EDGAR 10-K Filing

Company CIK: 1521951
Filing Year: 2022
Filename: 1521951_10-K_2022_0001521951-22-000016.json

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ITEM 1. BUSINESS
Item 1. Business
BUSINESS
General
First Business Financial Services, Inc. (together with all of its subsidiaries, collectively referred to as the “Corporation,” “FBFS,” “we,” “us,” or “our”) is a registered bank holding company originally incorporated in 1986 under the laws of the State of Wisconsin and is engaged in the commercial banking business through its wholly-owned bank subsidiary, First Business Bank (“FBB” or the “Bank”), headquartered in Madison, Wisconsin. All of our operations are conducted through FBB and First Business Specialty Finance, LLC (“FBSF”). The Bank operates as a business bank, delivering a full line of commercial banking products and services tailored to meet the specific needs of small and medium-sized businesses, business owners, executives, professionals, and high net worth individuals. Our products and services include those for business banking, private wealth, and bank consulting. Within business banking, we offer commercial lending, asset-based lending, accounts receivable financing, equipment financing, floorplan financing, vendor financing, Small Business Administration (“SBA”) lending and servicing, treasury management services, and company retirement plans. Our private wealth management services include trust and estate administration, financial planning, investment management, consumer lending and private banking for executives and owners of our business banking clients and others. Our bank consulting experts provide investment portfolio administrative services, asset liability management services, and asset liability management process validation for other financial institutions. We do not utilize a branch network to attract retail clients. Our operating philosophy is predicated on deep client relationships within our commercial bank markets and extensive expertise within our nationwide specialized lending business lines, combined with the efficiency of centralized administrative functions, such as information technology, loan and deposit operations, finance and accounting, credit administration, compliance, marketing, and human resources. Our focused model allows experienced staff to provide the level of financial expertise needed to develop and maintain long-term relationships with our clients. We conduct our commercial banking business operations through one operating segment.
As of December 31, 2021, on a consolidated basis, we had total assets of $2.653 billion, total gross loans and leases of $2.241 billion, total deposits of $1.958 billion, and total stockholders’ equity of $232.4 million.
Commercial Banking Business Lines
Commercial Lending
We strive to meet the specific commercial lending needs of small- to medium-sized companies in our primary markets in Wisconsin, Kansas, and Missouri, predominantly through lines of credit and term loans to businesses with annual sales of up to $75 million. Through FBB, we service South Central Wisconsin, Southeast Wisconsin, Northeast Wisconsin, and the greater Kansas City Metro.
Our commercial loans are typically secured by various types of business assets, including inventory, receivables, and equipment. We also originate loans secured by commercial real estate, including owner-occupied and non owner-occupied commercial facilities. In very limited cases, we may originate loans on an unsecured basis. As of December 31, 2021, our conventional commercial real estate and commercial loans - excluding consumer lending, asset-based lending, accounts receivable financing, equipment financing, floorplan financing, and SBA lending described below - represented approximately 78% of our total gross loans and leases receivable.
Asset-Based Lending
FBB, through its wholly-owned subsidiary FBSF, provides asset-based lending to small- to medium-sized companies. With sales offices located in several states, our asset-based lending team serves clients nationwide. We primarily provide revolving lines of credit and term loans for financial and strategic acquisitions, capital expenditures, working capital to support rapid growth, bank debt refinancing, debt restructuring, and corporate turnaround strategies. As a bank-owned, asset-based lender with strong underwriting standards, our team is positioned to provide cost-effective financing solutions to companies which do not have the established, stable cash flows necessary to qualify for traditional commercial lending products. These borrowing relationships generally range between $2 million and $15 million with terms of 24 to 60 months. Asset-based lending typically generates higher yields than traditional commercial lending. This line of business complements our traditional commercial loan portfolio and provides us with more diverse income opportunities. As of December 31, 2021, asset-based lending represented approximately 8% of our total gross loans and leases receivable.
Accounts Receivable Financing
FBB, through its wholly-owned subsidiary FBSF, provides funding to clients by purchasing accounts receivable primarily on a full recourse basis. With sales offices located in several states, our accounts receivable financing team serves clients nationwide. Our accounts receivable financing team provides working capital to support growth and other cash flow needs. Accounts receivable financing typically generates higher yields than traditional commercial lending and complements our traditional commercial portfolio. As of December 31, 2021, accounts receivable financing represented approximately 3% of our total gross loans and leases receivable.
Equipment Financing
FBB, through its wholly-owned subsidiary FBSF, delivers a broad range of equipment finance products, including loans and leases, to address the financing needs of commercial clients in a variety of industries. Our focus in this financing vertical includes manufacturing equipment, industrial assets, construction and transportation equipment, and a wide variety of other commercial equipment. These financings generally range between $250,000 and $5 million with terms of 36 to 84 months.
FBSF also delivers small ticket vendor equipment financing through its proprietary, online, credit scoring architecture. Through this nationwide distribution channel, FBSF provides financing solutions for equipment vendors and their end users. These equipment vendors specialize primarily in healthcare, manufacturing, and technology equipment, as well as specialty vehicles. The end users (i.e., our lessees and borrowers) are primarily businesses utilizing vocational trucks, physician group practices, veterinarians, and hospitals. These financings generally range between $25,000 and $250,000 with terms of 36 to 84 months. Small ticket vendor equipment financing typically generates higher yields than traditional commercial lending. As of December 31, 2021, equipment financing represented approximately 5% of our total gross loans and leases receivable.
Floorplan Financing
FBB, through its wholly-owned subsidiary FBSF, offers floorplan financing for independent car dealerships nationwide. Floorplan financing allows car dealers the flexibility to finance their acquisition of preowned cars, preserving liquidity and allowing dealers to purchase inventory. Floorplan financing is the latest expansion of the Bank’s specialized lending solutions, offering floorplan programs from $500,000 to $10 million for larger, well-established independent car dealers. As of December 31, 2021, floorplan financing represented approximately 2% of our total gross loans and leases receivable.
SBA Lending and Servicing
SBA loans are made through programs designed by the federal government to assist the small business community in obtaining financing. We are an approved participant in the SBA’s Preferred Lender Program (“PLP”). The PLP is part of the SBA's effort to streamline the procedures necessary to provide financial assistance to the small business community. Under this program, the SBA delegates the final credit decision and most servicing and liquidation authority and responsibility to PLP lenders. We leverage this program authority and capacity to package, underwrite, process, service, and liquidate, if necessary, SBA loans nationwide.
Excluding Paycheck Protection Program (“PPP”) loans, our SBA loans fall into three categories: loans originated under the SBA’s 7(a) term loan program; loans originated under the SBA’s 504 program; and SBA Express loans and lines of credit. Specific program guidelines vary based on the SBA loan program; however, all loans must be underwritten, originated, monitored, and serviced according to the SBA’s Standard Operating Procedures in order to maintain the guaranty, if any, under the SBA program. Except for loans originated under the SBA’s 504 program, the SBA generally provides a guaranty to the lender ranging from 50% to 90% of principal and interest as an inducement to the lender to originate the loan.
The majority of our SBA loans are originated using the 7(a) term loan program. This program typically provides a guaranty of 75% of principal and interest. In the event of default on the loan, the lender may request that the SBA purchase the guaranteed portion of the loan for an amount equal to outstanding principal plus accrued interest permissible under SBA guidelines. In addition, the SBA will share on a pro-rata basis in certain costs of collection, subject to SBA rules and limits, as well as the proceeds of liquidation.
SBA lending is designed to generate new business opportunities for the Bank by meeting the needs of clients that cannot be met with conventional bank loans. We earn interest income from these loans, generally at variable rates higher than those of our traditional commercial loans. We also obtain funding and service fee income by gathering deposits from these clients. Our SBA strategy generates non-interest income from two primary sources. First, we typically sell the guaranteed portions of the SBA loans to aggregators who securitize the assets for sale in the secondary market. We receive a premium on each loan sold, resulting in the recognition of a gain in the period of sale. Second, we receive servicing income from the holder
of the securitized asset over the life of the loan. As of December 31, 2021, the on-balance sheet portion of SBA loans represented approximately 2% of our total gross loans and leases receivable.
Treasury Management Services
FBB provides comprehensive cash management services for commercial banking and specialized lending clients to manage their cash and liquidity, including lockbox, accounts receivable collection services, electronic payment solutions, fraud detection and protection, information reporting, reconciliation, and data integration solutions. For our clients involved in international trade, the Bank offers international payment services, foreign exchange, and trade letters of credit. The Bank also offers a variety of deposit accounts and balance optimization solutions.
Company Retirement Plan Services
FBB acts as fiduciary and investment manager for corporate clients, creating and executing asset allocation strategies tailored to each corporation’s unique situation. FBB acts as a discretionary trustee and investment fiduciary, sharing responsibility for monitoring assets to match the client’s specifications. Offering only non-proprietary funds removes conflict of interest while designing cost-effective company retirement plans which provide a competitive return. As of December 31, 2021, FBB had $363.8 million of company retirement plan assets under management and administration.
Private Wealth Management
FBB acts as fiduciary and investment manager for individual clients, creating and executing asset allocation strategies tailored to each client’s unique situation. FBB has full fiduciary powers and offers trust and estate administration, financial planning, and investment management, acting in a trustee or agent capacity. FBB also provides brokerage and custody-only services, for which we administer and safeguard assets, but do not provide investment advice. As of December 31, 2021, FBB had $2.557 billion of private wealth assets under management and administration.
The Bank also originates a small amount of consumer loans to its Private Wealth Management clients. As of December 31, 2021, our consumer and other loans represented approximately 2% of our total gross loans and leases receivable.
Bank Consulting Services
FBB provides outsourced treasury services to assist banks and other financial institutions with balance sheet management. These services include investment portfolio management and administrative services, asset liability management services, and asset liability process validations required by regulators.
Competition
FBB encounters strong competition across all of our lines of business. Such competition includes banks, savings institutions, mortgage banking companies, credit unions, finance companies, equipment finance companies, mutual funds, insurance companies, brokerage firms, investment banking firms, and FinTech companies. The Bank also competes with regional and national financial institutions, many of which have greater liquidity, higher lending limits, greater access to capital, more established market recognition, and more resources than the Bank. We believe the experience, expertise, and responsiveness of our banking professionals as well as our focus on fostering long-lasting relationships sets us apart from our competitors.
Human Capital Management
At December 31, 2021, we had 312 employees which equated to approximately 304 full-time equivalent employees (“FTE”). None of our employees are represented by a union or subject to a collective bargaining agreement. Information with respect to Human Capital Management is included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the caption “Human Capital Management” and is incorporated herein by reference.
Subsidiaries
First Business Bank
FBB is a state bank chartered in 1909 in Wisconsin under the name Kingston State Bank. In 1990, FBB relocated its home office to Madison, Wisconsin, and began focusing on providing high-quality banking services to small- to medium-sized businesses located in Madison and the surrounding area. FBB’s business lines include commercial loans, commercial real estate
loans, asset-based loans, accounts receivable financing, SBA lending and servicing, floorplan financing, equipment loans and leases, commercial deposit accounts, company retirement solutions, and treasury management services. FBB offers a variety of deposit accounts and personal loans to business owners, executives, professionals, and high net worth individuals. FBB also offers private wealth management services and bank consulting services. FBB has four full-service banking locations in Madison, Brookfield, and Appleton, Wisconsin, and Leawood, Kansas.
As of December 31, 2021, FBB had seven wholly-owned subsidiaries and total gross loans and leases receivable of $2.241 billion, total deposits of $1.958 billion, and total stockholders’ equity of $265.0 million.
FBFS Statutory Trust II
In September 2008, FBFS formed FBFS Statutory Trust II (“Trust II”), a Delaware business trust wholly-owned by FBFS. In 2008, Trust II completed the sale of $10.0 million of 10.5% fixed rate trust preferred securities. Trust II also issued common securities in the amount of $315,000 to FBFS. Trust II used the proceeds from the offering to purchase $10.3 million of 10.5% junior subordinated notes issued by FBFS. FBFS has the right to redeem the junior subordinated notes at each interest payment date on or after September 26, 2013. The preferred securities are mandatorily redeemable upon the maturity of the junior subordinated notes on September 26, 2038. FBFS’s ownership interest in Trust II has not been consolidated into the financial statements.
Corporate Information
Our principal executive offices are located at 401 Charmany Drive, Madison, Wisconsin 53719 and our telephone number is (608) 238-8008. The contents of our website are not incorporated by reference into this Form 10-K. We maintain an Internet website at www.firstbusiness.bank. This Form 10-K and all of our other filings under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available free of charge through that website, including copies of our proxy statement, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we file those materials with, or furnish them to, the Securities and Exchange Commission (“SEC”).
Markets
Although certain of our business lines are marketed throughout the Midwest and beyond, our primary markets lie in Wisconsin, Kansas, and Missouri. Specifically, our three markets in Wisconsin consist of South Central Wisconsin, Southeast Wisconsin, and Northeast Wisconsin. We serve the greater Kansas City Metro through our Leawood, Kansas office, which is located in the Kansas City metropolitan area. Each of our primary markets provides a unique set of economic and demographic characteristics which provide us with a variety of strategic opportunities. A brief description of each of our primary markets is as follows:
South Central Wisconsin
As the capital of Wisconsin and home of the University of Wisconsin-Madison, the greater Madison area, specifically Dane County, offers an appealing economic environment populated by a highly educated workforce. While the economy of the South Central Wisconsin is driven in large part by the government and education sectors, there is also a diverse array of industries outside of these segments. South Central Wisconsin is also home to technology and research and development related companies, which benefit from the area’s strong governmental and academic ties, as well as several major health care systems and hospitals, which provides healthcare services to South Central Wisconsin.
Southeast Wisconsin
Our Southeast Wisconsin market, the primary commercial and industrial hub for Southeast Wisconsin, provides a diverse economic base, with both a highly skilled labor force and significant manufacturing base. The most prominent economic sectors include manufacturing, financial services, health care, diversified service companies, and education. The area is home to several major hospitals, providing health services to the greater Southeast Wisconsin market, several large academic institutions including the University of Wisconsin-Milwaukee and Marquette University, and a wide variety of small- to medium-sized firms with representatives in nearly every industrial classification.
Northeast Wisconsin
The cities of Appleton, Green Bay, and Oshkosh, Wisconsin serve as the primary population centers in our Northeast Wisconsin market and provide an attractive market to a variety of industries, including transportation, utilities, packaging, and diversified services, with the most significant economic drivers being the manufacturing, packaging, and paper goods industries.
Kansas City Metro
Geographically located in the center of the U.S., the greater Kansas City Metro includes 15 counties and more than 50 communities in Missouri and Kansas, including a central business district located in Kansas City, Missouri and communities on both sides of the state line. The area is known for the diversity of its economic base, with major employers in manufacturing and distribution, architecture and engineering, technology, telecommunications, financial services, and bioscience, as well as local government and higher education.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following contains certain information about the executive officers of FBFS. There are no family relationships between any directors or executive officers of FBFS.
Corey A. Chambas, age 59, has served as a director of FBFS since July 2002, as Chief Executive Officer since December 2006 and as President since February 2005. He served as Chief Operating Officer of FBFS from February 2005 to September 2006 and as Executive Vice President from July 2002 to February 2005. He served as Chief Executive Officer of FBB from July 1999 to September 2006 and as President of FBB from July 1999 to February 2005. Mr. Chambas has over 35 years of commercial banking experience. Prior to joining FBFS in 1993, he was a Vice President of Commercial Lending with M&I Bank, now known as BMO Harris Bank, N.A. (“BMO Harris Bank”), in Madison, Wisconsin.
Edward G. Sloane, Jr., age 61, has served as Chief Financial Officer of FBFS since January 2016. Mr. Sloane also serves as the Chief Financial Officer of the Bank. Mr. Sloane has over 35 years of financial services experience including mergers and acquisitions, strategic planning and financial reporting and analysis. Prior to joining FBFS, Mr. Sloane was Executive Vice President, Chief Financial Officer and Treasurer with Peoples Bancorp, Inc. in Marietta, Ohio from 2008 to 2015. He also served as Senior Vice President of Strategic Planning & Analysis for WesBanco, Inc. in Wheeling, West Virginia from 2006 to 2008, as Senior Vice President and Controller from 1998 to 2006 and in various other capacities from 1989 to 1998.
Barbara M. Conley, age 68, has served as FBFS’s General Counsel since June 2008. Ms. Conley also serves as General Counsel of the Bank. She has over 35 years of experience in commercial banking. Immediately prior to joining FBFS in 2007, Ms. Conley was a Senior Vice President in Corporate Banking with Associated Bank, National Association. She had been employed at Associated Bank since May 1976.
Jodi A. Chandler, age 57, has served as Chief Human Resources Officer of FBFS since January 2010. Prior to that, she held the position of Senior Vice President-Human Resources for several years. She has been an employee of FBFS for over 25 years.
Mark J. Meloy, age 60, has served as Chief Executive Officer of FBB since December 2007. Mr. Meloy joined FBFS in 2000 and has held various positions including Executive Vice President of FBB and President and Chief Executive Officer of FBB-Milwaukee. He also currently serves as a director of our subsidiaries FBB and FBSF. Mr. Meloy has over 35 years of commercial lending experience. Prior to joining FBFS, Mr. Meloy was a Vice President and Senior Relationship Manager with Firstar Bank, NA, in Cedar Rapids, Iowa and Milwaukee, Wisconsin, now known as U.S. Bank, working in their financial institutions group with mergers and acquisition financing.
Daniel S. Ovokaitys, age 48, has served as Chief Information Officer since June 2014. Prior to joining FBFS, Mr. Ovokaitys held the position of Head of Corporate IT (North/South America) for Merz Pharmaceuticals, located in Frankfurt, Germany, from 2010 to 2014. He also served as Director of IT for Aurora Health Care from 2006 to 2010 and Manager of IT for the American Transmission Company from 2000 to 2006.
David R. Seiler, age 57, has served as Chief Operating Officer of FBFS since April 2016. He also currently serves as a director for our subsidiary FBSF. Mr. Seiler has over 25 years of financial services experience including his previous position as Managing Director (formerly Senior Vice President/Manager) of the Correspondent Banking Division with BMO Harris
Bank in Milwaukee, Wisconsin which he held from 2007 to 2016. Prior to that, he held the position of Senior Vice President/Team Leader, Correspondent Real Estate Division from 2005 to 2007 and Vice President, Relationship Manager, Commercial Real Estate from 2002 to 2005.
Bradley A. Quade, age 56, has served as Chief Credit Officer of FBFS since April 2020. Mr. Quade had been serving as the Company’s Deputy Chief Credit Officer since October 2019. He also currently serves as a director for our subsidiary FBSF. Mr. Quade has over 30 years of experience in banking at publicly traded and privately-owned institutions and has led successful lending teams in commercial banking, investment real estate, equipment leasing, and treasury management. Prior to joining FBFS, Mr. Quade held the position of Senior Vice President with Johnson Bank in Milwaukee, Wisconsin which he held from 2008 to 2019.
James E. Hartlieb, age 51, has served as President of FBB since 2015. Mr. Hartlieb joined FBB in 2009 as Senior Vice President of Greater Dane County. Mr. Hartlieb has over 25 years of financial services experience. Prior to joining FBB, Mr. Hartlieb held the position of Regional President with AMCORE Bank in Madison, Wisconsin, which he held from 1998 to 2009.
SUPERVISION AND REGULATION
Below is a brief description of certain laws and regulations that relate to us and the Bank. This narrative does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.
General
Federal Deposit Insurance Corporation (“FDIC”)-insured institutions, like the Bank, their holding companies, and their affiliates are extensively regulated under federal and state law. As a result, our growth and earnings performance may be affected not only by management decisions and general economic conditions, but also by the requirements of federal and state statutes and by the regulations and policies of various bank regulatory agencies, including our primary regulator, the Board of Governors of the Federal Reserve System (“Federal Reserve”), the Bank’s state regulator, the Wisconsin Department of Financial Institutions (“WDFI”), and its primary federal regulator, the FDIC. Furthermore, taxation laws administered by the Internal Revenue Service (“IRS”) and state taxing authorities, accounting rules developed by the Financial Accounting Standards Board (“FASB”), securities laws administered by the SEC and state securities authorities, and anti-money laundering laws enforced by the U.S. Department of the Treasury (“Treasury”) have an impact on our business. The effect of these statutes, regulations, regulatory policies, and accounting rules are significant to our operations and results.
Federal and state banking laws impose a comprehensive system of supervision, regulation, and enforcement on the operations of FDIC-insured institutions, their holding companies, and affiliates that is intended primarily for the protection of the FDIC-insured deposits and depositors of banks, rather than shareholders. These laws, and the regulations of the bank regulatory agencies issued under them, affect, among other things, the scope of our business, the kinds and amounts of investments the Corporation and the Bank may make, reserve requirements, required capital levels relative to assets, the nature and amount of collateral for loans, the establishment of branches, the ability to merge, consolidate and acquire, dealings with the Corporation’s and the Bank’s insiders and affiliates, and payment of dividends. In reaction to the global financial crisis beginning in 2008 (the “global financial crisis”) and particularly following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), we experienced heightened regulatory requirements and scrutiny. Although the reforms primarily targeted systemically important financial service providers, their influence filtered down in varying degrees to community banks over time and caused our compliance and risk management processes, and the costs thereof, to increase. After the 2016 federal elections, momentum to decrease the regulatory burden on community banks gathered strength. In May 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Regulatory Relief Act”) was enacted to modify or remove certain financial reform rules and regulations. While the Regulatory Relief Act maintains most of the regulatory structure established by the Dodd-Frank Act, it amends certain aspects of the regulatory framework for small depository institutions with assets of less than $10 billion, like us, and for large banks with assets of more than $50 billion that were considered systemically important under the Dodd-Frank Act solely because of size. Many of these changes were intended to result in meaningful regulatory relief for community banks and their holding companies, including new rules that may make the capital requirements less complex. For a discussion of capital requirements, see The Role of Capital below. The Regulatory Relief Act also eliminated questions about the applicability of certain Dodd-Frank Act reforms to community bank systems, including relieving the Bank of any requirement to engage in mandatory stress tests, name a risk committee, or comply with the Volcker Rule’s complicated prohibitions on proprietary trading and ownership of private funds. The Corporation believes these reforms are generally favorable to its operations.
The supervisory framework for U.S. banking organizations subjects banks and bank holding companies to regular examination by their respective regulatory agencies, which results in examination reports and ratings that are not publicly
available and can impact the conduct and growth of their business. These examinations consider not only compliance with applicable laws and regulations, but also capital levels, asset quality and risk, management ability and performance, earnings, liquidity, information technology, and various other factors. The regulatory agencies generally have broad discretion to impose restrictions and limitations on the operations of a regulated entity where the agencies determine, among other things, that such operations are unsafe or unsound, fail to comply with applicable law, or are otherwise inconsistent with laws and regulations.
The following is a summary of the material elements of the supervisory and regulatory framework applicable to the Corporation and the Bank, beginning with a discussion of the continuing regulatory emphasis on our capital levels. It does not describe all of the statutes, regulations, and regulatory policies that apply, nor does it restate all of the requirements of those that are described. The descriptions are qualified in their entirety by reference to the particular statutory and regulatory provision.
The Role of Capital
Regulatory capital represents the net assets of a banking organization available to absorb losses. Because of the risks attendant to their business, FDIC-insured institutions are generally required to hold more capital than other businesses, which directly affects our earnings capabilities. While capital has historically been one of the key measures of the financial health of both bank holding companies and banks, its role became fundamentally more important in the wake of the global financial crisis, as the banking regulators recognized that the amount and quality of capital held by banks prior to the crisis was insufficient to absorb losses during periods of severe stress. Certain provisions of the Dodd-Frank Act and Basel III, discussed below, establish capital standards for banks and bank holding companies that are meaningfully more stringent than those in place previously.
Minimum Required Capital Levels. Banks have been required to hold minimum levels of capital based on guidelines established by the bank regulatory agencies since 1983. The minimums have been expressed in terms of ratios of “capital” divided by “total assets.” As discussed below, bank capital measures have become more sophisticated over the years and have focused more on the quality of capital and the risk of assets. Bank holding companies have historically had to comply with less stringent capital standards than their bank subsidiaries and have been able to raise capital with hybrid instruments such as trust preferred securities. The Dodd-Frank Act mandated the Federal Reserve to establish minimum capital levels for holding companies on a consolidated basis as stringent as those required for FDIC-insured institutions. A result of this change is that the proceeds of hybrid instruments, such as trust preferred securities, were excluded from capital over a phase-out period. However, if such securities were issued prior to May 19, 2010 by bank holding companies with less than $15 billion of assets, they may be retained, subject to certain restrictions. Because we have assets of less than $15 billion, we are able to maintain our trust preferred proceeds as capital but we have to comply with new capital mandates in other respects and will not be able to raise capital in the future through the issuance of trust preferred securities.
The Basel III Rule. The risk-based capital guidelines for U.S. banks since 1989 were based upon the 1988 capital accord known as “Basel I” adopted by the international Basel Committee on Banking Supervision, a committee of central banks and bank supervisors that acts as the primary global standard setter for prudential regulation, as implemented by the U.S. bank regulatory agencies on an interagency basis. The principles reached as part of Basel I have been subject to change in subsequent years. On September 12, 2010, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced agreement on a strengthened set of capital requirements for banking organizations around the world, known as Basel III, to address deficiencies recognized in connection with the global financial crisis. In July 2013, the U.S. federal banking agencies approved the implementation of the Basel III regulatory capital reforms in pertinent part, and, at the same time, promulgated rules effecting certain changes required by the Dodd-Frank Act (the “Basel III Rule”). In contrast to capital requirements historically, which were in the form of guidelines, Basel III was released in the form of enforceable regulations by each of the regulatory agencies. The Basel III Rule is applicable to all banking organizations that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies, other than “small bank holding companies” who are relieved from compliance with the Basel III Rule. While holding companies with consolidated assets of less than $3 billion, like the Corporation, are considered small bank holding companies for this purpose, the Corporation has securities registered with the SEC and that disqualifies us from taking advantage of the relief. Banking organizations became subject to the Basel III Rule on January 1, 2015, and its requirements were fully phased-in as of January 1, 2019.
The Basel III Rule increased the required quantity and quality of capital and, for nearly every class of assets, it requires a more complex, detailed and calibrated assessment of risk and calculation of risk-weight amounts.
Not only did the Basel III Rule increase most of the required minimum capital ratios in effect prior to January 1, 2015, but it introduced the concept of Common Equity Tier 1 Capital, which consists primarily of common stock, related surplus (net of treasury stock), retained earnings, and Common Equity Tier 1 minority interests subject to certain regulatory adjustments. The Basel III Rule also changed the definition of capital by establishing more stringent criteria that instruments must meet to be considered Additional Tier 1 Capital (primarily non-cumulative perpetual preferred stock that meets certain requirements) and
Tier 2 Capital (primarily other types of preferred stock and subordinated debt, subject to limitations). A number of instruments that qualified as Tier 1 Capital under Basel I do not qualify, or their qualifications changed. For example, noncumulative perpetual preferred stock, which qualified as simple Tier 1 Capital under Basel I, does not qualify as Common Equity Tier 1 Capital, but qualifies as Additional Tier 1 Capital. The Basel III Rule also constrained the inclusion of minority interests, mortgage-servicing assets, and deferred tax assets in capital and requires deductions from Common Equity Tier 1 Capital in the event that such assets exceed a certain percentage of a banking institution’s Common Equity Tier 1 Capital.
The Basel III Rule required minimum capital ratios as of January 1, 2015, as follows:
•A ratio of minimum Common Equity Tier 1 Capital equal to 4.5% of risk-weighted assets;
•An increase in the minimum required amount of Tier 1 Capital from 4% to 6% of risk-weighted assets;
•A continuation of the minimum required amount of Total Capital (Tier 1 plus Tier 2) at 8% of risk-weighted assets; and
•A minimum leverage ratio of Tier 1 Capital to total quarterly average assets equal to 4% in all circumstances.
In addition, institutions that seek the freedom to make capital distributions (including for dividends and repurchases of stock) and pay discretionary bonuses to executive officers without restriction must also maintain 2.5% in Common Equity Tier 1 Capital attributable to a capital conservation buffer (fully phased-in as of January 1, 2019). The purpose of the conservation buffer is to ensure that banking institutions maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. Factoring in the conservation buffer increases the minimum ratios depicted above to 7% for Common Equity Tier 1 Capital, 8.5% for Tier 1 Capital and 10.5% for Total Capital.
Well-Capitalized Requirements. The ratios described above are minimum standards in order for banking organizations to be considered “adequately capitalized.” Bank regulatory agencies uniformly encourage banks to hold more capital and be “well-capitalized” and, to that end, federal law and regulations provide various incentives for banking organizations to maintain regulatory capital at levels in excess of minimum regulatory requirements. For example, a banking organization that is well-capitalized may: (i) qualify for exemptions from prior notice or application requirements otherwise applicable to certain types of activities; (ii) qualify for expedited processing of other required notices or applications; and (iii) accept, roll-over, or renew brokered deposits. Higher capital levels could also be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities, or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 Capital less all intangible assets), well above the minimum levels.
Under the capital regulations of the FDIC, in order to be well-capitalized, a banking organization must maintain:
•A Common Equity Tier 1 Capital ratio to risk-weighted assets of 6.5% or more;
•A ratio of Tier 1 Capital to total risk-weighted assets of 8% or more (6% under Basel I);
•A ratio of Total Capital to total risk-weighted assets of 10% or more (the same as Basel I); and
•A leverage ratio of Tier 1 Capital to total adjusted average quarterly assets of 5% or greater.
As of December 31, 2021: (i) the Bank is not subject to a directive from the WDFI or the FDIC to increase its capital; and (ii) the Bank was well-capitalized, as defined by FDIC regulations. Additionally, the Corporation had regulatory capital in excess of the Federal Reserve’s requirements as of December 31, 2021.
Prompt Corrective Action. The concept of an institution being “well-capitalized” is part of a regulatory enforcement regime that provides the federal banking regulators with broad power to take “prompt corrective action” to resolve the problems of institutions based on the capital level of each particular institution. The extent of the regulators’ powers depends on whether the institution in question is “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation. Depending upon the capital category to which an institution is assigned, the regulators’ corrective powers include: (i) requiring the institution to submit a capital restoration plan; (ii) limiting the institution’s asset growth and restricting its activities; (iii) requiring the institution to issue additional capital stock (including additional voting stock) or to sell itself; (iv) restricting transactions between the institution and its affiliates; (v) restricting the interest rate that the institution may pay on deposits; (vi) ordering a new election of directors of the institution; (vii) requiring that senior executive officers or directors be dismissed; (viii) prohibiting the institution from accepting deposits from correspondent banks; (ix) requiring the institution to divest certain subsidiaries; (x) prohibiting the payment of principal or interest on subordinated debt; and (xi) ultimately, appointing a receiver for the institution.
Community Bank Capital Simplification. Community banks have long raised concerns with bank regulators about the regulatory burden, complexity, and costs associated with certain provisions of the Basel III Rule. In response, Congress provided a potential Basel III “off-ramp” for certain institutions, like us, under Section 201 of the Regulatory Relief Act. Pursuant to authority granted thereunder, on September 17, 2019, the agencies adopted a final rule, effective on January 1, 2020, providing that banks and bank holding companies that have less than $10 billion in total consolidated assets and meet other qualifying criteria, including a “Community Bank Leverage Ratio” (“CBLR”)-calculated by dividing tier 1 capital by average total consolidated assets-of greater than 9%, will be eligible to opt into the CBLR framework. By opting into the framework, qualifying banks and bank holding companies maintaining a CBLR greater than 9% will be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the agencies’ capital rules and, if applicable, will be considered to have met the well-capitalized ratio requirements for purposes of section 38 of the Federal Deposit Insurance Act. In addition to the consolidated assets and CBLR requirements described above, a qualifying bank or bank holding company must also have (i) total off-balance sheet exposures (excluding derivatives other than sold credit derivatives and unconditionally cancellable commitments) of 25% or less of total consolidated assets, and (ii) the sum of total trading assets and trading liabilities of 5% or less of total consolidated assets.
The Corporation and the Bank opted out of the CBLR framework for each reporting period in 2021 and has the option to opt into the framework for future reporting periods. The decision to opt into or out of the CBLR framework is monitored on an ongoing basis.
First Business Financial Services, Inc.
General. As the sole shareholder of the Bank, we are a bank holding company. As a bank holding company, we are registered with, and subject to regulation, supervision, and enforcement by, the Federal Reserve under the Bank Holding Company Act of 1956, as amended (“BHCA”). We are legally obligated to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where we might not otherwise do so. Under the BHCA, we are subject to periodic examination by the Federal Reserve. We are required to file with the Federal Reserve periodic reports of our operations and such additional information regarding the Corporation and our subsidiaries as the Federal Reserve may require.
Acquisitions and Activities. The primary purpose of a bank holding company is to control and manage banks. The BHCA generally requires the prior approval of the Federal Reserve for any merger involving a bank holding company or any acquisition by a bank holding company of another bank or bank holding company. Subject to certain conditions (including deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States. In approving interstate acquisitions, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its FDIC-insured institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state institutions or their holding companies) and state laws that require that the target bank has been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company. Furthermore, in accordance with the Dodd-Frank Act, bank holding companies must be well-capitalized and well-managed in order to effect interstate mergers or acquisitions. For a discussion of the capital requirements, see The Role of Capital above.
The BHCA generally prohibits the Corporation from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve prior to November 11, 1999 to be “so closely related to banking ... as to be a proper incident thereto.” This authority permits the Corporation to engage in a variety of banking-related businesses, including the ownership and operation of a savings association, or any entity engaged in consumer finance, equipment leasing, the operation of a computer service bureau (including software development), and mortgage banking and brokerage services. The BHCA does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.
Additionally, bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of non-banking activities, including securities and insurance underwriting and sales, merchant banking, and any other activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature or incidental to any such financial activity or that the Federal Reserve determines by order to be complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of FDIC-insured institutions or the financial system generally. The Corporation has not elected to operate as a financial holding company.
Change in Control. Federal law also prohibits any person or company from acquiring “control” of an FDIC-insured depository institution or its holding company without prior notice to the appropriate federal bank regulator. “Control” is conclusively presumed to exist upon the acquisition of 25% or more of the outstanding voting securities of a bank or bank holding company, but may arise under certain circumstances between 10% and 24.99% ownership. On January 30, 2020, the Federal Reserve issued a final rule clarifying and expanding upon the Federal Reserve’s position on determinations of whether a company has the ability to exercise a controlling influence over another company. In particular, the final rule is intended to provide a better understanding of the facts and circumstances that the Federal Reserve considers most relevant when assessing whether control exists. On March 31, 2020, the final rule’s original effective date was delayed and became effective on September 30, 2020.
Capital Requirements. The Corporation has been subject to the complex consolidated capital requirements of the Basel III Rule since the U.S. federal banking agencies approved its implementation effective January 1, 2015. Only qualifying small bank holding companies were excluded from compliance with the Basel III Rule by virtue of the Federal Reserve’s “Small Bank Holding Company Policy Statement.” Prior to 2018, our assets were in excess of the maximum permitted in the definition of a small bank holding company for this purpose; however, the Regulatory Relief Act expanded the category of holding companies that may rely on the policy statement by raising the maximum amount of assets they may hold to $3 billion, and the Federal Reserve issued an interim final rule, effective August 30, 2018, to bring the policy statement in line with the law. As a result, qualifying holding companies with assets of less than $3 billion are not subject to the capital requirements of the Basel III Rule and are deemed to be “well-capitalized.” However, one of the qualifications for this treatment is that the holding company not have securities registered with the SEC. The Corporation is a public reporting company and has shares registered with the SEC. As such, the Corporation does not meet the qualifications of the Small Bank Holding Company Policy Statement. For a discussion of capital requirements, see The Role of Capital above.
Dividend Payments. Our ability to pay dividends to our shareholders may be affected by both general corporate law considerations and policies of the Federal Reserve applicable to bank holding companies. As a Wisconsin corporation, we are subject to the limitations of Wisconsin law, which allows us to pay dividends unless, after giving effect to a dividend, any of the following would occur: (i) we would not be able to pay our debts as they become due in the usual course of business or (ii) the total assets would be less than the sum of its total liabilities plus any amount that would be needed if we were to be dissolved at the time of the dividend payment, to satisfy the preferential rights upon dissolution of shareholders whose rights are superior to the rights of the shareholders receiving the distribution.
As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should eliminate, defer, or significantly reduce dividends to shareholders if: (i) the company’s net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) the prospective rate of earnings retention is inconsistent with the company’s capital needs and overall current and prospective financial condition; or (iii) the company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. In addition, under the Basel III Rule, institutions that seek the freedom to pay dividends have to maintain 2.5% in Common Equity Tier 1 Capital attributable to the capital conservation buffer. See The Role of Capital above for additional information.
Monetary Policy. The monetary policy of the Federal Reserve has a significant effect on the operating results of financial or bank holding companies and their subsidiaries. Among the tools available to the Federal Reserve to affect the money supply are open market transactions in U.S. government securities, changes in the discount rate on bank borrowings, and changes in reserve requirements against bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid on deposits.
Federal Securities Regulation. The Corporation’s common stock is registered with the SEC under the Securities Act of 1933, as amended, and the Exchange Act. Consequently, we are subject to the information, proxy solicitation, insider trading, and other restrictions and requirements of the SEC under the Exchange Act.
Corporate Governance. The Dodd-Frank Act addressed many investor protection, corporate governance, and executive compensation matters that affect most U.S. publicly traded companies. The Dodd-Frank Act increased shareholder influence over boards of directors by requiring companies to give shareholders a nonbinding vote on executive compensation and so-called “golden parachute” payments, and by authorizing the SEC to promulgate rules that would allow shareholders to nominate and solicit voters for their own candidates using a company’s proxy materials. The legislation also directed the Federal Reserve to promulgate rules prohibiting excessive compensation paid to executives of bank holding companies, regardless of whether such companies are publicly traded.
The Bank
General. The Bank is a Wisconsin state-chartered bank. The deposit accounts of the Bank are insured by the FDIC’s Deposit Insurance Fund (“DIF”) to the maximum extent provided under federal law and FDIC regulations, currently $250,000 per insured depositor category. As a Wisconsin-chartered FDIC-insured bank, the Bank is subject to the examination, supervision, reporting, and enforcement requirements of the WDFI, the chartering authority for Wisconsin banks, and the FDIC, designated by federal law as the primary federal regulator of insured state banks that, like the Bank, are not members of the Federal Reserve System (nonmember banks).
Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system whereby FDIC-insured institutions pay insurance premiums at rates based on their risk classification. For institutions like the Bank that are not considered large and highly complex banking organizations, assessments are now based on examination ratings and financial ratios. The total base assessment rates currently range from 1.5 basis points to 30 basis points. At least semi-annually, the FDIC updates its loss and income projections for the DIF and, if needed, increases or decreases the assessment rates, following notice and comment on proposed rulemaking. The assessment base against which an FDIC-insured institution’s deposit insurance premiums paid to the DIF has been calculated since effectiveness of the Dodd-Frank Act is based on its average consolidated total assets less its average tangible equity. This method shifted the burden of deposit insurance premiums toward those large depository institutions that rely on funding sources other than U.S. deposits.
The reserve ratio is the FDIC insurance fund balance divided by estimated insured deposits. The Dodd-Frank Act altered the minimum reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits, and eliminating the requirement that the FDIC pay dividends to FDIC-insured institutions when the reserve ratio exceeds certain thresholds. The reserve ratio reached 1.36% as of September 30, 2018, exceeding the statutory required minimum reserve ratio of 1.35%. Accordingly, pursuant to rules adopted by the FDIC, in January 2019 the FDIC provided notice of assessment credits awarded to insured depository institutions, like the Bank, with total consolidated assets of less than $10 billion for the portion of their regular assessments that contributed to growth in the reserve ratio between 1.15% and 1.35%. The FDIC applies the credits each quarter (beginning with the September 2019 assessment invoice for the second quarter of 2019) that the reserve ratio is at least 1.38% to offset the regular deposit insurance assessments of institutions with credits. As of September 30, 2021, the most recent available date, the reserve ratio was 1.27%.
Supervisory Assessments. All Wisconsin banks are required to pay supervisory assessments to the WDFI to fund the operations of that agency. The amount of the assessment is calculated on the basis of the Bank’s total assets.
Capital Requirements. Banks are generally required to maintain capital levels in excess of other businesses. For a discussion of capital requirements, see The Role of Capital above.
Liquidity Requirements. Liquidity is a measure of the ability and ease with which bank assets may be converted to cash. Liquid assets are those that can be converted to cash quickly if needed to meet financial obligations. To remain viable, FDIC-insured institutions must have enough liquid assets to meet their near-term obligations, such as withdrawals by depositors. Because the global financial crisis was in part a liquidity crisis, Basel III also includes a liquidity framework that requires FDIC-insured institutions to measure their liquidity against specific liquidity tests. One test, referred to as the Liquidity Coverage Ratio (“LCR”), is designed to ensure that the banking entity has an adequate stock of unencumbered high-quality liquid assets that can be converted easily and immediately in private markets into cash to meet liquidity needs for a 30-calendar day liquidity stress scenario. The other test, known as the Net Stable Funding Ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of FDIC-insured institutions over a one-year horizon. These tests provide an incentive for banks and holding companies to increase their holdings in Treasury securities and other sovereign debt as a component of assets, increase the use of long-term debt as a funding source, and rely on stable funding like core deposits (in lieu of brokered deposits).
Dividend Payments. The primary source of funds for the Corporation is dividends from the Bank. Under Wisconsin law, the board of directors of a bank may declare and pay a dividend from its undivided profits in an amount it considers expedient. The board of directors must provide for the payment of all expenses, losses, required reserves, taxes, and interest accrued or due from the bank before the declaration of dividends from undivided profits. If dividends declared and paid in either of the two immediately preceding years exceeded net income for either of those two years respectively, the bank may not declare or pay any dividend in the current year that exceeds year-to-date net income except with the written consent of the WDFI. The FDIC and the WDFI may prohibit the payment of dividends by the Bank if either or both determine such payment would constitute an unsafe or unsound practice. In addition, under the Basel III Rule, institutions that seek the freedom to pay dividends will have to maintain 2.5% in Common Equity Tier 1 Capital attributable to the capital conservation buffer. See The Role of Capital above.
State Bank Investments and Activities. The Bank is permitted to make investments and engage in activities directly or through subsidiaries as authorized by Wisconsin law. However, under federal law and FDIC regulations, FDIC-insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC-insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines that the activity would not pose a significant risk to the DIF. These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.
Insider Transactions. The Bank is subject to certain restrictions imposed by federal law on “covered transactions” between the Bank and its “affiliates.” We are an affiliate of the Bank for purposes of these restrictions, and covered transactions subject to the restrictions include extensions of credit to the Corporation, investments in the stock or other securities of the Corporation, and the acceptance of the stock or other securities of the Corporation as collateral for loans made by the Bank. The Dodd-Frank Act enhanced the requirements for certain transactions with affiliates, including an expansion of the definition of “covered transactions” and an increase in the amount of time for which collateral requirements regarding covered transactions must be maintained.
Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Corporation and its subsidiaries, to principal shareholders of the Corporation, and to “related interests” of such directors, officers, and principal shareholders. In addition, federal law and regulations may affect the terms upon which any person who is a director or officer of the Corporation or the Bank, or a principal shareholder of the Corporation, may obtain credit from banks with which the Bank maintains a correspondent relationship.
Safety and Soundness Standards/Risk Management. The federal banking agencies have adopted operational and managerial standards to promote the safety and soundness of FDIC-insured institutions. The standards apply to internal controls, information systems, internal audit systems, risk mitigation, bank operations, compliance, credit underwriting, interest rate exposure, asset growth, compensation, fiduciary risk, asset quality, and earnings.
In general, the safety and soundness standards prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. While regulatory standards do not have the force of law, if an institution operates in an unsafe and unsound manner, the FDIC-insured institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an FDIC-insured institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the FDIC-insured institution’s rate of growth, require the FDIC-insured institution to increase its capital, restrict the rates the institution pays on deposits, or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with safety and soundness may also constitute grounds for other enforcement action by the federal bank regulatory agencies, including cease and desist orders and civil money penalty assessments.
During the past several years, the bank regulatory agencies have increasingly emphasized the importance of sound risk management processes and strong internal controls when evaluating the activities of the FDIC-insured institutions they supervise. Properly managing risks has been identified as critical to the conduct of safe and sound banking activities and has become even more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking markets. The agencies have identified a spectrum of risks facing a banking institution including, but not limited to, credit, market, liquidity, operational, compliance, and reputational risk. In particular, recent regulatory pronouncements have focused on operational risk, which arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses. New products and services, third-party risk, incentive compensation, and cybersecurity are critical sources of risk that FDIC-insured institutions are expected to address in the current environment. The Bank is expected to have active board and senior management oversight; adequate policies, procedures, and limits; adequate risk measurement, monitoring, and management information systems; and comprehensive internal controls.
Branching Authority. Wisconsin banks, such as the Bank, have the authority under Wisconsin law to establish branches anywhere in the State of Wisconsin, subject to receipt of all required regulatory approvals. The establishment of new interstate branches has historically been permitted only in those states the laws of which expressly authorize such expansion. The Dodd-Frank Act permits well-capitalized and well-managed banks to establish new interstate branches or acquire individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) without impediments. Federal law permits state and national banks to merge with banks in other states subject to: (i) regulatory
approval; (ii) federal and state deposit concentration limits; and (iii) state law limitations requiring the merging bank to have been in existence for a minimum period of time (not to exceed five years) prior to the merger.
Transaction Account Reserves. As announced on March 15, 2020, the Federal Reserve reduced reserve requirement ratios to zero percent by way of an interim final rule that was effective March 26, 2020, and a subsequent final rule adopting the interim final rule effective March 12, 2021. This action eliminated reserve requirements for all depository institutions. The Federal Reserve Act authorizes the Federal Reserve to establish reserve requirements within specified ranges for purposes of implementing monetary policy on certain types of deposits and other liabilities of depository institutions and impose reserve requirements on transaction accounts, non-personal time deposits, and Eurocurrency liabilities.
Prior to the change effective March 26, 2020, reserve requirement ratios on net transaction accounts differed based on the amount of net transactions accounts at the depository institution. A certain amount of net transaction accounts, known as the "reserve requirement exemption amount," was subject to a reserve requirement ratio of zero percent. Net transaction account balances above the reserve requirement exemption amount and up to a specified amount, known as the "low reserve tranche," were subject to a reserve requirement ratio of 3%. Net transaction account balances above the low reserve tranche were subject to a reserve requirement ratio of 10%. For 2022, the low reserve tranche amounts and exemption amounts were increased to $640.6 million and $32.4 million, respectively, compared to $182.9 million and $21.1 million, respectively, for 2021. These reserve requirements are subject to annual adjustment by the Federal Reserve.
Brokered Deposits. On December 19, 2018, the FDIC adopted a final rule on the treatment of reciprocal deposits pursuant to the Regulatory Relief Act. The final rule, effective March 6, 2019, exempts certain reciprocal deposits from being considered as brokered deposits for certain insured institutions. In particular, well-capitalized and well-rated institutions are not required to treat reciprocal deposits as brokered deposits up to the lesser of 20% of their total liabilities or $5 billion. Institutions that are not both well-capitalized and well-rated may also exclude reciprocal deposits from their brokered deposits under certain circumstances.
On December 15, 2020, the FDIC issued a final rule on brokered deposits. The rule aims to clarify and modernize the FDIC’s existing regulatory framework for brokered deposits. Among other things, the rule establishes bright-line standards for determining whether an entity meets the definition of a “deposit broker,” and identifies a number of business relationships (or “designated exceptions”) that automatically meet the “primary purpose” exception. The rule also establishes a transparent application process for entities that seek a “primary purpose” exception but do not meet one of the “designated exceptions.” The new rule also reflects technological changes across the banking industry and removes regulatory disincentives that limit banks’ ability to serve their customers.
Community Reinvestment Act (“CRA”) Requirements. The CRA requires the Bank to have a continuing and affirmative obligation in a safe and sound manner to help meet the credit needs of the entire community, including low- and moderate-income neighborhoods. Federal regulators regularly assess the Bank’s record of meeting the credit needs of its communities. An institution’s CRA assessment may be used by its regulators in their evaluation of certain applications, including a merger, acquisition, or the establishment of a branch office. An unsatisfactory rating may be used as a basis for denial of such an application.
On December 14, 2021, the Office of the Comptroller of the Currency (OCC) issued a final rule to rescind the June 2020 Community Reinvestment Act (CRA) rule and replace it with a rule based on the rules adopted jointly by the federal banking agencies in 1995, as amended. The final rule aligns the OCC’s CRA rules with the current Board of Governors of the Federal Reserve System and Federal Deposit Insurance Corporation rules and thereby facilitates the ongoing interagency work to modernize the CRA regulatory framework and create consistency for all insured depository institutions.
Anti-Money Laundering. The Bank is subject to several federal laws that are designed to combat money laundering and terrorist financing, and to restrict transactions with persons, companies, or foreign governments sanctioned by United States authorities. This category of laws includes the Bank Secrecy Act (the “BSA”), the Money Laundering Control Act, the USA PATRIOT Act (collectively, “AML laws”) and implementing regulations as administered by the United States Treasury Department’s Office of Foreign Assets Control (“sanctions laws”).
As implemented by federal banking and securities regulators and the Department of the Treasury, AML laws obligate depository institutions to verify their customers’ identity, conduct customer due diligence, report on suspicious activity, file reports of transactions in currency, and conduct enhanced due diligence on certain accounts. Sanctions laws prohibit persons of the United States from engaging in any transaction with a restricted person or restricted country. Depository institutions are required by their respective federal regulators to maintain policies and procedures in order to ensure compliance with the above obligations. Federal regulators regularly examine BSA/Anti-Money Laundering (“AML”) and sanctions compliance programs to ensure their adequacy and effectiveness, and the frequency and extent of such examinations and the remedial actions
resulting therefrom have been increasing. Non-compliance with sanctions laws and/or AML laws or failure to maintain an adequate BSA/AML compliance program can lead to significant monetary penalties and reputational damage, and federal regulators evaluate the effectiveness of an applicant in combating money laundering when determining whether to approve a proposed bank merger, acquisition, restructuring, or other expansionary activity.
On January 1, 2021, the National Defense Authorization Act was enacted by Congress. The new law establishes the most significant overhaul of BSA and AML since the USA PATRIOT Act of 2001, including: (i) new beneficial ownership reporting requirements; (ii) whistleblower and penalty enhancements; (iii) improvements to existing information sharing provisions that permit financial institutions to share information relating to suspicious activity reports for purposes of combating illicit finance risks; and (iv) provisions emphasizing the importance of risk-based approaches to AML program requirements.
Privacy and Cybersecurity. The Bank is subject to many U.S. federal and state laws and regulations governing requirements for maintaining policies and procedures to protect non-public personal information of their consumers. These laws require the Bank to periodically disclose their privacy policies and practices relating to sharing such information and permit consumers to opt out of their ability to share information with unaffiliated third parties under certain circumstances. They also impact the Bank’s ability to share certain information with affiliates and non-affiliates for marketing and/or non-marketing purposes, or to contact clients with marketing offers. In addition, the Bank is required to implement a comprehensive information security program that includes administrative, technical, and physical safeguards to ensure the security and confidentiality of customer records and information. These security and privacy policies and procedures, for the protection of personal and confidential information, are in effect across the Bank and its subsidiaries.
Moreover, given the increased focus on privacy and data security in the United States and internationally, laws and regulations related to the same are evolving. Multiple states and Congress are considering additional laws or regulations that could create or alter individual privacy rights and impose additional obligations on banks and related financial services companies in possession of or with access to personal data. On November 18, 2021, the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve System, and the Office of the Comptroller of the Currency (OCC) (collectively, the agencies) issued a joint final rule, to establish computer-security incident notification requirements for banking organizations and their bank service providers. The rule will provide the agencies with early awareness of emerging threats to banking organizations and the broader financial system, including potentially systemic cyber events. The final rule takes effect on April 1, 2022, with full compliance extended to May 1, 2022.
Concentrations in Commercial Real Estate. Concentration risk exists when FDIC-insured institutions deploy too many assets to any one industry or segment. A concentration in commercial real estate is one example of regulatory concern. The interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices guidance (“CRE Guidance”) provides supervisory criteria, including the following numerical indicators, to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny: (i) commercial real estate loans exceeding 300% of capital and increasing 50% or more in the preceding three years; or (ii) construction and land development loans exceeding 100% of capital. The CRE Guidance does not limit banks’ levels of commercial real estate lending activities, but rather guides institutions in developing risk management practices and levels of capital that are commensurate with the level and nature of their commercial real estate concentrations. On December 18, 2015, the federal banking agencies issued a statement to reinforce prudent risk-management practices related to CRE lending, having observed substantial growth in many CRE asset and lending markets, increased competitive pressures, rising CRE concentrations in banks, and an easing of CRE underwriting standards. The federal bank agencies reminded FDIC-insured institutions to maintain underwriting discipline and exercise prudent risk-management practices to identify, measure, monitor, and manage the risks arising from CRE lending. In addition, FDIC-insured institutions must maintain capital commensurate with the level and nature of their CRE concentration risk.
Consumer Financial Services. The historical structure of federal consumer protection regulation applicable to all providers of consumer financial products and services changed significantly on July 21, 2011, when the Consumer Financial Protection Bureau (“CFPB”) commenced operations to supervise and enforce consumer protection laws. The CFPB has broad rulemaking authority for a wide range of consumer protection laws that apply to all providers of consumer products and services, including the Bank, as well as the authority to prohibit “unfair, deceptive or abusive” acts and practices. The CFPB has examination and enforcement authority over providers with more than $10 billion in assets. FDIC-insured institutions with $10 billion or less in assets, like the Bank, continue to be examined by their applicable bank regulators.
Because abuses in connection with residential mortgages were a significant factor contributing to the financial crisis, many new rules issued by the CFPB and required by the Dodd-Frank Act addressed mortgage and mortgage-related products, their underwriting, origination, servicing, and sales. The Dodd-Frank Act significantly expanded underwriting requirements
applicable to loans secured by 1-4 family residential real property and augmented federal law combating predatory lending practices. In addition to numerous disclosure requirements, the Dodd-Frank Act imposed new standards for mortgage loan originations on all lenders, including banks and savings associations, in an effort to strongly encourage lenders to verify a borrower’s ability to repay, while also establishing a presumption of compliance for certain “qualified mortgages.” The Regulatory Relief Act provided relief in connection with mortgages for banks with assets of less than $10 billion, and, as a result, mortgages the Bank makes are now considered to be qualified mortgages if they are held in portfolio for the life of the loan.
Current Expected Credit Loss (“CECL”) Treatment. In June 2016, the FASB issued an accounting standard update, “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,” which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the CECL model. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. Pursuant to an additional FASB accounting standard update, “Financial Instruments-Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842),” issued in November 2019, the effective date of CECL was delayed from January 2020 to January 2023 for certain entities, including smaller reporting companies like the Corporation.
On May 8, 2020, four federal banking agencies issued an interagency policy statement on the new CECL methodology. The policy statement harmonizes the agencies' policies on allowance for credit losses with the FASB’s new accounting standards. Specifically, the statement (i) updates concepts and practices from prior policy statements issued in December 2006 and July 2001 and specifies which prior guidance documents are no longer relevant; (ii) describes the appropriate CECL methodology, in light of Topic 326, for determining Allowances for Credit Losses (“ACLs”) on financial assets measured at amortized cost, net investments in leases, and certain off-balance sheet credit exposures; and (iii) describes how to estimate an ACL for an impaired available-for-sale debt security in line with Topic 326. The policy statement is effective at the time that each institution adopts the new standards required by the FASB.
Legislation and Regulation Addressing the COVID-19 Pandemic
The COVID-19 pandemic has created unprecedented health and economic uncertainty in the United States and internationally and has prompted federal, state, and local legislative and regulatory action designed to address the pandemic’s challenges. Beginning in March 2020, the federal bank regulatory agencies began issuing various rulemakings and interagency statements providing temporary resources, flexibility and relief for financial institutions. These rulemakings and statements related to, among other things, deferrals for certain borrowers and compliance with capital adequacy guidelines.
In addition, on March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), a $2.2 trillion economic stimulus law, was enacted. The CARES Act and various regulations promulgated thereunder contain many provisions that impact financial institutions, including, among others, forbearance protections for certain borrowers, relief from characterizing loan modifications as “troubled debt restrictions, a new Paycheck Protection Program (“PPP”) available in the form of Small Business Administration 7(a) loans made by financial institutions to eligible borrowers, and various liquidity facilities to fund the PPP and other pandemic-related financing programs. After the initial fund for PPP loans was exhausted, the PPP was extended multiple times until expiring on August 8, 2020. In January 2021, the SBA reopened the PPP for eligible borrowers that did not receive a PPP loan during the initial PPP phase, as well as for a certain subset of borrowers who had received an initial PPP loan previously. The PPP expired for any new applicants on May 31, 2021.

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ITEM 1A. RISK FACTORS
Item 1A. Risk Factors
An investment in our common stock is subject to risks inherent to our business. Before making an investment decision, you should carefully read and consider the following risks and uncertainties. We may encounter risks in addition to those described below, including risks and uncertainties not currently known to us or those we currently deem to be immaterial. The risks described below, as well as such additional risks and uncertainties, may impair or materially and adversely affect our business, results of operations, and financial condition. The risks are organized in the following categories:
•Credit Risk
•Liquidity and Interest Rate Risk
•Operational Risk
•Strategic and External Risk
•Regulatory, Compliance, Legal, and Reputational Risk
•Risks Related to Investing in Our Common Stock
•General Risk Factors
Credit Risks
If we do not effectively manage our credit risk, we may experience increased levels of delinquencies, non-performing loans, and charge-offs, which would require increases in our provision for loan and lease losses.
There are risks inherent in making any loan or lease, including risks inherent in dealing with individual borrowers, risks of nonpayment, risks resulting from uncertainties as to the future value of collateral and cash flows available to service debt, and risks resulting from changes in economic and market conditions. We cannot assure you that our credit risk approval and monitoring procedures have identified or will identify all of these credit risks, and they cannot be expected to completely eliminate our credit risks. If the overall economic climate in the U.S., generally, or our markets, specifically, deteriorates, or if the financial condition of our borrowers otherwise declines, then our borrowers may experience difficulties in repaying their loans and leases, and the level of non-performing loans and leases, charge-offs, and delinquencies could rise and require increases in the provision for loan and lease losses, which may adversely affect our business, results of operations, and financial condition.
Our allowance for loan and lease losses may not be adequate to cover actual losses.
We establish our allowance for loan and lease losses and maintain it at a level considered appropriate by management based on an analysis of our portfolio and market environment. The allowance for loan and lease losses represents our estimate of probable losses inherent in the portfolio at each balance sheet date and is based upon relevant information available to us. The allowance contains provisions for probable losses that have been identified relating to specific relationships, as well as probable losses inherent in our loan and lease portfolio that are not specifically identified. Additions to the allowance for loan and lease losses, which are charged to earnings through the provision for loan and lease losses, are determined based on a variety of factors, including an analysis of our loan and lease portfolio by segment, historical loss experience, and an evaluation of current economic conditions in our markets. The actual amount of loan and lease losses is affected by changes in economic, operating, and other conditions within our markets, which may be beyond our control, and such losses may exceed current estimates.
At December 31, 2021, our allowance for loan and lease losses as a percentage of total loans and leases was 1.09% and as a percentage of total non-performing loans and leases was 382.76%. Although management believes the allowance for loan and lease losses is appropriate, we may be required to take additional provisions for losses in the future to further supplement the allowance, either due to management’s decision, based on credit conditions, or requirements by our banking regulators. In addition, bank regulatory agencies will periodically review our allowance for loan and lease losses and the value attributed to non-performing loans and leases. Such regulatory agencies may require us to adjust our determination of the value for these items. Any significant increases to the allowance for loan and lease losses may materially decrease our net income, which may adversely affect our business, results of operations, and financial condition.
A significant portion of our loan and lease portfolio is comprised of commercial real estate loans, which involve risks specific to real estate values and the real estate markets in general.
At December 31, 2021 we had $1.455 billion of commercial real estate loans, which represented 64.9% of our total loan and lease portfolio. Because payments on such loans are often dependent on the successful operation or development of the property or business involved, repayment of such loans is sensitive to conditions in the real estate market or the general economy, which are outside the borrower’s control. In the event that the cash flow from the property is reduced, the borrower’s ability to repay the loan could be negatively impacted. The deterioration of one or a few of these loans could cause a material increase in our level of non-performing loans, which would result in a loss of revenue from these loans and could result in an increase in the provision for loan and lease losses and an increase in charge-offs, all of which could have a material adverse impact on our net income. Additionally, many of these loans have real estate as a primary or secondary component of collateral. The market value of real estate can fluctuate significantly in a short period of time as a result of economic conditions. Adverse developments affecting real estate values in one or more of our markets could impact the collateral coverage associated with the commercial real estate segment of our portfolio, possibly leading to increased specific reserves or charge-offs, which may adversely affect our business, results of operations, and financial condition.
Because of the risks associated with commercial real estate loans, we closely monitor the concentration of such loans in our portfolio. If we or our regulators determine that this concentration is approaching or exceeds appropriate limits, we may need to reduce or cease the origination of additional commercial real estate loans, which could adversely affect our growth plans and profitability. In addition, we may be required to sell existing loans in our portfolio, but there can be no assurances that we would be able to do so at prices that are acceptable to us.
Real estate construction and land development loans are based upon estimates of costs and values associated with the completed project. These estimates may be inaccurate and we may be exposed to significant losses on loans for these projects.
Real estate construction and land development loans, subsets of commercial real estate loans, comprised approximately $179.8 million, or 8.0%, and $42.8 million, or 1.9%, of our gross loan and lease portfolio, respectively, as of December 31, 2021. Such lending involves additional risks as these loans are underwritten using the as-completed value of the project, which is uncertain prior to its completion, and costs may exceed realizable values in declining real estate markets. Because of the uncertainties inherent in estimating construction costs and the realizable market value of the completed project, it can be relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest. If the appraisal of the completed project’s value proves to be overstated or market values decline, we may have inadequate security for the repayment of the loan upon completion of construction of the project. If we are forced to foreclose on a project prior to or at completion due to a default, we may not be able to recover all of the unpaid balance of, and accrued interest on, the loan and may incur related foreclosure and holding costs. In addition, we may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time while we attempt to dispose of it.
A large portion of our loan and lease portfolio is comprised of commercial loans secured by various business assets, the deterioration in value of which could increase our exposure to future probable losses.
At December 31, 2021, approximately $730.8 million, or 32.6%, of our loan and lease portfolio was comprised of commercial loans to businesses collateralized by general business assets, including accounts receivable, inventory, and equipment. Our commercial loans are typically larger in amount than loans to individual consumers and therefore, have the potential for larger losses on an individual loan basis. Additionally, asset-based borrowers are usually highly leveraged and/or have inconsistent historical earnings. Significant adverse changes in various industries could cause rapid declines in values and collectability associated with those business assets resulting in inadequate collateral coverage that may expose us to future losses. An increase in specific reserves and charge-offs may adversely affect our business, results of operations, and financial condition.
The success of our SBA lending program is dependent upon the continued availability of SBA loan programs, our status as a Preferred Lender under the SBA loan programs, our ability to effectively compete and originate new SBA loans, and our ability to comply with applicable SBA lending requirements.
SBA loans (excluding PPP loans), consisting of both commercial real estate and commercial loans, comprised approximately $56.7 million, or 2.4%, of our gross loan and lease portfolio as of December 31, 2021.
As an SBA Preferred Lender, we enable our clients to obtain SBA loans without being subject to the potentially lengthy SBA approval process necessary for lenders that are not SBA Preferred Lenders. The SBA periodically reviews the lending operations of participating lenders to assess, among other things, whether the lender exhibits prudent risk management. When weaknesses are identified, the SBA may request corrective actions or impose other restrictions, including revocation of
the lender’s Preferred Lender status. If we lose our status as a Preferred Lender, we may lose our ability to compete effectively with other SBA Preferred Lenders, and as a result we could experience a material adverse effect to our financial results. Any changes to the SBA program, including changes to the level of guaranty provided by the federal government on SBA loans or changes to the level of funds appropriated by the federal government to the various SBA programs, may also have an adverse effect on our business, results of operations, and financial condition.
Typically we sell the guaranteed portions of our SBA 7(a) loans in the secondary market. These sales result in earning premium income and create a stream of future servicing income. There can be no assurance that we will be able to continue originating these loans, that a secondary market will exist, or that we will continue to realize premiums upon the sale of the guaranteed portions of these loans. Whether or not we sell the guaranteed portion of an SBA loan, we retain credit risk on the non-guaranteed portion of the loan. We also have credit risk on the guaranteed portion if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank.
In order for a borrower to be eligible to receive an SBA loan, it must be established that the borrower would not be able to secure a bank loan without the credit enhancements provided by a guaranty under the SBA program. Accordingly, the SBA loans in our portfolio generally have weaker credit characteristics than the rest of our portfolio, and may be at greater risk of default. In the event of a loss resulting from default and a determination by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank, the SBA may require the Bank to repurchase the previously sold portion of the loan, deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of the principal loss related to the deficiency from the Bank. Management has estimated losses in the outstanding guaranteed portions of SBA loans and recorded an allowance for loan and lease losses and a SBA recourse reserve at a level determined to be appropriate. Significant increases to the allowance for loan and leases losses and the recourse reserve may materially decrease our net income, which may adversely affect our business, results of operations, and financial condition.
Non-performing assets take significant time to resolve, adversely affect our results of operations and financial condition, and could result in losses.
At December 31, 2021, our non-performing loans and leases totaled $6.4 million, or 0.28% of our gross loan and lease portfolio, and our non-performing assets (which include non-performing loans and foreclosed properties) totaled $6.5 million, or 0.25% of total assets. Our non-performing assets adversely affect our net income in various ways. We do not record interest income on non-accrual loans, thereby adversely affecting our net income and returns on assets and equity, increasing our loan administration costs, and adversely affecting our efficiency ratio. When we take collateral in foreclosure and similar proceedings, we are required to mark the collateral to its then net realizable value, less estimated selling costs, which may result in a loss. These non-performing loans and foreclosed properties also increase our risk profile and the capital our regulators believe is appropriate in light of such risks. The resolution of non-performing assets requires significant time commitments from management and can be detrimental to the performance of their other responsibilities. If we experience increases in non-performing loans and non-performing assets, our net interest income may be negatively impacted and our loan administration costs could increase, each of which may adversely affect our business, results of operations, and financial condition.
The FASB issued an accounting standard that may require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.
The FASB has issued a new accounting standard that will be effective for us beginning on January 1, 2023. This standard, referred to as CECL, requires financial institutions to determine periodic estimates of lifetime expected credit losses on loans and leases and recognize the expected credit losses as allowances for loan and lease losses. This will change the current method of providing allowances for loan and lease losses that are probable, which may require us to increase our allowance for loan and lease losses, and to greatly increase the types of data we will need to collect and review to determine the appropriate level of the allowance for loan and lease losses. Any increase in our allowance for loan and lease losses or expenses incurred to determine the appropriate level of the allowance for loan and lease losses may have a material adverse effect on our financial condition and results of operations. See Note 1 - Nature of Operations and Summary of Significant Accounting Policies in the Consolidated Financial Statements for additional information.
Liquidity and Interest Rate Risks
Liquidity risks could affect operations and jeopardize our business, financial condition, and results of operations.
Our ability to implement our business strategy will depend on our liquidity and ability to obtain funding for loan originations, working capital, and other general purposes. An inability to raise funds through deposits, borrowings, the sale of loans, and other sources could have a substantial negative effect on our liquidity. Our preferred source of funds consists of client deposits, which we supplement with other sources, such as wholesale deposits made up of brokered deposits and deposits gathered through internet listing services. Such account and deposit balances can decrease when clients perceive alternative investments as providing a better risk/return profile. If clients move money out of bank deposits and into other investments, we may increase our utilization of wholesale deposits, FHLB advances, and other wholesale funding sources necessary to fund
desired growth levels. Because these funds generally are more sensitive to interest rate changes than our targeted in-market deposits, they are more likely to move to the highest rate available. In addition, the use of brokered deposits without regulatory approval is limited to banks that are “well capitalized” according to regulation. If the Bank is unable to maintain its capital levels at “well capitalized” minimums, we could lose a significant source of funding, which would force us to utilize different wholesale funding or potentially sell assets at a time when pricing may be unfavorable, increasing our funding costs and reducing our net interest income and net income.
Our access to funding sources in amounts adequate to finance or capitalize our activities or on terms that are acceptable to us could be impaired by factors that affect us directly or the financial services industry or economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry. Regional and community banks generally have less access to the capital markets than do national and super-regional banks because of their smaller size and limited analyst coverage. During periods of economic turmoil or decline, the financial services industry and the credit markets generally may be materially and adversely affected by declines in asset values and by diminished liquidity. Under such circumstances, the liquidity issues are often particularly acute for regional and community banks, as larger financial institutions may curtail their lending to regional and community banks to reduce their exposure to the risks of other banks. Correspondent lenders may also reduce or even eliminate federal funds lines for their correspondent clients in difficult economic times.
As a result, we rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities to ensure that we have adequate liquidity to fund our operations. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, pay dividends to our shareholders, or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse effect on our business, results of operations, and financial condition.
The Corporation is a bank holding company and its sources of funds necessary to meet its obligations are limited.
The Corporation is a bank holding company and its operations are primarily conducted by the Bank, which is subject to significant federal and state regulation. Cash available to pay dividends to our shareholders, pay our obligations, and meet our debt service requirements is derived primarily from our existing cash flow sources, our third party line of credit, dividends received from the Bank, or a combination thereof. Future dividend payments by the Bank to us will require the generation of future earnings by the Bank and are subject to certain regulatory guidelines. If the Bank is unable to pay dividends to us, we may not have the resources or cash flow to pay or meet all of our obligations.
Interest rate shifts may reduce net interest income and otherwise negatively impact our financial condition and results of operations.
Shifts in short-term interest rates may reduce net interest income, which is the principal component of our earnings. Net interest income is the difference between the amounts received by us on our interest-earning assets and the interest paid by us on our interest-bearing liabilities. In certain scenarios, when interest rates rise, the rate of interest we pay on our liabilities may rise more quickly than the rate of interest that we receive on our interest-bearing assets, which could cause our profits to decrease. Similarly, when interest rates fall, the rate of interest we pay on our liabilities may not decrease as quickly as the rate of interest we receive on our interest-bearing assets, which could cause our profits to decrease. However, the structure of our balance sheet and resultant sensitivity to interest rates in various scenarios may change in the future.
Additionally, interest rate increases on variable rate loans often result in larger payment requirements for our borrowers, which increases the potential for default. At the same time, the marketability of underlying collateral may be adversely affected by any reduced demand resulting from higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on certain loans as borrowers refinance at lower rates.
Changes in interest rates also can affect the value of loans. An increase in interest rates that adversely affects the ability of borrowers to pay the principal or interest on loans may lead to an increase in nonperforming assets and a reduction of income recognized, which could have a material adverse effect on our results of operations and cash flows. Further, when we place a loan on non-accrual status, we reverse any accrued but unpaid interest receivable, which decreases interest income. Subsequently, we continue to have a cost to fund the loan, which is reflected as interest expense, without any interest income to offset the associated funding expense. Thus, an increase in the amount of non-performing assets would have an adverse impact on net interest income.
Rising interest rates may also result in a decline in value of our fixed-rate debt securities. The unrealized losses resulting from holding these securities would be recognized in other comprehensive income and reduce total stockholders’ equity. If debt securities in an unrealized loss position are sold, such losses become realized and will reduce our regulatory capital ratios.
The transition to an alternative reference rate could cause instability and have a negative effect on financial market conditions.
The London Interbank Offered Rate (“LIBOR”) represents the interest rate at which banks offer to lend funds to one another in the international interbank market for short-term loans. Beginning in 2008, concerns were expressed that some of the member banks surveyed by the British Bankers’ Association (the “BBA”) in connection with the calculation of LIBOR rates may have been under-reporting or otherwise manipulating the interbank lending rates applicable to them. Regulators and law enforcement agencies from a number of governments have conducted investigations relating to the calculation of LIBOR across a range of maturities and currencies. If manipulation of LIBOR or another interbank lending rate occurred, it may have resulted in that rate being artificially lower (or higher) than it otherwise would have been. Responsibility for the calculation of LIBOR was transferred to Intercontinental Exchange Benchmark Administration Limited, as independent LIBOR administrator, effective February 1, 2014.
On July 27, 2017, the United Kingdom Financial Conduct Authority announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR rates after 2021 (the “July 27th Announcement”). The July 27th Announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021.
The dissolution of the London Interbank Offered Rate (LIBOR) impacts all borrowers and banks that use LIBOR as a base rate. LIBOR will continue to be published until June 30, 2023, however, banks are no longer allowed to issue new LIBOR-based products after December 31, 2021. FBB selected the Secured Overnight Financing Rate (“SOFR”) as a replacement rate. Beginning on July 1, 2023, FBB will no longer be able to rely on LIBOR as a benchmark in any contract, and as a result, the Bank and its customers will need to replace all references to LIBOR in existing contracts that go past that date.
The Corporation has developed a LIBOR transition team to complete the transition away from LIBOR to an alternative reference rate such as SOFR or Prime. In addition to SOFR or Prime, First Business Bank may also offer other benchmark rates as substitutions for LIBOR, including BSBY and Ameribor. The transition team has added language to new loan agreements regarding the use of alternative reference rates and the Corporation has evaluated existing loan agreements linked to LIBOR and will work with those parties to modify the agreements.
The manner and impact of the transition from LIBOR to an alternative reference rate, as well as the effect of these developments on our compliance costs, funding costs, loan and security portfolios, derivatives, asset-liability management, and business, is uncertain.
Operational Risks
Information security risks for financial institutions like us continue to increase in part because of new technologies, the increased use of the internet and telecommunications technologies (including mobile devices and cloud computing) to conduct financial and other business transactions, political activism, and the increased sophistication and activities of organized crime, terrorist, hackers, and perpetrators of fraud. A successful cyber-attack or other breach of our information systems could adversely affect the Corporation’s business, financial condition or results of operations and damage its reputation.
In addition to cyber-attacks or other security breaches involving the theft of sensitive and confidential information, hackers have engaged in attacks against our businesses and consumers. Because the methods of cyber-attacks change frequently or, in some cases, are not recognized until launch, we are not able to anticipate or implement effective preventive measures against all possible security breaches and the probability of a successful attack cannot be predicted. Although we employ detection and response mechanisms designed to detect and mitigate security incidents, early detection may be thwarted by persistent sophisticated attacks and malware designed to avoid detection. We also train employees and our business and consumer clients on fraud risks. We also face risks related to cyber-attacks and other security breaches that typically involve the transmission of sensitive information regarding our clients and monetary transactions through various third parties. Some of these parties have in the past been the target of security breaches and cyber-attacks, and because the transactions involve third parties and environments that we do not control or secure, future security breaches or cyber-attacks affecting any of these third parties could impact us through no fault of our own, and in some cases we may have exposure and suffer losses for breaches or attacks relating to them. We also rely on numerous other third-party service providers to conduct other aspects of our business operations and face similar risks relating to them. While we conduct security assessments on our higher risk third party service providers, we cannot be sure that their information security protocols are sufficient to withstand a cyber-attack or other security breach.
The Corporation regularly evaluates its systems and controls and implements upgrades as necessary. The additional cost to the Corporation of our cyber security monitoring and protection systems and controls includes the cost of hardware and software, third party technology providers, consulting and forensic testing firms, and insurance premium costs, in addition to the incremental cost of our personnel who focus a substantial portion of their responsibilities on cyber security.
Any successful cyber-attack or other security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information or funds or that compromises our ability to function could erode confidence in the security of our systems, products and services, result in monetary losses, potentially subject us to regulatory investigation with fines and penalties, expose us to litigation and liability, disrupt our operations and have a material adverse effect on our business, financial condition or results of operations and damage our reputation.
We are dependent upon third parties for certain information systems, data management and processing services, and key components of our business infrastructure, which are subject to operational, security, and other risks.
As with many other companies, we outsource certain information systems, data management, and processing functions to third-party providers, including key components of our business infrastructure like internet and network access, and core application processing. While we have selected these third-party vendors carefully, we do not control their actions, nor is any vendor due diligence perfect. These third-party service providers are sources of operational and informational security risk to us, including risks associated with operational errors, information system interruptions or outages, unauthorized access or disclosure of sensitive or confidential information. If our third-party service providers encounter any of these issues, or if we have difficulty exchanging information with or receiving services from them, we could be exposed to disruption of operations, an inability to provide products and services to our clients, a loss of service or connectivity, reputational damage, and litigation risk that could have a material adverse effect on our business, results of operations, and financial condition.
Our business continuity plans could prove to be inadequate, resulting in a material interruption in or disruption to our business and a negative impact on our results of operations.
We rely heavily on communications and information systems to conduct our business and our operations are dependent on our ability to protect our systems against damage from fire, power loss, telecommunication failure, or other emergencies. The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. These problems may arise in both our internally developed systems and the systems of our third-party service providers. Any failure or interruption of these systems could result in failures or disruptions in general ledger, core bank processing systems, client relationship management, and other systems. While we have a business continuity plan and other policies and procedures designed to prevent or limit the effect of a failure, interruption or security breach of our information systems, there can be no assurance that any of those events will not occur or, if they do occur, that they will be adequately remediated. The occurrence of any failure, interruption, or security breach of our information systems could damage our reputation, result in a loss of clients, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, results of operations, and financial condition.
New lines of business, products, and services are essential to our ability to compete but may subject us to additional risks.
Periodically, we implement new lines of business and/or offer new products and services within existing lines of business. There can be substantial risks and uncertainties associated with these efforts, particularly in instances where the markets for such services are still developing or due diligence is not fully vetted. In developing and marketing new lines of business and/or new products or services, we invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved, and price and profitability targets may not prove feasible. New technologies needed to support the new line of business or product may result in incremental operating costs and system defects. Compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. In instances of new lines of businesses offering credit services, weaknesses relating to underwriting and operations may impact credit and capital. Delinquency may negatively affect non-performing assets and increase the provision for loan and lease losses.
Any new line of business and/or new product or service could also have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations, and financial condition.
Our framework for managing risks may not be effective in mitigating risk and loss to us.
Our risk management framework seeks to mitigate risk and loss to us. We have established processes and procedures intended to identify, measure, monitor, control, and analyze the types of risk to which we are subject, including liquidity risk, credit risk, market risk, interest rate risk, operational risk, information and cyber security risk, compensation risk, legal and compliance risk, and reputational risk, among others. However, as with any risk management framework, there are inherent limitations to our risk management strategies as there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. Our ability to successfully identify and manage risks facing us is an important factor that can significantly impact our results. If our risk management framework proves ineffective, we could suffer unexpected losses which could adversely affect our business, results of operations, and financial condition.
We are subject to changes in accounting principles, policies, or guidelines.
Our financial performance is impacted by accounting principles, policies, and guidelines. Some of these policies require the use of estimates and assumptions that may affect the value of our assets or liabilities and financial results. Some of our accounting policies are critical because they require management to make difficult, subjective, and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. If such estimates or assumptions underlying our financial statements are incorrect, we may experience material losses.
From time to time, the FASB and SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our financial statements. These changes are beyond our control, can be difficult to predict, and could materially impact how we report our financial condition and results of operations. Changes in these standards are continuously occurring and more drastic changes may occur in the future. The implementation of such changes could have a material adverse effect on our business, results of operations, and financial condition.
Strategic and External Risks
The COVID-19 pandemic could materially adversely affect the Corporation’s business and financial results, and the extent of any such effects is dependent upon uncertain and unpredictable future events.
The COVID-19 pandemic has negatively impacted the global economy, disrupting global supply chains and equity markets and creating significant volatility and disruption in financial and labor markets. In addition, the pandemic resulted in temporary closures of many businesses and the institution of social distancing and stay-at-home requirements in many states and communities, including Wisconsin, Kansas, and Missouri. The pandemic could result in the continued and increased recognition of credit losses in the Corporation’s loan portfolio and increases in the Corporation’s allowance for credit losses, particularly if the impact on the global economy worsens. The COVID-19 pandemic, including, in part, supply chain disruption and the effects of the extensive pandemic-related government stimulus, has caused inflationary pressure in the U.S. economy. We expect to be impacted by elevated levels of inflation and the corresponding upward pressure on interest rates. Because of changing economic and market conditions affecting issuers, the Corporation may be required to recognize impairments on the securities it holds. Furthermore, the demand for the Corporation’s products and services may be impacted, which would adversely affect the Corporation’s revenue.
We cannot predict how further outbreaks, new variants, or the efficacy of vaccines might impact our financial condition and results of operation. The extent to which the COVID-19 pandemic impacts the Corporation’s business, results of operations, and financial condition, as well as the Corporation’s regulatory capital, liquidity ratios, and stock price, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.
Our business may be adversely affected by conditions in the financial markets and economic conditions generally.
Our operations and profitability are impacted by general business and economic conditions in the U.S. and, to some extent, abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity markets, broad trends in industry and finance, the strength of the U.S. economy and uncertainty in financial markets globally, all of which are beyond our control. A deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values, and a decrease in demand for our products and services, among other things, any of which could have a material adverse effect on our business, results of operations, and financial condition.
Our business is concentrated in and largely dependent upon the continued growth and welfare of the general geographical markets in which we operate.
Our operations are heavily concentrated in South Central Wisconsin and, to a lesser extent, the Southeast and Northeast regions of Wisconsin and the greater Kansas City Metro and, as a result, our financial condition, results of operations, and cash flows are significantly impacted by changes in the economic conditions in those areas. Our success depends to a significant extent upon the business activity, population, income levels, deposits, and real estate activity in these markets. Although our clients’ business and financial interests may extend well beyond these markets, adverse economic conditions that affect these markets, including, without limitation, adverse conditions resulting from the COVID-19 pandemic, could reduce our growth rate, affect the ability of our clients to repay their loans to us, affect the value of collateral underlying loans, and generally affect our financial condition and results of operations. Because of our geographic concentration, we are less able than other regional or national financial institutions to diversify our credit risks across multiple markets.
Our financial condition and results of operations could be negatively affected if we fail to effectively execute our strategic plan or manage the growth called for in our strategic plan.
Our strategic plan calls for above average performance by focusing on four key strategies - talent, efficiency, deposits, and optimizing business line performance. While we believe we have the management resources and internal systems in place to successfully execute our strategic plan, we cannot guarantee that opportunities will be available and that the strategic plan will be successful or effectively executed.
Although we do not have any current definitive plans to do so, in implementing our strategic plan we may expand into additional communities or attempt to strengthen our position in our current markets through opportunistic acquisitions of similar or complementary financial services organizations. To the extent that we do so, we may experience higher operating expenses relative to operating income from the new operations or certain one-time expenses associated with the closure of offices, all of which may have an adverse effect on our business, results of operations, and financial condition. Other effects of engaging in such strategies may include potential diversion of our management’s time and attention and general disruption to our business. To the extent that we grow through new locations, we cannot ensure that we will be able to adequately and profitably manage this growth. Acquiring other banks and businesses will involve similar risks to those commonly associated with branching, but may also involve additional risks, including potential exposure to unknown or contingent liabilities of banks and businesses we acquire and exposure to potential asset quality issues of the acquired bank or related business.
We could recognize impairment losses on securities held in our securities portfolio, goodwill, or other long-lived assets.
As of December 31, 2021, the fair value of our securities portfolio was approximately $226.0 million. Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. For example, fixed-rate securities acquired by us are generally subject to decreases in market value when interest rates rise. Additional factors include, but are not limited to, rating agency downgrades of the securities, defaults by the issuer or individual mortgagors with respect to the underlying securities, and instability in the credit markets. Any of the foregoing factors could cause other-than-temporary impairment in future periods and result in realized losses. The process for determining whether impairment is other-than-temporary usually requires difficult, subjective judgments about the future financial performance of the issuer and any collateral underlying the security in order to assess the probability of receiving all contractual principal and interest payments on the security. Because of changing economic and market conditions affecting interest rates, the financial condition of issuers of the securities and the performance of the underlying collateral, we may recognize realized and/or unrealized losses in future periods, which could have an adverse effect on our business, results of operations, and financial condition.
As of December 31, 2021, the Corporation had goodwill of $10.7 million. Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A decline in our stock price, decline in the performance of our acquired operations, or the occurrence of another triggering event could, under certain circumstances, result in an impairment charge being recorded. During 2021, our annual impairment test conducted August 1, 2021 indicated that the estimated fair value of the reporting unit exceeded the carrying value (including goodwill). Depending on market conditions, economic forecasts, results of operations, additional adverse circumstances or other factors, the goodwill impairment analysis may require additional review of assumptions and outcomes prior to our next annual impairment testing date of August 1, 2022. In the event that we conclude that all or a portion of our goodwill may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital or regulatory capital.
We could be required to establish a deferred tax asset valuation allowance and a corresponding charge against earnings if we experience a decrease in earnings.
Deferred tax assets are reported as assets on our balance sheet and represent the decrease in taxes expected to be paid in the future in connection with our allowance for loan and lease losses and other matters. If it becomes more likely than not that some portion or the entire deferred tax asset will not be realized, a valuation allowance must be recognized. The Corporation believes it will fully realize its deferred tax asset, and therefore, no valuation allowance was necessary as of December 31, 2021. This determination was based on the evaluation of several factors, including our recent earnings history, expected future earnings, and appropriate tax planning strategies. A decrease in earnings could adversely impact our ability to fully utilize our deferred tax assets. If we determine that it is more likely than not that some portion or all of the deferred tax assets will not be realized, a valuation allowance will need to be recognized and this would result in a corresponding charge against our earnings.
Competition from other financial institutions could adversely affect our profitability.
We encounter heavy competition in attracting commercial loan, specialty finance, deposit, and private wealth management clients. We believe the principal factors that are used to attract quality clients and distinguish one financial institution from another include value-added relationships, interest rates and rates of return, types of accounts and product offerings, service fees, and quality of service.
Our competition includes banks, savings institutions, mortgage banking companies, credit unions, finance companies, equipment finance companies, mutual funds, insurance companies, brokerage firms, investment banking firms, and financial technology (“FinTech”) companies. We also compete with regional and national financial institutions that have a substantial presence in our market areas, many of which have greater liquidity, higher lending limits, greater access to capital, more established market recognition, and more resources and collective experience than we do. In addition, some larger financial institutions that have not historically competed with us directly have substantial excess liquidity and have sought, and may continue to seek, smaller lending relationships in our primary markets. Furthermore, tax-exempt credit unions operate in our market areas and aggressively price their products and services to a large portion of the market. Finally, technology has also lowered the barriers to entry and made it possible for non-bank financial service providers to offer products and services we have traditionally offered, such as automatic funds transfer and automatic payment systems. Our profitability depends, in part, upon our ability to successfully maintain and increase market share.
Consumers and businesses are increasingly using non-banks to complete their financial transactions, which could adversely affect our business and results of operations.
Technology and other changes are allowing consumers and businesses to complete financial transactions that historically have involved financial institutions through alternative methods. The wide acceptance of Internet-based and person-to-person commerce has resulted in a number of alternative payment processing systems and lending platforms in which banks play only minor roles. Businesses and consumers can now maintain funds in social payment applications, prepaid debit cards or digital currencies, and pay bills and transfer funds directly without the direct assistance of financial institutions. The diminishing role of financial institutions as financial intermediaries has resulted, and could continue to result, in the loss of fee income, as well as the loss of client deposits and the related income generated from those deposits. The loss of these revenue streams and the potential loss of lower cost deposits as a source of funds could have a material adverse effect on our business, financial condition, and results of operations.
If we are unable to keep pace with technological advances in our industry, our ability to attract and retain clients could be adversely affected.
The banking industry is constantly subject to technological changes with frequent introductions of new technology-driven products and services. In addition to better serving clients, the effective use of technology increases our efficiency and enables us to reduce costs. Our future success will depend in part on our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands for convenience as well as create additional efficiencies in our operations. A number of our competitors have substantially greater resources to invest in technological improvements, as well as significant economies of scale. There can be no assurance that we will be able to implement and offer new technology-driven products and services to our clients. If we fail to do so, our ability to attract and retain clients may be adversely affected.
Our private wealth management results of operations may be negatively impacted by changes in economic and market conditions.
Our private wealth management results of operations may be negatively impacted by changes in general economic conditions and the conditions in the financial and securities markets, including the values of assets held under management. Our management contracts generally provide for fees payable for services based on the market value of assets under management; therefore, declines in securities prices will generally have an adverse effect on our results of operations from this business. Market declines and reductions in the value of our clients’ private wealth management services accounts could result in us losing private wealth management services clients, including those who are also banking clients, and negatively affect our earnings.
Potential acquisitions may disrupt our business and dilute shareholder value.
While we remain committed to organic growth, we also may consider additional acquisition opportunities involving complementary financial service organizations if the right situation were to arise. Various risks commonly associated with acquisitions include, among other things:
•Potential exposure to unknown or contingent liabilities of the target company.
•Exposure to potential asset quality issues of the target company.
•Potential diversion of our management’s time and attention.
•Possible loss of key employees and clients of the target company.
•Difficulty in estimating the value of the target company.
•Potential changes in banking or tax laws or regulations that may affect the target company.
•Difficulty in integrating operations, personnel, technologies, services, and products of acquired companies.
Acquisitions may involve the payment of a premium over book and market values, and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on our business, financial condition, and results of operations.
The investments we make in certain tax-advantaged projects may not generate returns as anticipated and may have an adverse impact on the Corporation’s financial results.
We invest in certain tax-advantaged projects promoting community development. Investments in these projects are designed to generate a return primarily through the realization of federal and state income tax credits, and other tax benefits, over specified time periods. The Corporation is subject to the risk that previously recorded tax credits, which remain subject to recapture by taxing authorities based on compliance features required to be met at the project level, will fail to meet certain government compliance requirements and will not be able to be realized. The possible inability to realize these tax credit and other tax benefits could have a negative impact on the Corporation’s financial results. The risk of not being able to realize the tax credits and other tax benefits depends on many factors outside of the Corporation’s control, including changes in the applicable tax code and the ability of the projects to be completed.
A prolonged U.S. government shutdown or default by the U.S. on government obligations would harm our results of operations.
Our results of operations, including revenue, non-interest income, expenses and net interest income, would be adversely affected in the event of widespread financial and business disruption due to a default by the United States on U.S. government obligations or a prolonged failure to maintain significant U.S. government operations. Of particular impact to the Corporation are the operations regulated by the SBA or the FDIC. Any failure to maintain such U.S. government operations, and the after-effects of such shutdown, could impede our ability to originate SBA loans and sell such loans in the secondary market, would materially adversely affect our business, results of operations, and financial condition.
In addition, many of our investment securities are issued by, and some of our loans are made to, the U.S. government and government agencies and sponsored entities. Uncertain domestic political conditions, including prior federal government shutdowns and potential future federal government shutdowns or other unresolved political issues, may pose credit default and liquidity risks with respect to investments in financial instruments issued or guaranteed by the federal government and loans to the federal government. Any downgrade in the sovereign credit rating of the United States, as well as sovereign debt issues facing the governments of other countries, could have a material adverse impact on financial markets and economic conditions in the United States and worldwide. Any such adverse impact could have a material adverse effect on our liquidity, financial condition, and results of operations.
Regulatory, Compliance, Legal and Reputational Risks
We operate in multiple states and in a highly regulated industry and the federal and state laws and regulations that govern our operations, corporate governance, executive compensation, and accounting principles, or changes in them, or our failure to comply with them, may adversely affect us.
We are subject to extensive regulation and supervision that govern almost all aspects of our operations. These laws and regulations, among other matters, prescribe minimum capital requirements, expose us to legal penalties, financial forfeiture and material loss if we fail to act in accordance with bank laws and regulations, impose limitations on our business activities and compensation practices, limit the dividends or distributions that we can pay, restrict the ability to guarantee our debt, and impose certain specific accounting requirements that may be more restrictive and may result in greater or earlier charges to earnings or reductions in our capital than generally accepted accounting principles. These regulations affect our lending practices, employment practices, privacy policies, operational controls, tax structure, and growth, among other things. Changes to federal and state laws, income and property tax regulations, or regulatory guidance, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, tax filing requirements, employment practices, and limit the types of financial services and products we may offer, among other things. Compliance with laws and regulations can be difficult and costly, and changes to laws and regulations often impose additional compliance costs. Further, our failure to comply with these laws and regulations, even if the failure was inadvertent or reflects a difference in interpretation, could subject us to restrictions on our business activities, fines, and other penalties, any of which could adversely affect our business, results of operations, and financial condition.
The financial services industry, as well as the broader economy, may be subject to new legislation, regulation, and government policy.
From time to time, federal and state governments and bank regulatory agencies modify the laws and regulations that govern financial institutions and the financial system generally. Such laws and regulations can affect our operating environment in substantial and unpredictable ways. Among other effects, such laws and regulations can increase or decrease the cost of doing business, limit or expand the scope of permissible activities, or affect the competitive balance among banks and other financial institutions. In addition, any changes in monetary policy, fiscal policy, tax laws, and other policies can affect the broader economic environment, interest rates, and patterns of trade. Any of these changes could affect our company and the banking industry as a whole in ways that are difficult to predict, and could adversely impact our business, financial condition, or results of operations.
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act (“BSA”) and other anti-money laundering (“AML”) statutes and regulations.
AML laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The Financial Crimes Enforcement Network (“FinCEN”), established by Treasury to administer the BSA, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and IRS. There is also increased scrutiny of compliance with the rules enforced by the FinCEN, Federal, and State regulators. Federal and state bank regulators also focus on compliance with AML laws.
If our policies, procedures, and systems are deemed deficient or the policies, procedures, and systems of the financial institutions that we may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions, such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan which would adversely affect our business, results of operations, and financial condition. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
We are periodically subject to examination and scrutiny by a number of banking agencies and, depending upon the findings and determinations of these agencies, we may be required to make adjustments to our business that could adversely affect us.
Federal and state banking agencies periodically conduct examinations of our business, including compliance with applicable laws and regulations. If, as a result of an examination, a federal banking agency was to determine that the financial condition, capital resources, asset quality, asset concentration, earnings prospects, management, liquidity, sensitivity to market risk, or other aspects of any of our operations has become unsatisfactory, or that we or our management is in violation of any law or regulation, it could take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to change the asset composition of our portfolio or balance sheet, to assess civil monetary penalties against our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance. If we become subject to such regulatory actions, our business, results of operations, and financial condition may be adversely affected.
We are subject to claims and litigation pertaining to our fiduciary responsibilities.
Some of the services we provide, such as private wealth management services, require us to act as fiduciaries for our clients and others. From time to time, third parties could make claims and take legal action against us pertaining to the performance of our fiduciary responsibilities. If fiduciary investment decisions are not appropriately documented to justify action taken or trades are placed incorrectly, among other possible claims, and if these claims and legal actions are not resolved in a manner favorable to us, we may be exposed to significant financial liability and/or our reputation could be damaged. These results may adversely impact demand for our products and services or otherwise have an adverse effect on our business, results of operations, and financial condition.
Risks Related to Investing in Our Common Stock
Our stock is thinly traded and our stock price can fluctuate.
Although our common stock is listed for trading on the Nasdaq Global Select Market, low volume of trading activity and volatility in the price of our common stock may make it difficult for our shareholders to sell common stock when desired and at prices they find attractive. Our stock price can fluctuate significantly in response to a variety of factors including, among other things:
•actual or anticipated variations in our quarterly results of operations;
•recommendations by securities analysts;
•operating and stock price performance of other companies that investors deem comparable to us;
•news reports relating to trends, concerns, and other issues in the financial services industry;
•perceptions in the marketplace regarding us or our competitors and other financial services companies;
•new technology used, or services offered, by competitors; and
•changes in government regulations.
General market fluctuations, industry factors, and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, or credit loss trends, could also cause our stock price to decrease regardless of our operating results.
To maintain adequate capital levels, we may be required to raise additional capital in the future, but that capital may not be available when it is needed and/or could be dilutive to our existing shareholders.
We are required by regulatory authorities to maintain adequate levels of capital to support our operations. In order to ensure our ability to support the operations of the Bank, we may need to limit or terminate cash dividends that can be paid to our shareholders. In addition, we may need to raise capital in the future. Our ability to raise capital, if needed, will depend in part on our financial performance and conditions in the capital markets at that time, and accordingly, we cannot guarantee our ability to raise capital on terms acceptable to us. In addition, if we decide to raise equity capital in the future, the interests of our shareholders could be diluted. Any issuance of common stock would dilute the ownership percentage of our current shareholders and any issuance of common stock at prices below tangible book value would dilute the tangible book value of each existing share of our common stock held by our current shareholders. The market price of our common stock could also decrease as a result of the sale of a large number of shares or similar securities, or the perception that such sales could occur. If we cannot raise capital when needed, our ability to serve as a source of strength to the Bank, pay dividends, maintain adequate capital levels and liquidity, or further expand our operations could be materially impaired.
If equity research analysts publish research or reports about our business with unfavorable commentary or downgrade our common stock, the price and trading volume of our common stock could decline.
The trading market for our common stock could be affected by whether equity research analysts publish research or reports about us and our business and what is included in such research or reports. If equity analysts publish research reports about us containing unfavorable commentary, downgrade our stock, or cease publishing reports about our business, the price of our stock could decline. If any analyst electing to cover us downgrades our stock, our stock price could decline rapidly. If any analyst electing to cover us ceases coverage of us, we could lose visibility in the market, which in turn could cause our common stock price or trading volume to decline and our common stock to be less liquid.
General Risk Factors
Negative publicity could damage our reputation and adversely impact our business and financial results.
Reputation risk, or the risk to our earnings and capital due to negative publicity, is inherent in our business. Negative publicity can result from our actual or alleged conduct in a number of activities, including lending practices, fraud, information security, management actions, corporate governance, and actions taken by government regulators and community organizations in response to those activities. Negative publicity can adversely affect our ability to keep and attract clients, employees, and shareholders and can expose us to litigation and regulatory action, all of which could have a material adverse effect on our business, financial condition, and results of operations.
Our internal controls may be ineffective.
Management regularly reviews and updates its internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, 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 controls are met. In addition, as we continue to grow the Corporation, our controls need to be updated to keep up with such growth. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could cause us to report a material weakness in internal control over financial reporting and conclude that our controls and procedures are not effective, which could have a material adverse effect on our business, results of operations, and financial condition.
We rely on our management and the loss of one or more of those managers may harm our business.
Our success has been and will be greatly influenced by our continuing ability to retain the services of our existing senior management and to attract and retain additional qualified senior and middle management. The unexpected loss of key management personnel or the inability to recruit and retain qualified personnel in the future could have an adverse effect on our business and financial results. In addition, our failure to develop and/or maintain an effective succession plan will impede our ability to quickly and effectively react to unexpected loss of key management, and in turn, may have an adverse effect on our business, results of operations, and financial condition.
Our ability to attract and retain talented employees is critical to our success.
Our success depends on our ability to continue to recruit and retain talented employees. Competition for such employees is intense, particularly as a result of labor market issues caused by the ongoing COVID-19 pandemic, which has led to an increase in compensation throughout the labor market, and accordingly, an increase in payroll costs for employers. Prospective employees are also placing an emphasis on flexible, including remote, work arrangements and other considerations, and such arrangements can provide employees with more employment options and mobility, making them more difficult to retain. If we are unable to meet the expectations of employees and prospective employees, and thus, retain or attract employees, it could have a substantial adverse effect on our business.

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ITEM 1B. UNRESOLVED STAFF COMMENTS
Item 1B. Unresolved Staff Comments
None.

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ITEM 2. PROPERTIES
Item 2. Properties
The following table provides certain summary information with respect to the principal properties in which we conduct our operations, all of which were leased, as of December 31, 2021:
Location Function Expiration
Date
401 Charmany Drive, Madison, WI Full-service banking location of FBB - Madison Region and office of FBFS 2028
18500 W. Corporate Drive, Brookfield, WI Full-service banking location of FBB - Southeast Region 2022
11300 Tomahawk Creek Pkwy, Leawood, KS Full-service banking location of FBB - Kansas City Region 2023
3913 West Prospect Avenue, Appleton, WI Full-service banking location of FBB - Northeast Region 2025
For the purpose of generating business development opportunities in our specialized lending and consulting businesses, as of December 31, 2021, office space was also leased in several states nationwide under shorter-term lease agreements, which generally have terms of one year or less.

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ITEM 3. LEGAL PROCEEDINGS
Item 3. Legal Proceedings
We believe that no litigation is threatened or pending in which we face potential loss or exposure which could materially affect our consolidated financial position, consolidated results of operations, or consolidated cash flows. Since our subsidiaries act as depositories of funds, lenders, and fiduciaries, they are occasionally named as defendants in lawsuits involving a variety of claims. This and other litigation is ordinary, routine litigation incidental to our business.

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ITEM 4. MINE SAFETY DISCLOSURE
Item 4. Mine Safety Disclosures
Not applicable.
PART II.

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ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Holders
The common stock of the Corporation is traded on the Nasdaq Global Select Market under the symbol “FBIZ.” As of February 16, 2022, there were 377 registered shareholders of record of the Corporation’s common stock.
Dividend Policy
It has been our practice to pay a dividend to common shareholders. Dividends historically have been declared in the month following the end of each calendar quarter. However, the timing and amount of future dividends are at the discretion of the Board of Directors of the Corporation (the “Board”) and will depend upon the consolidated earnings, financial condition, liquidity, and capital requirements of the Corporation and the Bank, the amount of cash dividends paid to the Corporation by the Bank, applicable government regulations and policies, supervisory actions, and other factors considered relevant by the Board. Refer to Item 1 - Business - Supervision and Regulation - Regulation and Supervision of the Bank - Dividend Payments for additional discussion regarding the limitations on dividends and other capital contributions by the Bank to the Corporation. The Board anticipates it will continue to declare dividends as appropriate based on the above factors.
Issuer Purchases of Securities
On January 28, 2021, the Board of Directors of the Corporation approved a new share repurchase program. The program authorized the repurchase by the Corporation of up to $5 million of its total outstanding shares of common stock over a period of approximately twelve months, ending January 31, 2022. The Corporation completed the $5 million repurchase program in October 2021, repurchasing a total of 182,151 shares during the year at a weighted average price of $27.40 per share. The Corporation did not have an active share repurchase plan as of December 31, 2021.
Under the share repurchase program, the Corporation was authorized to repurchase shares from time to time in the open market or negotiated transactions at prevailing market rates, or by other means in accordance with federal securities laws. In connection with the share repurchase program, the Corporation implemented a 10b5-1 trading plan. The trading plan allowed the Corporation to repurchase shares of its common stock at times when it otherwise might have been prevented from doing so under insider trading laws by requiring that an agent selected by the Corporation repurchase shares of common stock on the Corporation’s behalf on pre-determined terms.
The following table sets forth information about the Corporation's purchases of its common stock during the three months ended December 31, 2021.
Period Total Number of Shares Purchased(1)
Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Total Number of Shares that May Yet Be Purchased Under the Plans or Programs
October 1, 2021 - October 31, 2021 24,631 $ 29.05 24,631
November 1, 2021 - November 30, 2021 1,519 30.65 -
December 1, 2021 - December 31, 2021 - - -
Total 26,150 24,631 -
(1)During the fourth quarter of 2021, the Corporation repurchased an aggregate 26,150 shares of the Corporation’s common stock in open-market transactions, of which 24,631 shares were purchased pursuant to the repurchase program publicly announced on January 28, 2021, and of which 1,519 shares were surrendered to us to satisfy income tax withholding obligations in connection with the vesting of restricted awards.

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ITEM 6. SELECTED FINANCIAL DATA
Item 6. Selected Financial Data
Not applicable.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
When used in this report the words or phrases “may,” “could,” “should,” “hope,” “might,” “believe,” “expect,” “plan,” “assume,” “intend,” “estimate,” “anticipate,” “project,” “likely,” or similar expressions are intended to identify “forward-looking statements.” Such statements are subject to risks and uncertainties, including among other things:
•Adverse changes in the economy or business conditions, either nationally or in our markets, including, without limitation, inflation, supply chain issues, labor shortages, and the adverse effects of the COVID-19 pandemic on the global, national, and local economy, which may effect the Corporation’s credit quality, revenue, and business operations.
•Competitive pressures among depository and other financial institutions nationally and in our markets.
•Increases in defaults by borrowers and other delinquencies.
•Our ability to manage growth effectively, including the successful expansion of our client support, administrative infrastructure, and internal management systems.
•Fluctuations in interest rates and market prices.
•The consequences of continued bank acquisitions and mergers in our markets, resulting in fewer but much larger and financially stronger competitors.
•Changes in legislative or regulatory requirements applicable to us and our subsidiaries.
•Changes in tax requirements, including tax rate changes, new tax laws, and revised tax law interpretations.
•Fraud, including client and system failure or breaches of our network security, including our internet banking activities.
•Failure to comply with the applicable SBA regulations in order to maintain the eligibility of the guaranteed portions of SBA loans.
These risks, together with the risks identified in Item 1A - Risk Factors, could cause actual results to differ materially from what we have anticipated or projected. These risk factors and uncertainties should be carefully considered by our shareholders and potential investors. Investors should not place undue reliance on any such forward-looking statements, which speak only as of the date made.
Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, we caution that, while our management believes such assumptions or bases are reasonable and are made in good faith, assumed facts or bases can vary from actual results, and the differences between assumed facts or bases and actual results can be material, depending on the circumstances. Where, in any forward-looking statement, an expectation or belief is expressed as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will be achieved or accomplished.
We do not intend to, and specifically disclaim any obligation to, update any forward-looking statements.
The following discussion and analysis is intended as a review of significant events and factors affecting our financial condition and results of operations for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto.
Overview
We are a registered bank holding company incorporated under the laws of the State of Wisconsin and are engaged in the commercial banking business through our wholly-owned banking subsidiary, FBB. All of our operations are conducted through FBB and First Business Specialty Finance, LLC (“FBSF”), a wholly-owned subsidiary of FBB. We operate as a business bank focusing on delivering a full line of commercial banking products and services tailored to meet the specific needs of small and medium-sized businesses, business owners, executives, professionals, and high net worth individuals. Our products and services include those for business banking, private wealth, and bank consulting. Within business banking, we offer commercial lending, asset-based lending, accounts receivable financing, equipment financing, floorplan financing, vendor financing, SBA lending and servicing, treasury management services, and company retirement plans. Our private wealth services for executives and individuals include trust and estate administration, financial planning, investment management, consumer lending, and private banking. For other financial institutions, our bank consulting experts provide investment portfolio administrative services, asset liability management services, and asset liability management process validation. We do not utilize a branch network to attract retail clients. Our operating philosophy is predicated on deep client relationships within our commercial bank markets and extensive expertise within our nationwide specialized lending business lines, combined with the efficiency of centralized administrative functions, such as information technology, loan and deposit operations, finance and accounting, credit administration, compliance, marketing, and human resources. Our focused model allows experienced staff to provide the level of financial expertise needed to develop and maintain long-term relationships with our clients.
Long-Term Strategic Plan
In early 2019, management finalized the development of its five year strategic plan and began the implementation of strategies and initiatives that will drive successful execution. Management’s objective over this five year period is to excel by building an expert team with diverse experiences who work together to impact client success more than any other financial partner. To meet this objective, we identified four key strategies which are linked to corporate financial goals, all business lines, and centralized administration functions to ensure communication and execution are consistent at all levels of the Corporation. These four strategies are described below:
•We will identify, attract, develop, and retain a diverse, high performing team to positively impact the overall performance and efficiency of the Corporation.
•We will increase internal efficiencies, deliver a differentiated client experience, and drive client experience utilizing technology where possible.
•We will diversify and grow our deposit base.
•We will optimize our business lines for diversification and performance.
The following table below shows the Corporation’s performance for the years ended December 31, 2021, 2020, and 2019 in comparison to the key performance indicators included in the Corporation’s long-term strategic plan.
As of and for the Year Ended December 31,
Key Performance Indicators 2019 2020 2021 2023 Goal
Return on average equity (“ROAE”) 12.55% 8.64% 16.21% 13.50%
Return on average assets (“ROAA”) 1.14% 0.70% 1.37% 1.15%
Top line revenue growth 9.1% 11.5% 8.4% ≥ 10% per year
In-market deposits to total bank funding 75.5% 74.8% 82.9% ≥ 75%
Employee engagement (1)
82% 91% 87% ≥ 80%
Client satisfaction (1)
93% 96% 93% ≥ 90%
(1) Anonymous surveys conducted annually
Financial Performance Summary
Results as of and for the year ended December 31, 2021 include:
•Net income for the year ended December 31, 2021 was $35.8 million, increasing 110.6% compared to $17.0 million for the year ended December 31, 2020.
•Diluted earnings per common share were $4.17 for the year ended December 31, 2021, increasing 111.4% compared to $1.97 in the prior year.
•Return on average assets and return on average equity for the year ended December 31, 2021 were 1.37% and 16.21% respectively, compared to 0.70% and 8.64%, respectively, for 2020.
•Pre-tax, pre-provision adjusted earnings, which excludes certain one-time and discrete items, for the year ended December 31, 2021 was $41.2 million, increasing 7.2% compared to $38.4 million for the year ended December 31, 2020. Pre-tax, pre-provision adjusted return on average assets for the year ended December 31, 2021 was 1.58%, compared to 1.59% for the year ended December 31, 2020.
•Net interest margin was 3.44% for the year ended December 31, 2021, increasing 4 basis points from 3.40% for the year ended December 31, 2020. Adjusted net interest margin, which excludes certain one-time and discrete items, was 3.21% for the year ended December 31, 2021, decreasing seven basis points from 3.28% for the year ended December 31, 2020.
•Fees in lieu of interest, defined as prepayment fees, asset-based loan fees, non-accrual interest, and loan fee amortization, totaled $11.2 million for the year ended December 31, 2021, increasing 19.8% compared to $9.3 million for the year ended December 31, 2020. Loan fee amortization for the year ended December 31, 2021 and December 31, 2020 includes PPP processing fee income of $7.3 million and $5.3 million, respectively.
•Top line revenue, which consists of net interest income and non-interest income, grew 8.4% to $112.8 million for the year ended December 31, 2021, compared to $104.0 million for the year ended December 31, 2020.
•Provision for loan and lease losses was a net benefit of $5.8 million for the year ended December 31, 2021, compared to provision expense of $16.8 million for the year ended December 31, 2020. Net recoveries as a percentage of average loans and leases were 0.07% for the year ended December 31, 2021, compared to net charge-offs of 0.39% for the year ended December 31, 2020.
•Total assets at December 31, 2021 increased $85.1 million, or 3.3%, to $2.653 billion from $2.568 billion at December 31, 2020.
•Period-end gross loans and leases receivable at December 31, 2021 increased $93.4 million, or 4.4%, to $2.239 billion from $2.146 billion as of December 31, 2020. Average gross loans and leases of $2.179 billion increased $167.8 million, or 8.3% for the year ended December 31, 2021, compared to $2.011 billion for the same period in 2020.
•Period-end gross loans and leases receivable, excluding net PPP loans, at December 31, 2021 increased $291.5 million, or 15.18%, to $2.212 billion from $1.921 billion as of December 31, 2020. Average gross loans and leases, excluding net PPP loans, of $2.027 billion increased $230.6 million, or 12.8% for the year ended December 31, 2021, compared to $1.796 billion for the same period in 2020.
•PPP loans and PPP deferred processing fees were $27.9 million and $557,000, respectively, at December 31, 2021. Average PPP loans, net of deferred processing fees, were $152.3 million for the year ended December 31, 2021.
•Non-performing assets were $6.5 million or 0.25% of total assets as of December 31, 2021, compared to $26.7 million or 1.04% of total assets as of December 31, 2020. Non-performing assets to total assets, excluding net PPP loans were 0.25% as of December 31, 2021, compared to 1.14% as of December 31, 2020.
•The allowance for loan and lease losses as of December 31, 2021 decreased $4.2 million, or 14.7%, to $24.3 million, compared to $28.5 million as of December 31, 2020. The allowance for loan and lease losses was 1.09% of total loans as of December 31, 2021, compared to 1.33% as of December 31, 2020. Excluding net PPP loans, the allowance for loan and lease losses decreased to 1.10% of total loans as of December 31, 2021, compared to 1.48% as of December 31, 2020.
•Period-end in-market deposits at December 31, 2021 increased $245.3 million, or 14.6%, to $1.928 billion from $1.683 billion as of December 31, 2020. Average in-market deposits of $1.784 billion increased $215.8 million, or 13.8%, for the year ended December 31, 2021, compared to $1.569 billion for the same period in 2020.
•Trust assets under management and administration increased by $671.7 million, or 29.9%, to $2.921 billion at December 31, 2021, compared to $2.249 billion at December 31, 2020.
Results of Operations
Top Line Revenue
Top line revenue, comprised of net interest income and non-interest income, increased 8.4% for the year ended December 31, 2021 compared to the year ended December 31, 2020 primarily due to a $7.6 million, or 9.8%, increase in net interest income and a $1.2 million, or 4.3%, increase in non-interest income. The increase in net interest income was driven by an increase in PPP loan processing fees, a decrease in interest expense, and an increase in average loans and leases outstanding and related interest income, partially offset by a reduction in asset-based loan fees in lieu of interest. The increase in non-interest income was primarily due to a $2.2 million increase in trust and investment fee income, $2.2 million increase in other fee income, $1.1 million increase in gains on the sale of SBA loans, and $680,000 increase in loan fee income. These favorable variances in top line revenue were partially offset by a reduction in swap fee income, which decreased $5.5 million compared to the year ended December 31, 2020.
The components of top line revenue were as follows:
For the Year Ended December 31, Change From Prior Year
2021 2020 $ Change % Change
(Dollars in Thousands)
Net interest income $ 84,662 $ 77,071 $ 7,591 9.8 %
Non-interest income 28,100 26,940 1,160 4.3
Top line revenue $ 112,762 $ 104,011 $ 8,751 8.4
Return on Average Assets and Return on Average Equity
ROAA was 1.37% for the year ended December 31, 2021, compared to 0.70% for the year ended December 31, 2020 principally due to a $22.6 million decrease in provision for loan and lease losses. Please refer to the Components of the Provision for Loan and Lease Losses included in the Provision for Loan and Lease Losses section below for further discussion on the reasons driving the improvement in profitability. We consider ROAA a critical metric to measure the profitability of our organization and how efficiently our assets are deployed. ROAA also allows us to better benchmark our profitability to our peers without the need to consider different degrees of leverage which can ultimately influence return on equity measures.
ROAE for the year ended December 31, 2021 was 16.21% compared to 8.64% for the year ended December 31, 2020. The primary reason for the increase in ROAE is consistent with the net income variance explanation as discussed under Return on Average Assets above. We view ROAE as an important measurement for monitoring profitability and continue to focus on improving our return to our shareholders by enhancing the overall profitability of our client relationships, controlling our expenses, and minimizing our costs of credit.
Efficiency Ratio and Pre-Tax, Pre-Provision Adjusted Earnings
Efficiency ratio is a non-GAAP measure representing non-interest expense excluding the effects of the SBA recourse benefit, impairment of tax credit investments, net losses on foreclosed properties, amortization of other intangible assets, losses on early extinguishment of debt, and other discrete items, if any, divided by operating revenue, which is equal to net interest income plus non-interest income less realized net gains or losses on securities, if any. Pre-tax, pre-provision adjusted earnings is defined as operating revenue less operating expense. Management believes the adjustments made to non-interest expense and non-interest income allow investors and analysts to better assess the Corporation’s operating expenses in relation to its core operating revenue by removing the volatility that is associated with certain one-time items and other discrete items.
The efficiency ratio was 63.49% for the year ended December 31, 2021, compared to 63.09% for the year ended December 31, 2020. The Corporation generated positive operating leverage as pre-tax, pre-provision adjusted earnings increased $2.8 million, or 7.2%, to $41.2 million for the year ended December 31, 2021, compared to $38.4 million for the same period in 2020. The increase in operating revenue was partially offset by a $5.9 million, or 12.8%, increase in compensation.
We believe the Corporation will generate positive operating leverage annually and progress towards enhancing the long-term efficiency ratio at a measured pace as we focus on strategic initiatives directed toward revenue growth, process improvement, and automation. These initiatives include efforts to grow our existing specialized lending revenues, increase our commercial banking market share, and scale our private wealth management business in our less mature commercial banking markets.
We believe the efficiency ratio and pre-tax, pre-provision adjusted earnings allow investors and analysts to better assess the Corporation’s operating expenses in relation to its top line revenue by removing the volatility that is associated with certain non-recurring and other discrete items. The efficiency ratio and pre-tax, pre-provision adjusted earnings also allow management to benchmark performance of our model to our peers without the influence of the loan loss provision and tax considerations, which will ultimately influence other traditional financial measurements, including ROAA and ROAE. The information provided below reconciles the efficiency ratio to its most comparable GAAP measure.
Please refer to the Non-Interest Income and Non-Interest Expense sections below for discussion on additional drivers of the year-over-year change in the efficiency ratio.
For the Year Ended December 31, Change From Prior Year
2021 2020 $ Change % Change
(Dollars in Thousands)
Total non-interest expense $ 71,535 $ 68,898 $ 2,637 3.8 %
Less:
Net loss on foreclosed properties
15 383 (368) (96.1)
Amortization of other intangible assets
25 35 (10) (28.6)
SBA recourse benefit (76) (278) 202 (72.7)
Impairment of tax credit investments
- 2,395 (2,395) NM
Loss on early extinguishment of debt - 744 (744) NM
Total operating expense (a) $ 71,571 $ 65,619 $ 5,952 9.1
Net interest income $ 84,662 $ 77,071 $ 7,591 9.8
Total non-interest income 28,100 26,940 1,160 4.3
Less:
Net gain (loss) on sale of securities 29 (4) 33 NM
Adjusted non-interest income 28,071 26,944 1,127 4.2
Total operating revenue (b) $ 112,733 $ 104,015 $ 8,718 8.4
Efficiency ratio
63.49 % 63.09 %
Pre-tax, pre-provision adjusted earnings (b-a) $ 41,162 $ 38,396 $ 2,766 7.2
Average total assets 2,605,008 2,419,616 185,392 7.7
Pre-tax, pre-provision adjusted return on average assets 1.58 % 1.59 %
NM = Not meaningful
Net Interest Income
Net interest income levels depend on the amount of and yield on interest-earning assets as compared to the amount of and rate paid on interest-bearing liabilities. Net interest income is sensitive to changes in market rates of interest and the asset/liability management processes to prepare for and respond to such changes.
The table below shows average balances, interest, average rates, net interest margin and the spread between combined average rates earned on our interest-earning assets and cost of interest-bearing liabilities for the periods indicated. The average balances are derived from average daily balances.
For the Year Ended December 31,
2021 2020
Average
Balance Interest Average
Yield/
Rate Average
Balance Interest Average
Yield/
Rate
(Dollars in Thousands)
Interest-earning assets
Commercial real estate and other mortgage loans(1)
$ 1,387,434 $ 51,930 3.74 % $ 1,245,886 $ 51,188 4.11 %
Commercial and industrial loans(1)
727,923 37,470 5.15 % 701,328 35,487 5.06 %
Direct financing leases(1)
19,591 872 4.45 % 26,564 1,039 3.91 %
Consumer and other loans(1)
44,206 1,572 3.56 % 37,544 1,446 3.85 %
Total loans and leases receivable(1)
2,179,154 91,844 4.21 % 2,011,322 89,160 4.43 %
Mortgage-related securities(2)
159,242 2,633 1.65 % 173,084 3,548 2.05 %
Other investment securities(3)
44,739 777 1.74 % 31,809 639 2.01 %
FHLB stock 13,066 651 4.98 % 11,576 671 5.80 %
Short-term investments 64,308 90 0.14 % 37,314 161 0.43 %
Total interest-earning assets 2,460,509 95,995 3.90 % 2,265,105 94,179 4.16 %
Non-interest-earning assets 144,499 154,511
Total assets $ 2,605,008 $ 2,419,616
Interest-bearing liabilities
Transaction accounts
$ 506,693 988 0.19 % $ 392,577 1,448 0.37 %
Money market 693,608 1,183 0.17 % 651,402 2,842 0.44 %
Certificates of deposit 47,020 396 0.84 % 111,698 2,198 1.97 %
Wholesale deposits 119,831 986 0.82 % 142,591 2,434 1.71 %
Total interest-bearing deposits 1,367,152 3,553 0.26 % 1,298,268 8,922 0.69 %
FHLB advances
376,781 4,908 1.30 % 379,891 5,507 1.45 %
Federal reserve PPPLF - - - % 15,207 54 0.36 %
Other borrowings 31,935 1,759 5.51 % 24,472 1,509 6.17 %
Junior subordinated notes 10,068 1,113 11.05 % 10,054 1,116 11.10 %
Total interest-bearing liabilities 1,785,936 11,333 0.63 % 1,727,892 17,108 0.99 %
Non-interest-bearing demand deposit accounts
536,981 412,825
Other non-interest-bearing liabilities
61,580 82,337
Total liabilities 2,384,497 2,223,054
Stockholders’ equity 220,511 196,562
Total liabilities and stockholders’ equity
$ 2,605,008 $ 2,419,616
Net interest income $ 84,662 $ 77,071
Net interest spread 3.27 % 3.17 %
Net interest-earning assets $ 674,573 $ 537,213
Net interest margin 3.44 % 3.40 %
Average interest-earning assets to average interest-bearing liabilities
137.77 % 131.09 %
Return on average assets 1.37 % 0.70 %
Return on average equity 16.21 % 8.64 %
Average equity to average assets 8.46 % 8.12 %
Non-interest expense to average assets
2.75 % 2.85 %
(1)The average balances of loans and leases include non-accrual loans and leases and loans held for sale. Interest income related to non-accrual loans and leases is recognized when collected. Interest income includes net loan fees collected in lieu of interest.
(2)Includes amortized cost basis of assets available-for-sale and held-to-maturity.
(3)Yields on tax-exempt municipal securities are not presented on a tax-equivalent basis in this table.
The following table provides information with respect to: (1) the change in net interest income attributable to changes in rate (changes in rate multiplied by prior volume); and (2) the change in net interest income attributable to changes in volume (changes in volume multiplied by prior rate) for the year ended December 31, 2021 compared to the year ended December 31, 2020. The change in net interest income attributable to changes in rate and volume (changes in rate multiplied by changes in volume) has been allocated to the rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Rate/Volume Analysis
Increase (Decrease) for the Year Ended December 31,
2021 Compared to 2020
Rate Volume Net
(In Thousands)
Interest-earning assets
Commercial real estate and other mortgage loans(1)
$ (4,784) $ 5,526 $ 742
Commercial and industrial loans(1)
621 1,362 1,983
Direct financing leases(1)
130 (297) (167)
Consumer and other loans(1)
(117) 243 126
Total loans and leases receivable(1)
(4,150) 6,834 2,684
Mortgage-related securities(2)
(647) (268) (915)
Other investment securities (96) 234 138
FHLB Stock (100) 80 (20)
Short-term investments (147) 76 (71)
Total net change in income on interest-earning assets (5,140) 6,956 1,816
Interest-bearing liabilities
Transaction accounts (805) 345 (460)
Money market (1,832) 173 (1,659)
Certificates of deposit (895) (907) (1,802)
Wholesale deposits (1,107) (341) (1,448)
Total deposits (4,639) (730) (5,369)
FHLB advances (554) (45) (599)
Federal reserve PPPLF - (54) (54)
Other borrowings (174) 424 250
Junior subordinated notes (5) 2 (3)
Total net change in expense on interest-bearing liabilities (5,372) (403) (5,775)
Net change in net interest income $ 232 $ 7,359 $ 7,591
(1)The average balances of loans and leases include non-accrual loans and leases and loans held for sale. Interest income related to non-accrual loans and leases is recognized when collected. Interest income includes net loan fees collected in lieu of interest.
(2)Includes amortized cost basis of assets available-for-sale and held-to-maturity.
Net interest income increased by $7.6 million, or 9.8%, for the year ended December 31, 2021, compared to the year ended December 31, 2020. The increase compared to the prior year was principally due to an increase in average loans and leases outstanding, increase in PPP loan processing fees, and rate-driven decrease in interest expense. Average gross loans and leases of $2.179 billion increased by $167.8 million, or 8.3% for the year ended December 31, 2021, compared to $2.011 billion for the same period in 2020. Loan fees collected in lieu of interest increased 19.8% to $11.2 million, compared to $9.3 million during the same period of comparison. Excluding PPP fee amortization, loan fees collected in lieu of interest decreased 4.6% to $3.8 million, compared to $4.0 million during the same period of comparison. Excluding net PPP loans, average gross loans and leases for the year ended December 31, 2021 increased $230.6 million, or 12.8%, compared to the year ended December 31, 2020. Excluding fees in lieu of interest and interest income from PPP loans, net interest income increased $6.4 million, or 9.7%.
The yield on average earning assets for the year ended December 31, 2021 was 3.90%, a decrease of 26 basis points compared to 4.16% for the year ended December 31, 2020. This decrease was principally due to the renewal of fixed-rate loans and reinvestment of security cash flows at historically low interest rates and a decrease in recurring loan fees in lieu of interest.
This decrease was partially offset by the increase in PPP loan processing fees and reduction in average PPP loans earning 1% interest. Excluding the impact of recurring loan fees in lieu of interest and PPP fees in both 2021 and 2020, the yield on average earning assets for the year ended December 31, 2021 was 3.45%, a decrease of 30 basis points compared to 3.75% for the year ended December 31, 2020.
The average rate paid on interest-bearing liabilities was 0.63% for the year ended December 31, 2021, a decrease of 36 basis points from 0.99% for the year ended December 31, 2020. The average rate paid declined as the Corporation decreased deposit rates and renewed maturing FHLB advances at historically low fixed rates. In addition to the reduction in deposit rates and FHLB advance renewals, average wholesale deposits, which are typically longer duration and therefore a higher cost funding source than in-market deposits, decreased $22.8 million, or 16.0%.
Net interest margin increased four basis points to 3.44% for the year ended December 31, 2021, compared to 3.40% for the year ended December 31, 2020. Adjusted net interest margin measured 3.21% for the year ended December 31, 2021, compared to 3.28% for the year ended December 31, 2020. Adjusted net interest margin is a non-GAAP measure representing net interest income excluding the fees in lieu of interest and other recurring but volatile components of net interest margin divided by average interest-earning assets less average net PPP loans, if any, and other recurring but volatile components of average interest-earning assets. Fees in lieu of interest are defined as prepayment fees, asset-based loan fees, non-accrual interest, and loan fee amortization. The decrease in adjusted net interest margin was primarily due to the decrease in average yield on loans and leases receivable and investment securities, partially offset by a decrease in the average rate paid on in-market deposits and wholesale funding.
Management believes its success in growing in-market deposits, disciplined loan pricing, and increased production in existing higher-yielding specialized lending lines of business will allow the Corporation to achieve a net interest margin of at least 3.50%, on average, over the long-term. However, the collection of loan fees in lieu of interest is an expected source of volatility to quarterly net interest income and net interest margin, particularly given the nature of the Corporation’s asset-based lending business and the Corporation’s participation in the PPP. Net interest margin may also experience volatility due to events such as the collection of interest on loans previously in non-accrual status or the accumulation of significant short-term deposit inflows. Due to significant loan growth in 2021 and expectations for low double-digit loan growth in 2022, management believes excess liquidity will revert back to historical averages in 2022.
Provision for Loan and Lease Losses
We determine our provision for loan and lease losses pursuant to our allowance for loan and lease loss methodology, which is based on the magnitude of current and historical net charge-offs recorded throughout the established look-back period, the evaluation of several qualitative factors for each portfolio category, and the amount of specific reserves established for impaired loans that present collateral shortfall positions. Refer to Allowance for Loan and Lease Losses, below, for further information regarding our allowance for loan and lease loss methodology.
The Corporation recognized a $5.8 million provision benefit for the year ended December 31, 2021, compared to $16.8 million provision expense for the year ended December 31, 2020. The provision benefit for the year ended December 31, 2021 was primarily due to a net recovery of $1.6 million, a $4.5 million reduction in the general reserve from improving historical loss rates, and a $2.2 million decrease in specific reserves. These decreases were partially offset by a $2.9 million increase in the general reserve due to loan growth.
The following table shows the components of the provision for loan and lease losses for the year ended December 31, 2021 compared to the year ended December 31, 2020.
For the Year Ended December 31,
(Dollars in thousands) 2021 2020
Change in general reserve due to subjective factor changes $ (426) $ 5,460
Change in general reserve due to historical loss factor changes (4,456) 949
Charge-offs 3,508 8,139
Recoveries (5,126) (332)
Change in specific reserves on impaired loans, net (2,175) 316
Change due to loan growth, net 2,872 2,276
Total provision for loan and lease losses $ (5,803) $ 16,808
The addition of specific reserves on impaired loans represents new specific reserves established when collateral shortfalls or government guaranty deficiencies are present, while conversely the release of specific reserves represents the
reduction of previously established reserves that are no longer required. Changes in the allowance for loan and lease losses due to subjective factor changes reflect management’s evaluation of the level of risk within the portfolio based upon several factors for each portfolio segment. Charge-offs in excess of previously established specific reserves require an additional provision for loan and lease losses to maintain the allowance for loan and lease losses at a level deemed appropriate by management. This amount is net of the release of any specific reserve that may have already been provided. Change in the inherent risk of the portfolio is primarily influenced by the overall growth in gross loans and leases and an analysis of loans previously charged off, as well as movement of existing loans and leases in and out of an impaired loan classification where a specific evaluation of a particular credit may be required rather than the application of a general reserve loss rate. Refer to Asset Quality, below, for further information regarding the overall credit quality of our loan and lease portfolio.
Non-Interest Income
Non-interest income increased by $1.2 million, or 4.3%, to $28.1 million for the year ended December 31, 2021, from $26.9 million for the year ended December 31, 2020. Management continues to focus on revenue growth from multiple non-interest income sources in order to maintain a diversified revenue stream through greater contributions from fee-based revenues. Total non-interest income accounted for 24.9% of our total revenues in 2021 compared to 25.9% in 2020. The increase in total non-interest income for the year ended December 31, 2021 primarily reflected record private wealth management services fee income, an increase in other non-interest income and loan fees, and a significant increase in gain on the sale of SBA loans. These favorable variances were partially offset by a decrease in commercial loan interest rate swap fee income.
The components of non-interest income were as follows:
For the Year Ended December 31, Change From Prior Year
2021 2020 $ Change % Change
(Dollars in Thousands)
Private wealth management services fee income
$ 10,784 $ 8,611 $ 2,173 25.2 %
Gain on sale of SBA loans 4,044 2,899 1,145 39.5
Service charges on deposits 3,837 3,415 422 12.4
Loan fees 2,506 1,826 680 37.2
Increase in cash surrender value of bank-owned life insurance
1,413 1,402 11 0.8
Net gain (loss) on sale of securities 29 (4) 33 NM
Swap fees 1,368 6,860 (5,492) (80.1)
Other non-interest income 4,119 1,931 2,188 113.3
Total non-interest income $ 28,100 $ 26,940 $ 1,160 4.3
Fee income ratio(1)
24.9 % 25.9 %
(1)Fee income ratio is fee income, per the above table, divided by top line revenue (defined as net interest income plus non-interest income).
Private wealth management services fee income increased by $2.2 million, or 25.2%, to a record $10.8 million for the year ended December 31, 2021 compared to $8.6 million for the year ended December 31, 2020. Private wealth management services fee income is primarily driven by the amount of assets under management and administration, as well as the mix of business at different fee structures, and can be positively or negatively influenced by the timing and magnitude of volatility within the equity markets. This increase was driven by growth in assets under management and administration attributable to both new client relationships and increased equity values. At December 31, 2021, our trust assets under management and administration were a record $2.921 billion, or 29.9% more than trust assets under management and administration of $2.249 billion at December 31, 2020. We expect to continue to increase our revenue from assets under management and administration as we deepen existing and grow new client relationships in our less mature commercial bank markets, but market volatility may also affect the actual change in revenue.
Gain on sale of SBA loans for the year ended December 31, 2021 totaled $4.0 million, an increase of $1.1 million, or 39.5%, from the same period in 2020. Management believes SBA 7a loan production, while variable based on timing of closings, will continue to increase annually at a measured pace.
Loan fees increased $680,000, or 37.2%, to $2.5 million for the year ended December 31, 2021, compared to $1.8 million for the same period in 2020. The increase was principally due to recognizing a full year of floorplan financing
curtailment fees and an increase in SBA servicing fee income commensurate with the Corporation’s growing SBA sold portfolio.
Other non-interest income increased by $2.2 million to $4.1 million for the year ended December 31, 2021, compared to $1.9 million for the year ended December 31, 2020. The increase was primarily due to an above average increase in returns from the Corporation’s investments in mezzanine funds.
Commercial loan interest rate swap fee income was $1.4 million for the year ended December 31, 2021, compared to $6.9 million for the year ended December 31, 2020 as it became less advantageous for clients to secure long-term, fixed-rate financing with an interest rate swap relative to other fixed-rate alternatives. We originate commercial real estate loans in which we offer clients a floating rate and an interest rate swap. The client’s swap is then offset with a counter-party dealer. The execution of these transactions generates swap fee income. The aggregate amortizing notional value of interest rate swaps with various borrowers was $640.6 million as of December 31, 2021, compared to $629.1 million as of December 31, 2020. Interest rate swaps can be an attractive product for our commercial borrowers, although associated fee income can be variable from period to period based on client demand and the interest rate environment in any given quarter.
Non-Interest Expense
Non-interest expense increased by $2.6 million, or 3.8%, to $71.5 million for the year ended December 31, 2021 from $68.9 million for the year ended December 31, 2020. Operating expense, which excludes certain one-time and discrete items as defined in the Efficiency Ratio table above, increased $6.0 million, or 9.1%, to $71.6 million for the year ended December 31, 2021 compared to $65.6 million for the year ended December 31, 2020. The increase in operating expense was primarily due to an increase in compensation, marketing, and data processing. These increases were partially offset by a decrease in other non-interest expense.
The components of non-interest expense were as follows:
For the Year Ended December 31, Change From Prior Year
2021 2020 $ Change % Change
(Dollars in Thousands)
Compensation $ 51,710 $ 45,850 $ 5,860 12.8 %
Occupancy 2,180 2,252 (72) (3.2)
Professional fees 3,736 3,530 206 5.8
Data processing 3,087 2,734 353 12.9
Marketing 2,022 1,580 442 28.0
Equipment 990 1,199 (209) (17.4)
Computer software 4,260 3,900 360 9.2
FDIC insurance 1,143 1,238 (95) (7.7)
Collateral liquidation costs 265 328 (63) (19.2)
Net loss on foreclosed properties 15 383 (368) (96.1)
Impairment on tax credit investments - 2,395 (2,395) NM
SBA recourse (benefit) provision (76) (278) 202 (72.7)
Loss on early extinguishment of debt - 744 (744) NM
Other non-interest expense 2,203 3,043 (840) (27.6)
Total non-interest expense $ 71,535 $ 68,898 $ 2,637 3.8
Total operating expense(1)
$ 71,571 $ 65,619 $ 5,952 9.1
Full-time equivalent employees 304 301 3 1.0
NM = Not meaningful
(1)Total operating expense represents total non-interest expense, adjusted to exclude the impact of discrete items as previously defined in the non-GAAP efficiency ratio calculation above.
Compensation expense increased by $5.9 million, or 12.8%, to $51.7 million for the year ended December 31, 2021 from $45.9 million for the year ended December 31, 2020 principally due to an increase in average FTEs, annual merit increases, growth in employee benefit costs and increase in incentive compensation. The increase reflects a $2.1 million, or
7.0%, increase in employee salaries and a $2.3 million, or 35.5%, increase in individual and corporate performance-based incentive compensation accruals reflecting strong company performance relative to bonus criteria. Average FTEs were 307 for the year ended December 31, 2021, increasing by 16, or 5.5%, from 291 for the year ended December 31, 2020. Performance-based incentive compensation accruals will reset to target performance at the start of 2022 and will be evaluated quarterly and increased or decreased based on management’s forecast of full year performance for the Corporation.
Marketing expense increased by $442,000, or 28.0%, to $2.0 million for the year ended December 31, 2021 from $1.6 million for the year ended December 31, 2020. During 2020, the Corporation’s adherence to COVID-19 restrictions resulted in a reduction in marketing expenses, such as meals and entertainment, and advertisement expense. Management expects marketing expense to continue to increase modestly and return to pre-pandemic levels over the next several quarters primarily driven by sponsorships and business development activities.
Data processing expense increased by $353,000, or 12.91%, to $3.1 million for the year ended December 31, 2021 from $2.7 million for the year ended December 31, 2020. The increase in data processing expense was due to the increase in services associated with deposit accounts, as well as implementation costs for various client-facing products and functionality. Management expects data processing expense to continue to increase modestly commensurate with the increase in deposit accounts.
Other non-interest expense decreased by $840,000, or 27.6%, to $2.2 million for the year ended December 31, 2021 from $3.0 million for the year ended December 31, 2020. The decrease was principally due to a reduction in the credit valuation adjustment (“CVA”) related to the commercial loan interest rate swap program. The CVA represents a change in the market value of the Company’s commercial loan interest rate swaps to estimate potential borrower credit risk within the portfolio. The CVA can vary from period to period based on the size of the portfolio, credit metrics, and the interest rate environment in any given quarter. The CVA was $191,000 as of December 31, 2021, compared to $461,000 as of December 31, 2020.
The Corporation incurred a $744,000 loss, recognized through non-interest expense, on the early extinguishment of $59.5 million in FHLB term advances late in the second quarter of 2020, as the Corporation lowered wholesale funding costs and improved the Corporation’s funding position. Management believes this strategy helped stabilize net interest margin during the extended low interest rate environment in 2021.
No tax credits or related impairment was recognized for the year ended December 31, 2021. The impairment on tax credit investments for the year ended December 31, 2020 were related to a new market and historic tax credits. The impairment on tax credits were more than offset by a reduction to income tax expense resulting in a net benefit to earnings in the year the credits are earned in 2020.
Income Taxes
Income tax expense was $11.3 million for the year ended December 31, 2021, compared to $1.3 million for the year ended December 31, 2020. The Corporation recognized federal historic tax credits in 2020 which reduced income tax expense by $2.8 million. No tax credits were recognized in 2021. The effective tax rate for the year ended December 31, 2021 was 24.0% compared to 7.2% for the year ended December 31, 2020. The effective tax rate, excluding tax credits and other discrete items, for the year ended December 31, 2020 was 19.5%. For 2022, the Company expects to report an effective tax rate of 22%-23%, excluding discrete items, as management intends to continue actively pursuing tax credit opportunities.
FINANCIAL CONDITION
General
Total assets increased by $85.1 million, or 3.3%, to $2.653 billion as of December 31, 2021 compared to $2.568 billion at December 31, 2020. The increase in total assets was primarily driven by an increase in loans and leases receivable, securities available-for-sale, and short-term investments, partially offset by a decrease in cash and derivatives. Total liabilities increased by $58.8 million, or 2.5%, to $2.420 billion as of December 31, 2021 compared to $2.362 billion at December 31, 2020. The increase in total liabilities was principally due to an increase in deposits, partially offset by a decrease in FHLB advances and derivatives.
Cash and cash equivalents
Cash and cash equivalents include short-term investments and cash and due from banks. Short-term investments increased by $20.0 million to $47.4 million at December 31, 2021 from $27.4 million at December 31, 2020. The increase in short-term investments was offset by a decrease in cash and due from banks driven by a reduction in cash letter in transit. Short-term investments primarily consist of interest-bearing deposits held at the Federal Reserve Bank (“FRB”). We value the safety and soundness provided by the FRB, and therefore, we incorporate short-term investments in our on-balance sheet liquidity program. As of December 31, 2021 and 2020, interest-bearing deposits held at the FRB were $47.0 million and $26.7 million, respectively. In general, the level of our cash and short-term investments will be influenced by the timing of deposit gathering, scheduled maturities of wholesale deposits, funding of loan and lease growth when opportunities are presented, and the level of our securities portfolio. Please refer to the section entitled Liquidity and Capital Resources for further discussion.
Securities
Total securities, including available-for-sale and held-to-maturity, increased by $15.1 million to $225.4 million at December 31, 2021 from $210.3 million at December 31, 2020. As of December 31, 2021 and 2020, our total securities portfolio had a weighted average estimated maturity of approximately 5.7 years and 5.0 years, respectively. The investment portfolio primarily consists of mortgage-backed securities and is used to provide a source of liquidity, including the ability to pledge securities for possible future cash advances, while contributing to the earnings potential of the Bank. The overall duration of the securities portfolio is established and maintained to further mitigate interest rate risk present within our balance sheet as identified through asset/liability simulations. We purchase investment securities intended to protect net interest margin while maintaining an acceptable risk profile. In addition, we will purchase investment securities to utilize our cash position effectively within appropriate policy guidelines and estimates of future cash demands. While mortgage-backed securities present prepayment risk and extension risk, we believe the overall credit risk associated with these investments is minimal, as the majority of the securities we hold are guaranteed by the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”), or the Government National Mortgage Association (“GNMA”), a U.S. government agency. The estimated repayment streams associated with this portfolio also allow us to better match short-term liabilities. The Bank’s investment policies allow for various types of investments, including tax-exempt municipal securities. The ability to invest in tax-exempt municipal securities provides for further opportunity to improve our overall yield on the securities portfolio. We evaluate the credit risk of the municipal securities prior to purchase and generally limit exposure to general obligation issuances from municipalities, primarily in Wisconsin.
The majority of the securities we hold have active trading markets; therefore, we have not experienced difficulties in pricing our securities. We use a third-party pricing service as our primary source of market prices for the securities portfolio. On a quarterly basis, we validate the reasonableness of prices received from this source through independent verification of the portfolio, data integrity validation through comparison of current price to prior period prices, and an expectation-based analysis of movement in prices based upon the changes in the related yield curves and other market factors. On a periodic basis, we review the third-party pricing vendor’s methodology for pricing relevant securities and the results of its internal control assessments. Our securities portfolio is sensitive to fluctuations in the interest rate environment and has limited sensitivity to credit risk due to the nature of the issuers and guarantors of the securities as previously discussed. If interest rates decline and the credit quality of the securities remains constant or improves, the fair value of our debt securities portfolio would likely improve, thereby increasing total comprehensive income. If interest rates increase and the credit quality of the securities remains constant or deteriorates, the fair value of our debt securities portfolio would likely decline and therefore decrease total comprehensive income. The magnitude of the fair value change will be based upon the duration of the portfolio. A securities portfolio with a longer average duration will exhibit greater market price volatility than a securities portfolio with a shorter average duration in a changing rate environment. During the year ended December 31, 2021, we recognized unrealized holding losses of $4.3 million before income taxes through other comprehensive income. These losses were the result of a decrease in interest rates. No securities within our portfolio were deemed to be other-than-temporarily impaired as of December 31, 2021. We sold approximately $15.0 million of securities during the year ended December 31, 2021 to proactively manage our securities portfolio and meet our long-term investment objectives. As of December 31, 2021 no securities were classified as
trading securities. At December 31, 2021, $70.3 million of our securities were pledged to secure various obligations, including interest rate swap contracts and municipal deposits.
The tables below set forth information regarding the amortized cost and fair values of our securities.
As of December 31,
2021 2020
Amortized Cost Fair Value Amortized Cost Fair Value
(In Thousands)
Available-for-sale:
U.S. Treasuries $ 4,971 $ 4,914 $ - $ -
U.S. government agency securities - government-sponsored enterprises
19,797 19,935 22,699 22,629
Municipal securities 30,828 30,957 24,067 24,779
Residential mortgage-backed securities - government issued 19,563 19,661 9,894 10,403
Residential mortgage-backed securities - government-sponsored enterprises
85,748 85,705 102,843 105,006
Commercial mortgage-backed securities - government issued
5,801 5,771 5,289 5,464
Commercial mortgage-backed securities - government-sponsored enterprises
36,786 36,531 12,584 13,365
Other securities
2,205 2,228 2,205 2,279
$ 205,699 $ 205,702 $ 179,581 $ 183,925
As of December 31,
2021 2020
Amortized Cost Fair Value Amortized Cost Fair Value
(In Thousands)
Held-to-maturity:
Municipal securities
$ 13,009 $ 13,228 $ 17,106 $ 17,508
Residential mortgage-backed securities - government issued 2,226 2,266 3,564 3,676
Residential mortgage-backed securities - government-sponsored issued
2,502 2,578 3,693 3,856
Commercial mortgage-backed securities - government-sponsored enterprises
2,009 2,204 2,011 2,293
$ 19,746 $ 20,276 $ 26,374 $ 27,333
U.S. Treasuries represent treasury bonds issued by the United States Treasury. U.S. government agency securities - government-sponsored enterprises represent securities issued by FNMA and the SBA. Municipal securities include securities issued by various municipalities located primarily within Wisconsin and are primarily general obligation bonds that are tax-exempt in nature. Residential and commercial mortgage-backed securities - government issued represent securities guaranteed by GNMA. Residential and commercial mortgage-backed securities - government-sponsored enterprises include securities guaranteed by FHLMC, FNMA, and the FHLB. Other securities represent certificates of deposit of insured banks and savings institutions with an original maturity greater than three months. As of December 31, 2021, no issuer's securities exceeded 10% of our total stockholders' equity.
The following table sets forth the contractual maturity and weighted average yield characteristics of the fair value of our available-for-sale securities and the amortized cost of our held-to-maturity securities at December 31, 2021, classified by remaining contractual maturity. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay securities without call or prepayment penalties. Yields on tax-exempt securities have not been computed on a tax equivalent basis.
Less than One Year One to Five Years Five to Ten Years Over Ten Years
Fair Value Weighted
Average
Yield Fair Value Weighted
Average
Yield Fair Value Weighted
Average
Yield Fair Value Weighted
Average
Yield Total
(Dollars in Thousands)
Available-for-sale:
U.S. treasuries $ - - % $ 4,914 1.00 % $ - - % $ - - % $ 4,914
U.S. government agency securities - government-sponsored enterprises
- - 978 0.56 4,726 0.93 14,231 0.80 19,935
Municipal securities 496 0.30 2,951 1.33 11,839 1.41 15,671 1.85 30,957
Residential mortgage-backed securities - government issued
- - - - 2,273 2.94 17,388 1.89 19,661
Residential mortgage-backed securities - government-sponsored enterprises
- - 1,216 2.34 13,271 2.09 71,218 1.72 85,705
Commercial mortgage-backed securities - government issued
- - - - 1,658 3.10 4,113 1.60 5,771
Commercial mortgage-backed securities - government-sponsored enterprises
- - 1,878 2.41 24,703 1.63 9,950 1.53 36,531
Other securities 2,228 2.38 - - - - - - 2,228
$ 2,724 $ 11,937 $ 58,470 $ 132,571 $ 205,702
Less than One Year One to Five Years Five to Ten Years Over Ten Years
Amortized Cost Weighted
Average
Yield Amortized Cost Weighted
Average
Yield Amortized Cost Weighted
Average
Yield Amortized Cost Weighted
Average
Yield Total
(Dollars in Thousands)
Held-to-maturity:
Municipal securities $ 3,793 2.13 % $ 7,289 2.27 % $ 1,927 2.67 % $ - - % $ 13,009
Residential mortgage-backed securities - government issued
- - - - 1,491 2.00 735 2.14 2,226
Residential mortgage-backed securities - government-sponsored enterprises
- - - - 1,796 1.68 706 3.35 2,502
Commercial mortgage-backed securities - government-sponsored enterprises
- - - - 2,009 3.27 - - 2,009
$ 3,793 $ 7,289 $ 7,223 $ 1,441 $ 19,746
Derivatives
The Bank’s investment policies allow the Bank to participate in hedging strategies or to use financial futures, options, forward commitments, or interest rate swaps with prior approval from the Board. The Bank utilizes, from time to time, derivative instruments in the course of its asset/liability management. As of December 31, 2021 and 2020, the Bank did not hold any derivative instruments that were designated as fair value hedges. The Corporation offers interest rate swap products directly to qualified commercial borrowers. The Corporation economically hedges client derivative transactions by entering into offsetting interest rate swap contracts executed with a third party. Derivative transactions executed as part of this program are not considered hedging instruments and are marked-to-market through earnings each period. The derivative contracts have mirror-image terms, which results in the positions’ changes in fair value offsetting through earnings each period.
As of December 31, 2021, the aggregate amortizing notional value of interest rate swaps with various commercial borrowers was approximately $640.6 million, compared to $629.1 million as of December 31, 2020. We receive fixed rates and pay floating rates based upon LIBOR on the swaps with commercial borrowers. These swaps mature between January 2024 and March 2038. Commercial borrower swaps are completed independently with each borrower and are not subject to master netting arrangements. As of December 31, 2021, the commercial borrower swaps were reported on the Consolidated Balance Sheet as a derivative asset of $26.3 million and as a derivative liability of $6.6 million compared to a derivative asset and liability of $49.4 million and $58,000, respectively, as of December 31, 2020. On the offsetting swap contracts with dealer counterparties, we pay fixed rates and receive floating rates based upon LIBOR. These interest rate swaps also have maturity dates between January 2024 and March 2038. Dealer counterparty swaps are subject to master netting agreements among the contracts within our Bank and were reported on the Consolidated Balance Sheet as a net derivative liability of $19.7 million as of December 31, 2021, compared to $49.3 million as of December 31, 2020. The gross amount of dealer counterparty swaps as of December 31, 2021, without regard to the enforceable master netting agreement, was a gross derivative liability of $26.3 million and a gross derivative asset of $6.6 million, compared to a gross derivative liability and asset of $49.4 million and
$58,000, respectively, as of December 31, 2020. The decrease in derivative asset and liabilities as of December 31, 2021 compared to December 31, 2020 is due to the fluctuation in interest rates.
The Corporation also enters into interest rate swaps to manage interest rate risk and reduce the cost of match-funding certain long-term fixed rate loans. These derivative contracts involve the receipt of floating rate interest from a counterparty in exchange for the Corporation making fixed-rate payments over the life of the agreement, without the exchange of the underlying notional value. The instruments are designated as cash flow hedges as the receipt of floating rate interest from the counterparty is used to manage interest rate risk associated with forecasted issuances of short-term FHLB advances. The change in the fair value of these hedging instruments is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged transactions affects earnings. As of December 31, 2021, the aggregate notional value of interest rate swaps designated as cash flow hedges was $106.0 million. These interest rate swaps mature between December 2022 and December 2027. A pre-tax unrealized loss of $3.6 million was recognized in other comprehensive income for the year ended December 31, 2021 and there was no ineffective portion of these hedges.
Loans and Leases Receivable
Loans and leases receivable, net of allowance for loan and lease losses, increased by $97.6 million, or 4.6%, to $2.215 billion at December 31, 2021 from $2.117 billion at December 31, 2020. Excluding net PPP loans, loans and leases receivable, net of allowance for loan and lease losses, increased by $295.6 million, or 15.63%, to $2.188 billion at December 31, 2021 from $1.892 billion at December 31, 2020. Excluding PPP loans, commercial and industrial (“C&I”) loans, non-owner-occupied commercial real estate (“CRE”), and construction loans were the largest contributors to loan growth as of December 31, 2021, increasing $196.5 million, $96.9 million, and $38.8 million, respectively, from December 31, 2020.
There continues to be a concentration in CRE loans which represented 65.7% and 70.6% of our total loans, excluding net PPP loans, as of December 31, 2021 and December 31, 2020, respectively. As of December 31, 2021, approximately 16.2% of the CRE loans were owner-occupied CRE, compared to 18.7% as of December 31, 2020. We consider owner-occupied CRE more characteristic of the Corporation’s C&I portfolio as, in general, the client’s primary source of repayment is the cash flow from the operating entity occupying the commercial real estate property.
Our C&I portfolio decreased $1.5 million, or 0.2%, to $730.8 million at December 31, 2021 from $732.3 million at December 31, 2020. Excluding net PPP loans, C&I loans increased $196.5 million, or 38.8%, to $703.5 million from $507.0 million at December 31, 2020. Management does not believe this loan growth rate is sustainable and anticipates it will moderate to low double-digits as the Company’s specialized lending products scale over time. The Corporation experienced significant C&I loan growth in 2021, led by conventional commercial lending, as well as specialized commercial lending which represented 20.0% of total loans as of December 31, 2021, up from 17.0% as of December 31, 2020. Management believes the timely prior-period investments in the Corporation’s specialized lending business lines, such as dealer floorplan financing, small-ticket equipment vendor financing, accounts receivable financing, and asset based lending have positioned C&I lending for strong and sustainable growth in 2022 and beyond.
We will continue to actively pursue C&I loans across the Corporation as this segment of our loan and lease portfolio provides an attractive yield commensurate with an appropriate level of credit risk and creates opportunities for in-market deposit, treasury management, and private wealth management relationships which generate additional fee revenue.
Underwriting of new credit is primarily through approval from a serial sign-off or committee process and is a key component of our operating philosophy. Business development officers have no individual lending authority limits, and thus, a significant portion of our new credit extensions require approval from a loan approval committee regardless of the type of loan or lease, amount of the credit, or the related complexities of each proposal. In addition, we make every reasonable effort to ensure that there is appropriate collateral or a government guarantee at the time of origination to protect our interest in the related loan or lease. To monitor the ongoing credit quality of our loans and leases, each credit is evaluated for proper risk rating using a nine grade risk rating system at the time of origination, subsequent renewal, evaluation of updated financial information from our borrowers, or as other circumstances dictate.
While we continue to experience significant competition from banks operating in our primary geographic areas, we remain committed to our underwriting standards and will not deviate from those standards for the sole purpose of growing our loan and lease portfolio. We continue to expect our new loan and lease activity to be adequate to replace normal amortization, allowing us to continue growing in future years.
The following table presents information concerning the composition of the Bank’s consolidated loans and leases receivable.
As of December 31,
2021 2020
Amount Outstanding % of Total Loans and Leases Amount Outstanding % of Total Loans and Leases
(Dollars in Thousands)
Commercial real estate:
Commercial real estate - owner occupied
$ 235,589 10.5 % $ 253,882 11.8 %
Commercial real estate - non-owner occupied
661,423 29.5 564,532 26.3
Land development
42,792 1.9 49,839 2.3
Construction
179,841 8.0 141,043 6.6
Multi-family
320,072 14.3 311,556 14.5
1-4 family
14,911 0.7 38,284 1.8
Total commercial real estate
1,454,628 64.9 1,359,136 63.2
Commercial and industrial
730,819 32.6 732,318 34.0
Direct financing leases, net
15,743 0.7 22,331 1.1
Consumer and other:
Home equity and second mortgage
4,223 0.2 7,833 0.4
Other
35,518 1.6 28,897 1.3
Total consumer and other
39,741 1.8 36,730 1.7
Total gross loans and leases receivable
2,240,931 100.0 % 2,150,515 100.0 %
Less:
Allowance for loan and lease losses
24,336 28,521
Deferred loan fees
1,523 4,545
Loans and leases receivable, net
$ 2,215,072 $ 2,117,449
The following table shows the scheduled contractual maturities of the Bank’s consolidated gross loans and leases receivable, as well as the dollar amount of such loans and leases which are scheduled to mature after one year and have fixed or adjustable interest rates, as of December 31, 2021.
Amounts Due Interest Terms On Amounts Due after One Year
In One Year
or Less After One
Year through
Five Years After Five
Years Total Fixed Rate Variable
Rate
(In Thousands)
Commercial real estate:
Owner-occupied $ 14,481 $ 112,813 $ 108,295 $ 235,589 $ 164,074 $ 57,034
Non-owner occupied 83,881 294,650 282,892 661,423 310,930 266,612
Land development 17,074 23,964 1,754 42,792 8,432 17,286
Construction 34,103 30,941 114,797 179,841 56,351 89,387
Multi-family 23,216 98,516 198,340 320,072 99,619 197,237
1-4 family 3,013 7,587 4,311 14,911 11,755 143
Commercial and industrial 235,189 418,358 77,272 730,819 304,426 191,204
Direct financing leases 1,239 13,992 512 15,743 14,504 -
Consumer and other 4,367 34,418 956 39,741 30,055 5,319
$ 416,563 $ 1,035,239 $ 789,129 $ 2,240,931 $ 1,000,146 $ 824,222
Commercial Real Estate. The Bank originates owner-occupied and non-owner-occupied commercial real estate loans which have fixed or adjustable rates and generally terms of three to 10 years and amortizations of up to 30 years on existing commercial real estate. The Bank also originates loans to construct commercial properties and complete land development projects. The Bank’s construction loans generally have terms of six to 24 months with fixed or adjustable interest rates and fees that are due at the time of origination. Loan proceeds are disbursed in increments as construction progresses and as project inspections warrant.
The repayment of commercial real estate loans generally is dependent on sufficient income from the properties securing the loans to cover operating expenses and debt service. Payments on commercial real estate loans are often dependent on external market conditions impacting the successful operation or development of the property or business involved. Therefore, repayment of such loans is often sensitive to conditions in the real estate market or the general economy, which are outside the borrower’s control. In the event that the cash flow from the property is reduced, the borrower’s ability to repay the loan could be negatively impacted. The deterioration of one or a few of these loans could cause a material increase in our level of nonperforming loans, which would result in a loss of revenue from these loans and could result in an increase in the provision for loan and lease losses and an increase in charge-offs, all of which could have a material adverse impact on our net income. Additionally, many of these loans have real estate as a primary or secondary component of collateral. The market value of real estate can fluctuate significantly in a short period of time as a result of economic conditions. Adverse developments affecting real estate values in one or more of our markets could impact collateral coverage associated with the commercial real estate segment of our portfolio, possibly leading to increased specific reserves or charge-offs, which would adversely affect profitability. Of the $1.455 billion of commercial real estate loans outstanding as of December 31, 2021, $25.8 million were originated by our asset-based lending subsidiary, as part of a larger asset-based lending relationship.
Commercial and Industrial. The Bank’s commercial and industrial loan portfolio is comprised of loans for a variety of purposes which principally are secured by inventory, accounts receivable, equipment, machinery, and other corporate assets and are advanced within limits prescribed by our loan policy. The majority of such loans are secured and typically backed by personal guarantees of the owners of the borrowing business. Of the $730.8 million of C&I loans outstanding as of December 31, 2021, $354.2 million were conventional C&I loans and $447.1 million were specialized lending C&I loans. Specialized lending consists of asset-based lending, accounts receivable financing, floorplan financing, equipment financing, and SBA lending.
Direct Financing Leases. Direct financing leases initiated through FBSF are originated with a fixed rate and typically a term of seven years or less. It is customary in the leasing industry to provide 100% financing; however, FBSF will, from time-to-time, require a down payment or lease deposit to provide a credit enhancement. As of December 31, 2021, the Bank had $15.7 million in net direct financing receivables outstanding.
FBSF leases machinery and equipment to clients under leases which qualify as direct financing leases for financial reporting and as operating leases for income tax purposes. Under the direct financing method of accounting, the minimum lease payments to be received under the lease contract, together with the estimated unguaranteed residual value (approximating 3% to 20% of the cost of the related equipment), are recorded as lease receivables when the lease is signed and the lease property is delivered to the client. The excess of the minimum lease payments and residual values over the cost of the equipment is recorded as unearned lease income. Unearned lease income is recognized over the term of the lease on a basis which results in a level rate of return on the unrecovered lease investment. Lease payments are recorded when due under the lease contract. Residual value is the estimated fair market value of the equipment on lease at lease termination and was estimated to be $3.6 million as of December 31, 2021. In estimating the equipment’s fair value, FBSF relies on historical experience by equipment type and manufacturer, published sources of used equipment pricing, internal evaluations and, when available, valuations by independent appraisers, adjusted for known trends.
Consumer and Other. The Bank originates a small amount of consumer loans consisting of home equity, first and second mortgages, and other personal loans for professional and executive clients of the Bank.
Asset Quality
Non-accrual loans and leases decreased $20.3 million, or 76.1%, to $6.4 million at December 31, 2021 compared to $26.6 million at December 31, 2020.
Our total impaired assets consisted of the following:
As of December 31,
2021 2020
(Dollars in Thousands)
Non-accrual loans and leases
Commercial real estate:
Commercial real estate - owner occupied $ 348 $ 5,429
Commercial real estate - non-owner occupied - 3,783
Land development - 890
Construction - -
Multi-family - -
1-4 family 339 250
Total non-accrual commercial real estate 687 10,352
Commercial and industrial 5,572 16,155
Direct financing leases, net 99 49
Consumer and other:
Home equity and second mortgage - 40
Other - 21
Total non-accrual consumer and other loans - 61
Total non-accrual loans and leases 6,358 26,617
Foreclosed properties, net 164 34
Total non-performing assets 6,522 26,651
Performing troubled debt restructurings 217 46
Total impaired assets $ 6,739 $ 26,697
Total non-accrual loans and leases to gross loans and leases 0.28 % 1.24 %
Total non-performing assets to gross loans and leases plus foreclosed properties, net
0.29 % 1.24 %
Total non-performing assets to total assets 0.25 % 1.04 %
Allowance for loan and lease losses to gross loans and leases 1.09 % 1.33 %
Allowance for loan and lease losses to non-accrual loans and leases
382.76 % 107.15 %
As of December 31, 2021 and 2020, $627,000 and $6.5 million of the non-accrual loans were considered troubled debt restructurings, respectively. As noted in the table above, non-performing assets consisted of non-accrual loans and leases and foreclosed properties totaling $6.5 million, or 0.25% of total assets, as of December 31, 2021, a decrease in non-performing
assets of $20.1 million, or 75.5%, from December 31, 2020. Impaired loans and leases as of December 31, 2021 and 2020 also included $217,000 and $46,000, respectively, of loans classified as performing troubled debt restructurings, which are considered impaired due to the concession in terms, but are meeting the restructured payment terms and therefore are not on non-accrual status.
The following asset quality ratios exclude net PPP loans as they are fully guaranteed by the SBA:
As of December 31,
2021 2020
(In Thousands)
Total non-accrual loans and leases to gross loans and leases 0.29 % 1.38 %
Total non-performing assets to gross loans and leases plus foreclosed properties, net
0.29 1.38
Total non-performing assets to total assets 0.25 1.14
Allowance for loan and lease losses to gross loans and leases 1.10 1.48
We use a wide variety of available metrics to assess the overall asset quality of the portfolio and no one metric is used independently to make a final conclusion as to the asset quality of the portfolio. Non-performing assets as a percentage of total assets decreased to 0.25% at December 31, 2021 from 1.04% at December 31, 2020. As of December 31, 2021, the payment performance of our loans and leases did not point to any new areas of concern, as approximately 99.8% of the total portfolio was in a current payment status, compared to 99.0% as of December 31, 2020. We also monitor asset quality through our established categories as defined in Note 4 - Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses of the Consolidated Financial Statements. As we continue to actively monitor the credit quality of our loan and lease portfolios, we may identify additional loans and leases for which the borrowers or lessees are having difficulties making the required principal and interest payments based upon factors including, but not limited to, the inability to sell the underlying collateral, inadequate cash flow from the operations of the underlying businesses, liquidation events, or bankruptcy filings. We are proactively working with our impaired loan borrowers to find meaningful solutions to difficult situations that are in the best interests of the Bank.
In 2021, as well as in all previous reporting periods, there were no loans over 90 days past due and still accruing interest. Loans and leases greater than 90 days past due are considered impaired and are placed on non-accrual status. Cash received while a loan or a lease is on non-accrual status is generally applied solely against the outstanding principal. If collectability of the contractual principal and interest is not in doubt, payments received may be applied to both interest due on a cash basis and principal.
Additional information about impaired loans is as follows:
As of December 31,
2021 2020
(In Thousands)
Impaired loans and leases with no impairment reserves $ 4,419 $ 18,966
Impaired loans and leases with impairment reserves required 2,156 7,697
Total impaired loans and leases 6,575 26,663
Less: Impairment reserve (included in allowance for loan and lease losses)
1,505 3,681
Net impaired loans and leases $ 5,070 $ 22,982
Average impaired loans and leases $ 14,260 $ 27,703
For the years ended December 31,
2021 2020
(In Thousands)
Interest income attributable to impaired loans and leases $ 1,104 $ 2,794
Less: Interest income recognized on impaired loans and leases
454 636
Net foregone interest income on impaired loans and leases $ 650 $ 2,158
Loans and leases with no impairment reserves represent impaired loans where the collateral, based upon current information, is deemed to be sufficient or that have been partially charged-off to reflect our net realizable value of the loan.
When analyzing the adequacy of collateral, we obtain external appraisals as appropriate. Our policy regarding commercial real estate appraisals requires the utilization of appraisers from our approved list, the performance of independent reviews to monitor the quality of such appraisals, and receipt of new appraisals for impaired loans at least annually, or more frequently as circumstances warrant. We make adjustments to the appraised values for appropriate selling costs. In addition, the ordering of appraisals and review of the appraisals are performed by individuals who are independent of the business development process. Based on the specific evaluation of the collateral of each impaired loan, we believe the reserve for impaired loans was appropriate at December 31, 2021. However, we cannot provide assurance that the facts and circumstances surrounding each individual impaired loan will not change and that the specific reserve or current carrying value will not be different in the future, which may require additional charge-offs or specific reserves to be recorded.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses decreased $4.2 million, or 14.7%, to $24.3 million as of December 31, 2021 from $28.5 million as of December 31, 2020. The allowance for loan and lease losses as a percentage of gross loans and leases also decreased to 1.09% as of December 31, 2021 from 1.33% as of December 31, 2020. The allowance for loan and lease losses as a percentage of gross loans and leases, excluding net PPP loans, was 1.10% as of December 31, 2021 from 1.48% as of December 31, 2020. The decrease in allowance for loan and lease losses as a percent of gross loans and leases was principally driven by significant commercial real estate loan recoveries, and the related impact it had on our commercial real estate historical loss factors, and the release of specific reserves following loan payoffs and charge-offs. These general and specific reserve releases were partially offset by an increase in general reserve commensurate with loan growth. In addition to the commercial real estate recovery, all other loan segments experienced a reduction in historical loss factors as the look-back period began to roll off the Corporations higher loss rates from the Great Recession. Management believes this will continue in 2022, allowing for additional reserve release throughout the year.
During the year ended December 31, 2021, we recorded net recoveries on impaired loans and leases of approximately $1.6 million, which included $3.5 million of charge-offs and $5.1 million of recoveries. During the year ended December 31, 2020, we recorded net charge-offs on impaired loans and leases of approximately $7.8 million, which included $8.1 million of charge-offs and $332,000 of recoveries. The 2020 charge-off activity was principally driven by a $3.3 million charge-off for a previously reserved legacy SBA loan in the restaurant industry and a $2.8 million charge-off for a previously reserved conventional loan in the hospitality industry.
As of December 31, 2021 and 2020, our allowance for loan and lease losses to total non-accrual loans and leases was 382.76% and 107.15%, respectively. This ratio increased primarily due to the substantial decrease in non-accrual loans and leases discussed above, in comparison to the decrease in the allowance for loan and leases losses. Impaired loans and leases exhibit weaknesses that inhibit repayment in compliance with the original terms of the note or lease. However, the measurement of impairment on loans and leases may not always result in a specific reserve included in the allowance for loan and lease losses. As part of the underwriting process, as well as our ongoing monitoring efforts, we try to ensure that we have sufficient collateral to protect our interest in the related loan or lease. As a result of this practice, a significant portion of our outstanding balance of non-performing loans or leases may not require additional specific reserves or require only a minimal amount of required specific reserve. Management is proactive in recording charge-offs to bring loans to their net realizable value in situations where it is determined with certainty that we will not recover the entire amount of our principal. This practice may lead to a lower allowance for loan and lease loss to non-accrual loans and leases ratio as compared to our peers or industry expectations. As asset quality strengthens, our allowance for loan and lease losses is measured more through general characteristics, including historical loss experience, of our portfolio rather than through specific identification and we would therefore expect this ratio to rise. Conversely, if we identify further impaired loans, this ratio could fall if the impaired loans are adequately collateralized and therefore require no specific or general reserve. Given our business practices and evaluation of our existing loan and lease portfolio, we believe this coverage ratio is appropriate for the probable losses inherent in our loan and lease portfolio as of December 31, 2021.
To determine the level and composition of the allowance for loan and lease losses, we break out the portfolio by segments with similar risk characteristics. First, we evaluate loans and leases for potential impairment classification. We analyze each loan and lease identified as impaired on an individual basis to determine a specific reserve based upon the estimated value of the underlying collateral for collateral-dependent loans, or alternatively, the present value of expected cash flows. For each segment of loans and leases that has not been individually evaluated, management segregates the Bank’s loss factors into a quantitative general reserve component based on historical loss rates throughout the defined look back period. The quantitative general reserve component also considers an estimate of the historical loss emergence period, which is the period of time between the event that triggers the loss to the charge-off of that loss. The methodology also focuses on evaluation of several qualitative factors for each portfolio category, including but not limited to: management’s ongoing review and grading of the loan and lease portfolios, consideration of delinquency experience, changes in the size of the loan and lease portfolios,
existing economic conditions, level of loans and leases subject to more frequent review by management, changes in underlying collateral, concentrations of loans to specific industries, and other qualitative factors that could affect credit losses.
When it is determined that we will not receive our entire contractual principal or the loss is confirmed, we record a charge against the allowance for loan and lease loss reserve to bring the loan or lease to its net realizable value. Many of the impaired loans as of December 31, 2021 are collateral dependent. It is typically part of our process to obtain appraisals on impaired loans and leases that are primarily secured by real estate or equipment annually, or more frequently as circumstances warrant. As we have completed new appraisals and/or market evaluations, in specific situations current fair values collateralizing certain impaired loans were inadequate to support the entire amount of the outstanding debt. Foreclosure actions may have been initiated on certain of these commercial real estate and other mortgage loans.
As a result of our review process, we have concluded an appropriate allowance for loan and lease losses for the existing loan and lease portfolio was $24.3 million, or 1.09% of gross loans and leases, at December 31, 2021. However, given ongoing complexities with current workout situations and the uncertainty surrounding future economic conditions, further charge-offs, and increased provisions for loan and lease losses may be recorded if additional facts and circumstances lead us to a different conclusion. In addition, various federal and state regulatory agencies review the allowance for loan and lease losses. These agencies could require certain loan and lease balances to be classified differently or charged off when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination.
A summary of the activity in the allowance for loan and lease losses follows:
Year Ended December 31,
2021 2020
(Dollars in Thousands)
Allowance at beginning of period $ 28,521 $ 19,520
Charge-offs:
Commercial real estate
Commercial real estate - owner occupied (11) (3,339)
Commercial real estate - non-owner occupied - (2,780)
Construction and land development - -
Multi-family - -
1-4 family (245) -
Commercial and industrial (3,227) (1,951)
Direct financing leases - (56)
Consumer and other
Home equity and second mortgage - -
Other (25) (13)
Total charge-offs (3,508) (8,139)
Recoveries:
Commercial real estate
Commercial real estate - owner occupied 435 1
Commercial real estate - non-owner occupied 1,422 3
Construction and land development 2,078 -
Multi-family - -
1-4 family - -
Commercial and industrial 1,168 325
Direct financing leases - -
Consumer and other
Home equity and second mortgage 2 1
Other 21 2
Total recoveries 5,126 332
Net charge-offs 1,618 (7,807)
Provision for loan and lease losses (5,803) 16,808
Allowance at end of period $ 24,336 $ 28,521
Net charge-offs as a percent of average gross loans and leases (0.07) % 0.39 %
We review our methodology and periodically adjust allocation percentages of the allowance by segment, as reflected in the following table. Within the specific categories, certain loans or leases have been identified for specific reserve allocations as well as the whole category of that loan type or lease being reviewed for a general reserve based on the foregoing analysis of trends and overall balance growth within that category.
The table below shows our allocation of the allowance for loan and lease losses by loan portfolio segments. The allocation of the allowance by segment is management’s best estimate of the inherent risk in the respective loan segments. Despite the specific allocation noted in the table below, the entire allowance is available to cover any loss.
As of December 31,
2021 2020
Balance (a) Balance (a)
(Dollars in Thousands)
Loan and lease segments:
Commercial real estate $ 15,110 1.04 % $ 17,157 1.26 %
Commercial and industrial
8,413 1.13 10,593 1.40
Consumer and other 813 2.05 771 2.10
Total allowance for loan and lease losses $ 24,336 1.09 % $ 28,521 1.33 %
(a)Allowance for loan losses category as a percentage of total loans by category.
Although we believe the allowance for loan and lease losses was appropriate based on the current level of loan and lease delinquencies, non-accrual loans and leases, trends in charge-offs, economic conditions, and other factors as of December 31, 2021, there can be no assurance that future adjustments to the allowance will not be necessary.
Deposits
As of December 31, 2021, deposits increased by $102.4 million to $1.958 billion from $1.856 billion at December 31, 2020. The increase in deposits was primarily due to a $143.0 million and $112.9 million increase in transaction accounts and money market accounts, respectively partially offset by a decrease in wholesale deposits and certificates of deposit of $142.9 million and $10.6 million, respectively. The large increase in in-markets deposits was primarily due to successful business development efforts and PPP loan proceeds.
The following table presents the composition of the Bank’s consolidated deposits.
As of December 31,
2021 2020
Balance % of Total Deposits Balance % of Total Deposits
(Dollars in Thousands)
Non-interest-bearing transaction accounts
$ 589,559 30.1 % $ 472,818 25.4 %
Interest-bearing transaction accounts
530,225 27.1 503,992 27.2
Money market accounts
754,410 38.5 641,504 34.6
Certificates of deposit
54,091 2.8 64,694 3.5
Wholesale deposits 29,638 1.5 172,508 9.3
Total deposits
$ 1,957,923 100.0 % $ 1,855,516 100.0 %
Period-end deposit balances associated with in-market relationships will fluctuate based upon maturity of time deposits, client demands for the use of their cash, and our ability to service and maintain existing and new client relationships. Deposits continue to be the primary source of the Bank’s funding for lending and other investment activities. A variety of accounts are designed to attract both short- and long-term deposits. These accounts include non-interest-bearing transaction accounts, interest-bearing transaction accounts, money market accounts, and certificates of deposit. Deposit terms offered by the Bank vary according to the minimum balance required, the time period the funds must remain on deposit, the rates and products offered by competitors, and the interest rates charged on other sources of funds, among other factors. Our Bank’s in-market deposits are obtained primarily from the South Central, Northeast and Southeast regions of Wisconsin and the greater Kansas City Metro.
We measure the success of in-market deposit gathering efforts based on the average balances of our deposit accounts as compared to ending balances due to the volatility of some of our larger relationships. Average in-market deposits for the year ended December 31, 2021 were approximately $1.784 billion, or 78.23% of total bank funding. Total bank funding is defined as total deposits plus FHLB advances and Federal Reserve PPPLF advances. This compares to average in-market deposits of
$1.569 billion, or 75.01% of total bank funding, for 2020. Refer to Note 9 - Deposits in the Consolidated Financial Statements for additional information regarding our deposit composition.
The following table sets forth the amount and maturities of the Bank’s certificates of deposit and term wholesale deposits at December 31, 2021.
Interest Rate Three Months and Less Over Three Months Through Six Months Over Six Months Through Twelve Months Over Twelve Months Total
(In Thousands)
0.00% to 0.99% $ 36,821 $ 6,797 $ 4,343 $ 4,897 $ 52,858
1.00% to 1.99% 370 - 300 403 1,073
2.00% to 2.99% - - - 112 112
3.00% to 3.99% 9,389 - 10,000 297 19,686
$ 46,580 $ 6,797 $ 14,643 $ 5,709 $ 73,729
At December 31, 2021, time deposits included $7.9 million of certificates of deposit and wholesale deposits in denominations greater than or equal to $250,000. Of these certificates, $3.0 million are scheduled to mature in three months or less, $2.1 million in greater than three through six months, $251,000 in greater than six through twelve months and $2.6 million in greater than twelve months.
Of the total time deposits outstanding as of December 31, 2021, $68.0 million are scheduled to mature in 2022, $4.5 million in 2023, $349,000 in 2024, $324,000 in 2025, and $488,000 in 2026. As of December 31, 2021, we have no wholesale certificates of deposit which the Bank has the right to call prior to the scheduled maturity.
Borrowings
We had total borrowings of $413.5 million as of December 31, 2021, a decrease of $15.7 million, or 3.7%, from $429.2 million at December 31, 2020. While total wholesale funding as a percentage of total bank funding has decreased meaningfully overall due to significant in-market deposit growth, we continue to replace our maturing brokered certificates of deposit with FHLB advances at lower rates, if needed, to match-fund fixed rate loans and mitigate interest rate risk. Total bank funding is defined as total deposits plus FHLB advances and Federal Reserve PPPLF advances.
As of December 31, 2021 and December 31, 2020, the Corporation had other borrowings of $10.4 million and $920,000, respectively, which consisted of sold loans accounted for as secured borrowings because they did not qualify for true sale accounting, as well as borrowings associated with our investment in a community development entity.
During the second quarter of 2020, management tested the availability of the Federal Reserve PPPLF due to the uncertainty of when PPP loans would be required to close and fund and obtained a $29.6 million PPPLF advance. As of December 31, 2021, the Corporation had no PPPLF advances outstanding.
The Corporation incurred a $744,000 loss, recognized through non-interest expense, on the early extinguishment of $59.5 million in FHLB term advances late in the second quarter of 2020, as the Corporation lowered wholesale funding costs and improved the Corporation’s funding position. Management believes this strategy helped stabilize net interest margin during the extended low interest rate environment.
Consistent with our funding philosophy to manage interest rate risk, we will use the most efficient and cost effective source of wholesale funds. We will utilize FHLB advances to the extent we maintain an adequate level of excess borrowing capacity for liquidity and contingency funding purposes and pricing remains favorable in comparison to the wholesale deposit alternative. We will use FHLB advances and/or brokered certificates of deposit in specific maturity periods needed, typically three to five years, to match-fund fixed rate loans and effectively mitigate the interest rate risk measured through our asset/liability management process and to support asset growth initiatives while taking into consideration our operating goals and desired level of usage of wholesale funds. Please refer to the section titled Liquidity and Capital Resources, below, for further information regarding our use and monitoring of wholesale funds.
The following table sets forth the outstanding balances, weighted average balances, and weighted average interest rates for our borrowings (short-term and long-term) as indicated.
December 31, 2021 December 31, 2020
Balance Weighted
Average
Balance Weighted
Average
Rate Balance Weighted
Average
Balance Weighted
Average
Rate
(Dollars in Thousands)
Federal funds purchased $ - $ - - % $ - $ 71 0.69 %
Federal Reserve PPPLF - - - - 15,207 0.35
FHLB advances
368,800 376,781 1.30 394,500 379,891 1.45
Line of credit 500 78 2.90 - - -
Other borrowings 10,363 8,090 4.11 920 676 12.60
Subordinated notes payable 23,788 23,766 5.94 23,747 23,725 5.95
Junior subordinated notes
10,076 10,068 11.05 10,062 10,054 11.09
$ 413,527 $ 418,783 1.86 $ 429,229 $ 429,624 1.91
A summary of annual maturities of borrowings at December 31, 2021 is as follows:
(In Thousands)
Maturities during the year ended December 31,
2022 $ 173,500
2023 37,300
2024 35,500
2025 23,363
2026 -
Thereafter 143,864
$ 413,527
The subordinated notes payable consist of two series of notes, each of which qualifies as Tier II capital. At December 31, 2021, $15.0 million bore a fixed interest rate of 5.50% with a maturity date of August 15, 2029 and $9.1 million bore a fixed interest rate of 6.00% with a maturity date of April 15, 2027. The Corporation may, at its option, redeem the 5.50% notes, in whole or part, at any time after August 15, 2024, and may redeem the 6.00% notes any time after June 15, 2022. The 5.50% notes will begin to lose Tier II capital treatment at a rate of 20% per year effective August 15, 2024, while the 6.00% note will begin to lose Tier II capital treatment at a rate of 20% per year effective June 15, 2022.
Given the historically low interest rate environment, management continues to evaluate options to optimize the Corporation’s capital structure and reduce borrowing costs, wherein we may redeem and replace various notes at the next earliest redemption periods. Refer to Note 10 - FHLB Advances, Other Borrowings and Junior Subordinated Notes in the Consolidated Financial Statements for additional information on the terms of Corporation’s current debt instruments.
Stockholders’ Equity
As of December 31, 2021, stockholders’ equity was $232.4 million, or 8.76% of total assets, compared to stockholders’ equity of $206.2 million, or 8.03% of total assets, as of December 31, 2020. Excluding PPP loans, stockholders’ equity was 8.85% of total assets as of December 31, 2021, compared to 8.80%. Stockholders’ equity increased by $26.3 million during the year ended December 31, 2021 attributable to net income of $35.8 million for the year ended December 31, 2021, partially offset by dividend declarations of $6.2 million and stock repurchases of $5.0 million authorized under the repurchase program discussed below.
On January 28, 2021, the Board of Directors of the Corporation approved a new share repurchase program. The program authorized the repurchase by the Corporation of up to $5 million of its total outstanding shares of common stock over a period of approximately twelve months, ending January 31, 2022. The Corporation completed the $5 million repurchase program in October 2021, repurchasing a total of 182,151 shares during the year at a weighted average price of $27.40 per share. The Corporation did not have an active share repurchase plan as of December 31, 2021.
Under the share repurchase program, shares were repurchased from time to time in the open market or negotiated transactions at prevailing market rates, or by other means in accordance with federal securities laws. In connection with the share repurchase program, the Corporation implemented a 10b5-1 trading plan. The trading plan allowed the Corporation to repurchase shares of its common stock at times when it otherwise might have been prevented from doing so under insider trading laws by requiring that an agent selected by the Corporation repurchase shares of common stock on the Corporation’s behalf on pre-determined terms.
LIQUIDITY AND CAPITAL RESOURCES
The Corporation expects to meet its liquidity needs through existing cash on hand, established cash flow sources, its third party senior line of credit, and dividends received from the Bank. While the Bank is subject to certain generally applicable regulatory limitations regarding its ability to pay dividends to the Corporation, we do not believe that the Corporation will be adversely affected by these dividend limitations. The Corporation’s principal liquidity requirements at December 31, 2021 were the interest payments due on subordinated and junior subordinated notes. During 2021 and 2020, FBB declared and paid dividends totaling $8.5 million and $12.0 million, respectively. The capital ratios of the Bank met all applicable regulatory capital adequacy requirements in effect on December 31, 2021, and continue to meet the heightened requirements imposed by Basel III, including the capital conservation buffer that was fully phased-in as of January 1, 2019. The Corporation’s Board and management teams adhere to the appropriate regulatory guidelines on decisions which affect their capital positions, including but not limited to, decisions relating to the payment of dividends and increasing indebtedness.
The Bank maintains liquidity by obtaining funds from several sources. The Bank’s primary source of funds are principal and interest payments on loans receivable and mortgage-related securities, deposits, and other borrowings, such as federal funds and FHLB advances. The scheduled payments of loans and mortgage-related securities are generally a predictable source of funds. Deposit flows and loan prepayments, however, are greatly influenced by general interest rates, economic conditions, and competition.
We view on-balance sheet liquidity as a critical element to maintaining adequate liquidity to meet our cash and collateral obligations. We define our on-balance sheet liquidity as the total of our short-term investments, our unencumbered securities available-for-sale, and our unencumbered pledged loans. As of December 31, 2021 and 2020, our immediate on-balance sheet liquidity was $529.5 million and $640.2 million, respectively. At December 31, 2021 and 2020, the Bank had $47.0 million and $26.7 million on deposit with the FRB recorded in short-term investments, respectively. Any excess funds not used for loan funding or satisfying other cash obligations were maintained as part of our on-balance sheet liquidity in our interest-bearing accounts with the FRB, as we value the safety and soundness provided by the FRB. We plan to utilize excess liquidity to fund loan and lease portfolio growth, pay down maturing debt, allow run off of maturing wholesale certificates of deposit or to invest in securities to maintain adequate liquidity at an improved margin.
We had $398.4 million of outstanding wholesale funds at December 31, 2021, compared to $567.0 million of wholesale funds as of December 31, 2020, which represented 17.1% and 25.2%, respectively, of period end total bank funding. Wholesale funds include FHLB advances, Federal Reserve PPPLF advances, brokered certificates of deposit, and deposits gathered from internet listing services. Total bank funding is defined as total deposits plus FHLB advances and Federal Reserve PPPLF advances. We are committed to raising in-market deposits while utilizing wholesale funds to mitigate interest rate risk. Wholesale funds continue to be an efficient and cost effective source of funding for the Bank and allows it to gather funds across a larger geographic base at price levels and maturities that are more attractive than local time deposits when required to raise a similar level of in-market deposits within a short time period. Access to such deposits and borrowings allows us the flexibility to refrain from pursuing single service deposit relationships in markets that have experienced unfavorable pricing levels. In addition, the administrative costs associated with wholesale funds are considerably lower than those that would be incurred to administer a similar level of local deposits with a similar maturity structure. During the time frames necessary to accumulate wholesale funds in an orderly manner, we will use short-term FHLB advances to meet our temporary funding needs. The short-term FHLB advances will typically have terms of one week to one month to cover the overall expected funding demands.
Period-end in-market deposits increased $245.3 million, or 14.6%, to $1.928 billion at December 31, 2021 from $1.683 billion at December 31, 2020 as in-market deposit balances increased due to successful business development efforts and PPP loan proceeds. Our in-market relationships continue to grow; however, deposit balances associated with those relationships will fluctuate. We expect to establish new client relationships and continue marketing efforts aimed at increasing the balances in existing clients’ deposit accounts. Nonetheless, we will continue to use wholesale funds in specific maturity periods, typically three to five years, needed to effectively mitigate the interest rate risk measured through our asset/liability management process or in shorter time periods if in-market deposit balances decline. In order to provide for ongoing liquidity and funding, all of our wholesale funds are certificates of deposit which do not allow for withdrawal at the option of the depositor before the stated maturity (with the exception of deposits accumulated through the internet listing service which have the same early withdrawal privileges and fees as do our other in-market deposits) and FHLB advances with contractual maturity terms and no call provisions. The Bank limits the percentage of wholesale funds to total bank funds in accordance with liquidity policies approved by its Board. The Bank was in compliance with its policy limits as of December 31, 2021.
The Bank was able to access the wholesale funding market as needed at rates and terms comparable to market standards during the year ended December 31, 2021. In the event that there is a disruption in the availability of wholesale funds at maturity, the Bank has managed the maturity structure, in compliance with our approved liquidity policy, so at least one year of maturities could be funded through on-balance sheet liquidity. These potential funding sources include deposits maintained
at the FRB or Federal Reserve Discount Window utilizing currently unencumbered securities and acceptable loans as collateral. As of December 31, 2021, the available liquidity was in excess of the stated policy minimum. We believe the Bank will also have access to the unused federal funds lines, cash flows from borrower repayments, and cash flows from security maturities. The Bank also has the ability to raise local market deposits by offering attractive rates to generate the level required to fulfill its liquidity needs.
The Bank is required by federal regulation to maintain sufficient liquidity to ensure safe and sound operations. We believe that the Bank has sufficient liquidity to match the balance of net withdrawable deposits and short-term borrowings in light of present economic conditions and deposit flows.
During the year ended December 31, 2021, operating activities resulted in a net cash inflow of $36.0 million driven by net income of $35.8 million. Net cash used in investing activities for the year ended December 31, 2021 was $111.0 million which consisted of $86.7 million in cash outflows to fund net loan growth and $20.3 million in net cash outflows to purchase available-for-sale securities. Net cash provided by financing activities for the year ended December 31, 2021 was $75.2 million. Financing cash flows included a $102.4 million net increase in deposits, partially offset by a $25.7 million net decrease in FHLB advances, cash dividends paid of $6.2 million, and authorized share repurchases of $5.0 million, respectively.
Refer to Note 11 - Regulatory Capital for additional information regarding the Corporation’s and the Bank’s capital ratios and the ratios required by their federal regulators at December 31, 2021 and 2020.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the Corporation’s financial position or results of operations. Actual results could differ from those estimates. Discussed below are certain policies that are critical to the Corporation. We view critical accounting policies to be those which are highly dependent on subjective or complex judgments, estimates and assumptions, and where changes in those estimates and assumptions could have a significant impact on the financial statements.
Allowance for Loan and Lease Losses. The allowance for loan and lease losses represents our recognition of the risks of extending credit and our evaluation of the quality of the loan and lease portfolio and as such, requires the use of judgment as well as other systematic objective and quantitative methods which may include additional assumptions and estimates. The risks of extending credit and the accuracy of our evaluation of the quality of the loan and lease portfolio are neither static nor mutually exclusive and could result in a material impact on our Consolidated Financial Statements. We may over-estimate the quality of the loan and lease portfolio, resulting in a lower allowance for loan and lease losses than necessary, overstating net income and equity. Conversely, we may under-estimate the quality of the loan and lease portfolio, resulting in a higher allowance for loan and lease losses than necessary, understating net income and equity. The allowance for loan and lease losses is a valuation allowance for probable credit losses, increased by the provision for loan and lease losses and decreased by charge-offs, net of recoveries. We estimate the allowance reserve balance required and the related provision for loan and lease losses based on quarterly evaluations of the loan and lease portfolio, with particular attention paid to loans and leases that have been specifically identified as needing additional management analysis because of the potential for further problems. During these evaluations, consideration is also given to such factors as the level and composition of impaired and other non-performing loans and leases, historical loss experience, results of examinations by regulatory agencies, independent loan and lease reviews, our estimate of the fair value of the underlying collateral taking into consideration various valuation techniques and qualitative adjustments to inputs to those estimates of fair value, the strength and availability of guarantees, concentration of credits, and other factors. Allocations of the allowance may be made for specific loans or leases, but the entire allowance is available for any loan or lease that, in our judgment, should be charged off. Loan and lease losses are charged against the allowance when we believe that the uncollectability of a loan or lease balance is confirmed. See Note 1 - Nature of Operations and Summary of Significant Accounting Policies and Note 4 - Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses in the Consolidated Financial Statements for further discussion of the allowance for loan and lease losses.
We also continue to exercise our legal rights and remedies as appropriate in the collection and disposal of non-performing assets, and adhere to rigorous underwriting standards in our origination process in order to achieve strong asset quality. Although we believe that the allowance for loan and lease losses was appropriate as of December 31, 2021 based upon the evaluation of loan and lease delinquencies, non-performing assets, charge-off trends, economic conditions, and other factors, there can be no assurance that future adjustments to the allowance will not be necessary. If the quality of loans or leases
deteriorates, then the allowance for loan and lease losses would generally be expected to increase relative to total loans and leases. If loan or lease quality improves, then the allowance would generally be expected to decrease relative to total loans and leases.
Goodwill Impairment Assessment. Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, including goodwill. The Corporation conducted its annual impairment test as of August 1, 2021, utilizing a qualitative assessment, and concluded that it was more likely than not the estimated fair value of the reporting unit exceeded its carrying value, resulting in no impairment. Although no goodwill impairment was noted, there can be no assurances that future goodwill impairment will not occur. See Note 1 - Nature of Operations and Summary of Significant Accounting Policies for the Corporation's accounting policy on goodwill and see Note 7 - Goodwill and Other Intangible Assets in the Consolidated Financial Statements for a detailed discussion of the factors considered by management in the assessment.
Income Taxes. The Corporation and its wholly owned subsidiaries file a consolidated federal income tax return and a combined Wisconsin state tax return. Deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The determination of current and deferred income taxes is based on complex analysis of many factors, including the interpretation of federal and state income tax laws, the difference between the tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts currently due or owed, such as the timing of reversals of temporary differences, and current accounting standards. We apply a more likely than not approach to each of our tax positions when determining the amount of tax benefit to record in our Consolidated Financial Statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
We have made our best estimate of valuation allowances utilizing available evidence and evaluation of sources of taxable income including tax planning strategies and expected reversals of timing differences to determine if valuation allowances were needed for deferred tax assets. Realization of deferred tax assets over time is dependent on our ability to generate sufficient taxable earnings in future periods and a valuation allowance may be necessary if management determines that it is more likely than not that the deferred asset will not be utilized. These estimates and assumptions are subject to change. Changes in these estimates and assumptions could adversely affect future consolidated results of operations. The Corporation believes the tax assets and liabilities are properly recorded in the Consolidated Financial Statements. See also Note 15 - Income Taxes in the Consolidated Financial Statements.
The Corporation also invests in certain development entities that generate federal and state historic and low income housing tax credits. The tax benefits associated with these investments are accounted for either under the flow-through method, equity method, or proportional amortization method and are recognized when the respective project is placed in service or over the investment term.
The federal and state taxing authorities who make assessments based on their determination of tax laws may periodically review our interpretation of federal and state income tax laws. Tax liabilities could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities based on the completion of examinations by taxing authorities.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Our primary market risk is interest rate risk, which arises from exposure of our financial position to changes in interest rates. It is our strategy to reduce the impact of interest rate risk on net interest margin by maintaining a match-funded position between the maturities and repricing dates of interest-earning assets and interest-bearing liabilities. This strategy is monitored by the Bank’s Asset/Liability Management Committee, in accordance with policies approved by the Bank’s Board. The committee meets regularly to review the sensitivity of the Bank’s assets and liabilities to changes in interest rates, liquidity needs and sources, and pricing and funding strategies.
The primary technique we use to measure interest rate risk is simulation of earnings. In this measurement technique the balance sheet is modeled as an ongoing entity whereby future growth, pricing, and funding assumptions are implemented. These assumptions are modeled under different rate scenarios that include a simultaneous, instant and sustained change in interest rates.
The following table illustrates the potential impact of changes in market rates on our net interest income for the next twelve months, as of December 31, 2021.
Change in interest rate in basis points Down 50 No Change Up 100 Up 200 Up 300
Impact on net interest income (2.48) % - % 0.77 % 5.64 % 10.67 %
We manage the structure of interest-earning assets and interest-bearing liabilities by adjusting their mix, yield, maturity and/or repricing characteristics based on market conditions. FHLB advances and, to a lesser extent, wholesale certificates of deposit are a significant source of funds. We use a variety of maturities to augment our management of interest rate exposure. Currently, we do not employ any derivatives to assist in managing our interest rate risk exposure; however, management has the authorization, as permitted within applicable approved policies, and ability to utilize such instruments should they be appropriate to manage interest rate exposure. We maintained our historically neutral-to-asset-sensitive balance sheet throughout 2021 and ended the year appropriately positioned for net interest income to benefit from rising short-term interest rates in 2022.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Item 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF FIRST BUSINESS FINANCIAL SERVICES
Consolidated Financial Statements Page No.
Consolidated Balance Sheets as of December 31, 2021 and 2020
Consolidated Statements of Income for the Years Ended December 31, 2021 and 2020
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2021 and 2020
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2021 and 2020
Consolidated Statements of Cash Flows for the Years Ended December 31, 2021 and 2020
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm (PCAOB ID 173)
First Business Financial Services, Inc.
Consolidated Balance Sheets
December 31,
2021 December 31,
(In Thousands, Except Share Data)
Assets
Cash and due from banks $ 9,697 $ 29,538
Short-term investments 47,413 27,371
Cash and cash equivalents
57,110 56,909
Securities available-for-sale, at fair value 205,702 183,925
Securities held-to-maturity, at amortized cost
19,746 26,374
Loans held for sale
3,570 8,695
Loans and leases receivable, net of allowance for loan and lease losses of $24,336 and $28,521, respectively
2,215,072 2,117,449
Premises and equipment, net 1,694 1,998
Foreclosed properties 164 34
Right-of-use assets, net 4,910 5,814
Bank-owned life insurance 53,600 52,188
Federal Home Loan Bank stock, at cost 13,336 13,578
Goodwill and other intangible assets 12,268 12,018
Derivatives 26,343 49,377
Accrued interest receivable and other assets 39,390 39,478
Total assets
$ 2,652,905 $ 2,567,837
Liabilities and Stockholders’ Equity
Deposits $ 1,957,923 $ 1,855,516
Federal Home Loan Bank advances and other borrowings 403,451 419,167
Junior subordinated notes 10,076 10,062
Lease liabilities 5,406 6,386
Derivatives 28,283 54,927
Accrued interest payable and other liabilities 15,344 15,617
Total liabilities
2,420,483 2,361,675
Stockholders’ equity:
Preferred stock, $0.01 par value, 2,500,000 shares authorized, none issued or outstanding
- -
Common stock, $0.01 par value, 25,000,000 shares authorized, 9,326,361 and 9,234,460 shares issued, 8,457,564 and 8,566,960 shares outstanding at December 31, 2021 and 2020, respectively
93 92
Additional paid-in capital 85,797 83,125
Retained earnings 170,020 140,431
Accumulated other comprehensive loss (1,457) (933)
Treasury stock, 868,797 and 667,500 shares at December 31, 2021 and 2020, respectively, at cost
(22,031) (16,553)
Total stockholders’ equity
232,422 206,162
Total liabilities and stockholders’ equity
$ 2,652,905 $ 2,567,837
See accompanying Notes to Consolidated Financial Statements.
First Business Financial Services, Inc.
Consolidated Statements of Income
For the Year Ended December 31,
2021 2020
(In Thousands, Except Share Data)
Interest income
Loans and leases $ 91,844 $ 89,160
Securities 3,410 4,187
Short-term investments 741 832
Total interest income 95,995 94,179
Interest expense
Deposits 3,553 8,922
Federal Home Loan Bank advances and other borrowings 6,667 7,070
Junior subordinated notes 1,113 1,116
Total interest expense 11,333 17,108
Net interest income 84,662 77,071
Provision for loan and lease losses (5,803) 16,808
Net interest income after provision for loan and lease losses 90,465 60,263
Non-interest income
Private wealth management service fees 10,784 8,611
Gain on sale of Small Business Administration loans 4,044 2,899
Service charges on deposits 3,837 3,415
Loan fees 2,506 1,826
Increase in cash surrender value of bank-owned life insurance 1,413 1,402
Net gain (loss) on sale of securities 29 (4)
Swap fees 1,368 6,860
Other non-interest income 4,119 1,931
Total non-interest income 28,100 26,940
Non-interest expense
Compensation 51,710 45,850
Occupancy 2,180 2,252
Professional fees 3,736 3,530
Data processing 3,087 2,734
Marketing 2,022 1,580
Equipment 990 1,199
Computer software 4,260 3,900
FDIC insurance 1,143 1,238
Collateral liquidation costs 265 328
Net loss on foreclosed properties 15 383
Impairment of tax credit investments - 2,395
SBA recourse benefit (76) (278)
Loss on early extinguishment of debt - 744
Other non-interest expense 2,203 3,043
Total non-interest expense 71,535 68,898
Income before income tax expense 47,030 18,305
Income tax expense 11,275 1,327
Net income $ 35,755 $ 16,978
Earnings per common share:
Basic $ 4.17 $ 1.97
Diluted 4.17 1.97
Dividends declared per share 0.72 0.66
See accompanying Notes to Consolidated Financial Statements.
First Business Financial Services, Inc.
Consolidated Statements of Comprehensive Income
For the Year Ended December 31,
2021 2020
(In Thousands)
Net income $ 35,755 $ 16,978
Other comprehensive (loss) income
Securities available-for-sale:
Unrealized securities (losses) gains arising during the period (4,312) 3,526
Reclassification adjustment for net (gain) loss realized in net income (29) 4
Securities held-to-maturity:
Amortization of net unrealized losses transferred from available-for-sale 26 39
Interest rate swaps:
Unrealized gains (losses) on interest rate swaps arising during the period 3,610 (3,011)
Income tax benefit (expense) 181 (143)
Total other comprehensive (loss) income (524) 415
Comprehensive income
$ 35,231 $ 17,393
See accompanying Notes to Consolidated Financial Statements.
First Business Financial Services, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
Common Shares Outstanding Common
Stock Additional
Paid-in
Capital Retained
Earnings Accumulated
Other
Comprehensive
Loss Treasury
Stock Total
(In Thousands, Except Share Data)
Balance at January 1, 2020 8,566,044 $ 92 $ 81,188 $ 129,105 $ (1,348) $ (14,881) $ 194,156
Net income - - - 16,978 - - 16,978
Other comprehensive income - - - - 415 - 415
Share-based compensation - restricted shares and employee stock purchase plan 67,773 - 1,871 - - - 1,871
Issuance of common stock under the employee stock purchase plan 3,967 - 66 - - - 66
Cash dividends ($0.66 per share)
- - - (5,652) - - (5,652)
Treasury stock purchased (70,824) - - - - (1,672) (1,672)
Balance at December 31, 2020 8,566,960 92 83,125 140,431 (933) (16,553) 206,162
Net income - - - 35,755 - - 35,755
Other comprehensive loss - - - - (524) - (524)
Share-based compensation - restricted shares and employee stock purchase plan 85,370 1 2,512 - - - 2,513
Issuance of common stock under the employee stock purchase plan 6,531 - 160 - - - 160
Cash dividends ($0.72 per share)
- - - (6,166) - - (6,166)
Treasury stock purchased (201,297) - - - - (5,478) (5,478)
Balance at December 31, 2021 8,457,564 $ 93 $ 85,797 $ 170,020 $ (1,457) $ (22,031) $ 232,422
See accompanying Notes to Consolidated Financial Statements.
First Business Financial Services, Inc.
Consolidated Statements of Cash Flows
For the Year Ended December 31,
2021 2020
(In Thousands)
Operating activities
Net income $ 35,755 $ 16,978
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes, net 1,223 (2,007)
Impairment of tax credit investments - 2,395
Provision for loan and lease losses (5,803) 16,808
SBA recourse benefit (76) (278)
Derivative credit valuation adjustment (270) 461
Depreciation, amortization and accretion, net 3,554 3,465
Share-based compensation 2,513 1,871
Net loss on disposal of fixed assets 78 -
Net (gain) loss on sale of securities (29) 4
Gain on sale of historic development entity state tax credit - (275)
Increase in value of bank-owned life insurance policies (1,413) (1,402)
Origination of loans for sale (99,266) (81,609)
Sale of SBA loans originated for sale 108,435 81,018
Gain on sale of loans originated for sale (4,044) (2,899)
Net loss on foreclosed properties, including impairment valuation 15 383
Gain on sale of community development entity 1 -
Loan servicing asset impairment valuation recovery (63) (16)
Return on investment in limited partnerships 371 -
Excess tax benefit (expense) from share-based compensation 48 (32)
Payments on operating lease liabilities (1,601) (1,557)
Payments received on operating leases 170 113
Net increase in accrued interest receivable and other assets (6,607) (10,837)
Net increase in accrued interest payable and other liabilities 3,001 4,051
Net cash provided by operating activities 35,992 26,635
Investing activities
Proceeds from maturities, redemptions and paydowns of available-for-sale securities 51,166 58,290
Proceeds from maturities, redemptions and paydowns of held-to-maturity securities 6,586 6,268
Proceeds from sale of available-for-sale securities 14,955 839
Purchases of available-for-sale securities (93,019) (66,879)
Proceeds from sale of foreclosed properties - 2,582
Net increase in loans and leases (86,660) (439,223)
Investments in limited partnerships (1,059) (1,986)
Returns of investments in limited partnerships 32 211
Investment in low-income housing (2,964) -
Investment in historic development entities - (3,254)
Distribution from historic development entities 57 30
Proceeds from sale of historic development entity state tax credit - 2,529
Investment in Federal Home Loan Bank and Federal Reserve Bank Stock (7,439) (20,509)
Proceeds from the sale of Federal Home Loan Bank Stock 7,680 14,884
Purchases of leasehold improvements and equipment, net (391) (264)
Proceeds from sale of leasehold improvements and equipment, net 44 -
Purchases of bank owned life insurance policies - (8,000)
Premium payment on bank owned life insurance policies - (25)
Net cash used in investing activities (111,012) (454,507)
Financing activities
Net increase in deposits 102,407 325,137
For the Year Ended December 31,
2021 2020
(In Thousands)
Repayment of Federal Home Loan Bank advances (814,000) (1,219,944)
Proceeds from Federal Home Loan Bank advances 788,300 1,318,700
Loss on early extinguishment of debt - 744
Repayment of the Federal Reserve Paycheck Protection Program Lending Facility - (29,605)
Proceeds from the Federal Reserve Paycheck Protection Program Lending Facility - 29,605
Net increase in long-term borrowed funds 9,998 300
Cash dividends paid (6,166) (5,652)
Proceeds from issuance of common stock under ESPP 160 66
Purchase of treasury stock (5,478) (1,672)
Net cash provided by financing activities 75,221 417,679
Net decrease in cash and cash equivalents 201 (10,193)
Cash and cash equivalents at the beginning of the period 56,909 67,102
Cash and cash equivalents at the end of the period $ 57,110 $ 56,909
Supplementary cash flow information
Cash paid during the period for:
Interest paid on deposits and borrowings $ 13,206 $ 18,412
Income taxes paid 14,519 3,451
Non-cash investing and financing activities:
Transfer of loans to foreclosed properties 146 80
Remeasurement of lease liability 316 190
See accompanying Notes to Consolidated Financial Statements.
First Business Financial Services, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Nature of Operations and Summary of Significant Accounting Policies
Nature of Operations. The accounting and reporting practices of First Business Financial Services, Inc. (“FBFS” or the “Corporation”), through our wholly-owned subsidiary, First Business Bank (“FBB” or the “Bank”), have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). FBB operates as a commercial banking institution primarily in Wisconsin and the greater Kansas City metropolitan area. The Bank provides a full range of financial services to businesses, business owners, executives, professionals, and high net worth individuals. FBB also offers private wealth management services and bank consulting services. The Bank is subject to competition from other financial institutions and service providers, and is also subject to state and federal regulations. As of December 31 2021, FBB had the following wholly-owned subsidiaries: First Business Specialty Finance (“FBSF”), First Madison Investment Corp. (“FMIC”), ABKC Real Estate, LLC (“ABKC”), FBB Real Estate 2, LLC (“FBB RE 2”), BOC Investment, LLC (“BOC”), Mitchell Street Apartments Investment, LLC (“Mitchell Street”), and FBB Tax Credit Investment LLC (“FBB Tax Credit”).
Basis of Presentation. The Consolidated Financial Statements include the accounts of the Corporation and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. In accordance with the provisions of Accounting Standards Codification (“ASC”) Topic 810, the Corporation’s ownership interest in FBFS Statutory Trust II (“Trust II”) has not been consolidated into the financial statements.
Management of the Corporation is required to make estimates and assumptions which affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates. Material estimates that could significantly change in the near-term include the value of securities and interest rate swaps, level of the allowance for loan and lease losses, lease residuals, property under operating leases, goodwill, level of the Small Business Administration (“SBA”) recourse reserve, and income taxes. Certain amounts in prior periods may have been reclassified to conform to the current presentation. Subsequent events have been evaluated through the date of the issuance of the Consolidated Financial Statements. No significant subsequent events have occurred through this date requiring adjustment to the financial statements or disclosures.
Cash and Cash Equivalents. The Corporation considers federal funds sold, interest-bearing deposits, and short-term investments that have original maturities of three months or less to be cash equivalents.
Securities. The Corporation classifies its investment and mortgage-related securities as available-for-sale, held-to-maturity, and trading. Debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity and are stated at amortized cost. Debt securities bought expressly for the purpose of selling in the near term are classified as trading securities and are measured at fair value with unrealized gains and losses reported in earnings. Debt securities not classified as held-to-maturity or as trading are classified as available-for-sale. Available-for-sale securities are measured at fair value with unrealized gains and losses reported as a separate component of stockholders’ equity, net of tax. Realized gains and losses, and declines in value deemed to be other than temporary, are included in the Consolidated Statements of Income as a component of non-interest income. The cost of securities sold is based on the specific identification method. The Corporation did not hold any trading securities at December 31, 2021 or 2020.
Discounts and premiums on securities are accreted and amortized into interest income using the effective yield method over the estimated life (based on maturity date, call date, or weighted average life) of the related security.
Declines in the fair value of investment securities (with certain exceptions for debt securities noted below) that are deemed to be other-than-temporary are charged to earnings as a realized loss and a new cost basis for the securities is established. In evaluating other-than-temporary impairment, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. Declines in the fair value of debt securities below amortized cost are deemed to be other-than-temporary in circumstances where: (1) the Corporation has the intent to sell a security; (2) it is more likely than not that the Corporation will be required to sell the security before recovery of its amortized cost basis; or (3) the Corporation does not expect to recover the entire amortized cost basis of the security. If the Corporation intends to sell a security or if it is more likely than not that the Corporation will be required to sell the security before recovery, an other-than-temporary impairment write-down is recognized in earnings equal to the difference between the security’s amortized cost basis and its fair value. If the Corporation does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income.
Loans Held for Sale. The guaranteed portions of SBA loans which are originated and intended for sale in the secondary market are classified as held for sale. These loans are carried at the lower of cost or fair value in the aggregate. Unrealized losses on such loans are recognized through a valuation allowance by a charge to other non-interest income. Gains and losses on the sale of loans are also included in other non-interest income. As assets specifically originated for sale, the origination of, disposition of, and gain/loss on these loans are classified as operating activities in the Consolidated Statement of Cash Flows. Fees received from the borrower and direct costs to originate the loans are deferred and recognized as part of the gain or loss on sale. There was $3.6 million and $8.7 million in loans held for sale outstanding at December 31, 2021 and 2020, respectively.
Loans and Leases. Loans and leases which management has the intent and ability to hold for the foreseeable future or until maturity are reported at their outstanding principal balance with adjustments for partial charge-offs, the allowance for loan and lease losses, deferred fees or costs on originated loans and leases, and unamortized premiums or discounts on any purchased loans.
A loan or a lease is accounted for as a troubled debt restructuring if the Corporation, for economic or legal reasons related to the borrower’s financial condition, grants a concession to the borrower that it would not otherwise consider. A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan or lease or a modification of terms, such as a reduction of the stated interest rate or face amount of the loan or lease, a reduction of accrued interest, an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan or lease with similar risk, or some combination of these concessions. Restructured loans can involve loans remaining on non-accrual, moving to non-accrual, or continuing on accrual status, depending on individual facts and circumstances. Non-accrual restructured loans are included and treated with all other non-accrual loans. In addition, all accruing restructured loans are reported as troubled debt restructurings which are considered and accounted for as impaired loans. Generally, restructured loans remain on non-accrual until the borrower has attained a sustained period of repayment performance under the modified loan terms (generally a minimum of six months). However, performance prior to the restructuring, or significant events that coincide with the restructuring, are considered in assessing whether the borrower can meet the new terms and whether the loan should be returned to or maintained on accrual status. If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan remains on non-accrual. The CARES Act (as modified by the Consolidated Appropriations Act, 2021) permitted banks to suspend requirements under GAAP for loan modifications to borrowers affected by COVID-19 that would otherwise be characterized as TDRs if the loan was not more than 30 days delinquent as of December 31, 2019 and the modification was made before January 1, 2022. Interagency guidance from the federal bank regulatory agencies regarding TDRs has also been issued in response to COVID-19 and is generally consistent with the relief granted under the CARES Act. The Corporation is applying this statutory and regulatory guidance to qualifying loan modifications.
Interest on non-impaired loans and leases is accrued and credited to income on a daily basis based on the unpaid principal balance and is calculated using the effective interest method. Per policy, a loan or a lease is considered impaired and placed on non-accrual status when it becomes 90 days past due or it is doubtful that contractual principal and interest will be collected in accordance with the terms of the contract. A loan or lease is determined to be past due if the borrower fails to meet a contractual payment and will continue to be considered past due until all contractual payments are received. When a loan or lease is placed on non-accrual, the interest accrual is discontinued and previously accrued but uncollected interest is deducted from interest income. If collectability of the contractual principal and interest is in doubt, payments received are first applied to reduce the loan principal. If collectability of the contractual payments is not in doubt, payments may be applied to interest for interest amounts due on a cash basis. As soon as it is determined with certainty that the principal of an impaired loan or lease is uncollectable, either through collections from the borrower or disposition of the underlying collateral, the portion of the carrying balance that exceeds the estimated measurement value of the loan or lease is charged off. Loans or leases are returned to accrual status when they are brought current in terms of both principal and accrued interest due, have performed in accordance with contractual terms for a reasonable period of time, and when the ultimate collectability of total contractual principal and interest is no longer doubtful.
Transfers of assets, including but not limited to the guaranteed portions of SBA loans and participation interests in other, non-SBA originated loans, that upon completion of the transfer satisfy the conditions to be reported as a sale, including legal isolation, are derecognized from the Consolidated Financial Statements. Transfers of assets that upon completion of the transfer do not meet the conditions of a sale are recorded on a gross basis with a secured borrowing identified to reflect the amount of the transferred interest.
Loan and lease origination fees as well as certain direct origination costs are deferred and amortized as an adjustment to loan yields over the stated term of the loan or lease. Loans or leases that result from a refinance or restructuring, other than a troubled debt restructuring, where terms are at least as favorable to the Corporation as the terms for comparable loans to other borrowers with similar collection risks and result in an essentially new loan or lease, are accounted for as a new loan or lease. Any unamortized net fees, costs, or penalties are recognized when the new loan or lease is originated. Unamortized net loan or lease fees or costs for loans and leases that result from a refinance or restructure with only minor modifications to the original
loan or lease contract are carried forward as a part of the net investment in the new loan or lease. For troubled debt restructurings, all fees received in connection with a modification of terms are applied as a reduction of the loan or lease and any related costs, including direct loan origination costs, are charged to expense as incurred.
Allowance for Loan and Lease Losses. The allowance for loan and lease losses is maintained at a level that management deems appropriate to absorb probable and estimable losses inherent in the loan and lease portfolios. The methodology applied for determining inherent losses stems from current risk characteristics of the loan and lease portfolio, an assessment of individual impaired loans and leases, actual loss experience, and adverse situations that may affect the borrower’s ability to repay. The methodology also focuses on evaluation of several factors for each portfolio category, including but not limited to: management’s ongoing review and grading of the loan and lease portfolios, consideration of delinquency experience, changes in the size of the loan and lease portfolios, existing economic conditions, level of loans and leases subject to more frequent review by management, changes in underlying collateral, concentrations of loans to specific industries, and other qualitative and quantitative factors that could affect credit losses. Impaired and other loans and leases have risk characteristics that are unique to an individual borrower and the loss must be estimated on an individual basis. Loans and leases that are not individually reviewed and measured for impairment are aggregated and historical loss statistics are primarily used to determine the risk of loss.
The measurement of the estimate of loss is reliant upon historical experience, information about the ability of the individual debtor to pay, and the appraisal of loan collateral in light of current economic conditions. An estimate of loss is an approximation of what portion of all amounts receivable, according to the contractual terms of that receivable, is deemed uncollectible. Determination of the allowance is inherently subjective because it requires estimation of amounts and timing of expected future cash flows on impaired loans and leases, estimation of losses on types of loans and leases based on historical losses, and consideration of current economic trends, both local and national. Based on management’s periodic review using all previously mentioned pertinent factors, a provision for loan and lease losses is charged to expense when it is determined an increase in the allowance for loan and lease losses is appropriate. A negative provision for loan and lease losses may be recognized if management determines a reduction in the level of allowance for loan and lease losses is appropriate. Loan and lease losses are charged against the allowance and recoveries are credited to the allowance.
The allowance for loan and lease losses contains specific allowances established for expected losses on impaired loans and leases. Impaired loans and leases are defined as loans and leases for which, based on current information and events, it is probable that the Corporation will be unable to collect scheduled principal and interest payments according to the contractual terms of the loan or lease agreement. Loans and leases subject to impairment are defined as non-accrual and restructured loans and leases.
Impaired loans and leases are evaluated on an individual basis to determine the amount of specific reserve or charge-off required, if any. The measurement value of impaired loans and leases is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate (the contractual interest rate adjusted for any net deferred loan fees or costs, premium or discount existing at the origination or acquisition of the loan), the market price of the loan or lease, or the fair value of the underlying collateral less costs to sell, if the loan or lease is collateral dependent. A loan or lease is collateral dependent if repayment is expected to be provided principally by the underlying collateral. A loan’s effective interest rate may change over the life of the loan based on subsequent changes in rates or indices, or may be fixed at the rate in effect at the date the loan was determined to be impaired.
Subsequent to the initial impairment, any significant change in the amount or timing of an impaired loan or lease’s future cash flows will result in a reassessment of the valuation allowance to determine if an adjustment is necessary. Measurements based on observable market price or fair value of the collateral may change over time and require a reassessment of the allowance if there is a significant change in either measurement base. Any increase in the present value of expected future cash flows attributable to the passage of time is recorded as interest income accrued on the net carrying amount of the loan or lease at the effective interest rate used to discount the impaired loan or lease’s estimated future cash flows. Any change in present value attributable to changes in the amount or timing of expected future cash flows is recorded as loan loss expense in the same manner in which impairment was initially recognized or as a reduction of loan loss expense that otherwise would be reported. Where the level of loan or lease impairment is measured using observable market price or fair value of collateral, any decrease in the observable market price of an impaired loan or lease or fair value of the collateral of an impaired collateral-dependent loan or lease is recorded as loan loss expense in the same manner in which impairment was initially recognized. Any increase in the observable market value of the impaired loan or lease or fair value of the collateral of an impaired collateral-dependent loan or lease is recorded as a reduction in the amount of loan loss expense that otherwise would be reported.
Net Investment in Direct Financing Leases. The net investment in direct financing lease agreements represents total undiscounted payments plus estimated unguaranteed residual value (approximating 3% to 20% of the cost of the related equipment) and is recorded as lease receivables when the lease is signed and the leased property is delivered to the client. The excess of the minimum lease payments and residual values over the cost of the equipment is recorded as unearned lease income.
Unearned lease income is recognized over the term of the lease on a basis which results in an approximate level rate of return on the unrecovered lease investment. Lease payments are recorded when due under the lease contract. Residual values are established at lease inception equal to the estimated value to be received from the equipment following termination of the initial lease and such estimated value considers all relevant information and circumstances regarding the equipment. In estimating the equipment’s fair value at lease termination, the Corporation relies on internally or externally prepared appraisals, published sources of used equipment prices, and historical experience adjusted for known current industry and economic trends. The Corporation’s estimates are periodically reviewed to ensure reasonableness; however, the amounts the Corporation will ultimately realize could differ from the estimated amounts. When there are other than temporary declines in the Corporation’s carrying amount of the unguaranteed residual value, the carrying value is reduced and charged to non-interest expense.
Premises and Equipment, net. The cost of capitalized leasehold improvements is amortized on the straight-line method over the lesser of the term of the respective lease or estimated economic life. Equipment is stated at cost less accumulated depreciation and amortization which is calculated by the straight-line method over the estimated useful lives of three to ten years. Maintenance and repair costs are charged to expense as incurred. Improvements which extend the useful life are capitalized and depreciated over the remaining useful life of the assets.
Foreclosed Properties. Property acquired by repossession, foreclosure, or by deed in lieu of foreclosure is recorded at the fair value of the underlying property, less costs to sell. This fair value becomes the new cost basis for the foreclosed property. Any write-down in the carrying value of a loan or lease at the time of acquisition is charged to the allowance for loan and lease losses. Any subsequent write-downs to reflect current fair value, as well as gains and losses on disposition and revenues are recorded in non-interest expense. Costs relating to the development and improvement of the property are capitalized while holding period costs are charged to other non-interest expense.
Leases. At contract inception, the Company determines whether the arrangement is or contains a lease and determines the lease classification. The lease term is determined based on the non-cancellable term of the lease adjusted to the extent optional renewal terms and termination rights are reasonably certain. Lease expense is recognized evenly over the lease term. Variable lease payments are recognized as period costs. The present value of remaining lease payments is recognized as a liability on the balance sheet with a corresponding right-of-use asset adjusted for prepaid or accrued lease payments. The Company uses the Federal Home Loan Bank fixed advance rate as of the lease inception date that most closely resembles the remaining term of the lease as the incremental borrowing rate, unless the interest rate implicit in the lease contract is readily determinable. The Company has elected to exclude short-term leases as well as all non-lease items, such as common area maintenance, from being included in the lease liability on the Consolidated Balance Sheets.
Bank-Owned Life Insurance. Bank-owned life insurance (“BOLI”) is reported at the amount that would be realized if the life insurance policies were surrendered on the balance sheet date. BOLI policies owned by the Bank are purchased with the objective to fund certain future employee benefit costs with the death benefit proceeds. The cash surrender value of such policies is recorded in bank-owned life insurance on the Consolidated Balance Sheets and changes in the value are recorded in non-interest income. The total death benefit of all BOLI policies was $135.9 million and $136.1 million as of December 31, 2021 and 2020, respectively. There are no restrictions on the use of BOLI proceeds nor are there any contractual restrictions on the ability to surrender the policy. As of December 31, 2021 and 2020, there were no borrowings against the cash surrender value of the BOLI policies.
Federal Home Loan Bank Stock. The Bank is required to maintain Federal Home Loan Bank (“FHLB”) stock as members of the FHLB, and in amounts as required by the FHLB. This equity security is “restricted” in that it can only be sold back to the FHLB or another member institution at par. Therefore, it is less liquid than other marketable equity securities and the fair value is equal to cost. At December 31, 2021 and 2020, the Bank had FHLB stock of $13.3 million and $13.6 million, respectively. The Corporation periodically evaluates its holding in FHLB stock for impairment. Should the stock be impaired, it would be written down to its estimated fair value. There were no impairments recorded on FHLB stock during the years ended December 31, 2021 or 2020.
Goodwill and Other Intangible Assets. Goodwill and other intangible assets consist primarily of goodwill, core deposit intangibles, and loan servicing rights. Core deposit intangibles have estimated finite lives and are amortized on an accelerated basis to expense over a period of seven years. Loan servicing rights, when originated, are initially recorded at fair value and subsequently amortized in proportion to and over the period of estimated net servicing income. The Corporation reviews other intangible assets for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in which case an impairment charge would be recorded.
Goodwill is not amortized but is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount (including goodwill). An initial qualitative evaluation is made to assess the likelihood of impairment and determine whether further quantitative testing to calculate the fair value is necessary. When the qualitative evaluation indicates that impairment is
more likely than not, quantitative testing is required whereby the fair value of each reporting unit is calculated and compared to the recorded book value. If the calculated fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired. If the carrying value of a reporting unit exceeds its calculated fair value, an impairment charge is recognized in earnings in an amount equal to the difference.
Other Investments. The Corporation owns certain equity investments in other corporate organizations which are not consolidated because the Corporation does not own more than a 50% interest or exercise control over the organization. Investments in corporations representing at least a 20% interest are generally accounted for using the equity method and investments in corporations representing less than 20% interest are generally accounted for at cost. Investments in limited partnerships representing from at least a 3% up to a 50% interest in the entity are generally accounted for using the equity method and investments in limited partnerships representing less than 3% are generally accounted for at cost. All of these investments are periodically evaluated for impairment. Should an investment be impaired, it would be written down to its estimated fair value. The equity investments are reported in other assets and the income and expense from such investments, if any, is reported in non-interest income and non-interest expense.
Derivative Instruments. The Corporation uses derivative instruments to protect against the risk of adverse price or interest rate movements on the value of certain assets, liabilities, future cash flows, and economic hedges for written client derivative contracts. Derivative instruments represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash to the other party based on a notional amount and an underlying variable, as specified in the contract, and may be subject to master netting agreements.
Market risk is the risk of loss arising from an adverse change in interest rates, exchange rates, or equity prices. The Corporation’s primary market risk is interest rate risk. Instruments designed to manage interest rate risk include interest rate swaps, interest rate options, and interest rate caps and floors with indices that relate to the pricing of specific assets and liabilities. The nature and volume of the derivative instruments used to manage interest rate risk depend on the level and type of assets and liabilities on the balance sheet and the risk management strategies for the current and anticipated rate environments. Counterparty risk with respect to derivative instruments occurs when a counterparty to a derivative contract with an unrealized gain fails to perform according to the terms of the agreement. Counterparty risk is managed by limiting the counterparties to highly rated dealers, requiring collateral postings when values are in deficit positions, applying uniform credit standards to all activities with credit risk, and monitoring the size and the maturity structure of the derivative portfolio.
All derivative instruments are to be carried at fair value on the Consolidated Balance Sheets. The accounting for the gain or loss due to changes in the fair value of a derivative instrument depends on whether the derivative instrument qualifies as a hedge. If the derivative instrument does not qualify as a hedge, the gains or losses are reported in earnings when they occur. However, if the derivative instrument qualifies as a hedge, the accounting varies based on the type of risk being hedged. The Corporation utilizes interest rate swaps offered directly to qualified commercial borrowers, which do not qualify for hedge accounting, and therefore, all changes in fair value and gains and losses on these instruments are reported in earnings as they occur. The effects of netting arrangements are disclosed within the Notes of the Consolidated Financial Statements. The Corporation offers interest rate swap products directly to qualified commercial borrowers. The Corporation economically hedges client derivative transactions by entering into offsetting interest rate swap contracts executed with a third party. Derivative transactions executed as part of this program are not considered hedging instruments and are marked-to-market through earnings each period. The derivative contracts have mirror-image terms, which results in the positions’ changes in fair value offsetting through earnings each period. The credit risk and risk of non-performance embedded in the fair value calculations is different between the dealer counterparties and the commercial borrowers which may result in a difference in the changes in the fair value of the mirror-image swaps. The Corporation incorporates credit valuation adjustments to appropriately reflect both its own non-performance risk and the counterparty’s risk in the fair value measurements. When evaluating the fair value of its derivative contracts for the effects of non-performance and credit risk, the Corporation considers the impact of netting and any applicable credit enhancements such as collateral postings, thresholds and guarantees.
The Corporation also enters into interest rate swaps to manage interest rate risk and reduce the cost of match-funding certain long-term fixed rate loans. These derivative contracts are designated as a cash flow hedge as the receipt of floating interest from the counterparty is used to manage interest rate risk associated with forecasted issuances of short-term FHLB advances. The change in fair value of the hedging instrument is recorded in accumulated other comprehensive income.
SBA Recourse Reserve. The Corporation establishes SBA recourse reserves on the guaranteed portions of sold SBA loans. The recourse reserve is reported in accrued interest payable and other liabilities on the Consolidated Balance Sheets and consists of two components: (1) specific reserves for individually evaluated impaired loans that present a collateral shortfall where the guaranty associated with the sold portion of the SBA loan is determined to most likely be ineligible; and (2) general reserves for estimated probable losses on the remaining sold portfolio. The general reserve methodology is based on the evaluation of several factors, including but not limited to: credit quality trends within the SBA portfolio, changes in underlying collateral, and the Corporation’s ability to originate, fund, or service sold SBA loans in accordance with SBA regulations.
In the ordinary course of business, the Corporation sells the guaranteed portions of SBA loans to third parties. The Corporation has a continuing involvement in each of the transferred lending arrangements by way of relationship management, servicing the loans, as well as being subject to normal and customary requirements of the SBA loan program; however, there are no further obligations to the third-party participant required of the Corporation, other than standard representations and warranties related to sold amounts. In the event of a loss resulting from default and a determination by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Corporation, the SBA may require the Corporation to repurchase the loan, deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of the principal loss related to the deficiency from the Corporation. The Corporation must comply with applicable SBA regulations in order to maintain the guaranty. In addition, the Corporation retains the option to repurchase the sold guaranteed portion of an SBA loan if the loan defaults.
Income Taxes. Deferred income tax assets and liabilities are computed for temporary differences in timing between the financial statement and tax basis of assets and liabilities that result in taxable or deductible amounts in the future based on enacted tax law and rates applicable to periods in which the differences are expected to affect taxable income. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversals of deferred tax liabilities, appropriate tax planning strategies, and projections for future taxable income over the period which the deferred tax assets are deductible. When necessary, valuation allowances are established to reduce deferred tax assets to the realizable amount. Management believes it is more likely than not that the Corporation will realize the benefits of these deductible differences, net of the existing valuation allowances.
Income tax expense or benefit represents the tax payable or tax refundable for a period, adjusted by the applicable change in deferred tax assets and liabilities for that period. The Corporation also invests in certain development entities that generate federal and state historic tax credits. The tax benefits associated with these investments are accounted for under the flow-through method and are recognized when the respective project is placed in service. The Corporation and its subsidiaries file a consolidated federal income tax return and separate state income tax returns. Tax sharing agreements allocate taxes to each legal entity for the settlement of intercompany taxes. The Corporation applies a more likely than not standard to each of its tax positions when determining the amount of tax expense or benefit to record in its financial statements. Unrecognized tax benefits are recorded in other liabilities. The Corporation recognizes accrued interest relating to unrecognized tax benefits in income tax expense and penalties in other non-interest expense.
Other Comprehensive Income or Loss. Comprehensive income or loss, shown as a separate financial statement, includes net income or loss, changes in unrealized gains and losses on available-for-sale securities, changes in deferred gains and losses on investment securities transferred from available-for-sale to held-to-maturity, if any, changes in unrealized gains and losses associated with cash flow hedging instruments, if any, and the amortization of deferred gains and losses associated with terminated cash flow hedges, if any. For the year ended December 31, 2021, realized securities gains of $29,000 and for the year ended December 31, 2020, realized securities losses of $4,000, each were reclassified out of accumulated other comprehensive loss, respectively.
Earnings Per Common Share. Earnings per common share (“EPS”) is computed using the two-class method. Basic EPS is computed by dividing net income allocated to common shares by the weighted average number of common shares outstanding for the period, excluding any participating securities. Participating securities include unvested restricted shares. Unvested restricted shares are considered participating securities because holders of these securities receive non-forfeitable dividends at the same rate as the holders of the Corporation’s common stock. Diluted EPS is computed by dividing net income allocated to common shares adjusted for reallocation of undistributed earnings of unvested restricted shares by the weighted average number of common shares determined for the basic EPS plus the dilutive effect of common stock equivalents using the treasury stock method based on the average market price for the period.
Segments and Related Information. The Corporation is required to report each operating segment based on materiality thresholds of ten percent or more of certain amounts, such as revenue. Additionally, the Corporation is required to report separate operating segments until the revenue attributable to such segments is at least 75 percent of total consolidated revenue. The Corporation provides a broad range of financial services to individuals and companies. These services include demand, time, and savings products, the sale of certain non-deposit financial products, and commercial and retail lending, leasing and private wealth management services. While the Corporation’s chief decision-maker monitors the revenue streams of the various products, services, and locations, operations are managed and financial performance is evaluated on a corporate-wide basis. The Corporation’s business units have similar basic characteristics in the nature of the products, production processes and type or class of client for products or services; therefore, these business units are considered one operating segment.
Share-Based Compensation. The Corporation may grant restricted stock awards, restricted stock units, and other stock based awards to plan participants, subject to forfeiture upon the occurrence of certain events until the dates specified in the
participant’s award agreement. The Corporation accounts for forfeitures as they occur. While restricted stock is subject to forfeiture, restricted stock award participants may exercise full voting rights and will receive all dividends and other distributions paid with respect to the restricted shares. Restricted stock units do not have voting rights and are provided dividend equivalents. The restricted stock granted under the 2019 Equity Incentive Plan (the “Plan”) is typically subject to a three or four-year vesting period. Compensation expense for restricted stock is recognized over the requisite service period of generally four years for the entire award on a straight-line basis. Upon vesting of restricted stock, the benefit of tax deductions in excess of recognized compensation expense is reflected as an income tax benefit in the Consolidated Statements of Income.
The Corporation issues a combination of performance based restricted stock units and restricted stock awards to plan participants. Vesting of the performance based restricted stock units will be measured on Total Shareholder Return (“TSR”) and Return on Average Equity (“ROAE”) and will cliff-vest after a three-year measurement period based on the Corporation’s performance relative to a custom peer group. At the end of the performance period, the number of actual shares to be awarded varies between 0% and 200% of target amounts. The restricted stock awards issued to executive officers will vest ratably over a three-year period. Compensation expense is recognized for performance based restricted stock units over the requisite service and performance period of generally three years for the entire expected award on a straight-line basis. The compensation expense for the awards expected to vest for the percentage of performance based restricted stock units subject to the ROAE metric will be adjusted if there is a change in the expectation of ROAE. The compensation expense for the awards expected to vest for the percentage of performance based restricted stock units subject to the TSR metric are never adjusted, and are amortized utilizing the accounting fair value provided using a Monte Carlo pricing model.
The Corporation offers an Employee Stock Purchase Plan (“ESPP”) to all qualifying employees. The plan qualifies as an ESPP under section 423 of the Internal Revenue Code of 1986. Under the ESPP, eligible employees may enroll in a three month offer period that begins January, April, July, and October of each year. Employees may purchase a limited number of shares on the Corporation’s common stock at 90% of the fair market value on the last day of the offering period. The ESPP is treated as a compensatory plan for purposes of share-based compensation expense.
Recent Accounting Pronouncements. In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments- Credit Losses (Topic 326),” which is often referred to as CECL. The ASU replaces the incurred loss impairment methodology for recognizing credit losses with a methodology that reflects all expected credit losses. The ASU also requires consideration of a broader range of information to inform credit loss estimates, including such factors as past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, and any other financial asset not excluded from the scope under which the Corporation has the contractual right to receive cash. Entities will apply the amendments in the ASU through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. In November 2019, the FASB issued ASU No. 2019-10, “Financial Instruments-Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842).” The ASU delays the effective date for the credit losses standard from January 1, 2020 to January 1, 2023 for certain entities, including certain Securities and Exchange Commission filers, public business entities, and private companies. As a smaller reporting company, the Corporation is eligible for the delay and will be deferring adoption. The Corporation has established a cross-functional committee and has implemented a third-party software solution to assist with the adoption of the standard. Management has gathered all necessary data and reviewed potential methods to calculate the expected credit losses. Management is currently calculating sample expected loss computations and developing the allowance methodology and assumptions that will be used under the new standard. Management will continue to progress on its implementation project plan and improve the Corporation’s approach throughout the deferral period.
In March 2020, the FASB issued ASU No. 2020-04 "“Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” These amendments provide temporary, optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. In January 2021, the FASB issued ASU 2021-01 which 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 guidance is effective for all entities as of March 12, 2020 through December 31, 2022. The Corporation continues to implement its transition plan toward cessation of LIBOR and the modification of its loans and other financial instruments with attributes that are either directly or indirectly influenced by LIBOR. The Corporation expects to utilize the LIBOR transition relief allowed under ASU 2020-04 and ASU 2020-01, as applicable, and does not expect such adoption to have a material impact on its accounting and disclosures. The Corporation will continue to assess the impact as the reference rate transition occurs over the next two years.
Note 2 - Cash and Cash Equivalents
Cash and due from banks was approximately $9.7 million and $29.5 million at December 31, 2021 and 2020, respectively. As of March 26, 2020, the Federal Reserve Bank (“FRB”) reduced reserve requirement ratios to zero percent for all depository institutions. FRB balances were $47.0 million and $26.7 million at December 31, 2021 and 2020, respectively, and are included in short-term investments on the Consolidated Balance Sheets. Short-term investments, considered cash equivalents, were $47.4 million and $27.4 million at December 31, 2021 and 2020, respectively.
Note 3 - Securities
The amortized cost and fair value of securities available-for-sale and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:
As of December 31, 2021
Amortized Cost Gross
Unrealized
Gains Gross
Unrealized
Losses Fair Value
(In Thousands)
Available-for-sale:
U.S. treasuries $ 4,971 $ - $ (57) $ 4,914
U.S. government agency securities - government-sponsored enterprises
19,797 248 (110) 19,935
Municipal securities 30,828 473 (344) 30,957
Residential mortgage-backed securities - government issued 19,563 238 (140) 19,661
Residential mortgage-backed securities - government-sponsored enterprises
85,748 741 (784) 85,705
Commercial mortgage-backed securities - government issued 5,801 36 (66) 5,771
Commercial mortgage-backed securities - government-sponsored enterprises 36,786 313 (568) 36,531
Other securities
2,205 23 - 2,228
$ 205,699 $ 2,072 $ (2,069) $ 205,702
As of December 31, 2020
Amortized Cost Gross
Unrealized
Gains Gross
Unrealized
Losses Fair Value
(In Thousands)
Available-for-sale:
U.S. government agency securities - government-sponsored enterprises
$ 22,699 $ 9 $ (79) $ 22,629
Municipal securities 24,067 716 (4) 24,779
Residential mortgage-backed securities - government issued 9,894 509 - 10,403
Residential mortgage-backed securities - government-sponsored enterprises
102,843 2,212 (49) 105,006
Commercial mortgage-backed securities - government issued 5,289 175 - 5,464
Commercial mortgage-backed securities - government-sponsored enterprises 12,584 781 - 13,365
Other securities 2,205 74 - 2,279
$ 179,581 $ 4,476 $ (132) $ 183,925
The amortized cost and fair value of securities held-to-maturity and the corresponding amounts of gross unrealized gains and losses were as follows:
As of December 31, 2021
Amortized Cost Gross
Unrealized
Gains Gross
Unrealized
Losses Fair Value
(In Thousands)
Held-to-maturity:
Municipal securities $ 13,009 $ 222 $ (3) $ 13,228
Residential mortgage-backed securities - government issued 2,226 40 - 2,266
Residential mortgage-backed securities - government-sponsored enterprises
2,502 76 - 2,578
Commercial mortgage-backed securities - government-sponsored enterprises
2,009 195 - 2,204
$ 19,746 $ 533 $ (3) $ 20,276
As of December 31, 2020
Amortized Cost Gross
Unrealized
Gains Gross
Unrealized
Losses Fair Value
(In Thousands)
Held-to-maturity:
Municipal securities $ 17,106 $ 417 $ (15) $ 17,508
Residential mortgage-backed securities - government issued 3,564 112 - 3,676
Residential mortgage-backed securities - government-sponsored enterprises
3,693 163 - 3,856
Commercial mortgage-backed securities - government-sponsored enterprises
2,011 282 - 2,293
$ 26,374 $ 974 $ (15) $ 27,333
U.S. Treasuries contains treasury bonds issued by the United States Treasury. U.S. government agency securities - government-sponsored enterprises represent securities issued by Federal National Mortgage Association (“FNMA”) and the SBA. Municipal securities include securities issued by various municipalities located primarily within Wisconsin and are primarily general obligation bonds that are tax-exempt in nature. Residential and commercial mortgage-backed securities - government issued represent securities guaranteed by the Government National Mortgage Association. Residential and commercial mortgage-backed securities - government-sponsored enterprises include securities guaranteed by the Federal Home Loan Mortgage Corporation, FNMA, and the FHLB. Other securities represent certificates of deposit of insured banks and savings institutions with an original maturity greater than three months. There were seven and one sales of available-for-sale securities that occurred during the year ended December 31, 2021 and 2020, respectively.
Total proceeds and gross realized gains and losses from sales of securities available-for-sale were as follows:
For the Year Ended December 31,
2021 2020
(In Thousands)
Gross gains $ 92 $ -
Gross losses (63) (4)
Net gains (losses) on sale of available-for-sale securities $ 29 $ (4)
Proceeds from sale of available-for-sale securities $ 14,955 $ 839
At December 31, 2021 and 2020, securities with a fair value of $70.3 million and $73.7 million, respectively, were pledged to secure various obligations, including interest rate swap contracts and municipal deposits.
The amortized cost and fair value of securities by contractual maturity at December 31, 2021 are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Available-for-Sale Held-to-Maturity
Amortized Cost Fair Value Amortized Cost Fair Value
(In Thousands)
Due in one year or less $ 2,701 $ 2,724 $ 3,793 $ 3,808
Due in one year through five years 11,887 11,937 7,289 7,391
Due in five through ten years 58,270 58,470 7,223 7,576
Due in over ten years 132,841 132,571 1,441 1,501
$ 205,699 $ 205,702 $ 19,746 $ 20,276
The tables below show the Corporation’s gross unrealized losses and fair value of available-for-sale investments, aggregated by investment category and length of time that individual investments were in a continuous loss position at December 31, 2021 and 2020. At December 31, 2021, the Corporation held 46 available-for-sale securities that were in an unrealized loss position. Such securities have not experienced credit rating downgrades; however, they have primarily declined in value due to the current interest rate environment. At December 31, 2021, the Corporation held three available-for-sale securities that have been in a continuous unrealized loss position for twelve months or greater.
The Corporation also has not specifically identified available-for-sale securities in a loss position that it intends to sell in the near term and does not believe that it will be required to sell any such securities. The Corporation reviews its securities on a quarterly basis to monitor its exposure to other-than-temporary impairment. Consideration is given to such factors as the length of time and extent to which the security has been in an unrealized loss position, changes in security ratings, and an evaluation of the present value of expected future cash flows, if necessary. Based on the Corporation’s evaluation, it is expected that the Corporation will recover the entire amortized cost basis of each security. Accordingly, no other-than-temporary impairment was recorded in the Consolidated Statements of Income for the years ended December 31, 2021 and 2020.
A summary of unrealized loss information for securities available-for-sale, categorized by security type and length of time for which the security has been in a continuous unrealized loss position, follows:
December 31, 2021
Less than 12 Months 12 Months or Longer Total
Fair Value Unrealized
Losses Fair Value Unrealized
Losses Fair Value Unrealized
Losses
(In Thousands)
Available-for-sale:
U.S. treasuries $ 4,914 $ 57 $ - $ - $ 4,914 $ 57
U.S. government agency securities - government-sponsored enterprises 978 22 2,412 88 3,390 110
Municipal securities
12,568 344 - - 12,568 344
Residential mortgage-backed securities - government issued 12,745 140 - - 12,745 140
Residential mortgage-backed securities - government-sponsored enterprises
41,276 629 4,250 155 45,526 784
Commercial mortgage-backed securities - government issued 2,193 66 - - 2,193 66
Commercial mortgage-backed securities - government-sponsored enterprises 25,906 568 - - 25,906 568
$ 100,580 $ 1,826 $ 6,662 $ 243 $ 107,242 $ 2,069
December 31, 2020
Less than 12 Months 12 Months or Longer Total
Fair Value Unrealized
Losses Fair Value Unrealized
Losses Fair Value Unrealized
Losses
(In Thousands)
Available-for-sale:
U.S. government agency obligations - government-sponsored enterprises
$ 11,602 $ 45 $ 4,031 $ 34 $ 15,633 $ 79
Municipal securities
2,863 4 - - 2,863 4
Residential mortgage-backed securities - government-sponsored enterprises
19,078 49 - - 19,078 49
$ 33,543 $ 98 $ 4,031 $ 34 $ 37,574 $ 132
The tables below show the Corporation’s gross unrealized losses and fair value of held-to-maturity investments, aggregated by investment category and length of time that individual investments were in a continuous loss position at December 31, 2021 and 2020. At December 31, 2021, the Corporation held one held-to-maturity security that was in an unrealized loss position. Such securities have not experienced credit rating downgrades; however, they have primarily declined in value due to the current interest rate environment. At December 31, 2021, the Corporation held one held-to-maturity security that had been in a continuous loss position for twelve months or greater. It is expected that the Corporation will recover the entire amortized cost basis of each held-to-maturity security based upon an evaluation of aforementioned factors. Accordingly, no other-than-temporary impairment was recorded in the Consolidated Statements of Income for the years ended December 31, 2021 and 2020.
A summary of unrealized loss information for securities held-to-maturity, categorized by security type and length of time for which the security has been in a continuous unrealized loss position, follows:
December 31, 2021
Less than 12 Months 12 Months or Longer Total
Fair Value Unrealized
Losses Fair Value Unrealized
Losses Fair Value Unrealized
Losses
(In Thousands)
Held-to-maturity:
Municipal securities
$ - $ - $ 284 $ 3 $ 284 $ 3
December 31, 2020
Less than 12 Months 12 Months or Longer Total
Fair Value Unrealized
Losses Fair Value Unrealized
Losses Fair Value Unrealized
Losses
(In Thousands)
Held-to-maturity:
Municipal securities
$ 276 $ 13 $ 213 $ 2 $ 489 $ 15
Note 4 - Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses
Loan and lease receivables consist of the following:
December 31,
2021 December 31,
(In Thousands)
Commercial real estate:
Commercial real estate - owner occupied
$ 235,589 $ 253,882
Commercial real estate - non-owner occupied
661,423 564,532
Land development
42,792 49,839
Construction
179,841 141,043
Multi-family
320,072 311,556
1-4 family
14,911 38,284
Total commercial real estate 1,454,628 1,359,136
Commercial and industrial 730,819 732,318
Direct financing leases, net 15,743 22,331
Consumer and other:
Home equity and second mortgages 4,223 7,833
Other 35,518 28,897
Total consumer and other
39,741 36,730
Total gross loans and leases receivable
2,240,931 2,150,515
Less:
Allowance for loan and lease losses
24,336 28,521
Deferred loan fees
1,523 4,545
Loans and leases receivable, net $ 2,215,072 $ 2,117,449
As of December 31, 2021 and 2020, the Corporation had $27.9 million and $228.9 million, respectively, in gross PPP loans outstanding included in the commercial and industrial loan category and deferred processing fees outstanding of $557,000 and $3.5 million, respectively, included in deferred loan fees. The processing fees are deferred and recognized over the contractual life of the loan, or accelerated at forgiveness, as an adjustment of yield using the interest method. The SBA provides a guaranty to the lender of 100% of principal and interest, unless the lender violated an obligation under the agreement. As loan losses are expected to be immaterial, if any at all, due to the guaranty, management excluded the PPP loans from the allowance for loan and lease losses calculation. Management funded these short-term loans primarily through a combination of excess cash held at the Federal Reserve and from an increase in in-market deposits.
The total amount of the Corporation’s ownership of SBA loans on-balance sheet is comprised of the following:
December 31,
2021 December 31,
(In Thousands)
SBA 7(a) loans $ 33,223 $ 36,266
SBA 504 loans 41,394 26,327
SBA Express loans and lines of credit 387 1,251
SBA PPP loans 27,854 228,870
Total SBA loans $ 102,858 $ 292,714
As of December 31, 2021 and 2020, $1.7 million and $9.3 million of SBA loans were considered impaired, respectively.
Loans transferred to third parties consist of the guaranteed portions of SBA loans which the Corporation sold in the secondary market and participation interests in other, non-SBA originated loans. The total principal amount of the guaranteed portions of SBA loans sold during the year ended December 31, 2021 and 2020 was $33.5 million and $29.2 million, respectively. Each of
the transfers of these financial assets met the qualifications for sale accounting, and therefore, all of the loans transferred during the year ended December 31, 2021 and 2020 have been derecognized in the Consolidated Financial Statements. The guaranteed portions of SBA loans were transferred at their fair value and the related gain was recognized upon the transfer as non-interest income in the Consolidated Financial Statements. The total outstanding balance of sold SBA loans at December 31, 2021 and 2020 was $93.0 million and $79.5 million, respectively.
The total principal amount of transferred participation interests in other, non-SBA originated loans during the year ended December 31, 2021 and 2020 was $70.9 million and $48.9 million, respectively, all of which were treated as sales and derecognized under the applicable accounting guidance at the time of transfer. No gain or loss was recognized on participation interests in other, non-SBA originated loans as they were transferred at or near the date of loan origination and the payments received for servicing the portion of the loans participated represents adequate compensation. The total outstanding balance of these transferred loans at December 31, 2021 and 2020 was $195.2 million and $153.6 million, respectively. As of December 31, 2021 and 2020, the total amount of the Corporation’s partial ownership of these transferred loans on the Consolidated Balance Sheets was $314.5 million and $276.5 million, respectively. As of December 31, 2021, the non-SBA originated participation portfolio contained no impaired loans. As of December 31, 2020, the non-SBA originated participation portfolio contained an impaired loan totaling $3.0 million with a sold portion of $4.2 million. The Corporation does not share in the participant’s portion of any potential charge-offs. There were no loan participations purchased on the Consolidated Balance Sheets as of December 31, 2021 and $410,000 as of December 31, 2020.
Certain of the Corporation’s executive officers, directors, and their related interests are loan clients of the Bank. These loans to related parties are summarized below:
December 31, 2021 December 31, 2020
(In Thousands)
Balance at beginning of year $ 1,632 $ 1,683
New loans 570 325
Repayments (914) (376)
Balance at end of year $ 1,288 $ 1,632
The following tables illustrate ending balances of the Corporation’s loan and lease portfolio, including impaired loans by class of receivable, and considering certain credit quality indicators:
December 31, 2021
Category
I II III IV Total
(Dollars in Thousands)
Commercial real estate:
Commercial real estate - owner occupied $ 192,849 $ 31,611 $ 10,781 $ 348 $ 235,589
Commercial real estate - non-owner occupied 540,572 88,880 31,971 - 661,423
Land development 41,745 1,047 - - 42,792
Construction 130,285 18,973 30,583 - 179,841
Multi-family 280,183 28,623 11,266 - 320,072
1-4 family 12,057 2,113 402 339 14,911
Total commercial real estate 1,197,691 171,247 85,003 687 1,454,628
Commercial and industrial 594,388 97,678 32,964 5,789 730,819
Direct financing leases, net 10,829 168 4,647 99 15,743
Consumer and other:
Home equity and second mortgages 2,473 1,683 67 - 4,223
Other 35,249 269 - - 35,518
Total consumer and other 37,722 1,952 67 - 39,741
Total gross loans and leases receivable $ 1,840,630 $ 271,045 $ 122,681 $ 6,575 $ 2,240,931
Category as a % of total portfolio 82.14 % 12.10 % 5.47 % 0.29 % 100.00 %
December 31, 2020
Category
I II III IV Total
(Dollars in Thousands)
Commercial real estate:
Commercial real estate - owner occupied $ 185,943 $ 34,917 $ 27,593 $ 5,429 $ 253,882
Commercial real estate - non-owner occupied 432,053 90,942 37,754 3,783 564,532
Land development 47,777 987 185 890 49,839
Construction 104,083 26,444 10,516 - 141,043
Multi-family 278,145 23,386 10,025 - 311,556
1-4 family 35,053 620 2,315 296 38,284
Total commercial real estate 1,083,054 177,296 88,388 10,398 1,359,136
Commercial and industrial 623,346 27,201 65,616 16,155 732,318
Direct financing leases, net 15,597 730 5,955 49 22,331
Consumer and other:
Home equity and second mortgages 7,206 496 91 40 7,833
Other 28,701 175 - 21 28,897
Total consumer and other 35,907 671 91 61 36,730
Total gross loans and leases receivable $ 1,757,904 $ 205,898 $ 160,050 $ 26,663 $ 2,150,515
Category as a % of total portfolio 81.75 % 9.57 % 7.44 % 1.24 % 100.00 %
Each credit is evaluated for proper risk rating upon origination, at the time of each subsequent renewal, upon receipt and evaluation of updated financial information from the Corporation’s borrowers or as other circumstances dictate. The Corporation primarily uses a nine grade risk rating system to monitor the ongoing credit quality of its loans and leases. The risk rating grades follow a consistent definition and are then applied to specific loan types based on the nature of the loan. Each risk rating is subjective and, depending on the size and nature of the credit, subject to various levels of review and concurrence on the stated risk rating. In addition to its nine grade risk rating system, the Corporation groups loans into four loan and related risk categories which determine the level and nature of review by management.
Category I - Loans and leases in this category are performing in accordance with the terms of the contract and generally exhibit no immediate concerns regarding the security and viability of the underlying collateral, financial stability of the borrower, integrity or strength of the borrowers’ management team or the industry in which the borrower operates. The Corporation monitors Category I loans and leases through payment performance, continued maintenance of its personal relationships with such borrowers and continued review of such borrowers’ compliance with the terms of their respective agreements.
Category II - Loans and leases in this category are beginning to show signs of deterioration in one or more of the Corporation’s core underwriting criteria such as financial stability, management strength, industry trends or collateral values. Management will place credits in this category to allow for proactive monitoring and resolution with the borrower to possibly mitigate the area of concern and prevent further deterioration or risk of loss to the Corporation. Category II loans are considered performing but are monitored frequently by the assigned business development officer and by asset quality review committees.
Category III - Loans and leases in this category are identified by management as warranting special attention. However, the balance in this category is not intended to represent the amount of adversely classified assets held by the Bank. Category III loans and leases generally exhibit undesirable characteristics, such as evidence of adverse financial trends and conditions, managerial problems, deteriorating economic conditions within the related industry or evidence of adverse public filings and may exhibit collateral shortfall positions. Management continues to believe that it will collect all contractual principal and interest in accordance with the original terms of the contracts relating to the loans and leases in this category, and therefore Category III loans are considered performing with no specific reserves established for this category. Category III loans are monitored by management and asset quality review committees on a monthly basis.
Category IV - Loans and leases in this category are considered to be impaired. Impaired loans and leases, with the exception of performing troubled debt restructurings, have been placed on non-accrual as management has determined that it is unlikely that the Bank will receive the contractual principal and interest in accordance with the original terms of the agreement. Impaired
loans are individually evaluated to assess the need for the establishment of specific reserves or charge-offs. When analyzing the adequacy of collateral, the Corporation obtains external appraisals at least annually for impaired loans and leases. External appraisals are obtained from the Corporation’s approved appraiser listing and are independently reviewed to monitor the quality of such appraisals. To the extent a collateral shortfall position is present, a specific reserve or charge-off will be recorded to reflect the magnitude of the impairment. Loans and leases in this category are monitored by management and asset quality review committees on a monthly basis.
The delinquency aging of the loan and lease portfolio by class of receivable was as follows:
December 31, 2021
30-59
Days Past Due 60-89
Days Past Due Greater
Than 90
Days Past Due Total Past Due Current Total Loans and Leases
(Dollars in Thousands)
Accruing loans and leases
Commercial real estate:
Owner occupied $ 420 $ - $ - $ 420 $ 234,821 $ 235,241
Non-owner occupied - - - - 661,423 661,423
Land development - - - - 42,792 42,792
Construction 394 - - 394 179,447 179,841
Multi-family - - - - 320,072 320,072
1-4 family 100 - - 100 14,472 14,572
Commercial and industrial 907 536 - 1,443 723,804 725,247
Direct financing leases, net 281 14 - 295 15,349 15,644
Consumer and other:
Home equity and second mortgages - - - - 4,223 4,223
Other - - - - 35,518 35,518
Total 2,102 550 - 2,652 2,231,921 2,234,573
Non-accruing loans and leases
Commercial real estate:
Owner occupied - - 113 113 235 348
Non-owner occupied - - - - - -
Land development - - - - - -
Construction - - - - - -
Multi-family - - - - - -
1-4 family - - - - 339 339
Commercial and industrial 23 36 1,445 1,504 4,068 5,572
Direct financing leases, net - - 84 84 15 99
Consumer and other:
Home equity and second mortgages - - - - - -
Other - - - - - -
Total 23 36 1,642 1,701 4,657 6,358
Total loans and leases
Commercial real estate:
Owner occupied 420 - 113 533 235,056 235,589
Non-owner occupied - - - - 661,423 661,423
Land development - - - - 42,792 42,792
Construction 394 - - 394 179,447 179,841
Multi-family - - - - 320,072 320,072
1-4 family 100 - - 100 14,811 14,911
Commercial and industrial 930 572 1,445 2,947 727,872 730,819
Direct financing leases, net 281 14 84 379 15,364 15,743
Consumer and other:
Home equity and second mortgages - - - - 4,223 4,223
Other - - - - 35,518 35,518
Total $ 2,125 $ 586 $ 1,642 $ 4,353 $ 2,236,578 $ 2,240,931
Percent of portfolio 0.09 % 0.03 % 0.07 % 0.19 % 99.81 % 100.00 %
December 31, 2020
30-59
Days Past Due 60-89
Days Past Due Greater
Than 90
Days Past Due Total Past Due Current Total Loans and Leases
(Dollars in Thousands)
Accruing loans and leases
Commercial real estate:
Owner occupied $ - $ - $ - $ - $ 248,453 $ 248,453
Non-owner occupied - - - - 560,749 560,749
Land development 7,784 - - 7,784 41,165 48,949
Construction - - - - 141,043 141,043
Multi-family - - - - 311,556 311,556
1-4 family - 46 - 46 37,988 38,034
Commercial and industrial 663 111 - 774 715,389 716,163
Direct financing leases, net - - - - 22,282 22,282
Consumer and other:
Home equity and second mortgages - - - - 7,793 7,793
Other - - - - 28,876 28,876
Total 8,447 157 - 8,604 2,115,294 2,123,898
Non-accruing loans and leases
Commercial real estate:
Owner occupied - - 272 272 5,157 5,429
Non-owner occupied - - 3,783 3,783 - 3,783
Land development 890 - - 890 - 890
Construction - - - - - -
Multi-family - - - - - -
1-4 family - - - - 250 250
Commercial and industrial 103 342 7,557 8,002 8,153 16,155
Direct financing leases, net - - - - 49 49
Consumer and other:
Home equity and second mortgages - - - - 40 40
Other - - 21 21 - 21
Total 993 342 11,633 12,968 13,649 26,617
Total loans and leases
Commercial real estate:
Owner occupied - - 272 272 253,610 253,882
Non-owner occupied - - 3,783 3,783 560,749 564,532
Land development 8,674 - - 8,674 41,165 49,839
Construction - - - - 141,043 141,043
Multi-family - - - - 311,556 311,556
1-4 family - 46 - 46 38,238 38,284
Commercial and industrial 766 453 7,557 8,776 723,542 732,318
Direct financing leases, net - - - - 22,331 22,331
Consumer and other:
Home equity and second mortgages - - - - 7,833 7,833
Other - - 21 21 28,876 28,897
Total $ 9,440 $ 499 $ 11,633 $ 21,572 $ 2,128,943 $ 2,150,515
Percent of portfolio 0.44 % 0.02 % 0.54 % 1.00 % 99.00 % 100.00 %
The Corporation’s total impaired assets consisted of the following:
December 31,
2021 December 31,
(In Thousands)
Non-accrual loans and leases
Commercial real estate:
Commercial real estate - owner occupied $ 348 $ 5,429
Commercial real estate - non-owner occupied - 3,783
Land development - 890
Construction - -
Multi-family - -
1-4 family 339 250
Total non-accrual commercial real estate 687 10,352
Commercial and industrial 5,572 16,155
Direct financing leases, net 99 49
Consumer and other:
Home equity and second mortgages - 40
Other - 21
Total non-accrual consumer and other loans - 61
Total non-accrual loans and leases 6,358 26,617
Foreclosed properties, net 164 34
Total non-performing assets 6,522 26,651
Performing troubled debt restructurings 217 46
Total impaired assets $ 6,739 $ 26,697
December 31,
2021 December 31,
Total non-accrual loans and leases to gross loans and leases 0.28 % 1.24 %
Total non-performing assets to total gross loans and leases plus foreclosed properties, net 0.29 1.24
Total non-performing assets to total assets 0.25 1.04
Allowance for loan and lease losses to gross loans and leases 1.09 1.33
Allowance for loan and lease losses to non-accrual loans and leases 382.76 107.15
As of December 31, 2021 and 2020, $627,000 and $6.5 million of the non-accrual loans and leases were considered troubled debt restructurings, respectively. The Corporation has allocated $134,000 and $760,000 of specific reserves to troubled debt restructurings as of December 31, 2021 and 2020, respectively. There were no unfunded commitments associated with troubled debt restructured loans and leases as of December 31, 2021.
All loans and leases modified as a troubled debt restructuring are measured for impairment. The nature and extent of the impairment of restructured loans, including those which have experienced a default, is considered in the determination of an appropriate level of the allowance for loan and lease losses.
The following table provides the number of loans modified in a troubled debt restructuring and the pre- and post-modification recorded investment by class of receivable:
For the Year Ended December 31,
2021 2020
Number of Loans Pre-Modification
Recorded
Investment Post-Modification
Recorded
Investment Number of Loans Pre-Modification
Recorded
Investment Post-Modification
Recorded
Investment
(Dollars in Thousands)
Commercial real estate:
Commercial real estate - owner occupied
- $ - $ - 2 $ 299 $ 272
Commercial and industrial 3 239 217 4 6,286 895
Total 3 $ 239 $ 217 6 $ 6,585 $ 1,167
Restructured loan modifications may include payment schedule modifications, interest rate concessions, maturity date extensions, principal reduction, or some combination of these concessions. For the year ended December 31, 2021, the modification of terms primarily consisted of payment schedule modifications or principal reductions.
There were no loans modified in a troubled debt restructuring during the previous 12 months which subsequently defaulted during the year ended December 31, 2021. There were two commercial and industrial loans for $617,000 and two owner-occupied commercial real estate loans for a total of $272,000 modified in a troubled debt restructuring during the previous 12 months which subsequently defaulted during the year ended December 31, 2020.
Additionally, the Corporation continues to work with borrowers impacted by COVID-19 and has provided modifications to include interest only deferrals and principal and interest deferrals. These modifications are excluded from troubled debt restructuring classification under Section 4013 of the CARES Act or under applicable interagency guidance of the federal banking regulators. As of December 31, 2021 and 2020, the Corporation had three and 38 deferral requests outstanding, representing $293,000 and $27.0 million in total loans, respectively.
The following represents additional information regarding the Corporation’s impaired loans and leases, including performing troubled debt restructurings, by class:
As of and for the Year Ended December 31, 2021
Recorded
Investment(1)
Unpaid
Principal
Balance Impairment
Reserve Average
Recorded
Investment(2)
Foregone
Interest
Income Interest
Income
Recognized Net Foregone
Interest
Income
(In Thousands)
With no impairment reserve recorded:
Commercial real estate:
Owner occupied $ 348 $ 386 $ - $ 2,217 $ 145 $ 218 $ (73)
Non-owner occupied - - - 2,281 233 16 217
Land development - - - 7 - - -
Construction - - - - - - -
Multi-family - - - - - - -
1-4 family 339 344 - 285 60 24 36
Commercial and industrial 3,717 3,819 - 7,914 522 179 343
Direct financing leases, net 15 15 - 2 1 - 1
Consumer and other:
Home equity and second mortgages
- - - 40 7 9 (2)
Other - - - 8 23 - 23
Total 4,419 4,564 - 12,754 991 446 545
With impairment reserve recorded:
Commercial real estate:
Owner occupied - - - - - - -
Non-owner occupied - - - - - - -
Land development - - - - - - -
Construction - - - - - - -
Multi-family - - - - - - -
1-4 family - - - - - - -
Commercial and industrial 2,072 2,072 1,439 1,456 109 8 101
Direct financing leases, net 84 84 66 50 4 - 4
Consumer and other:
Home equity and second mortgages
- - - - - - -
Other - - - - - - -
Total 2,156 2,156 1,505 1,506 113 8 105
Total:
Commercial real estate:
Owner occupied 348 386 - 2,217 145 218 (73)
Non-owner occupied - - - 2,281 233 16 217
Land development - - - 7 - - -
Construction - - - - - - -
Multi-family - - - - - - -
1-4 family 339 344 - 285 60 24 36
Commercial and industrial 5,789 5,891 1,439 9,370 631 187 444
Direct financing leases, net 99 99 66 52 5 - 5
Consumer and other:
Home equity and second mortgages
- - - 40 7 9 (2)
Other - - - 8 23 - 23
Grand total $ 6,575 $ 6,720 $ 1,505 $ 14,260 $ 1,104 $ 454 $ 650
(1)The recorded investment represents the unpaid principal balance net of any partial charge-offs.
(2)Average recorded investment is calculated primarily using daily average balances.
As of and for the Year Ended December 31, 2020
Recorded
Investment(1)
Unpaid
Principal
Balance Impairment
Reserve Average
Recorded
Investment(2)
Foregone
Interest
Income Interest
Income
Recognized Net Foregone
Interest
Income
(In Thousands)
With no impairment reserve recorded:
Commercial real estate:
Owner occupied $ 4,338 $ 4,365 $ - $ 4,565 $ 291 $ 72 $ 219
Non-owner occupied 3,783 6,563 - 1,519 486 - 486
Land development 890 5,187 - 1,192 14 - 14
Construction - - - - - - -
Multi-family - - - - - - -
1-4 family 46 51 - 307 31 141 (110)
Commercial and industrial 9,888 12,337 - 13,951 1,219 423 796
Direct financing leases, net - - - 89 - - -
Consumer and other:
Home equity and second mortgages
- - - 1 - - -
Other 21 688 - 85 41 - 41
Total 18,966 29,191 - 21,709 2,082 636 1,446
With impairment reserve recorded:
Commercial real estate:
Owner occupied 1,091 4,792 471 2,349 384 - 384
Non-owner occupied - - - - - - -
Land development - - - - - - -
Construction - - - - - - -
Multi-family - - - - - - -
1-4 family 250 250 29 21 - - -
Commercial and industrial 6,267 6,972 3,125 3,585 324 - 324
Direct financing leases, net 49 49 49 39 3 - 3
Consumer and other:
Home equity and second mortgages
40 40 7 - 1 - 1
Other - - - - - - -
Total 7,697 12,103 3,681 5,994 712 - 712
Total:
Commercial real estate:
Owner occupied 5,429 9,157 471 6,914 675 72 603
Non-owner occupied 3,783 6,563 - 1,519 486 - 486
Land development 890 5,187 - 1,192 14 - 14
Construction - - - - - - -
Multi-family - - - - - - -
1-4 family 296 301 29 328 31 141 (110)
Commercial and industrial 16,155 19,309 3,125 17,536 1,543 423 1,120
Direct financing leases, net 49 49 49 128 3 - 3
Consumer and other:
Home equity and second mortgages 40 40 7 1 1 - 1
Other 21 688 - 85 41 - 41
Grand total $ 26,663 $ 41,294 $ 3,681 $ 27,703 $ 2,794 $ 636 $ 2,158
(1)The recorded investment represents the unpaid principal balance net of any partial charge-offs.
(2)Average recorded investment is calculated primarily using daily average balances.
The difference between the recorded investment of loans and leases and the unpaid principal balance of $145,000 and $14.6 million as of December 31, 2021 and 2020, respectively, represents partial charge-offs of loans and leases resulting from losses due to the appraised value of the collateral securing the loans and leases being below the carrying values of the loans and leases. Impaired loans and leases also included $217,000 and $46,000 of loans as of December 31, 2021 and 2020, respectively, that were performing troubled debt restructurings, and although not on non-accrual, were reported as impaired due to the concession
in terms. When a loan is placed on non-accrual, interest accrual is discontinued and previously accrued but uncollected interest is deducted from interest income. Cash payments collected on non-accrual loans are first applied to such loan’s principal. Foregone interest represents the interest that was contractually due on the loan but not received or recorded. To the extent the amount of principal on a non-accrual loan is fully collected and additional cash is received, the Corporation will recognize interest income.
To determine the level and composition of the allowance for loan and lease losses, the Corporation categorizes the portfolio into segments with similar risk characteristics. First, the Corporation evaluates loans and leases for potential impairment classification. The Corporation analyzes each loan and lease determined to be impaired on an individual basis to determine a specific reserve based upon the estimated value of the underlying collateral for collateral-dependent loans, or alternatively, the present value of expected cash flows. The Corporation applies historical trends from established risk factors to each category of loans and leases that has not been individually evaluated for the purpose of establishing the general portion of the allowance.
A summary of the activity in the allowance for loan and lease losses by portfolio segment is as follows:
As of and for the Year Ended December 31, 2021
Commercial
Real Estate Commercial
and
Industrial Consumer
and Other Total
(In Thousands)
Beginning balance $ 17,157 $ 10,593 $ 771 $ 28,521
Charge-offs (256) (3,227) (25) (3,508)
Recoveries 3,935 1,168 23 5,126
Net recoveries (charge-offs) 3,679 (2,059) (2) 1,618
Provision for loan and lease losses (5,726) (121) 44 (5,803)
Ending balance $ 15,110 $ 8,413 $ 813 $ 24,336
As of and for the Year Ended December 31, 2020
Commercial
Real Estate Commercial
and
Industrial Consumer
and Other Total
(In Thousands)
Beginning balance $ 10,852 $ 8,078 $ 590 $ 19,520
Charge-offs (6,119) (2,007) (13) (8,139)
Recoveries 4 325 3 332
Net charge-offs (6,115) (1,682) (10) (7,807)
Provision for loan and lease losses 12,420 4,197 191 16,808
Ending balance $ 17,157 $ 10,593 $ 771 $ 28,521
The following tables provide information regarding the allowance for loan and lease losses and balances by type of allowance methodology:
December 31, 2021
Commercial
Real Estate Commercial
and
Industrial Consumer
and Other Total
(In Thousands)
Allowance for loan and lease losses:
Collectively evaluated for impairment $ 15,110 $ 6,908 $ 813 $ 22,831
Individually evaluated for impairment - 1,505 - 1,505
Total $ 15,110 $ 8,413 $ 813 $ 24,336
Loans and lease receivables:
Collectively evaluated for impairment $ 1,453,941 $ 740,674 $ 39,741 2,234,356
Individually evaluated for impairment 687 5,888 - 6,575
Total $ 1,454,628 $ 746,562 $ 39,741 $ 2,240,931
December 31, 2020
Commercial
Real Estate Commercial
and
Industrial Consumer
and Other Total
(In Thousands)
Allowance for loan and lease losses:
Collectively evaluated for impairment $ 16,657 $ 7,419 $ 764 $ 24,840
Individually evaluated for impairment 500 3,174 7 3,681
Total $ 17,157 $ 10,593 $ 771 $ 28,521
Loans and lease receivables:
Collectively evaluated for impairment $ 1,348,738 $ 738,445 $ 36,669 $ 2,123,852
Individually evaluated for impairment 10,398 16,204 61 26,663
Total $ 1,359,136 $ 754,649 $ 36,730 $ 2,150,515
The Corporation’s net investment in direct financing leases consists of the following:
December 31,
2021 December 31,
(In Thousands)
Minimum lease payments receivable $ 13,641 $ 19,106
Estimated unguaranteed residual values in leased property 3,564 5,434
Unearned lease and residual income (1,462) (2,209)
Investment in commercial direct financing leases $ 15,743 $ 22,331
The Corporation leases equipment under direct financing leases expiring in future years. Some of these leases provide for additional rents based on use in excess of a stipulated minimum number of hours and generally allow the lessees to purchase the equipment for fair value at the end of the lease term.
Future aggregate maturities of minimum lease payments to be received are as follows:
(In Thousands)
Maturities during year ended December 31,
2022 $ 5,381
2023 3,998
2024 2,526
2025 1,246
2026 349
Thereafter 141
$ 13,641
Note 5 - Premises and Equipment
A summary of premises and equipment was as follows:
As of December 31,
2021 2020
(In Thousands)
Leasehold improvements $ 2,727 $ 2,670
Furniture and equipment 6,824 6,961
Total premises and equipment 9,551 9,631
Less: accumulated depreciation (7,857) (7,633)
Total premises and equipment, net $ 1,694 $ 1,998
Depreciation expense was $585,000 and $822,000 for the years ended December 31, 2021 and 2020, respectively.
Note 6 - Leases
The Corporation leases various office spaces and specialized lending production offices under non-cancellable operating leases which expire on various dates through 2028. The Corporation also leases office equipment. The Corporation recognizes a right-of-use asset and an operating lease liability for all leases, with the exception of short-term leases. Right-of-use assets represent the right to use an underlying asset for the lease term and lease liabilities are recognized at the lease commencement date based on the estimated present value of lease payments over the lease term. Lease expense for operating leases and short-term leases is recognized on a straight-line basis over the lease term. During 2021, the Corporation extended the term of two of its office spaces by one and three years, resulting in a $316,000 increase in the right-of-use assets in exchange for a lease liability. Also during 2021, the Corporation entered into a new lease in Indiana resulting in a $117,000 increase to the right of use asset.
In 2019, the Corporation entered into a sublease for office space it vacated in its Kansas City metropolitan area which expires in 2023.
The components of total lease expense were as follows:
For the Year Ended December 31,
2021 2020
(In Thousands)
Operating lease cost
$ 1,513 $ 1,494
Short-term lease cost
158 222
Variable lease cost
492 522
Less: sublease income
(170) (113)
Total lease cost, net
$ 1,993 $ 2,125
Quantitative information regarding the Corporation’s operating leases was as follows:
December 31, 2021 December 31, 2020
Weighted-average remaining lease term (in years)
5.05 5.80
Weighted-average discount rate
2.51 % 3.03 %
The following maturity analysis shows the undiscounted cash flows due on the Corporation’s operating lease liabilities:
(In Thousands)
2022 $ 1,628
2023 1,103
2024 816
2025 666
2026 646
Thereafter 996
Total undiscounted cash flows 5,855
Discount on cash flows (449)
Total lease liability $ 5,406
Note 7 - Goodwill and Other Intangible Assets
Goodwill
Goodwill is not amortized, but is subject to impairment tests on an annual basis and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount (including goodwill). At December 31, 2021 and 2020, the Corporation had goodwill of $10.7 million, which was related to the acquisition of Alterra in 2014.
The Corporation conducted its annual impairment test on August 1, 2021, utilizing a qualitative assessment, and concluded that it was more likely than not the estimated fair value of the reporting unit exceeded its carrying value, resulting in no impairment.
Other Intangible Assets
The Corporation has intangible assets that are amortized consisting of loan servicing rights and core deposit intangibles.
Loan servicing rights are recognized upon sale of the guaranteed portions of SBA loans with servicing rights retained. When SBA loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Loan servicing assets are subsequently measured using the amortization method, which requires servicing rights to be amortized into interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. For the years ended December 31, 2021 and 2020, loan servicing asset amortization totaled $412,000 and $458,000, respectively.
The estimated fair value of the Corporation’s loan servicing asset was $1.6 million and $1.3 million as of December 31, 2021 and 2020, respectively. The Corporation periodically reviews this portfolio for impairment and engages a third-party valuation firm to assess the fair value of the overall servicing rights portfolio. During the years ended December 31, 2021 and 2020, impairment recovery of $63,000 and $16,000, respectively, was recognized.
The core deposit intangibles have a finite life and is amortized over a period of seven years, and were fully amortized during 2021. There was no net book value of the core deposit intangible as of December 31, 2021 and $25,000 as of December 31, 2020. For the years ended December 31, 2021 and 2020, amortization totaled $25,000 and $35,000, respectively.
Note 8 - Other Assets
The Corporation is a limited partner in several limited partnership investments. The Corporation is not the general partner, does not have controlling ownership, and is not the primary beneficiary in any of these limited partnerships and the limited partnerships have not been consolidated. These investments are accounted for using the equity method of accounting and are evaluated for impairment at the end of each reporting period.
Historic Rehabilitation Tax Credits
The Corporation invests in development entities through BOC, Mitchell Street, and FBB Tax Credit, wholly-owned subsidiaries of FBB, to rehabilitate historic buildings. At December 31, 2021 and 2020, the net carrying value of the investments were $2.3 million and $2.4 million, respectively. During 2020, the Corporation contributed $4.4 million to these partnerships and recognized $2.8 million in federal historic tax credits, and $1.9 million in impairment related to these investments. During 2021, the Corporation had no activity related to these investments. The state historic tax credits received during the year ended December 31, 2020 was $2.7 million and were sold to a third party resulting in a gain on sale $275,000.
Low-Income Housing Tax Credits
The Corporation invests in development entities through FBB Tax Credit, wholly-owned subsidiaries of FBB, to develop buildings that offer low-income housing. At December 31, 2021, the net carrying value of the investments were $3.0 million. During 2021, the Corporation contributed $3.0 million to these partnerships, and did not recognize any tax credits or impairment related to these partnerships. As of December 31, 2020 the Corporation had no low-income housing tax credit investments.
New Market Tax Credits
The Corporation invested in a community development entity (“CDE”) through Rimrock Road, a wholly-owned subsidiary of FBB, to develop and operate a real estate project located in a low-income community. On November 24, 2021, the Corporation exercised the put option and exited the Rimrock Road entity. As of December 31, 2021, the Corporation had no remaining investment in the CDE. At December 31, 2020, Rimrock Road had one CDE investment with a net carrying value of $5.3 million. The Corporation’s use of the federal new market tax credit during the year ended December 31, 2020 was $450,000.
Other Investments
The Corporation had an equity investment in Aldine Capital Fund, LP, a mezzanine fund. As of December 31, 2020, the Corporation had an equity investment in Aldine Capital Fund, LP of $60,000 and the final distribution was received January 15, 2021. The Corporation’s equity investment in Aldine Capital Fund II, LP, also a mezzanine fund, totaled $4.9 million and $3.5 million as of December 31, 2021 and 2020, respectively. As of December 31, 2021, the Corporation had $1.3 million remaining of the original $5.0 million commitment to Aldine II. The Corporation’s equity investment in Aldine Capital Fund III, LP, also a mezzanine fund, totaled $4.5 million and $2.8 million as of December 31, 2021 and 2020, respectively. As of December 31, 2021, the Corporation had $1.1 million remaining of the $5.0 million commitment. The Corporation’s share of these partnerships’ income included in other non-interest income in the Consolidated Statements of Income for the years ended December 31, 2021 and 2020 was $2.5 million and $520,000, respectively. The Corporation’s share of these partnerships’ losses included in other non-interest expense in the Consolidated Statements of Income for the year ended December 31, 2021 and 2020 was $24,000 and $99,000, respectively.
The Corporation has an equity investment in Dane Workforce Housing Fund LLC, a Wisconsin limited liability company, focused on community development by providing affordable workforce housing units in Dane County, Wisconsin, of $367,000 and $275,000 recorded as of December 31, 2021 and 2020, respectively. The Corporation had a $615,000 commitment remaining of the original $1.0 million as of December 31, 2021. The Corporation’s share of the investment fund’s income included in other non-interest income in the Consolidated Statements of Income for the year ended December 31, 2021 was $2,000. The Corporation’s share of these partnerships’ losses included in other non-interest expense in the Consolidated Statements of Income for the year ended December 31, 2021 was $19,000. No activity was recognized for the year ended December 31, 2020.
The Corporation has an equity investment in BankTech Ventures, LP, a venture capital fund, focused on the community banking industry through strategic investments in growth-stage startups that directly support banking needs, of $120,000 recorded as of December 31, 2021. The Corporation had a $880,000 commitment remaining of the original $1.0 million as of December 31, 2021. No activity was recognized for the years ended December 31, 2021 and 2020.
The Corporation is the sole owner of $315,000 of common securities issued by Trust II. The purpose of Trust II was to complete the sale of $10.0 million of 10.50% fixed rate preferred securities. Trust II, a wholly owned subsidiary of the
Corporation, is not consolidated into the financial statements of the Corporation. The investment in Trust II of $315,000 as of December 31, 2021 and 2020 is included in accrued interest receivable and other assets.
A summary of accrued interest receivable and other assets was as follows:
December 31, 2021 December 31, 2020
(In Thousands)
Accrued interest receivable $ 5,497 $ 8,564
Net deferred tax asset 6,175 7,217
Investment in historic development entities 2,299 2,356
Investment in low-income housing development entity 2,964 -
Investment in a community development entity - 5,306
Investment in limited partnerships 9,874 6,673
Investment in Trust II 315 315
Prepaid expenses 2,689 2,165
Other assets 9,577 6,882
Total accrued interest receivable and other assets $ 39,390 $ 39,478
Note 9 - Deposits
The composition of deposits is shown below.
December 31, 2021 December 31, 2020
Balance Average Balance Average Rate Balance Average Balance Average Rate
(Dollars in Thousands)
Non-interest-bearing transaction accounts
$ 589,559 $ 536,981 - % $ 472,818 $ 412,825 - %
Interest-bearing transaction accounts
530,225 506,693 0.19 503,992 392,576 0.37
Money market accounts 754,410 693,608 0.17 641,504 651,402 0.44
Certificates of deposit 54,091 47,020 0.84 64,694 111,698 1.97
Wholesale deposits 29,638 119,831 0.82 172,508 142,591 1.71
Total deposits $ 1,957,923 $ 1,904,133 0.19 $ 1,855,516 $ 1,711,092 0.52
A summary of annual maturities of in-market and wholesale certificates of deposit at December 31, 2021 is as follows:
(In Thousands)
Maturities during the year ended December 31,
2022 $ 68,020
2023 4,548
2024 349
2025 324
2026 488
Thereafter -
$ 73,729
Wholesale deposits include $19.6 million and $10.0 million of wholesale certificates of deposit and non-reciprocal interest-bearing transaction accounts, respectively, at December 31, 2021, compared to $47.5 million and $125.0 million of wholesale certificates of deposit and non-reciprocal interest-bearing transaction accounts at December 31, 2020.
Deposits include $7.9 million and $28.7 million of certificates of deposit and wholesale deposits which are denominated in amounts greater than $250,000 at December 31, 2021 and 2020, respectively.
Note 10 - FHLB Advances, Other Borrowings and Junior Subordinated Notes
The composition of borrowed funds is shown below.
December 31, 2021 December 31, 2020
Balance Weighted
Average
Balance Weighted
Average
Rate Balance Weighted
Average
Balance Weighted
Average
Rate
(Dollars in Thousands)
Federal funds purchased $ - $ - - % $ - $ 71 0.69 %
Federal Reserve PPPLF - - - - 15,207 0.35
FHLB advances
368,800 376,781 1.30 394,500 379,891 1.45
Line of credit
500 78 2.90 - - -
Other borrowings 10,363 8,090 4.11 920 676 12.60
Subordinated notes payable 23,788 23,766 5.94 23,747 23,725 5.95
Junior subordinated notes 10,076 10,068 11.05 10,062 10,054 11.09
$ 413,527 $ 418,783 1.86 $ 429,229 $ 429,624 1.91
A summary of annual maturities of borrowings at December 31, 2021 is as follows:
(In Thousands)
Maturities during the year ended December 31,
2022 $ 173,500
2023 37,300
2024 35,500
2025 23,363
2026 -
Thereafter $ 143,864
$ 413,527
The Corporation has a $695.6 million FHLB line of credit available for advances which is collateralized as noted below. At December 31, 2021, $326.8 million of this line remained unused. There were $368.8 million of term FHLB advances outstanding at December 31, 2021 with stated fixed interest rates ranging from 0.00% to 2.51% compared to $394.5 million of term FHLB advances outstanding at December 31, 2020 with stated fixed interest rates ranging from 0.00% to 2.75%. The term FHLB advances outstanding at December 31, 2021 are due at various dates through February 2030.
The Corporation is required to maintain as collateral mortgage-related securities, unencumbered first mortgage loans and secured small business loans in its portfolio aggregating at least the amount of outstanding advances from the FHLB. Loans totaling approximately $1.305 billion and $1.219 billion were pledged as collateral at December 31, 2021 and 2020, respectively.
The Corporation has a senior line of credit with a third-party financial institution of $10.5 million. As of December 31, 2021, the line of credit carried an interest rate of LIBOR + 2.75% with an interest rate floor of 2.85% that matured on February 19, 2021 and had certain performance debt covenants of which the Corporation was in compliance. The Corporation pays a commitment fee on this senior line of credit. For the years ended December 31, 2021 and 2020 the Corporation incurred $13,000 additional interest expense due to this fee. There was $500,000 outstanding balance on the line of credit as of December 31, 2021. On February 11, 2022, the credit line was renewed for one additional year with pricing terms of 1-month term SOFR + 2.36% and a maturity date of February 19, 2023.
The Corporation has two series of subordinated notes payable, each of which qualifies as Tier II capital. At December 31, 2021, the aggregate principal amount of subordinated notes payable outstanding was $23.8 million, which qualified for Tier 2 capital. At December 31, 2021, $15.0 million bore a fixed interest rate of 5.50% with a maturity date of August 15, 2029 and $9.1 million bore a fixed interest rate of 6.00% with a maturity date of April 15, 2027. The $15.0 million subordinated notes payable have certain performance debt covenants of which the Corporation was in compliance. The Corporation may, at its option, redeem the 5.50% notes, in whole or part, at any time after August 15, 2024, and may redeem the 6.00% notes any time after June 15, 2022. As of December 31, 2021, $302,000 of debt issuance costs remain in the subordinated notes payable balance.
In September 2008, Trust II completed the sale of $10.0 million of 10.50% fixed rate trust preferred securities (“Preferred Securities”). Trust II also issued common securities of $315,000. Trust II used the proceeds from the offering to purchase $10.3 million of 10.50% junior subordinated notes (“Notes”) of the Corporation. The Preferred Securities are mandatorily redeemable upon the maturity of the Notes on September 26, 2038. The Preferred Securities qualify under the risk-based capital guidelines as Tier 1 capital for regulatory purposes. Per the provisions of the Dodd-Frank Act, bank holding companies with total assets of less than $15 billion are not required to phase out trust preferred securities as an element of Tier 1 capital as other, larger institutions must. The Corporation used the proceeds from the sale of the Notes for general corporate purposes including providing additional capital to its subsidiaries. As of December 31, 2021, $239,000 of debt issuance costs remain reflected in junior subordinated notes on the Consolidated Balance Sheets.
The Corporation has the right to redeem the Notes at each interest payment date on or after September 26, 2013. The Corporation also has the right to redeem the Notes, in whole but not in part, after the occurrence of certain special events. Special events are limited to: (1) a change in capital treatment resulting in the inability of the Corporation to include the Notes in Tier 1 capital, (2) a change in laws or regulations that could require Trust II to register as an investment company under the Investment Company Act of 1940, as amended; and (3) a change in laws or regulations that would require Trust II to pay income tax with respect to interest received on the Notes or, prohibit the Corporation from deducting the interest payable by the Corporation on the Notes or result in greater than a de minimis amount of taxes for Trust II.
During the second quarter of 2020, the Corporation tested its ability to borrow from the Federal Reserve Paycheck Protection Program Liquidity Facility (“PPPLF”) in the event funding was required to support the Banks PPP lending efforts. On April 28, 2020, the Corporation borrowed $29.6 million from the PPPLF at a rate of 0.35%. As of November 2, 2020, the borrowing was paid in full.
As of December 31, 2021, the Corporation had other borrowings of $10.4 million, which consisted of $10.4 million of sold loans accounted for as secured borrowings because they did not qualify for true sale accounting. During 2021, the Corporation paid in full the borrowings associated with our investment in a community development entity.
Note 11 - Regulatory Capital
The Corporation and the Bank are subject to various regulatory capital requirements administered by Federal and Wisconsin banking agencies. Failure to meet minimum capital requirements can result in certain mandatory, and possibly additional discretionary actions on the part of regulators, that if undertaken, could have a direct material effect on the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory practices. The Corporation’s and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. The Corporation regularly reviews and updates, when appropriate, its Capital and Liquidity Action Plan, which is designed to help ensure appropriate capital adequacy, to plan for future capital needs, and to ensure that the Corporation serves as a source of financial strength to the Bank. The Corporation’s and the Bank’s Boards of Directors and management teams adhere to the appropriate regulatory guidelines on decisions which affect their respective capital positions, including but not limited to, decisions relating to the payment of dividends and increasing indebtedness.
As a bank holding company, the Corporation’s ability to pay dividends is affected by the policies and enforcement powers of the Board of Governors of the Federal Reserve system (the “Federal Reserve”). Federal Reserve guidance urges financial institutions to strongly consider eliminating, deferring, or significantly reducing dividends if: (i) net income available to common shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividend; (ii) the prospective rate of earnings retention is not consistent with the bank holding company’s capital needs and overall current and prospective financial condition; or (iii) the bank holding company will not meet, or is in danger of not meeting, its minimum regulatory capital ratios. Management intends, when appropriate under regulatory guidelines, to consult with the Federal Reserve Bank of Chicago and provide it with information on the Corporation’s then-current and prospective earnings and capital position in advance of declaring any cash dividends. As a Wisconsin corporation, the Corporation is subject to the limitations of the Wisconsin Business Corporation Law, which prohibit the Corporation from paying dividends if such payment would: (i) render the Corporation unable to pay its debts as they become due in the usual course of business, or (ii) result in the Corporation’s assets being less than the sum of its total liabilities plus the amount needed to satisfy the preferential rights upon dissolution of any shareholders with preferential rights superior to those shareholders receiving the dividend.
The Bank is also subject to certain legal, regulatory, and other restrictions on their ability to pay dividends to the Corporation. As a bank holding company, the payment of dividends by the Bank to the Corporation is one of the sources of funds the Corporation could use to pay dividends, if any, in the future and to make other payments. Future dividend decisions by the
Bank and the Corporation will continue to be subject to compliance with various legal, regulatory, and other restrictions as defined from time to time.
Qualitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios of Total Common Equity Tier 1 and Tier 1 capital to risk-weighted assets and of Tier 1 capital to adjusted total assets. These risk-based capital requirements presently address credit risk related to both recorded and off-balance sheet commitments and obligations.
In July 2013, the FRB and the FDIC approved the final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks. These rules are applicable to all financial institutions that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as bank and savings and loan holding companies other than “small bank holding companies” (generally non-publicly traded bank holding companies with consolidated assets of less than $1 billion). Under the final rules, minimum requirements increased for both the quantity and quality of capital held by the Corporation. The rules include a new Common Equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, require a minimum ratio of Total Capital to risk-weighted assets of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. The rules also permit banking organizations with less than $15 billion in assets to retain, through a one-time election, the past treatment for accumulated other comprehensive income, which did not affect regulatory capital. The Corporation elected to retain this treatment, which reduces the volatility of regulatory capital ratios. The Corporation also must comply with the 2.5% conservation buffer, which the Corporation met as of December 31, 2021.
As of December 31, 2021, the Corporation’s capital levels exceeded the regulatory minimums and the Bank’s capital levels remained characterized as well capitalized under the regulatory framework. The following tables summarize both the Corporation’s and the Bank’s capital ratios and the ratios required by their federal regulators:
As of December 31, 2021
Actual Minimum Required for Capital Adequacy Purposes For Capital Adequacy Purposes Plus Capital Conservation Buffer Minimum Required to Be Well Capitalized Under Prompt Corrective Action
Requirements
Amount Ratio Amount Ratio Amount Ratio Amount Ratio
(Dollars in Thousands)
Total capital
(to risk-weighted assets)
Consolidated $ 281,745 10.82 % $ 208,337 8.00 % $ 273,443 10.50 % N/A N/A
First Business Bank 280,448 10.78 % 208,142 8.00 % 273,187 10.50 % 260,178 10.00 %
Tier 1 capital
(to risk-weighted assets)
Consolidated $ 232,795 8.94 % $ 156,253 6.00 % $ 221,358 8.50 % N/A N/A
First Business Bank 255,286 9.81 156,107 6.00 221,151 8.50 208,142 8.00
Common equity tier 1 capital
(to risk-weighted assets)
Consolidated $ 222,719 8.55 % $ 117,190 4.50 % $ 182,295 7.00 % N/A N/A
First Business Bank 255,286 9.81 117,080 4.50 182,124 7.00 169,116 6.50
Tier 1 leverage capital
(to adjusted assets)
Consolidated $ 232,795 8.94 % $ 104,145 4.00 % $ 104,145 4.00 % N/A N/A
First Business Bank 255,286 9.81 104,045 4.00 104,045 4.00 130,056 5.00
As of December 31, 2020
Actual Minimum Required for Capital Adequacy Purposes For Capital Adequacy Purposes Plus Capital Conservation Buffer Minimum Required to Be Well Capitalized Under Prompt Corrective Action
Requirements
Amount Ratio Amount Ratio Amount Ratio Amount Ratio
(Dollars in Thousands)
Total capital
(to risk-weighted assets)
Consolidated $ 258,607 11.25 % $ 183,965 8.00 % $ 241,454 10.50 % N/A N/A
First Business Bank 251,116 10.97 183,053 8.00 240,257 10.50 % $ 228,816 10.00 %
Tier 1 capital
(to risk-weighted assets)
Consolidated $ 206,104 8.96 % $ 137,974 6.00 % $ 195,463 8.50 % N/A N/A
First Business Bank 222,500 9.72 137,290 6.00 194,494 8.50 % $ 183,053 8.00 %
Common equity tier 1 capital
(to risk-weighted assets)
Consolidated $ 196,042 8.53 % $ 103,480 4.50 % $ 160,970 7.00 % N/A N/A
First Business Bank 222,500 9.72 102,967 4.50 160,171 7.00 % $ 148,731 6.50 %
Tier 1 leverage capital
(to adjusted assets)
Consolidated $ 206,104 7.99 % $ 103,228 4.00 % $ 103,228 4.00 % N/A N/A
First Business Bank 222,500 8.67 102,635 4.00 102,635 4.00 $ 128,294 5.00 %
The following table reconciles stockholders’ equity to federal regulatory capital at December 31, 2021 and 2020, respectively:
As of December 31,
2021 2020
(In Thousands)
Stockholders’ equity of the Corporation $ 232,422 $ 206,162
Net unrealized and accumulated losses on specific items
1,457 933
Disallowed servicing assets (727) (587)
Disallowed goodwill and other intangibles (10,433) (10,466)
Junior subordinated notes 10,076 10,062
Tier 1 capital 232,795 206,104
Allowable general valuation allowances and subordinated debt 48,950 52,503
Total capital $ 281,745 $ 258,607
Note 12 - Earnings per Common Share
Earnings per common share are computed using the two-class method. Basic earnings per common share are computed by dividing net income allocated to common shares by the weighted average number of shares outstanding during the applicable period, excluding outstanding participating securities. Participating securities include unvested restricted shares. Unvested restricted shares are considered participating securities because holders of these securities receive non-forfeitable dividends, or dividend equivalents, at the same rate as holders of the Corporation’s common stock. Diluted earnings per share are computed by dividing net income allocated to common shares adjusted for reallocation of undistributed earnings of unvested restricted shares by the weighted average number of shares determined for the basic earnings per common share computation plus the dilutive effect of common stock equivalents using the treasury stock method.
For the Year Ended December 31,
2021 2020
(Dollars in Thousands, Except Share Data)
Basic earnings per common share
Net income $ 35,755 $ 16,978
Less: earnings allocated to participating securities 1,053 423
Basic earnings allocated to common shareholders $ 34,702 $ 16,555
Weighted-average common shares outstanding, excluding participating securities
8,314,921 8,384,464
Basic earnings per common share $ 4.17 $ 1.97
Diluted earnings per common share
Earnings allocated to common shareholders, diluted $ 34,702 $ 16,555
Weighted-average diluted common shares outstanding, excluding participating securities
8,314,921 8,384,464
Diluted earnings per common share $ 4.17 $ 1.97
Note 13 - Share-Based Compensation
The Corporation adopted the 2019 Equity Incentive Plan (the “Plan”) during the quarter ended June 30, 2019. At the 2021 annual shareholders meeting, an amendment to the 2019 equity plan was approved, increasing the number of shares in the Plan by 180,000. The Plan is administered by the Compensation Committee of the Board of Directors of the Corporation and provides for the grant of equity ownership opportunities through incentive stock options and nonqualified stock options (“Stock Options”), restricted stock, restricted stock units, dividend equivalent units, and any other type of award permitted by the Plan. As of December 31, 2021, 219,837 shares were available for future grants under the Plan. Shares covered by awards that expire, terminate, or lapse will again be available for the grant of awards under the Plan. The Corporation may issue new shares and shares from its treasury stock for shares delivered under the Plan.
Restricted Stock
Under the Plan, the Corporation may grant restricted stock awards, restricted stock units, and other stock based awards to plan participants, subject to forfeiture upon the occurrence of certain events until the dates specified in the participant’s award agreement. While restricted stock is subject to forfeiture, restricted stock award participants may exercise full voting rights and will receive all dividends and other distributions paid with respect to the restricted shares. Restricted stock units do not have voting rights and are provided dividend equivalents. The restricted stock granted under the Plan is typically subject to a vesting period. Compensation expense for restricted stock is recognized over the requisite service period of generally three or four years for the entire award on a straight-line basis. Upon vesting of restricted stock, the benefit of tax deductions in excess of recognized compensation expense is reflected as an income tax benefit in the Consolidated Statements of Income.
The Corporation may issue a combination of performance based restricted stock units and restricted stock awards to its plan participants. Vesting of the performance based restricted stock units will be measured on Total Shareholder Return (“TSR”) and Return on Average Equity (“ROAE”) and will cliff-vest after a three-year measurement period based on the Corporation’s TSR performance and ROAE performance relative to a custom peer group. At the end of the performance period, the number of actual shares to be awarded varies between 0% and 200% of target amounts. The restricted stock awards issued to executive officers will vest ratably over a three-year period. Compensation expense is recognized for performance based restricted stock units over the requisite service and performance period of generally three years for the entire expected award on a straight-line basis. The compensation expense for the awards expected to vest for the percentage of performance based restricted stock units subject to the ROAE metric will be adjusted if there is a change in the expectation of ROAE. The compensation expense for the awards expected to vest for the percentage of performance based restricted stock units subject to the TSR metric are never adjusted, and are amortized utilizing the accounting fair value provided using a Monte Carlo pricing model.
Restricted stock activity was as follows:
For the Year Ended December 31,
2021 2020
Number of Restricted Shares Weighted
Average
Grant-Date
Fair Value Number of
Restricted
Shares Weighted
Average
Grant-Date
Fair Value
Nonvested balance at beginning of year 187,804 $ 24.29 176,935 $ 22.51
Granted (1)
93,130 23.57 78,775 25.82
Vested (63,385) 22.28 (56,904) 22.26
Forfeited (7,760) 23.24 (11,002) 22.86
Nonvested balance as of end of year 209,789 24.62 187,804 24.29
(1)The number of restricted shares/units shown includes the shares that would be granted if the target level of performance is achieved related to the performance based restricted stock units. The number of shares actually issued may vary.
As of December 31, 2021, the Corporation had $3.3 million of unrecognized compensation cost related to nonvested share-based compensation expense, which the Corporation expects to recognize over a weighted-average period of approximately 2.10 years.
Employee Stock Purchase Plan
During 2020, an employee stock purchase plan ("ESPP") was approved by the Corporation’s shareholders and is offered to all qualifying employees. The Company is authorized to issue up to 250,000 shares of common stock under the ESPP. The plan qualifies as an employee stock purchase plan under section 423 of the Internal Revenue Code of 1986. Under the ESPP, eligible employees may enroll in a three month offer period that begins January, April, July, and October of each year. Employees may elect to purchase a limited number of shares on the Corporation's common stock at 90% of the fair market value on the last day of the offering period. The ESPP is treated as a compensatory item for purposes of share-based compensation expense.
During the year ended December 31, 2021, the Corporation issued 6,532 shares of common stock under the ESPP. At December 31, 2021, 239,502 shares remained available for issuance under the ESPP.
Share-based compensation expense related to restricted stock and ESPP included in the Consolidated Statements of Income was as follows:
For the Year Ended December 31,
2021 2020
(In Thousands)
Share-based compensation expense $ 2,513 $ 1,871
Note 14 - Employee Benefit Plans
The Corporation maintains a contributory 401(k) defined contribution plan covering substantially all employees. The Corporation matches 100% of amounts contributed by each participating employee, up to 3% of the employee’s compensation. The Corporation may also make discretionary profit sharing contributions up to an additional 6% of salary. Contributions are expensed in the period incurred and recorded in compensation expense in the Consolidated Statements of Income. The Corporation made a matching contribution of 3% to all eligible employees which totaled $987,000 and $896,000, for the years ended December 31, 2021 and 2020, respectively. Discretionary profit sharing contributions for substantially all employees of 4.7%, or $1.3 million, and 5.0%, or $1.2 million, were made in 2021 and 2020, respectively.
As of December 31, 2021 and 2020, the Corporation had a deferred compensation plan under which it provided contributions to supplement the retirement income of one executive. Under the terms of the plan, benefits to be received are generally payable within six months of the date of the termination of employment with the Corporation. The expense associated with the deferred compensation plan for the years ended December 31, 2021 and 2020 was $237,000 and $193,000, respectively. The present value of future payments under the remaining plan of $1.9 million and $1.6 million at December 31, 2021 and 2020, respectively, is included in accrued interest payable and other liabilities on the Consolidated Balance Sheets.
The Corporation owned life insurance policies on the life of the executive covered by the deferred compensation plan, which had cash surrender values and death benefits of approximately $2.8 million and $6.1 million, respectively, at December 31, 2021 and cash surrender values and death benefits of approximately $2.7 million and $6.0 million, respectively, at December 31, 2020. The remaining balance of the cash surrender value of bank-owned life insurance of $50.8 million and $49.5 million as of December 31, 2021 and 2020, respectively, is related to policies on a number of then-qualified individuals affiliated with the Bank.
Note 15 - Income Taxes
Income tax expense consists of the following:
For the Year Ended December 31,
2021 2020
(In Thousands)
Current:
Federal $ 6,965 $ 1,948
State 3,087 1,386
Current tax expense 10,052 3,334
Deferred:
Federal 1,333 (1,678)
State (110) (329)
Deferred tax expense (benefit) 1,223 (2,007)
Total income tax expense $ 11,275 $ 1,327
Deferred income tax assets and liabilities reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their tax basis. Deferred tax assets and liabilities are measured using enacted tax rates to apply to taxable income in the period in which the temporary differences are expected to be recovered or settled. Net deferred tax assets are included in accrued interest receivable and other assets in the Consolidated Balance Sheets.
The significant components of the Corporation’s deferred tax assets and liabilities were as follows:
December 31, 2021 December 31, 2020
(In Thousands)
Deferred tax assets:
Allowance for loan and lease losses $ 6,312 $ 7,276
SBA recourse reserve 215 302
Deferred compensation 2,016 1,457
State net operating loss carryforwards 436 482
Write-down of foreclosed properties 5 -
Tax credit carryforwards - 1,831
Non-accrual loan interest 176 820
Capital loss carryforwards 21 21
Unrealized losses on securities 501 319
Other 619 356
Total deferred tax assets 10,301 12,864
Deferred tax liabilities:
Leasing and fixed asset activities 3,014 4,363
Loan servicing asset 420 358
Other 692 926
Total deferred tax liabilities 4,126 5,647
Net deferred tax asset $ 6,175 $ 7,217
The tax effects of unrealized gains and losses on securities are components of other comprehensive income. A reconciliation of the change in net deferred tax assets to deferred tax expense is as follows:
December 31, 2021 December 31, 2020
(In Thousands)
Change in net deferred tax assets $ (1,042) $ 1,864
Deferred taxes allocated to other comprehensive income (181) 143
Deferred income tax (expense) benefit $ (1,223) $ 2,007
Realization of the deferred tax asset over time is dependent upon the Corporation generating sufficient taxable earnings in future periods. In making the determination that the realization of the deferred tax was more likely than not, the Corporation considered several factors including its recent earnings history, its expected earnings in the future, appropriate tax planning strategies, and expiration dates associated with operating loss carryforwards. The Corporation had state net operating loss carryforwards of approximately $7.0 million and $7.7 million at December 31, 2021 and 2020, respectively, which can be used to offset future state taxable income. The Corporation believes it will be able to fully utilize its established deferred tax assets and Wisconsin state net operating losses and therefore no valuation allowance has been established as of December 31, 2021and 2020.
The provision for income taxes differs from that computed at the federal statutory corporate tax rate as follows:
Year Ended December 31,
2021 2020
(Dollars in Thousands)
Income before income tax expense $ 47,030 $ 18,305
Tax expense at statutory federal rate of 21% applied to income before income tax expense
$ 9,876 $ 3,844
State income tax, net of federal effect 2,351 837
Tax-exempt security and loan income, net of TEFRA adjustments (710) (648)
Bank-owned life insurance (297) (294)
Tax credits, net - (2,535)
Other 55 123
Total income tax expense $ 11,275 $ 1,327
Effective tax rate 23.97 % 7.25 %
There were no uncertain tax positions outstanding as of December 31, 2021 and 2020. As of December 31, 2021, tax years remaining open for the State of Wisconsin tax were 2017 through 2020. Federal tax years that remained open were 2018 through 2020. As of December 31, 2021, there were also no unrecognized tax benefits that are expected to significantly increase or decrease within the next twelve months.
Note 16 - Derivative Financial Instruments
The Corporation offers interest rate swap products directly to qualified commercial borrowers. The Corporation economically hedges client derivative transactions by entering into offsetting interest rate swap contracts executed with a third party. Derivative transactions executed as part of this program are not considered hedging instruments and are marked-to-market through earnings each period. The derivative contracts have mirror-image terms, which results in the positions’ changes in fair value offsetting through earnings each period. The credit risk and risk of non-performance embedded in the fair value calculations is different between the dealer counterparties and the commercial borrowers which may result in a difference in the changes in the fair value of the mirror-image swaps. The Corporation incorporates credit valuation adjustments to appropriately reflect both its own non-performance risk and the counterparty’s risk in the fair value measurements. When evaluating the fair value of its derivative contracts for the effects of non-performance and credit risk, the Corporation considered the impact of netting and any applicable credit enhancements such as collateral postings, thresholds and guarantees. The credit valuation allowance was $191,000 and $461,000 as of December 31, 2021 and 2020, respectively.
At December 31, 2021, the aggregate amortizing notional value of interest rate swaps with various commercial borrowers was $640.6 million. The Corporation receives fixed rates and pays floating rates based upon LIBOR on the swaps with commercial borrowers. These interest rate swaps mature between January 2024 and March 2038. Commercial borrower swaps are completed independently with each borrower and are not subject to master netting arrangements. These commercial borrower swaps were reported on the Consolidated Balance Sheet as a derivative asset of $26.3 million and as a derivative liability of $6.6 million. As of December 31, 2021, no interest rate swaps were in default.
At December 31, 2021, the aggregate amortizing notional value of interest rate swaps with dealer counterparties was also $640.6 million. The Corporation pays fixed rates and receives floating rates based upon LIBOR on the swaps with dealer counterparties. These interest rate swaps mature in January 2024 through March 2038. Dealer counterparty swaps are subject to master netting agreements among the contracts within our Bank and are reported on the Consolidated Balance Sheet as a net derivative liability of $19.7 million. The gross amount of dealer counterparty swaps, without regard to the enforceable master netting agreement, was a gross derivative liability of $26.3 million and a gross derivative asset of $6.6 million. No right of offset existed with the dealer counterparty swaps as of December 31, 2021.
All changes in the fair value of these instruments are recorded in other non-interest income. Given the mirror-image terms of the outstanding derivative portfolio, the change in fair value for the years ended December 31, 2021 and 2020 had an insignificant impact on the Consolidated Statements of Income.
The Corporation also enters into interest rate swaps to manage interest rate risk and reduce the cost of match-funding certain long-term fixed rate loans. These derivative contracts involve the receipt of floating rate interest from a counterparty in
exchange for the Corporation making fixed-rate payments over the life of the agreement, without the exchange of the underlying notional value. The instruments are designated as cash flow hedges as the receipt of floating rate interest from the counterparty is used to manage interest rate risk associated with forecasted issuances of short-term FHLB advances. The change in the fair value of these hedging instruments is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged transactions affects earnings.
As of December 31, 2021, the aggregate notional value of interest rate swaps designated as cash flow hedges was $106.0 million. These interest rate swaps mature between December 2022 and December 2027. A pre-tax unrealized loss of $3.6 million was recognized in other comprehensive income for the year ended December 31, 2021 and there was no ineffective portion of these hedges.
Information about the balance sheet location and fair value of the Corporation’s derivative instruments is below:
Interest Rate Swap Contracts
Asset Derivatives Liability Derivatives
Balance Sheet Location Fair Value Balance Sheet Location Fair Value
(In Thousands)
Derivatives not designated as hedging instruments
December 31, 2021 Derivatives $ 26,343 Derivatives $ 26,343
December 31, 2020 Derivatives $ 49,377 Derivatives $ 49,377
Derivatives designated as hedging instruments
December 31, 2021 Accumulated other comprehensive income (1)
$ 1,940 Derivatives $ 1,940
December 31, 2020 Accumulated other comprehensive income (1)
$ 5,550 Derivatives $ 5,550
(1)The fair value of derivatives designated as hedging instruments included in accumulated other comprehensive income represent pre-tax amounts, which are reported net of tax on the Consolidated Balance Sheets.
Note 17 - Commitments and Contingencies
The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of clients. These financial instruments include commitments to extend credit and standby letters of credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the Consolidated Financial Statements. The contract amounts reflect the extent of involvement the Bank has in these particular classes of financial instruments.
In the event of non-performance, the Bank’s exposure to credit loss for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for instruments reflected in the Consolidated Financial Statements. An accrual for credit losses on financial instruments with off-balance sheet risk would be recorded separate from any valuation account related to any such recognized financial instrument. As of December 31, 2021 and 2020, there were no accrued credit losses for financial instruments with off-balance sheet risk.
Financial instruments whose contract amounts represent potential credit risk were as follows:
At December 31,
2021 2020
(In Thousands)
Commitments to extend credit, primarily commercial loans $ 768,442 $ 654,093
Standby letters of credit 16,815 8,086
Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition in the contract. Commitments generally have fixed expiration dates or other termination clauses and may have a fixed interest rate or a rate which varies with the prime rate or other market indices and may require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the Bank. The Bank evaluates the creditworthiness of each client on a case-by-case basis and generally extends credit only on a secured basis. Collateral obtained varies but consists primarily of commercial real estate, accounts receivable, inventory, equipment, and securities. There is generally no market for commercial loan commitments, the fair value of which would approximate the present value of any fees expected to be received as a result of the commitment. These are not considered to be material to the financial statements.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a client to a third party. Generally, standby letters of credit expire within one year and are collateralized by accounts receivable, equipment, inventory, and commercial properties. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. The fair value of standby letters of credit is recorded as a liability when the standby letter of credit is issued. The fair value has been estimated to approximate the fees received by the Bank for issuance. The fees are recorded into income and the fair value of the guarantee is decreased ratably over the term of the standby letter of credit.
The Corporation sells the guaranteed portions of SBA 7(a) loans, as well as participation interests in other, non-SBA originated, loans to third parties. The Corporation has a continuing involvement in each of the transferred lending arrangements by way of relationship management and servicing the loans, as well as being subject to normal and customary requirements of the SBA loan program and standard representations and warranties related to sold amounts. In the event of a loss resulting from default and a determination by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Corporation, the SBA may require the Corporation to repurchase the loan, deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of the principal loss related to the deficiency from the Corporation. The Corporation must comply with applicable SBA regulations in order to maintain the guaranty. In addition, the Corporation retains the option to repurchase the sold guaranteed portion of an SBA loan if the loan defaults.
Management has assessed estimated losses inherent in the outstanding guaranteed portions of SBA loans sold in accordance with ASC 450, Contingencies, and determined a recourse reserve based on the probability of future losses for these loans to be $635,000 and $723,000 at December 31, 2021 and 2020, respectively, which is reported in accrued interest payable and other liabilities on the Consolidated Balance Sheets.
The summary of the activity in the SBA recourse reserve is as follows:
As of and For the Year Ended December 31,
2021 2020
(In Thousands)
Balance at the beginning of the period $ 723 $ 1,345
SBA recourse benefit (76) (278)
Charge-offs, net (12) (344)
Balance at the end of the period $ 635 $ 723
In the normal course of business, various legal proceedings involving the Corporation are pending. Management, based upon advice from legal counsel, does not anticipate any significant losses as a result of these actions. Management believes that any liability arising from any such proceedings currently existing or threatened will not have a material adverse effect on the Corporation’s financial position, results of operations, and cash flows.
Note 18 - Fair Value Disclosures
The Corporation determines the fair values of its financial instruments based on the fair value hierarchy established in ASC Topic 820, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Fair value is defined as the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date and is based on exit prices. Fair value includes assumptions about risk,
such as nonperformance risk in liability fair values, and is a market-based measurement, not an entity-specific measurement. The standard describes three levels of inputs that may be used to measure fair value.
Level 1 - Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access at the measurement date.
Level 2 - Level 2 inputs are inputs, other than quoted prices included with Level 1, that are observable for the asset or liability either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Level 3 inputs are supported by little or no market activity and are significant to the fair value of the assets or liabilities.
In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Corporation’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.
Assets and liabilities measured at fair value on a recurring basis, segregated by fair value hierarchy level, are summarized below:
December 31, 2021
Fair Value Measurements Using
Level 1 Level 2 Level 3 Total
(In Thousands)
Assets:
Securities available-for-sale:
U.S. treasuries $ - $ 4,914 $ - $ 4,914
U.S. government agency securities - government-sponsored enterprises - 19,935 - 19,935
Municipal securities - 30,957 - 30,957
Residential mortgage-backed securities - government issued - 19,661 - 19,661
Residential mortgage-backed securities - government-sponsored enterprises - 85,705 - 85,705
Commercial mortgage-backed securities - government issued - 5,771 - 5,771
Commercial mortgage-backed securities - government-sponsored enterprises - 36,531 - 36,531
Other securities - 2,228 - 2,228
Interest rate swaps - 26,343 - 26,343
Liabilities:
Interest rate swaps - 28,283 - 28,283
December 31, 2020
Fair Value Measurements Using
Level 1 Level 2 Level 3 Total
(In Thousands)
Assets:
Securities available-for-sale:
U.S. government agency securities - government-sponsored enterprises $ - $ 22,629 $ - $ 22,629
Municipal securities - 24,779 - 24,779
Residential mortgage-backed securities - government issued - 10,403 - 10,403
Residential mortgage-backed securities - government-sponsored enterprises - 105,006 - 105,006
Commercial mortgage-backed securities - government issued - 5,464 - 5,464
Commercial mortgage-backed securities - government-sponsored enterprises - 13,365 - 13,365
Other securities - 2,279 - 2,279
Interest rate swaps - 49,377 - 49,377
Liabilities:
Interest rate swaps - 54,927 - 54,927
For assets and liabilities measured at fair value on a recurring basis, there were no transfers between the levels during the year ended December 31, 2021 or 2020 related to the above measurements.
Assets and liabilities measured at fair value on a non-recurring basis, segregated by fair value hierarchy, are summarized below:
December 31, 2021
Fair Value Measurements Using
Level 1 Level 2 Level 3 Total
(In Thousands)
Impaired loans $ - $ - $ 1,000 $ 1,000
Foreclosed properties - - 164 164
Loan servicing rights - - 1,601 1,601
December 31, 2020
Fair Value Measurements Using
Level 1 Level 2 Level 3 Total
(In Thousands)
Impaired loans $ - $ - $ 17,203 $ 17,203
Foreclosed properties - - 34 34
Loan servicing rights - - 1,325 1,325
Impaired loans were written down to the fair value of their underlying collateral less costs to sell of $1.0 million and $17.2 million at December 31, 2021 and 2020, respectively, through the establishment of specific reserves or by recording charge-offs when the carrying value exceeded the fair value of the underlying collateral of impaired loans. Valuation techniques consistent with the market approach, income approach, or cost approach were used to measure fair value. These techniques included observable inputs for the individual impaired loans being evaluated such as current appraisals, recent sales of similar assets, or other observable market data, and unobservable inputs, typically when discounts are applied to appraisal values to adjust such values to current market conditions or to reflect net realizable values. The quantification of unobservable inputs for Level 3 impaired loan values range from 13% - 90% as of the measurement date of December 31, 2021. The weighted average of those unobservable inputs was 24%. The majority of the impaired loans are considered collateral dependent loans or are supported by an SBA guaranty.
Foreclosed properties, upon initial recognition, are remeasured and reported at fair value through a charge-off to the allowance for loan and lease losses, if deemed necessary, based upon the fair value of the foreclosed property. The fair value of a foreclosed property, upon initial recognition, is estimated using a market approach or based on observable market data, typically a current appraisal, or based upon assumptions specific to the individual property or equipment, such as management applied discounts used to further reduce values to a net realizable value when observable inputs become stale.
Loan servicing rights represent the asset retained upon sale of the guaranteed portion of certain SBA loans. When SBA loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. The servicing rights are subsequently measured using the amortization method, which requires amortization into interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
The Corporation periodically reviews this portfolio for impairment and engages a third-party valuation firm to assess the fair value of the overall servicing rights portfolio. Loan servicing rights do not trade in an active, open market with readily observable prices. While sales of loan servicing rights do occur, the precise terms and conditions typically are not readily available to allow for a “quoted price for similar assets” comparison. Accordingly, the Corporation utilizes an independent valuation from a third party which uses a discounted cash flow model to estimate the fair value of its loan servicing rights. The valuation model incorporates prepayment assumptions to project loan servicing rights cash flows based on the current interest rate scenario, which is then discounted to estimate an expected fair value of the loan servicing rights. The valuation model considers portfolio characteristics of the underlying serviced portion of the SBA loans and uses the following significant unobservable inputs: (1) constant prepayment rate (“CPR”) assumptions based on the SBA sold pools historical CPR as quoted in Bloomberg and (2) a discount rate. Due to the nature of the valuation inputs, loan servicing rights are classified in Level 3 of the fair value hierarchy.
Fair Value of Financial Instruments
The Corporation is required to disclose estimated fair values for its financial instruments. Fair value estimates, methods and assumptions, consistent with exit price concepts for fair value measurements, are set forth below:
December 31, 2021
Carrying
Amount Fair Value
Total Level 1 Level 2 Level 3
(In Thousands)
Financial assets:
Cash and cash equivalents $ 57,110 $ 57,110 $ 57,110 $ - $ -
Securities available-for-sale 205,702 205,702 - 205,702 -
Securities held-to-maturity 19,746 20,276 - 20,276 -
Loans held for sale 3,570 3,927 - 3,927 -
Loans and lease receivables, net 2,215,072 2,241,093 - - 2,241,093
Federal Home Loan Bank stock 13,336 N/A N/A N/A N/A
Accrued interest receivable 5,497 5,497 5,497 - -
Interest rate swaps 26,343 26,343 - 26,343 -
Financial liabilities:
Deposits 1,957,923 1,968,195 1,894,273 73,922 -
Federal Home Loan Bank advances and other borrowings 403,451 409,894 - 409,894 -
Junior subordinated notes 10,076 8,844 - - 8,844
Accrued interest payable 1,008 1,008 1,008 - -
Interest rate swaps 28,283 28,283 - 28,283 -
Off-balance sheet items:
Standby letters of credit 203 203 - - 203
N/A = The fair value is not applicable due to restrictions placed on transferability
December 31, 2020
Carrying
Amount Fair Value
Total Level 1 Level 2 Level 3
(In Thousands)
Financial assets:
Cash and cash equivalents $ 56,909 $ 56,909 $ 56,909 $ - $ -
Securities available-for-sale 183,925 183,925 - 183,925 -
Securities held-to-maturity 26,374 27,333 - 27,333 -
Loans held for sale 8,695 9,478 - 9,478 -
Loans and lease receivables, net 2,117,449 2,121,107 - - 2,121,107
Federal Home Loan Bank stock 13,578 N/A N/A N/A N/A
Accrued interest receivable 8,564 8,564 8,564 - -
Interest rate swaps 49,377 49,377 - 49,377 -
Financial liabilities:
Deposits 1,855,516 1,856,910 1,743,314 113,596 -
Federal Home Loan Bank advances and other borrowings 419,167 429,347 - 429,347 -
Junior subordinated notes 10,062 9,986 - - 9,986
Accrued interest payable 1,578 1,578 1,578 - -
Interest rate swaps 54,927 54,927 - 54,927 -
Off-balance sheet items:
Standby letters of credit 75 75 - - 75
N/A = The fair value is not applicable due to restrictions placed on transferability
Disclosure of fair value information about financial instruments, for which it is practicable to estimate that value, is required whether or not recognized in the Consolidated Balance Sheets. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are excluded from the disclosure requirements. Accordingly, the aggregate fair value amounts presented do not necessarily represent the underlying value of the Corporation.
Securities: The fair value measurements of investment securities are determined by a third-party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, trade execution data, market consensus prepayment speeds, credit information and the securities’ terms and conditions, among other things. The fair value measurements are subject to independent verification by another pricing source on a quarterly basis to review for reasonableness. Any significant differences in pricing are reviewed with appropriate members of management who have the relevant technical expertise to assess the results. The Corporation has determined that these valuations are classified in Level 2 of the fair value hierarchy. When the independent pricing service does not provide a fair value measurement for a particular security, the Corporation will estimate the fair value based on specific information about each security. Fair values derived in this manner are classified in Level 3 of the fair value hierarchy.
Loans Held for Sale: Loans held for sale, which consist of the guaranteed portions of SBA loans, are carried at the lower of cost or estimated fair value. The estimated fair value is based on what secondary markets are currently offering for portfolios with similar characteristics.
Interest Rate Swaps: The carrying amount and fair value of existing derivative financial instruments are based upon independent valuation models, which use widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative contract. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The Corporation incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the
respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Corporation considers the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.
Limitations: Fair value estimates are made at a discrete point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holding of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and are not considered in the estimates.
Note 19 - Condensed Parent Only Financial Information
The following represents the condensed financial information of the Corporation only:
Condensed Balance Sheets
December 31,
2021 December 31,
(In Thousands)
Assets
Cash and cash equivalents $ 331 $ 3,268
Investments in subsidiaries, at equity 265,303 232,935
Premises and equipment, net 76 1,325
Right-of-use assets - 3,797
Other assets 2,045 5,819
Total assets $ 267,755 $ 247,144
Liabilities and Stockholders’ Equity
Junior subordinated notes and other borrowings $ 34,364 $ 33,809
Lease liabilities - 4,114
Accrued interest payable and other liabilities 969 3,059
Total liabilities 35,333 40,982
Stockholders’ equity 232,422 206,162
Total liabilities and stockholders’ equity $ 267,755 $ 247,144
Condensed Statements of Income
For the Year Ended December 31,
2021 2020
(In Thousands)
Net interest expense $ 2,539 $ 2,540
Non-interest income
Consulting and rental income from consolidated subsidiaries 2,417 21,320
Other non-interest income 34 34
Total non-interest income 2,451 21,354
Non-interest expense 5,747 24,507
Loss before income tax benefit and equity in undistributed net income of consolidated subsidiaries
5,835 5,693
Income tax benefit 1,483 1,388
Loss before equity in undistributed net income of consolidated subsidiaries 4,352 4,305
Equity in undistributed net income of consolidated subsidiaries 40,107 21,283
Net income $ 35,755 $ 16,978
Condensed Statements of Cash Flows
For the Year Ended December 31,
2021 2020
(In Thousands)
Operating activities
Net income $ 35,755 $ 16,978
Adjustments to reconcile net income to net cash used in operating activities:
Equity in undistributed earnings of consolidated subsidiaries (40,107) (21,283)
Share-based compensation 2,513 1,871
Excess tax (benefit) expense from share-based compensation (27) 8
Payments on operating lease liabilities - (560)
Net decreases in other liabilities (2,090) (574)
Other, net 3,413 560
Net cash used in operating activities (543) (3,000)
Investing activities
Dividends received from subsidiaries 8,534 12,034
Net cash provided by investing activities 8,534 12,034
Financing activities
Net increase in long-term borrowed funds 55 55
Proceeds from purchased funds and other short-term debt 500 -
Purchase of treasury stock (5,477) (1,672)
Cash dividends paid (6,166) (5,652)
Net proceeds from purchases of ESPP shares 160 66
Net cash used in financing activities (10,928) (7,203)
Net (decrease) increase in cash and due from banks (2,937) 1,831
Cash and cash equivalents at the beginning of the period 3,268 1,437
Cash and cash equivalents at the end of the period $ 331 $ 3,268
Note 20 - Condensed Quarterly Earnings (unaudited)
2021 2020
Fourth
Quarter Third
Quarter Second
Quarter First
Quarter Fourth
Quarter Third
Quarter Second
Quarter First
Quarter
(Dollars in Thousands, Except Per Share Data)
Interest income $ 23,575 $ 24,014 $ 24,599 $ 23,807 $ 25,770 $ 22,276 $ 22,761 $ 23,372
Interest expense 2,651 2,791 2,947 2,944 3,258 3,655 3,873 6,322
Net interest income 20,924 21,223 21,652 20,863 22,512 18,621 18,888 17,050
Provision for loan and lease losses
(508) (2,269) (958) (2,068) 4,322 3,835 5,469 3,182
Non-interest income 7,569 7,015 6,321 7,195 6,799 7,408 6,319 6,414
Non-interest expense 17,531 18,490 18,184 17,330 17,651 16,758 18,343 16,146
Income before income tax expense
11,470 12,017 10,747 12,796 7,338 5,436 1,395 4,136
Income tax expense (benefit)
2,879 2,819 2,512 3,065 1,254 1,143 (1,928) 858
Net income $ 8,591 $ 9,198 $ 8,235 $ 9,731 $ 6,084 $ 4,293 $ 3,323 $ 3,278
Per common share:
Basic earnings $ 1.01 $ 1.07 $ 0.95 $ 1.12 $ 0.71 $ 0.50 $ 0.38 $ 0.38
Diluted earnings
1.01 1.07 0.95 1.12 0.71 0.50 0.38 0.38
Dividends declared 0.18 0.18 0.18 0.18 0.165 0.165 0.165 0.165
Report of Independent Registered Public Accounting Firm
Shareholders and the Board of Directors
First Business Financial Services, Inc.
Madison, Wisconsin
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of First Business Financial Services, Inc. (the "Corporation") as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the "financial statements"). We also have audited the Corporation’s internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Corporation as of December 31, 2021 and 2020, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control - Integrated Framework: (2013) issued by COSO.
Basis for Opinions
The Corporation management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Corporation’s financial statements and an opinion on the Corporation’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Corporation in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance and Provision for Loan and Lease Losses - Qualitative Factors
As described in Notes 1- Nature of Operations and Summary of Significant Accounting Policies, and 4- Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses to the consolidated financial statements, the Corporation’s allowance for loan and lease losses is an accounting estimate that requires significant management judgment in the evaluation of the quality of the loan and lease portfolio and the application of qualitative factors. The allowance for loan and lease losses is composed of loans collectively and individually evaluated for impairment. The specific allowance on loans individually evaluated for impairment relates to non-accrual and restructured loans and leases. The portion of the allowance for the collectively evaluated loans is reliant upon historical experience, as well as quantitative and qualitative factors.
The calculation of the allowance for loan losses involves significant estimates and subjective assumptions, which require a high degree of judgment. The methodology applied for determining inherent losses stems from current risk characteristics of the loan and lease portfolio, an assessment of individual impaired loans and leases, actual loss experience, and adverse situations that may affect the borrower’s ability to repay. The collectively evaluated component of the allowance for loan and lease losses utilizes a historical loss rate calculation for each loan and lease category with similar risk characteristics. The average loss rates are adjusted for qualitative factors and applied to the end of period loan and lease portfolio balances to estimate probable incurred losses in the loan and lease portfolio. The qualitative factors and measurements used to quantify the risks within each of these categories are subjectively selected by management, using certain objective measurements period over period. The current period measurements are evaluated and assigned a factor commensurate with the current level of risk within each loan and lease category. The qualitative factor is increased or decreased for each loan and lease category based on management’s assessment of these qualitative factors: management’s ongoing review and grading of the loan and lease portfolios, changes in the size of the loan and lease portfolios, existing economic conditions, level of loans and leases subject to more frequent review by management, and other qualitative factors that could affect credit losses. The evaluation of these factors contributes significantly to the collectively evaluated for impairment component of the estimate for the allowance for loan and lease losses. We identified auditing the estimate of the aggregate effect of the qualitative factors as a critical audit matter as it involved especially subjective auditor judgment. Auditing management’s determination of qualitative factors involved especially subjective auditor judgment because management’s estimate relies on an inherently subjective analysis to determine the quantitative impact the factors have on the allowance. Management’s analysis of these factors requires significant judgment.
The primary procedures we performed to address this critical audit matter included:
Testing the effectiveness of controls over the evaluation of the items used to estimate the qualitative factors, including controls addressing:
•The reliability and relevancy of data used as the basis for the adjustments relating to qualitative factors;
•Management’s judgments related to the assessed level of risk and the qualitative factor used to adjust the average loss rates;
•The mathematical accuracy of the dollar amount applied to the qualitative factor; and
•Management’s review of trends and the movement within each qualitative factor and the overall allowance balance.
Substantively testing management’s process, including evaluating their judgments and assumptions, for developing the qualitative factors, which included:
•Evaluation of the reliability and relevancy of data used as a basis for the adjustments relating to qualitative factors;
•Evaluation of the reasonableness of management’s judgments related to the qualitative and quantitative assessment of the data used in the determination of qualitative factors and the resulting allocation to the allowance;
•Analytically evaluating the collectively evaluated for impairment component year over year;
•Verifying the mathematical accuracy of the adjustment factors for the qualitative component and the dollar amount of the reserve derived from the qualitative factor assessment;
•Tracing the allowance allocation from the qualitative factor analysis to the overall allowance calculation.
/s/Crowe LLP
We have served as the Company’s auditor since 2017, which is the year the engagement letter was signed for the audit of the 2018 financial statements.
Oak Brook, Illinois
February 23, 2022

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.

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ITEM 9A. CONTROLS AND PROCEDURES
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Corporation’s management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has evaluated the Corporation’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based upon that evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer have concluded that the Corporation’s disclosure controls and procedures were effective as of December 31, 2021.
Changes in Internal Control over Financial Reporting
There was no change in the Corporation’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities and Exchange Act of 1934, as amended) that occurred during the quarter ended December 31, 2021 that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
Management’s Annual Report on Internal Control over Financial Reporting
The Corporation’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Corporation’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Corporation’s financial statements for external purposes in accordance with generally accepted accounting principles.
Management, under the supervision of the Chief Executive Officer and the Chief Financial Officer, assessed the effectiveness of the Corporation’s internal control over financial reporting based on criteria for effective internal control over financial reporting established in Internal Control - Integrated Framework (2013), issued by the Committee of Sponsoring Organization of the Treadway Commission (COSO). Based on this assessment, management has determined that the Corporation’s internal control over financial reporting was effective as of December 31, 2021.
Crowe LLP, the independent registered public accounting firm that audited the Consolidated Financial Statements of the Corporation included in this Annual Report on Form 10-K, has issued an attestation report on the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2021. The report, which expresses an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2021, is included under the heading “Report of Independent Registered Public Accounting Firm.”

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ITEM 9B. OTHER INFORMATION
Item 9B. Other Information
None.

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ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Item 10. Directors, Executive Officers and Corporate Governance
(a)Directors of the Registrant. The information included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the caption “Item 1 - Election of Directors” is incorporated herein by reference.
(b)Executive Officers of the Registrant. The information presented in Item 1 of this document is incorporated herein by reference.
(c)Code of Ethics. The Corporation has adopted a code of ethics applicable to all employees, including the principal executive officer, principal financial officer and principal accounting officer of the Corporation. The FBFS Code of Ethics is posted on the Corporation’s website at ir.firstbusiness.bank/govdocs. The Corporation intends to satisfy the disclosure requirements under Item 5.05(c) of Form 8-K regarding any amendment to or waiver of the code with respect to its Chief Executive Officer, Chief Financial Officer, principal accounting officer, and persons performing similar functions, by posting such information to the Corporation’s website.
(d)Audit Committee. The information included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the caption “Item 1 - Election of Directors” is incorporated herein by reference.

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ITEM 11. EXECUTIVE COMPENSATION
Item 11. Executive Compensation
Information with respect to compensation for our directors and officers included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the captions “Executive Compensation”, “Director Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference.

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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
Information with respect to security ownership of certain beneficial owners and management included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the caption “Principal Shareholders” is incorporated herein by reference.
Equity Compensation Plan Information
The following table summarizes certain information with respect to compensation plans under which equity securities of the Corporation are authorized for issuance as of December 31, 2021.
Plan category Number of securities to be issued upon exercise of outstanding options, warrants, and rights Weighted-average exercise price of outstanding options, warrants, and rights Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
(a) (b) (c)
Equity compensation plans approved by security holders - - 219,837
Equity compensation plans not approved by security holders - - -

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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information with respect to certain relationships and related transactions included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the captions “Related Party Transactions” and “Item 1 - Election of Directors” is incorporated herein by reference.

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ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Item 14. Principal Accountant Fees and Services
Information with respect to principal accounting fees and services included in the definitive Proxy Statement for the Annual Meeting of the Shareholders to be held on April 29, 2022 under the caption “Miscellaneous” is incorporated herein by reference.
PART IV.

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ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Item 15. Exhibits and Financial Statement Schedules
The Consolidated Financial Statements listed on the Index included under “Item 8. Financial Statements and Supplementary Data” are filed as a part of this Form 10-K. All financial statement schedules have been included in the Consolidated Financial Statements or are either not applicable or not significant.
Exhibit Index
Exhibit No. Exhibit Name
3.1 Amended and Restated Articles of Incorporation of First Business Financial Services, Inc. (incorporated by reference to Exhibit 3.1 to the Annual Report on Form 10-K filed on March 10, 2017)
3.2 Amended and Restated Bylaws of First Business Financial Services, Inc. (incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K filed on October 31, 2018)
Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Registrant agrees to furnish to the Securities and Exchange Commission, upon request, any instrument defining the rights of holders of long-term debt not being registered that is not filed as an exhibit to this Annual Report on Form 10-K. No such instrument authorizes securities in excess of 10% of the total assets of the Registrant.
4.1 Form of Common Stock Certificate (incorporated by reference to Exhibit 4.3 to Amendment No. 1 to the Registration Statement on Form S-1 filed on November 26, 2012)
4.2 Description of Registrant’s Securities (filed herewith)
10.1*
2012 Equity Incentive Plan (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q filed on July 27, 2012)
10.2*
Form of Executive Change-in-Control and Severance Agreement (incorporated by reference to Exhibit 10.2 to the Annual Report on Form 10-K filed on February 24, 2021)
10.3*
Amended and Restated Agreement effective December 22, 2014 between First Business Bank and Corey A. Chambas (incorporated by reference to Exhibit 10.8 of the Registrant’s Annual Report on Form 10-K filed on March 16, 2015)
10.4*
First Amendment of Agreement by and between First Business Bank and Corey Chambas (Amended and Restated December 22, 2014) (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on December 29, 2016)
10.5*
Annual Cash Bonus Plan, effective January 1, 2019 (incorporated by reference to Exhibit 10.6 of the Registrant’s Annual Report on Form 10-K filed on February 28, 2019)
10.6*
First Business Financial Services, Inc. 2019 Equity Incentive Plan, as amended (incorporated by reference to Appendix A to the Definitive Proxy Statement filed on March 9, 2021)
10.7*
Form of Performance-Based Restricted Stock Unit Agreement (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.8*
Form of Restricted Stock Unit Agreement (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.9*
Form of Restricted Stock Agreement (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.10*
Form of Performance-Based Restricted Stock Unit Agreement - Retiree (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.11*
Form of Restricted Stock Unit Agreement - Retiree (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.12*
Form of Performance-Based Restricted Stock Unit Exchange Agreement - Retiree (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.13*
Form of Restricted Stock Unit Exchange Agreement - Retiree (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
10.14* Form of Restricted Stock Agreement - Director (incorporated by reference to the Quarterly Report on Form 10-Q filed on October 29, 2021)
21 Subsidiaries of the Registrant
23 Consent of Crowe LLP
31.1 Certification of the Chief Executive Officer
31.2 Certification of the Chief Financial Officer
32 Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350
101 The following financial information from First Business Financial Services, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2021, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of December 31, 2021 and December 31, 2020, (ii) Consolidated Statements of Income for the years ended December 31, 2021 and 2020, (iii) Consolidated Statements of Comprehensive Income for the years ended December 31, 2021 and 2020, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2021 and 2020, (v) Consolidated Statements of Cash Flows for the years ended December 31, 2021 and 2020, and (vi) the Notes to Consolidated Financial Statements
104 Cover page interactive data file (formatted as inline XBRL and contained in Exhibit 101)
* Management contract or compensatory plan.