intended or may not prevent significant interruptions of our operations.
In recent years, it has been reported that several of the larger U.S. banking institutions have been the target of various denial-of-service or other cyberattacks (including attempts to inject malicious code and viruses into computer systems) that have, for limited periods, resulted in the disruption of various operations of the targeted banks. These cyber-attacks originate from a variety of sophisticated sources who may be involved with organized crime, linked to terrorist organizations or hostile countries and have extensive resources to disrupt the operations of the Bank or the financial system more generally. The potential for denial-of-service and other attacks requires substantial resources to defend and may affect customer satisfaction and behavior. To date we have not experienced any material losses relating to cyberattacks or other information security breaches, but there can be no assurance that we will not suffer such losses or information security breaches in the future. A successful cyber-attack could result in a material disruption of the Bank’s operations, exposure of confidential information and financial loss to the Bank, its clients, customers and counterparties and could lead to significant exposure to litigation and regulatory fines, penalties and other sanctions as well as reputational damage. While we have a variety of cyber-security measures in place, the consequences to our business, if we were to become a target of such attacks, cannot be predicted with any certainty.
In addition, there have been increasing efforts on the part of third parties to breach data security at financial institutions or with respect to financial transactions, including through the use of social engineering schemes such as “phishing.” The ability of our customers to bank remotely, including online and though mobile devices, requires secure transmission of confidential information and increases the risk of data security breaches which would expose us to claims by customers or others and which could adversely affect our reputation and could lead to a material loss.
We, and other banking institutions, are also at risk of increased losses from fraudulent conduct of criminals using increasingly sophisticated techniques which, in some cases, are part of larger criminal organizations which allow them to be more effective. This criminal activity is taking many forms, including information theft, debit/credit card fraud, check fraud, mechanical devices affixed to ATM’s, social engineering, phishing attacks to obtain personal information, or impersonation of customers through falsified or stolen credentials, business email compromise, and other criminal endeavors. We, and other banking institutions are also at risk of fraudulent or criminal activities by employees, contractors, vendors and others with whom we do business. There is also the risk of errors by our employees and others responsible for the systems and controls on which we depend and any resulting failures of these systems and controls could significantly harm the Company, including customer remediation costs, regulatory fines and penalties, litigation or enforcement actions, or limitations on our business activities.
Even if cyber-attacks and similar tactics are not directed specifically at the Bank, such attacks on other large financial institutions could disrupt the overall functioning of the financial system and undermine consumer confidence in banks generally, to the detriment of other financial institutions, including the Bank. A data security breach at a large U.S. retailer resulted in the compromise of data related to credit and debit cards of large numbers of customers requiring many banks, including the Bank, to reissue credit and debit cards for affected customers and reimburse these customers for losses sustained.
We maintain insurance which we believe provides sufficient coverage against these risks at a manageable expense for an institution of our size and scope with similar technological systems. However, we cannot assure that this insurance would be sufficient to cover all financial losses, damages, penalties, including lost revenues, should we experience any one or more of our or a third-party’s systems failing or experiencing attack.
Environmental Hazards Could Have a Material Adverse Effect on the Company’s Business, Financial Condition, and Results of Operations
The Company, in its ordinary course of business, acquires real property securing loans that are in default, and there is a risk that hazardous substances or waste, contaminants or pollutants could exist on such properties. The Company may be required to remove or remediate such substances from the affected properties at its expense, and the cost of such removal or remediation may substantially exceed the value of the affected properties or the loans secured by such properties. Furthermore, the Company may not have adequate remedies against the prior owners or other responsible parties to recover its costs. Finally, the Company may find it difficult or impossible to sell the affected properties either prior to or following any such removal. In addition, the Company may be considered liable for environmental liabilities in connection with its borrowers’ properties, if, among other things, it participates in the management of its borrowers’ operations. The occurrence of such an event could have a material adverse effect on the Company’s business, financial condition, results of operations, and cash flows.
The Company May Not Be Successful in Raising Additional Capital Needed in the Future
If additional capital is needed in the future as a result of losses or growth or our business strategy or regulatory requirements, there is no assurance that our efforts to raise such additional capital will be successful or that shares sold in the future will be sold at prices or on terms equal to or better than the current market price. The inability to raise additional capital when needed or at prices and terms acceptable to us could adversely affect our ability to implement our business strategies.
In the Future, the Company May Be Required to Recognize Impairment With Respect to Investment Securities, Which May Adversely Affect our Results of Operations
The Company’s securities portfolio currently includes securities with unrecognized losses. The Company may continue to observe declines in the fair market value of these securities. Management evaluates the securities portfolio for any other-than-temporary impairment each reporting period, as required by generally accepted accounting principles. There can be no assurance, however, that future evaluations of the securities portfolio will not require us to recognize impairment charges with respect to these and other holdings, which could adversely affect our results of operations.
Changes in the U.S. Tax Laws Have Impacted Our Business and Results of Operations in a Variety of Ways, Some of Which Are Positive, and Others Which May Be Negative
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. These changes have impacted our business and results of operations in a variety of ways, some of which are positive and others which are negative. 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 has also benefited 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, is constrained by the lower tax rate. There are presently pending in the U.S. Congress measures which would substantially increase the U.S. corporate tax rate. If enacted, such measures could adversely impact our profitability and that of our business and commercial customers.
Our Operations, Businesses and Customers Could be Materially Adversely Affected by the Physical Effects of Climate Change, as well as Governmental and Societal Responses to Climate Change
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. Elevated temperatures and carbon dioxide levels can have large impacts on appropriate nutrient levels, soil moisture, water availability, working condition, and various other critical performance conditions. Such climate-related impacts could disrupt our operations or the operations of customers or third parties on which we rely, result in market volatility, negatively impact our customers’ ability to pay outstanding loans, damage collateral or result in the deterioration of the value of collateral or insurance shortfalls. These events could reduce the Company’s earnings and cause volatility in the Company’s financial results for any fiscal quarter or year and have a material adverse effect on the Company’s financial condition and results of operations.
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.
| ITEM 1B – | UNRESOLVED STAFF COMMENTS |
Not applicable.
Cybersecurity Risk Management and Strategy
The Company recognizes the security of our banking operations and the confidentiality, security and availability of the information that the Company collects and stores, is critical to protecting our customers, maintaining our reputation and preserving the value of the Company. Cybersecurity risks are constantly evolving and becoming increasingly pervasive across all industries. The Company has implemented a comprehensive cybersecurity risk management program that we believe is reasonably designed to mitigate these risks and protect sensitive customer data, financial transactions and our information systems. Key components of the cybersecurity risk management program include:
| • | A risk assessment process that identifies and prioritizes material cybersecurity risks; defines and evaluates the effectiveness of controls to mitigate the risks; and reports results to executive management and the Board of Directors. |
| • | A third-party Managed Detection and Response (“MDR”) service, which monitors the security of our information systems around-the-clock, including intrusion detection and alerting. |
| • | A third-party Managed Security Service Provider (“MSSP”) covering all critical cyber defense functions such as data protection, identity and access management, insider risk management, security operations and threat intelligence. |
| • | A training program that educates employees and management about cybersecurity risks and how to protect themselves from cyberattacks. |
| • | An incident response plan that outlines the steps the Company will take to respond to a cybersecurity incident, which is tested on a periodic basis. |
The Company engages reputable third-party auditors and security assessors to conduct various independent risk assessments on a regular basis, including cybersecurity program maturity assessments and network and systems testing to identify and address potential vulnerabilities. Following a defense-in-depth strategy, the Company leverages both in-house resources and third-party service providers to implement and maintain processes and controls to manage the identified risks.
Our vendor management program is designed to ensure that our vendors meet current cybersecurity and information security standards. This includes conducting periodic reviews of independent control audits of the security, infrastructure, application standards or controls, and recovery plans of our most critical vendors.
The Company’s cybersecurity risk management program and strategy are designed to ensure the Company’s information and information systems are appropriately protected from a variety of threats, both natural and man-made. Periodic risk assessments are performed to validate control requirements and ensure that the Company’s information is protected at a level commensurate with its sensitivity, value, and criticality. Preventative and detective security controls are employed on all media where information is stored, the systems that process it, and infrastructure components that facilitate its transmission, to ensure the confidentiality, integrity, and availability of Company information. These controls include, but are not limited to, access control, data encryption, data loss prevention, incident response, security monitoring, third-party risk management, and vulnerability management.
The Company has an incident response program in place that is designed to enable a coordinated response to mitigate the impact of cyber-attacks, recover from the attack and provide for the prompt escalation of certain cybersecurity incidents to management, including for decisions regarding timely reporting of material incidents in accordance with SEC rules.
The Company’s cybersecurity risk management program and strategy are regularly reviewed and updated to ensure that they are aligned with the Company’s business objectives and are designed to address evolving cybersecurity threats and satisfy regulatory requirements and industry standards.
Material Effects of Cybersecurity Threats
While cybersecurity risks have the potential to materially affect the Company’s business, financial condition, and results of operations, the Company does not believe that risks from cybersecurity threats or attacks, including as a result of any previous cybersecurity incidents, have materially affected the Company, including its business strategy, results of operations or financial condition. However, the sophistication of cyber threats continues to increase, and the Company’s cybersecurity risk management and strategy may be insufficient or may not be successful in protecting against all cyber incidents. Accordingly, no matter how well designed or implemented the Company’s controls are, it will not be able to anticipate all cyber security breaches, preventative measures cannot provide absolute security and may not be sufficient in all circumstances or mitigate all potential risks, and the Company may not be able to implement effective preventive measures against cyber security breaches in a timely manner. For more information on how cybersecurity risk may materially affect the Company’s business strategy, results of operations or financial condition, please refer to Part I, Item 1A, “Risk Factors” in this report.
Governance
Board of Directors Oversight
The Company’s Board of Directors is charged with overseeing the establishment and execution of the Company’s cybersecurity risk management framework and monitoring adherence to related policies required by applicable statutes, regulations and principles of safety and soundness. Consistent with this responsibility, the Board has delegated primary oversight responsibility over the Company’s cybersecurity risk and cybersecurity risk management to the Information Services Steering Committee of the Board of Directors. The Information Services Steering Committee receives regular updates on cybersecurity risks and incidents and the cybersecurity program through direct interaction with the Information Security Officer (“ISO”) and/or the Chief Information Officer (“CIO”). The ISO and/or CIO also provide periodic updates regarding cybersecurity risks and the cybersecurity program to the Audit Committee of the Board of Directors and to the full Board of Directors. Additionally, awareness and training on cybersecurity topics is provided to the Board on an annual basis.
Management’s Role
The ISO and the CIO are responsible for implementing and maintaining the Company’s cybersecurity risk management program. Information Security is led by the ISO, who reports directly to the President/Chief Executive Officer. The Company’s ISO has over 35 years of experience in IT management, information security, and cybersecurity with the Company. The ISO and CIO are responsible for ensuring the protection of electronic and physical information through the identification and management of risk activities. Information security risk is reported by the ISO or the CIO through quarterly metric reporting to the Information Services Steering Committee. This Committee establishes and oversees policies, programs, and other guidance to provide specific expectations for managing the Company’s cybersecurity risk.
As of December 31, 2023, the Company and the Bank are engaged in the banking business through 17 offices in five counties in Northern California operating out of three offices in Solano County, six in Yolo County, two in Sacramento County, two in Placer County, two in Glenn County, one in Colusa County and one in Contra Costa County. In addition, the Company owns three vacant lots, two in northern Solano County and one in eastern Sacramento County, for possible future bank sites.
As of December 31, 2023, the Bank owns six branch office locations and two administrative facilities and leases 11 facilities. Most of the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.
See Item 1 “Business - General” in this report for more information regarding our properties.
| ITEM 3 – | LEGAL PROCEEDINGS |
Neither the Company nor the Bank is a party to any material pending legal proceeding, nor is any of its property the subject of any material pending legal proceeding, except ordinary routine litigation arising in the ordinary course of the Bank’s business and incidental to its business, none of which is expected to have a material adverse impact upon the Company’s or the Bank’s business, financial position or results of operations.
| 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 Company’s common stock is not listed on any exchange. However, trades may be reported on the OTC Markets under the symbol “FNRN.” The Company is aware that JWTT, Inc., Monroe Securities and Raymond James all currently make a market in the Company’s common stock. Management is aware that there are also private transactions in the Company’s common stock, and the data set forth below may not reflect all such transactions.
The following table summarizes the range of reported high and low bid quotations of the Company’s Common Stock for each quarter during the last two fiscal years and is based on information provided by D.A. Davidson. The quotations reflect the price that would be received by the seller without retail mark-up, mark-down or commissions and may not have represented actual transactions:
* Price adjusted for stock dividends in the indicated periods for the 5% stock dividends payable March 25, 2024 and March 24, 2023, as described below.
As of March 1, 2024, there were approximately 1,387 holders of record of the Company’s common stock, no par value.
In the prior two fiscal years and to date, the Company has declared the following stock dividends:
| Shareholder Record Date | | Dividend Percentage | | Date Payable |
| February 28, 2022 | | 5% | | March 25, 2022 |
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The Company does not expect to pay a cash dividend in the foreseeable future. Our ability to declare and pay dividends is affected by certain regulatory restrictions. See “Business – Restrictions on Dividends and Other Distributions” above.
For information regarding securities authorized for issuance under equity compensation plans, see Part III, Item 12 of this Annual Report on Form 10-K.
Issuer Purchases of Equity Securities
The Company made no repurchases of its common stock during the three months ended December 31, 2023.
| ITEM 7 – | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION |
Introduction
This overview highlights selected information in this Annual Report on Form 10-K and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should carefully read this entire Annual Report on Form 10-K. For a discussion of changes in results of operations comparing the years ended December 31, 2022 and 2021, for the Company and its subsidiary, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the SEC on March 10, 2023.
Our subsidiary, First Northern Bank of Dixon, is a California state-chartered bank that derives most of its revenues from lending and deposit taking in the Sacramento Valley region of Northern California. Interest rates, business conditions and customer confidence all affect our ability to generate revenues. In addition, the regulatory environment and competition can challenge our ability to generate those revenues.
Financial highlights for 2023 include:
The Company reported net income of $21.6 million for 2023, a 35.7% increase compared to net income of $15.9 million for 2022. Net income per common share for 2023 was $1.42, an increase of 35.2% compared to net income per common share of $1.05 for 2022. Net income per common share on a fully diluted basis was $1.41 for 2023, an increase of 35.6% compared to net income per common share on a fully diluted basis of $1.04 for 2022.
Net interest income totaled $66.5 million for 2023, an increase of 21.7% from $54.7 million in 2022, primarily due to loan growth and an increasing interest rate environment. Net interest margin was 3.70% for the year ended 2023 which was a 20.9% or 64 basis point improvement from the 3.06% reported for the year ended 2022.
Provision for credit losses totaled $1.1 million in 2023, an increase of 22.2% from $0.9 million in 2022. The year-to-date provision for credit loss was primarily due to loan growth.
Non-interest income totaled $7.8 million in 2023, an increase of 13.2% from $6.9 million in 2022. The increase was primarily due to a gain on bargain purchase of $1.4 million as a result of the acquisition of the Colusa, Willows, and Orland branches in the first quarter of 2023, which was partially offset by decreases in loan servicing income and non-taxable income from bank owned life insurance policies.
Non-interest expenses totaled $43.6 million for 2023, up 11.7% from $39.1 million in 2022. The increase was primarily due to increases in salaries and employee benefits, occupancy and equipment, data processing and amortization of core deposit intangibles. The increase in salaries and benefits was primarily due to an increase in full-time-equivalent employees. The increases in occupancy and equipment, data processing and amortization of core deposit intangibles was primarily due to the branch acquisitions in the first quarter of 2023.
The Company reported total assets of $1.87 billion for each of the years ended December 31, 2023 and 2022.
Investments decreased to $572.4 million as of December 31, 2023, a 7.4% decrease from $618.1 million as of December 31, 2022. U.S. Treasury securities totaled $87.2 million as of December 31, 2023, down 23.4% from $113.8 million as of December 31, 2022; securities of U.S. government agencies and corporations totaled $115.1 million, down 3.2% from $118.9 million as of December 31, 2022; obligations of state and political subdivisions totaled $51.7 million, down 3.1% from $53.3 million as of December 31, 2022; collateralized mortgage obligations totaled $90.9 million, down 4.6% from $95.4 million as of December 31, 2022; and mortgage-backed securities totaled $227.5 million, down 3.9% from $236.7 million as of December 31, 2022.
Loans (including loans held-for-sale), net of allowance, totaled $1.05 billion as of December 31, 2023, an 8.5% increase from $970.1 million as of December 31, 2022. Commercial loans totaled $106.9 million as of December 31, 2023, up 0.1% from $106.8 million as of December 31, 2022; commercial real estate loans were $721.7 million, up 11.9% from $645.2 million as of December 31, 2022; agriculture loans were $105.8 million, down 7.2% from $114.0 million as of December 31, 2022; residential mortgage loans were $107.3 million, up 15.7% from $92.7 million as of December 31, 2022; residential construction loans were $12.3 million, up 21.6% from $10.2 million as of December 31, 2022; and consumer loans totaled $14.9 million, down 2.6% from $15.3 million as of December 31, 2022.
Deposits decreased to $1.69 billion as of December 31, 2023, a 2.0% decrease from $1.73 billion as of December 31, 2022.
There were no FHLB advances outstanding as of December 31, 2023 and December 31, 2022.
Stockholders’ equity increased to $159.2 million as of December 31, 2023, a 27.4% increase from $125.0 million as of December 31, 2022. The increase was primarily due to the decrease in accumulated other comprehensive loss on unrealized losses on investment securities coupled with 2023 net income of $21.6 million.
Critical Accounting Policies and Estimates
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, income and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to the allowance for credit losses and business combinations. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:
Allowance for Credit Losses on Loans
The Company believes the allowance for credit losses (ACL) accounting policy is critical because the loan portfolio represents the largest asset on the consolidated balance sheet, and there is significant judgment used in determining the adequacy of the ACL. Management estimates the ACL using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for credit losses is based on the Company’s periodic evaluation of the factors mentioned below, as well as other pertinent factors.
In determining the ACL, accruing loans with similar risk characteristics are generally evaluated collectively. To estimate expected losses the Company generally utilizes historical loss trends and the remaining contractual lives of the loan portfolios to determine estimated credit losses through a reasonable and supportable forecast period. The Company utilized a reasonable and supportable forecast period of approximately four quarters and obtained the forecast data from Moody’s Analytics. Individual loan credit quality indicators, including historical credit losses, have been statistically correlated with various econometrics, including California unemployment rate, and California gross domestic product. Model forecasts may be adjusted for inherent limitations or biases that have been identified through independent validation and back-testing of model performance to actual realized results. The Company also considered the impact of portfolio concentrations, changes in underwriting practices, imprecision in its economic forecasts, and other risk factors that might influence its loss estimation process. Increases in external risk factors due to more pessimistic business and economic conditions could potentially add $3.4 million based on existing loan balances, if not more, to the ACL. While management utilizes its best judgment and information available, the ultimate adequacy of our allowance accounts is dependent upon a variety of factors beyond our control, including the performance of our portfolios, the economy and changes in interest rates.
Business Combinations
The Company accounts for acquisitions of businesses using the acquisition method of accounting. Under the acquisition method, assets acquired and liabilities assumed are recorded at their estimated fair values at the date of acquisition. Management utilizes various valuation techniques including discounted cash flow analyses to determine these fair values. Any excess of the purchase consideration over the fair value of acquired assets, including identifiable intangible assets, and liabilities assumed is recorded as goodwill and a deficit is recognized as a bargain purchase gain.
Goodwill and intangible assets acquired in a business combination and that are determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exist that indicate the necessity for such impairment tests to be performed. The Company has no goodwill arising from business combinations. The Compnay recognized a bargain purchase gain arising from business combinations. The Company recorded the fair values based on the valuations available as of reporting date. In accordance with business combination accounting guidance, the Company continued to evaluate these fair values for one year following the acquisition date. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Core deposit intangible assets arising from business combinations are amortized on an accelerated basis reflecting the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. The estimated life of the core deposit intangible is approximately 10 years.
Impact of Recently Issued Accounting Standards
Accounting Standards Adopted in 2023
On January 1, 2023, the Company adopted ASU 2016-13 Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which replaces the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (CECL) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized costs, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in certain leases. In addition, ASC 326 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities, based on management’s intent to sell the security, or likelihood the Company will be required to sell the security, before recovery of the amortized cost basis.
Upon adoption of ASU 2016-13, the Company made the accounting policy election to not measure an estimate of credit losses on accrued interest receivable as the Company writes off any uncollectible accrued interest receivable in a timely manner.
Results for the reporting periods beginning January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. Upon adoption of CECL, the Company recognized an increase in the ACL for loans and reserve for unfunded commitments totaling $1,300,000 as a cumulative effect adjustment from change in accounting policies, with a corresponding decrease in retained earnings of $916,000, net of deferred taxes of $384,000.
On January 1, 2023, the Company adopted ASU 2022-02, Financial Instruments—Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures. These amendments eliminate the troubled debt restructuring (TDR) recognition and measurement guidance and, instead, require that an entity evaluate (consistent with the accounting for other loan modifications) whether the modification represents a new loan or a continuation of an existing loan. The amendments also enhance existing disclosure requirements and introduce new requirements related to certain modifications of receivables made to borrowers experiencing financial difficulty. For public business entities, these amendments require that an entity disclose current-period gross write-offs by year of origination for financing receivables and net investment in leases within the scope of Subtopic 326-20. Results for the reporting periods beginning January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP.
Recently Issued Accounting Pronouncements
In January 2021, the FASB issued ASU 2021-01, Reference Rate Reform (Topic 848): Scope. This ASU clarifies that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivatives that are affected by the discounting transition. The ASU also amends the expedients and exceptions in Topic 848 to capture the incremental consequences of the scope clarification and to tailor the existing guidance to derivative instruments affected by the discounting transition. An entity may elect to apply ASU 2021-01 on contract modifications that change the interest rate used for margining, discounting, or contract price alignment retrospectively as of any date from the beginning of the interim period that includes March 12, 2020, or prospectively to new modifications from any date within the interim period that includes or is subsequent to January 7, 2021, up to the date that financial statements are available to be issued. An entity may elect to apply ASU 2021-01 to eligible hedging relationships existing as of the beginning of the interim period that includes March 12, 2020, and to new eligible hedging relationships entered into after the beginning of the interim period that includes March 12, 2020. In December 2022, the FASB issued ASU 2022-06, Reference Rate Reform (Topic 848): Deferral of the Sunset Date of Topic 848. This ASU extends the period of time preparers can utilize the reference rate reform relief guidance in Topic 848. ASU 2022-06 defers the sunset date of Topic 848 from December 31, 2022, to December 31, 2024, after which entities will no longer be permitted to apply the relief in Topic 848. The Company is in the process of evaluating the provisions of this ASU but does not expect it to have a material impact on the Company’s consolidated financial statements.
In June 2022, the FASB issued ASU 2022-03, Fair Value Measurement (Topic 820): Fair Value Measurement of Equity Securities Subject to Contractual Sale Restrictions. These amendments clarify that a contractual restriction on the sale of an equity security is not considered part of the unit of account of the equity security and, therefore, is not considered in measuring fair value. This ASU is effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2023. The Company does not expect this ASU to have a material impact on the Company’s consolidated financial statements.
In November 2023, the FASB issued ASU 2023-07, Segment Reporting (Topic 280): Improvements to Reportable Segment Disclosures. The amendments in this ASU is intended to improve reportable segment disclosure requirements primarily through enhanced disclosures about significant segment expenses. This ASU is effective for fiscal years beginning after December 15, 2023, and interim periods within fiscal years beginning after December 15, 2024. Early adoption is permitted. The Company does not expect this ASU to have a material impact on the Company’s consolidated financial statements.
In December 2023, the FASB issued ASU 2023-09, Income Taxes (Topic 740): Improvements to Income Tax Disclosures. Among other things, these amendments require that public business entities on an annual basis (1) disclose specific categories in the rate reconciliation and (2) provide additional information for reconciling items that meet a quantitative threshold. This ASU is effective for annual periods beginning after December 15, 2024. The Company is evaluating whether this ASU will have a material impact on the Company’s consolidated financial statements.
STATISTICAL INFORMATION AND DISCUSSION
The following statistical information and discussion should be read in conjunction with the audited consolidated financial statements and accompanying notes included in Part II (Item 8) of this Annual Report on Form 10-K.
The following tables present information regarding the consolidated average assets, liabilities and stockholders’ equity, the amounts of interest income from average earning assets and the resulting yields, and the amount of interest expense paid on interest-bearing liabilities. Average loan balances include non-performing loans. Interest income includes proceeds from loans on non-accrual status only to the extent cash payments have been received and applied as interest income. Tax-exempt income is not shown on a tax equivalent basis.
Distribution of Assets, Liabilities and Stockholders’ Equity;
Interest Rates and Interest Differential
(Dollars in thousands)
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| | | Average Balance | | | Percent | | | Average Balance | | | Percent | | | Average Balance | | | Percent | |
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Stock in Federal Home Loan Bank and other equity securities, at cost | | | | | | | | | | | | | | | | | | | | | | | | |
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Total Liabilities and Stockholders’ Equity | | | | | | | | | | | | | | | | | | | | | | | | |
| (1) | Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for credit losses. |
Net Interest Earnings
Average Balances, Yields and Rates
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Total Loans, Including Loan Fees(1) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Total Investment Securities | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Interest Receivable and Other Assets | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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| (1) | Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for credit losses, but non-accrued interest thereon is excluded. Includes amortization of deferred loan fees and costs. |
| (2) | Interest income and yields on tax-exempt securities are not presented on a taxable equivalent basis. |
Continuation of
Net Interest Earnings
Average Balances, Yields and Rates
(Dollars in thousands)
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Liabilities and Stockholders’ Equity | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Interest-Bearing Deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Total Interest-Bearing Deposits | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Federal Home Loan Bank Advances | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Interest payable and Other Liabilities | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Total Liabilities and Stockholders’ Equity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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Net Interest Income and Net Interest Margin (1) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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| (1) | Net interest margin is computed by dividing net interest income by total average interest-earning assets. |
| (2) | Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. |
Analysis of Changes
in Interest Income and Interest Expense
(Dollars in thousands)
Following is an analysis of changes in interest income and expense (dollars in thousands) for 2023 over 2022. Changes not solely due to interest rate or volume have been allocated proportionately to interest rate and volume.
| | | 2023 Over 2022 | |
| | | Volume | | | Interest Rate | | | Change | |
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Increase (Decrease) in Interest Income: | | | | | | | | | |
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Investment Securities - Taxable | | | | | | | | | | | | |
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Investment Securities - Non-taxable | | | | | | | | | | | | |
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Increase (Decrease) in Interest Expense: | | | | | | | | | | | | |
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Interest-Bearing Transaction Deposits | | | | | | | | | | | | |
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INVESTMENT PORTFOLIO
Composition of Investment Securities
The mix of investment securities held by the Company at December 31 of the previous two fiscal years is as follows (dollars in thousands):
| | | 2023 | | | 2022 | |
| Investment securities available-for-sale (at fair value): | | | | | | |
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Securities of U.S. Government Agencies and Corporations | | | | | | | | |
Obligations of State and Political Subdivisions | | | | | | | | |
Collateralized Mortgage Obligations | | | | | | | | |
Mortgage-Backed Securities | | | | | | | | |
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Maturities of Investment Securities
The following table summarizes the contractual maturity (dollars in thousands) and projected yields of the Company’s investment securities as of December 31, 2023. The yields on tax-exempt securities are shown on a tax equivalent basis. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. In addition, factors such as prepayments and interest rates may affect the yield on carrying value of mortgage related securities.
Period to Maturities
| | | Within One Year | | | After One But Within Five Years | | | After Five But Within Ten Years | |
| | | Amount | | | Yield | | | Amount | | | Yield | | | Amount | | | Yield | |
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| Investment securities available-for-sale (at fair value): | | | | | | | | | | | | | | | | | | |
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Securities of U.S. Government Agencies and Corporations | | | | | | | | | | | | | | | | | | | | | | | | |
Obligations of State and Political Subdivisions | | | | | | | | | | | | | | | | | | | | | | | | |
Collateralized Mortgage Obligations | | | | | | | | | | | | | | | | | | | | | | | | |
Mortgage-Backed Securities | | | | | | | | | | | | | | | | | | | | | | | | |
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| | | After Ten Years | | | Total | |
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| Investment securities available-for-sale (at fair value): | | | | | | | | | | | | |
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Securities of U.S. Government Agencies and Corporations | | | | | | | | | | | | | | | | |
Obligations of State & Political Subdivisions | | | | | | | | | | | | | | | | |
Collateralized Mortgage Obligations | | | | | | | | | | | | | | | | |
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LOAN PORTFOLIO
Composition of Loans
The mix of loans, net of deferred origination fees and costs and allowance for credit losses and excluding loans held-for-sale, at December 31, 2023 and December 31, 2022 is as follows (dollars in thousands):
| | | 2023 | | | 2022 | |
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Allowance for credit losses | | | | | | | | | | | | | | | | |
Net deferred origination fees and costs | | | | | | | | | | | | | | | | |
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As shown in the comparative figures for loan mix during 2023 and 2022, total loans increased primarily as a result of increases in commercial real estate, residential mortgage and residential construction loans, which was partially offset by decreases in agriculture loans.
Commercial loans are primarily for financing the needs of a diverse group of businesses located in the Bank’s market areas. Commercial real estate loans generally fall into two categories, owner-occupied and non-owner occupied. Real estate construction loans are generally for financing the construction of single-family residential homes for individuals and builders we believe are well-qualified. These loans are secured by real estate and have short maturities. Residential mortgage loans, which are secured by real estate, include owner-occupied and non-owner-occupied properties in the Bank’s market areas. Loans are considered agriculture loans when the primary source of repayment is from the sale of an agricultural or agricultural-related product or service. Such loans are secured and/or unsecured to producers and processors of crops and livestock. The Bank also makes loans to individuals for investment purposes.
Maturities and Sensitivities of Loans to Changes in Interest Rates
The following table presents the maturity distribution of our loan portfolio at December 31, 2023 (dollars in thousands) (excludes loans held-for-sale). The table also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index.
| | | Due in One Year or Less | | | After One, but Within Five Years | | | After Five but Within Fifteen Years | | | After Fifteen Years | | | Total | |
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Loans with fixed interest rates: | | | | | | | | | | | | | | | | | | | | |
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Loans with variable interest rates: | | | | | | | | | | | | | | | | | | | | |
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Non-Accrual, Past Due, OREO and Loan Modifications
It is generally the Company’s policy to discontinue interest accruals once a loan is past due for a period of 90 days as to interest or principal payments. When a loan is placed on non-accrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Payments received on non-accrual loans are applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected and an appropriate period of performance has been demonstrated.
The following table summarizes the Company’s non-accrual loans by loan category (dollars in thousands), net of guarantees of the State of California and U.S. Government, including its agencies and its government-sponsored agencies, at December 31, 2023 and 2022.
| | | At December 31, 2023 | | | At December 31, 2022 | |
| | | Gross | | | Guaranteed | | | Net | | | Gross | | | Guaranteed | | | Net | |
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Non-accrual loans amounted to $3,998,000 at December 31, 2023, and were comprised of two agriculture loans totaling $2,871,000 three residential mortgage loan totaling $424,000 and four consumer loans totaling $703,000. Non-accrual loans amounted to $8,176,000 at December 31, 2022, and were comprised of three agriculture loans totaling $7,416,000, one residential mortgage loan totaling $123,000 and four consumer loans totaling $637,000.
If interest on non-accrual loans had been accrued, such interest income would have approximated $364,000 and $812,000 during the years ended December 31, 2023 and 2022, respectively. Income actually recognized on nonaccrual loans at payoff approximated $1,626,000 and $51,000 for the years ended December 31, 2023 and 2022, respectively.
A loan is considered to be collateral dependent when repayment is expected to be provided substantially through the operation or sale of the collateral. The ACL on collateral dependent loans is measured using the fair value of the underlying collateral, adjusted for costs to sell when applicable, less the amortized cost basis of the financial asset. It is generally the Company’s policy that if the value of the underlying collateral is determined to be less than the recorded amount of the loan, a charge-off will be taken.
As the following table illustrates, total non-performing assets, which consists of loans on non-accrual status, loans past due 90-days and still accruing and Other Real Estate Owned (“OREO”) net of guarantees of the State of California and U.S. Government, including its agencies and its government-sponsored agencies, decreased $245,000, or 2.86%, to $8,334,000 from December 31, 2022 to December 31, 2023. Non-performing assets net of guarantees represented 0.5% of total assets at each of the periods ended December 31, 2023 and 2022. The Bank’s management believes that the $3,998,000 in non-accrual loans were appropriately reflected at their fair value at December 31, 2023. However, no assurance can be given that the existing or any additional collateral will be sufficient to secure full recovery of the obligations owed under these loans.
| | | At December 31, 2023 | | | At December 31, 2022 | |
| | | Gross | | | Guaranteed | | | Net | | | Gross | | | Guaranteed | | | Net | |
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Loans 90 days past due and still accruing | | | | | | | | | | | | | | | | | | | | | | | | |
Total non-performing loans | | | | | | | | | | | | | | | | | | | | | | | | |
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Total non-performing assets | | | | | | | | | | | | | | | | | | | | | | | | |
Non-performing loans (net of guarantees) to total loans | | | | | | | | | | | | | | | | | | | | | | | | |
Non-performing assets (net of guarantees) to total assets | | | | | | | | | | | | | | | | | | | | | | | | |
Allowance for credit losses to non-performing loans (net of guarantees) | | | | | | | | | | | | | | | | | | | | | | | | |
The Company had two loans totaling $4,336,000 and one loan totaling $403,000 that were 90 days or more past due and still accruing at December 31, 2023 and 2022, respectively. The two loans totaling $4,336,000 that were 90 days or more past due and still accruing at December 31, 2023 was comprised of one residential construction loan totaling $3,420,000 and one residential mortgage loan totaling $916,000 that were both well secured and in process of collection.
OREO consists of property that the Company has acquired by deed in lieu of foreclosure or through foreclosure proceedings, and property that the Company does not hold title to but is in actual control of, known as in-substance foreclosure. The estimated fair value of the property is determined prior to transferring the balance to OREO. The balance transferred to OREO is the estimated fair value of the property less estimated cost to sell. Impairment may be deemed necessary to bring the book value of the loan equal to the appraised value. Appraisals or loan officer evaluations are then conducted periodically thereafter charging any additional impairment to the appropriate expense account. The Company had no OREO as of the years ended December 31, 2023 and 2022.
Potential Problem Loans
The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix. The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for credit losses at all times. Asset quality reviews of loans and other non-performing assets are administered using credit risk rating standards and criteria similar to those employed by state and federal banking regulatory agencies. The federal banking regulatory agencies utilize the following definitions for assets adversely classified for supervisory purposes: “Substandard Assets: a substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.” “Doubtful Assets: An asset classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. OREO and loans rated Substandard and Doubtful are deemed “classified assets.” This category, which includes both performing and non-performing assets, receives an elevated level of attention regarding collection.
Commercial loans, whether secured or unsecured, generally are made to support the short-term operations and other needs of small businesses. These loans are generally secured by the receivables, equipment, and other real property of the business and are susceptible to the related risks described above. Problem commercial loans are generally identified by periodic review of financial information that may include financial statements, tax returns, and payment history of the borrower. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. When repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation. Appropriate valuations are obtained at origination of the credit and periodically thereafter (generally every 3-12 months depending on the collateral type and market conditions), once repayment is questionable, and the loan has been deemed classified.
Commercial real estate loans generally fall into two categories, owner-occupied and non-owner occupied. Loans secured by owner occupied real estate are primarily susceptible to changes in the market conditions of the related business. This may be driven by, among other things, industry changes, geographic business changes, changes in the individual financial capacity of the business owner, general economic conditions, and changes in business cycles. These same risks apply to commercial loans whether secured by equipment, receivables, or other personal property or unsecured. Problem commercial real estate loans are generally identified by periodic review of financial information that may include financial statements, tax returns, payment history of the borrower, and site inspections. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Losses on loans secured by owner-occupied real estate, equipment, or other personal property generally are dictated by the value of underlying collateral at the time of default and liquidation of the collateral. When default is driven by issues related specifically to the business owner, collateral values tend to provide better repayment support and may result in little or no loss. Alternatively, when default is driven by more general economic conditions, underlying collateral generally has devalued more and results in larger losses due to default. Loans secured by non-owner occupied real estate are primarily susceptible to risks associated with swings in occupancy or vacancy and related shifts in lease rates, rental rates or room rates. Most often, these shifts are a result of changes in general economic or market conditions or overbuilding and resultant over-supply of space. Losses are dependent on the value of underlying collateral at the time of default. Values are generally driven by these same factors and influenced by interest rates and required rates of return as well as changes in occupancy costs. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, sales invoices, or other appropriate means. Appropriate valuations are obtained at origination of the credit and periodically thereafter (generally every 3-12 months depending on the collateral type and market conditions), once repayment is questionable, and the loan has been deemed classified.
Agricultural loans, whether secured or unsecured, generally are made to producers and processors of crops and livestock. Repayment is primarily from the sale of an agricultural product or service. Agricultural loans are generally secured by inventory, receivables, equipment, and other real property. Agricultural loans primarily are susceptible to changes in market demand for specific commodities. This may be exacerbated by, among other things, industry changes, changes in the individual financial capacity of the business owner, general economic conditions and changes in business cycles, as well as changing weather conditions. Problem agricultural loans are generally identified by periodic review of financial information that may include financial statements, tax returns, crop budgets, payment history, and crop inspections. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation. Appropriate valuations are obtained at origination of the credit and periodically thereafter (generally every 3-12 months depending on the collateral type and market conditions), once repayment is questionable, and the loan has been deemed classified.
Residential mortgage loans, which are secured by real estate, are primarily susceptible to four risks: non-payment due to diminished or lost income, over-extension of credit, a lack of borrower’s cash flow to sustain payments, and shortfalls in collateral value. In general, non-payment is due to loss of employment and follows general economic trends in the marketplace, particularly the upward movement in the unemployment rate, loss of collateral value, and demand shifts. Problem residential mortgage loans are generally identified via payment default. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. When repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation. Appropriate valuations are obtained at origination of the credit and periodically thereafter (generally every 3-12 months depending on the collateral type and market conditions), once repayment is questionable, and the loan has been deemed classified.
Construction loans, whether owner occupied or non-owner occupied residential development loans, are not only susceptible to the related risks described above but the added risks of construction itself, including cost over-runs, mismanagement of the project, or lack of demand and market changes experienced at time of completion. Again, losses are primarily related to underlying collateral value and changes therein as described above. Problem construction loans are generally identified by periodic review of financial information that may include financial statements, tax returns and payment history of the borrower. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors, or repossession or foreclosure of the underlying collateral. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation. Appropriate valuations are obtained at origination of the credit and periodically thereafter (generally every 3-12 months depending on the collateral type and market conditions), once repayment is questionable, and the loan has been deemed classified.
Consumer loans, whether unsecured or secured, are primarily susceptible to four risks: non-payment due to diminished or lost income, over-extension of credit, a lack of borrower’s cash flow to sustain payments, and shortfall in collateral value. In general, non-payment is due to loss of employment and will follow general economic trends in the marketplace, particularly the upward movements in the unemployment rate, loss of collateral value, and demand shifts. Problem consumer loans are generally identified via payment default. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. When repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation. Appropriate valuations are obtained at origination of the credit and periodically thereafter (generally every 3-12 months depending on the collateral type and market conditions), once repayment is questionable, and the loan has been deemed classified.
Once a loan becomes delinquent or repayment becomes questionable, a Company collection officer will address collateral shortfalls with the borrower and attempt to obtain additional collateral or a principal payment. If this is not forthcoming and payment of principal and interest in accordance with the contractual terms of the loan agreement becomes unlikely, the Company will consider the loan to be individually evaluated and will estimate its probable loss, using the present value of future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. For collateral dependent loans, the Company will utilize a recent valuation of the underlying collateral less estimated costs of sale, and charge-off the loan down to the estimated net realizable amount. Depending on the length of time until final collection, the Company may periodically revalue the estimated loss and take additional charge-offs or specific reserves as warranted. Revaluations may occur as often as every 3-12 months depending on the underlying collateral and volatility of values. Final charge-offs or recoveries are taken when the collateral is liquidated and the actual loss is confirmed. Unpaid balances on loans after or during collection and liquidation may also be pursued through legal action and attachment of wages or judgment liens on the borrower’s other assets.
Excluding the non-performing loans cited previously, loans totaling $12,327,000 and $6,490,000 were classified as substandard or doubtful loans, representing potential problem loans at December 31, 2023 and 2022, respectively. In Management’s opinion, the potential loss related to these problem loans was sufficiently covered by the Bank’s existing loan loss reserve (Allowance for Credit Losses) at December 31, 2023 and 2022. The ratio of the allowance for credit losses to total loans at December 31, 2023 and 2022 was 1.55% and 1.50%, respectively. Management considered the allowance for credit losses of $16,596,000 to be adequate as a reserve against expected losses as of December 31, 2023.
Analysis of the Allowance for Credit Losses On Loans
(Dollars in thousands)
| | | 2023 | | | 2022 | | | 2021 | |
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Balance at Beginning of Year | | | | | | | | | | | | |
Impact of adopting ASC 326 | | | | | | | | | | | | |
Provision for Credit Losses | | | | | | | | | | | | |
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Net (Charge-offs) Recoveries | | | | | | | | | | | | |
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Ratio of Net (Charge-Offs) Recoveries | | | | | | | | | | | | |
During the Year to Average Loans | | | | | | | | | | | | |
Outstanding During the Year | | | | | | | | | | | | |
Allowance for Credit Losses to Total Loans | | | | | | | | | | | | |
Nonaccrual loans to Total Loans | | | | | | | | | | | | |
Allowance for Credit Losses to Nonaccrual loans | | | | | | | | | | | | |
Allocation of the Allowance for Credit Losses
The Allowance for Credit Losses has been established as a general component available to absorb expected credit losses throughout the loan portfolio. The following table is an allocation of the Allowance for Credit Losses balance on the dates indicated (dollars in thousands):
| | | December 31, 2023 | | | December 31, 2022 | |
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| | | Allocation of Allowance for Credit Losses Balance | | | Allowance as a % of Total Allowance | | | Loans as a % of Total Loans, net | | | Allocation of Allowance for Credit Losses Balance | | | Allowance as a % of Total Allowance | | | Loans as a % of Total Loans, net | |
| Loan Type: | | | | | | | | | | | | | | | | | | |
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The Bank believes that any breakdown or allocation of the allowance into loan categories lends an appearance of exactness, which does not exist, because the allowance is available for all loans. The allowance breakdown shown above is computed taking actual experience into consideration but should not be interpreted as an indication of the specific amount and allocation of actual charge-offs that may ultimately occur.
Deposits
The following table sets forth the average amount and the average rate paid on each of the listed deposit categories (dollars in thousands) during the periods specified:
| | | 2023 | | | 2022 | | | 2021 | |
| | | Average Amount | | | Average Rate | | | Average Amount | | | Average Rate | | | Average Amount | | | Average Rate | |
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| Deposit Type: | | | | | | | | | | | | | | | | | | |
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Non-interest-Bearing Demand | | | | | | | | | | | | | | | | | | | | | | | | |
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Interest-Bearing Demand (NOW) | | | | | | | | | | | | | | | | | | | | | | | | |
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Approximately 37% and 45% of our deposits were uninsured as of December 31, 2023 and 2022, respectively.
Time Deposits include brokered deposits purchased in 2023 totaling $39,986,000 as of December 31, 2023. The brokered deposits purchased are time deposits $250,000 (dollars in thousands) or less that mature within twelve months.
The following table sets forth by time remaining to maturity for the Bank’s time deposits over $250,000 (dollars in thousands) as of December 31, 2023:
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Over three months through six months | | | | |
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Over six months through twelve months | | | | |
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Short-Term Borrowings
The Company had no secured borrowings and no Federal Funds purchased at December 31, 2023 and 2022.
Additional short-term borrowings available to the Company consist of a line of credit and advances with the Federal Home Loan Bank (“FHLB”) secured under terms of a blanket collateral agreement by a pledge of FHLB stock and all loans held by the Company. At December 31, 2023, the Company had a current collateral borrowing capacity with the FHLB of $395,455,000 and, at such date, also had unsecured formal lines of credit totaling $132,000,000 with correspondent banks.
The Bank is eligible for participation in the newly created Bank Term Funding Program at the Federal Reserve which is intended to provide liquidity to U.S. depository institutions using one-year advances, prepayable without penalty, provided at the one-year overnight index swap rate plus 10 basis points limited to the value of eligible collateral. Eligible collateral includes any collateral eligible for purchase by the Federal Reserve Bank, at par value, provided such collateral was owned by the borrower at March 12, 2023. As of December 31, 2023, the Company had $523,888,000 in par value of unpledged securities available to pledge to secure advances under the newly created Bank Term Funding Program.
The Company had no Federal Funds purchased during the years ended December 31, 2023 and 2022.
Long-Term Borrowings
The Company had no long-term borrowings at December 31, 2023 and 2022. There were no average outstanding balances of long-term borrowings during 2023 and 2022.
Supplemental Compensation Plans
The Company and the Bank maintain an unfunded non-contributory defined benefit pension plan (“Salary Continuation Plan”) and related split dollar plan for a select group of highly compensated employees. Eligibility to participate in the Salary Continuation Plan is limited to a select group of management or highly compensated employees of the Bank that are designated by the Board. Additionally, the Company and the Bank adopted a supplemental executive retirement plan (“SERP”) in 2006. The SERP is intended to integrate the various forms of retirement payments offered to executives. There are currently two active and two retired participants in the SERP. At December 31, 2023, the accrued benefit liability was $4,979,000, of which $4,879,000 was recorded in interest payable and other liabilities and $100,000 was recorded in accumulated other comprehensive loss, net, in the Consolidated Balance Sheets. At December 31, 2022, the accrued benefit liability was $5,339,000, of which $4,901,000 was recorded in interest payable and other liabilities and $438,000 was recorded in accumulated other comprehensive income, net, in the Consolidated Balance Sheets.
The Company and the Bank maintain an unfunded non-contributory defined benefit pension plan (“Directors’ Retirement Plan”) and related split dollar plan for the directors of the Bank. At December 31, 2023, the accrued benefit liability was $424,000, of which $596,000 was recorded in interest payable and other liabilities and $(172,000) was recorded in accumulated other comprehensive loss, net, in the Consolidated Balance Sheets. At December 31, 2022, the accrued benefit liability was $560,000, of which $636,000 was recorded in interest payable and other liabilities and $(76,000) was recorded in accumulated other comprehensive income, net, in the Consolidated Balance Sheets.
For additional information, see Note 17 to the Consolidated Financial Statements in this Form 10-K.
Overview
Year Ended December 31, 2023 Compared to Year Ended December 31, 2022
Net income for the year ended December 31, 2023, was $21.6 million, representing an increase of $5.7 million, or 35.7%, compared to net income of $15.9 million for the year ended December 31, 2022. The increase in net income was attributable to an increase in net interest income of $11.8 million and an increase in non-interest income of $0.9 million, which was partially offset by an increase in provision for credit losses of $0.2 million, increase in non-interest expenses of $4.6 million and $2.3 million increase in provision for income taxes. The increase in non-interest income was primarily due to the bargain purchase gain of $1.4 million as a result of the acquisition of the Colusa, Willows, and Orland branches located in California in the first quarter of 2023.
Total assets were $1.87 billion for each of the years ended December 31, 2023 and 2022. For the year ended December 31, 2023 compared to the year ended December 31, 2022, there was an $82.3 million increase in net loans (including loans held-for-sale), a $3.8 million increase in premises and equipment and a $4.1 million increase in core deposit intangible, which was partially offset by a $38.2 million decrease in cash and cash equivalents, a $45.7 million decrease in investments securities and a $5.7 million decrease in interest receivable and other assets. Total deposits decreased $34.4 million, or 2.0%, to $1.69 billion as of December 31, 2023, compared to $1.73 billion at December 31, 2022.
Results of Operations
Net Interest Income
Net interest income is the excess of interest and fees earned on the Bank’s loans, investment securities, federal funds sold and banker’s acceptances over the interest expense paid on deposits and other borrowed funds which are used to fund those assets. Net interest income is primarily affected by the yields and mix of the Bank’s interest-earning assets and interest-bearing liabilities outstanding during the period. The $18,241,000 increase in the Bank’s interest and dividend income in 2023 from 2022 was primarily driven by increased interest rates and loan growth improving the earning asset mix. The $9,887,000 increase in the Bank’s interest income on loans was primarily driven by an increase of $5,508,000 attributable to increasing interest rates compounded by an increase of $4,379,000 driven by an increase in average loans outstanding. The $5,048,000 increase in the Bank’s interest income on due from banks was primarily driven by an increase of $6,106,000 due to the increase in average interest rates paid on excess reserves at the FRB, partially offset by a decrease of $1,058,000 driven by decreased average due from bank balances outstanding. The $474,000 increase in the Bank’s interest income on certificates of deposit was driven by an increase of $238,000 due to the increase in average certificates of deposit outstanding coupled with an increase of $236,000 due to the increase in average interest rates paid on certificates of deposit. The $2,559,000 increase in the Bank’s interest income on investment securities was driven by an increase of $3,093,000 due to increasing interest rates, which was partially offset by a decrease of $534,000 driven by decreased investment securities balances outstanding. The $6,398,000 increase in the Bank’s interest expense on deposits was primarily driven by a $6,125,000 increase in rates. See “Analysis of Changes in Interest Income and Interest Expense” set forth on page 37 of this Annual Report on Form 10-K for the effects of interest rates and loan/deposit volume on net interest income.
The FRB influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is significantly affected by changes in the prime interest rate. As of December 31, 2022, the prime rate was 7.50%. The prime rate increased numerous times during 2023, increasing to 8.50% as of December 31, 2023.
As of December 31, 2022, the target range for the federal funds rate was 4.25% to 4.50%. During 2023 the FRB continued to raise interest rates due to the inflationary trends in the economy. As of December 31, 2023, the target range for the federal funds rate was 5.25% to 5.50%. For additional information, see “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”, in “Risk Factors” (Item 1A) of this Annual Report on Form 10-K.
We are primarily funded by core deposits, with non-interest-bearing demand deposits historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on our net interest income and net interest margin in a rising interest rate environment.
The nature and impact of future changes in interest rates and monetary policy on the business and earnings of the Company cannot be predicted. For additional information, see “The Effects of Changes or Increases in, or Supervisory Enforcement of, Banking or Other Laws and Regulations or Governmental Fiscal or Monetary Policies Could Adversely Affect Us” and “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” in “Risk Factors” (Item 1A) of this Annual Report on Form 10-K.
Interest income on loans for 2023 was up 23.4% from 2022, increasing from $42,316,000 to $52,203,000. The increase in interest income on loans was primarily due to higher yields earned on newly originated loans and loans repricing at higher rates coupled with a 9.8% increase in average balance of loans, which was partially offset by a decrease in fee recognition from the SBA’s Paycheck Protection Program (“PPP”). The Company recognized no PPP loan fees during the year ended December 31, 2023. The Company recognized $2.7 million of PPP loan fees during the year ended December 31, 2022.
Interest income on interest-bearing due from banks for 2023 was up 142.4% from 2022, increasing from $3,546,000 to $8,594,000. The increase in interest income on interest-bearing due from banks was the result of a 353 basis point increase in yield on interest-bearing due from banks, which was partially offset by a 24.5% decrease in average balances of interest-bearing due from banks. The increase in yield was due to the increase in the effective federal funds rate, as discussed above.
Interest income on certificates of deposit for 2023 was up 167.5% from 2022, increasing from $283,000 to $757,000. The increase in interest income on certificates of deposit was primarily due to a 64.1% increase in average balances of certificates of deposit coupled with a 140 basis point increase in yield on certificates of deposit.
Interest income on investment securities for 2023 was up 27.8% from 2022, increasing from $9,205,000 to $11,764,000. The increase in interest income on investment securities was the result of a 52 basis point increase in investment securities yields, which was partially offset by a 5.5% decrease in average investment securities volume. The Bank deployed excess liquidity into the investment portfolio over the course of 2023 at higher reinvestment rates. Investment securities yields were 1.98% and 1.46% for 2023 and 2022, respectively.
Interest expense on deposits for 2023 was up 539.5% from 2022, increasing from $1,186,000 to $7,584,000. The increase in interest expense on deposits was the result of a 65 basis point increase in interest rates paid on interest-bearing deposits coupled with a 3.9% increase in average balances of interest-bearing deposits.
The mix of deposits for the previous three years was as follows (dollars in thousands):
| | | 2023 | | | 2022 | | | 2021 | |
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| | | Average Balance | | | Percent | | | Average Balance | | | Percent | | | Average Balance | | | Percent | |
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Non-interest-Bearing Demand | | | | | | | | | | | | | | | | | | | | | | | | |
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Interest-Bearing Demand (NOW) | | | | | | | | | | | | | | | | | | | | | | | | |
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The Bank’s net interest margin (net interest income divided by average earning assets) was 3.70% in 2023 and 3.06% in 2022. The net interest spread (average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities) was 3.34% in 2023 and 2.99% in 2022. The 35 basis point increase in net spread in 2023 over 2022 was due to an overall increase in interest rates on earning assets, which was partially offset by an overall increase in interest rates on interest-bearing deposits.
Provision for Credit Losses
The provision for credit losses is established by charges to earnings on management’s evaluation of expected losses on the loan portfolio. Based on this evaluation, the Company recorded provision for credit losses of $1,100,000 and $900,000 in 2023 and 2022, respectively. The provision for credit losses in 2023 and 2022 was primarily due to loan growth. The ratio of the Allowance for Credit Losses to total loans at December 31, 2023 was 1.55% compared to 1.50% at December 31, 2022. The ratio of the Allowance for Credit Losses to total non-accrual loans and loans past due 90 days or more, net of guarantees was 199.1% at December 31, 2023, compared to 172.4% at December 31, 2022. The increase was primarily due to the $1.8 million increase in Allowance for Credit Losses.
Non-Interest Income and Expenses
Non-interest income consisted primarily of service charges on deposit accounts, net losses on sale of available-for-sale securities, net realized gains on sales of loans held-for-sale, debit card income, gain on bargain purchase and other income. Non-interest income increased to $7,845,000 in 2023 from $6,933,000 in 2022, representing an increase of $912,000, or 13.2%. The increase was primarily driven by a bargain purchase gain, which was partially offset by a decrease in other income. The Company recognized a bargain purchase gain totaling $1.4 million as a result of the acquisition of the Colusa, Willows, and Orland branches in the first quarter of 2023. The decrease in other income was primarily due to decreases in loan servicing income and non-taxable income from bank owned life insurance policies.
Non-interest expenses consisted primarily of salaries and employee benefits, occupancy and equipment expense, data processing expense, amortization of core deposit intangible and other expenses. Non-interest expenses increased to $43,638,000 in 2023 from $39,063,000 in 2022, representing an increase of $4,575,000, or 11.7%.
Following is an analysis of the increase or decrease in the components of non-interest expenses (dollars in thousands) during the periods specified:
| | | 2023 over 2022 | |
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Salaries and Employee Benefits | | | | | | | | |
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Amortization of core deposit intangible | | | | | | | | |
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The increase in salaries and employee benefits in 2023 was primarily due to a 6.3% increase in regular salaries, and a 35.7% increase in profit sharing plan contributions, partially offset by a 15.7% decrease in contingent compensation and a 28.9% decrease in commissions. The increase in regular salaries expense was primarily due to merit increases and an increase in full-time equivalent employees as a result of the acquisition of the Colusa, Willows and Orland branches in the first quarter of 2023. The increase in profit sharing plan contributions was primarily the result of improved financial performance. The decrease in contingent compensation was primarily due to a decrease in incentive goals met. The decrease in commissions paid was primarily due to a decrease in mortgage loan production volumes. The increases in occupancy and equipment expense, data processing expense and amortization of core deposit intangible were primarily due to the branch acquisitions in the first quarter of 2023. The increase in other expenses was primarily due to a 67.9% increase in FDIC assessments, a 38.1% increase in consulting fees, a 96.2% increase in messenger services, and a 16.4% increase in debit card income, which was partially offset by a 33.7% decrease in legal fees, and a 153.8% decrease in loan collection expense.
Income Taxes
The provision for income taxes is primarily affected by the tax rate, the level of earnings before taxes and the level of tax-exempt income. In 2023, tax expense increased to $8,092,000 from $5,782,000 in 2022, due to an increase in income before taxes. Non-taxable municipal bond income was $914,000 and $909,000 for the years ended December 31, 2023 and 2022, respectively.
Liquidity
Liquidity is defined as the ability to generate cash at a reasonable cost to fulfill lending commitments and support asset growth, while satisfying the withdrawal demands of deposit customers and any debt repayment requirements. The Bank’s principal sources of liquidity are core deposits and loan and investment payments and proceeds of sale and prepayments. Providing secondary sources of liquidity are excess reserves at the Federal Reserve Bank and the available-for-sale investment portfolio. The Company held $104,466,000 and $572,357,000 in excess reserves at the Federal Reserve Bank and total investment securities at December 31, 2023, respectively. Under certain deposit, borrowing, and other arrangements, the Company must hold and pledge investment securities as collateral. At December 31, 2023, such collateral requirements totaled approximately $43,884,000. As a smaller source of liquidity, the Bank can utilize existing credit arrangements.
The Company’s primary source of liquidity on a stand-alone basis is dividends from the Bank. As discussed in Part I (Item 1) of this Annual Report on Form 10-K, dividends from the Bank are subject to regulatory and corporate law restrictions.
Liquidity risk can result from the mismatching of asset and liability cash flows, or from disruptions in the financial markets. The Bank experiences seasonal swings in deposits, which can impact liquidity. Management has sought to address these seasonal swings by scheduling investment maturities and developing seasonal credit arrangements with the FHLB, Federal Reserve Bank and Federal Funds lines of credit with correspondent banks. The Company maintains short-term unsecured lines of credit with other banks which totaled $132,000,000 at December 31, 2023. Additionally, the Company has a line of credit with the FHLB, with a remaining borrowing capacity at December 31, 2023 of $395,455,000; credit availability is subject to certain collateral requirements. In addition, the Bank is eligible for participation in the newly created Bank Term Funding Program at the FRB which is intended to provide liquidity to U.S. depository institutions using one-year advances, prepayable without penalty, provided at the one-year overnight index swap rate plus 10 basis points limited to the value of eligible collateral. Eligible collateral includes any collateral eligible for purchase by the Federal Reserve Bank, at par value, provided such collateral was owned by the borrower at March 12, 2023. As of December 31, 2023, the Company had $523,888,000 in par value of unpledged securities available to pledge to secure advances under the newly created Bank Term Funding Program.
In addition, the ability of the Bank’s real estate department to originate and sell loans into the secondary market has provided another tool for the management of liquidity. As of December 31, 2023, the Company has not created any special purpose entities to securitize assets or to obtain off-balance sheet funding.
The liquidity position of the Bank is managed daily, thus enabling the Bank to adapt its position according to market fluctuations. Liquidity is measured by various ratios, the most common of which is the ratio of net loans (including loans held-for-sale) to deposits. This ratio was 62.2% on December 31, 2023, and 56.2% on December 31, 2022. At December 31, 2023 and 2022, the Bank’s ratio of core deposits to total assets was 87.0% and 91.8%, respectively. Core deposits include demand deposits, interest-bearing transaction deposits, savings and money market deposit accounts, and non-brokered time deposits of $250,000 or less. Core deposits are important in maintaining a strong liquidity position as they represent a stable and relatively low-cost source of funds. Management believes that the Bank’s liquidity position was adequate in 2023. This is best illustrated by the change in the Bank’s net non-core ratio, which explains the degree of reliance on non-core liabilities to fund long-term assets. At December 31, 2023, the Bank’s net core funding dependence ratio, the difference between non-core funds, time deposits $250,000 or more and brokered time deposits under $250,000, and short-term investments to long-term assets, was (8.45)% as of December 31, 2023, and (13.58%) as of December 31, 2022. This ratio indicated that, at December 31, 2023, the Bank did not significantly rely upon non-core deposits and borrowings to fund the Bank’s long-term assets, namely loans and investments. The Bank believes that by maintaining adequate volumes of short-term investments and implementing competitive pricing strategies on deposits, it can ensure adequate liquidity to support future growth. The Bank also believes that its liquidity position remains strong to meet both present and future financial obligations and commitments, events or uncertainties that have resulted or are reasonably likely to result in material changes with respect to the Bank’s liquidity.
Commitments
The following table details the amounts and expected maturities of commitments as of December 31, 2023 (amounts in thousands):
| | | Maturities by period | |
| Commitments | | Total | | | Less than 1 year | | | 1-3 years | | | 3-5 years | | | More than 5 years | |
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| Commitments to extend credit | | | | | | | | | | | | | | | |
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Commitments to sell loans | | | | | | | | | | | | | | | | | | | | |
Standby Letters of Credit | | | | | | | | | | | | | | | | | | | | |
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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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Off-Balance Sheet Arrangements
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. These loans have been sold to third parties without recourse, subject to customary default, representations and warranties, recourse for breaches of the terms of the sales contracts and payment default recourse.
Financial instruments, whose contract amounts represent credit risk at December 31 of the indicated years, were as follows (amounts in thousands):
| | | 2023 | | | 2022 | |
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Undisbursed loan commitments | | | | | | | | |
Standby letters of credit | | | | | | | | |
Commitments to sell loans | | | | | | | | |
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Our liquidity position is continuously monitored and adjustments are made to balance between sources and uses of funds as deemed appropriate. The Bank believes that it has the means to provide adequate liquidity for funding normal operations in 2024.
Capital
The Company believes a strong capital position is essential to the Company’s continued growth and profitability. A solid capital base provides depositors and shareholders with a margin of safety, while allowing the Company to take advantage of profitable opportunities, support future growth and provide protection against any unforeseen losses.
At December 31, 2023, stockholders’ equity totaled $159.2 million, an increase of $34.2 million from $125.0 million at December 31, 2022. The increase in 2023 was primarily due to net income of $21.6 million and a decrease in other comprehensive loss, net of tax of $12.8 million. Also affecting capital in 2023 were stock repurchases totaling $0.1 million and paid-in capital in the amount of $0.9 million resulting from employee stock purchases and stock plan accruals. See “Business – Capital Standards” in Part I, Item 1 of this Annual Report on Form 10-K, for additional information.
On May 20, 2021, the Company approved a stock repurchase program effective June 15, 2021. The stock repurchase program, which remained in effect until June 14, 2023, allowed for repurchases by the Company in an aggregate amount of up to 4% of the Company’s 13,680,085 outstanding shares of common stock as of March 31, 2021. This represented total shares of 547,203 eligible for repurchase. The Company repurchased 20,054 shares of the Company’s outstanding common stock during the year ended December 31, 2023, and no shares remained available for repurchase under the stock repurchase program at December 31, 2023. The purpose of the stock repurchase program was to give management the ability to manage capital and create liquidity for shareholders who want to sell their stock. Management believed that the stock repurchase program was a prudent use of excess capital.
The capital of the Company and the Bank historically have been maintained at a level that is in excess of regulatory guidelines for a “well capitalized” institution. The policy of annual stock dividends rather than cash dividends has, over time, allowed the Company to match capital and asset growth through retained earnings and a managed program of geographic growth.
| ITEM 7A – | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
Not applicable.
