EDGAR 10-K Filing

Company CIK: 1412707
Filing Year: 2022
Filename: 1412707_10-K_2022_0001412707-22-000013.json

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ITEM 1. BUSINESS
Item 1 - Business
Company Overview
Level One Bancorp, Inc. (the "Company," "Level One," "we," "our," or "us") is the bank holding company, registered under the Bank Holding Company Act of 1956, as amended ("BHCA"), for Level One Bank (the "Bank"), headquartered in Farmington Hills located in Oakland County, Michigan. The Company is a Michigan corporation incorporated in 2006 and a financial holding company. The Bank has grown rapidly since its founding in 2007 and is one of the largest locally-headquartered commercial banks in southeastern Michigan. This growth has been driven primarily by our entrepreneurial culture, our experienced management team and by the economic strength of our core market area in Oakland County, which, as of December 31, 2021, had the eighteenth highest median income in the United States of counties with over one million residents. As of December 31, 2021, we had $2.52 billion in assets, $1.65 billion in loans, $2.04 billion in deposits and total shareholders’ equity of $240.1 million. We generated net income of $32.5 million for the year ended December 31, 2021, or $3.95 per diluted common share, and $20.4 million for the year ended December 31, 2020, or $2.57 per diluted common share.
Since our formation 15 years ago, we have grown to 17 offices, including nine banking centers (our full-service branches) in Oakland County, one banking center in each of Detroit and Grand Rapids, Michigan’s two largest cities, one banking center in Sterling Heights, one banking center in Jackson, and three banking centers and a mortgage loan production office in Ann Arbor. In addition to our organic growth, we acquired Michigan Heritage Bank in 2009, Paramount Bank in 2010, Lotus Bank in 2015, and Bank of Michigan in 2016, which added to our commercial banking, retail banking and mortgage lending while expanding our product suite and staffing levels. We also acquired Ann Arbor State Bank as of January 2, 2020, which expanded our client base in Ann Arbor by adding two banking centers to our already established banking center and a mortgage production office, and another banking center in Jackson.
On November 4, 2021, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with First Merchants Corporation., an Indiana corporation (“First Merchants”). The Merger Agreement provides that, upon the terms and subject to the conditions set forth therein, we will merge with and into First Merchants (the “Merger”), with First Merchants as the surviving corporation in the Merger. Immediately following the Merger, the Bank will consolidate with and into First Merchant’s’ wholly owned bank subsidiary, First Merchants Bank, with First Merchants Bank as the surviving entity.
Upon the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger, each share of our common stock outstanding immediately prior to the effective time of the Merger will be converted into the right to receive (i) 0.7167 shares of First Merchants common stock and (ii) $10.17 in cash. Each share of our 7.50% Non-Cumulative Perpetual Preferred Stock, Series B (“Level One Preferred Stock”) outstanding immediately prior to the effective time of the Merger will be converted into the right to receive a share of a newly created series of preferred stock of First Merchants having voting powers, preferences and special rights that are substantially identical to the Level One Preferred Stock (“First Merchants Preferred Stock”). Each depositary share issued pursuant to the Deposit Agreement, dated as of August 13, 2020, among Level One, Continental Stock Transfer & Trust Company, as depositary, and the holders from time to time of the depositary receipts described therein, representing one-hundredth of one share of the Level One Preferred Stock, shall thereupon represent one-hundredth of one share of the First Merchants Preferred Stock.
Lending Activities
We offer a broad and growing set of lending products and related services, made up of commercial real estate loans, including construction and land development loans; commercial and industrial loans, including lines of credit, term loans, and loans under the Small Business Administration (SBA) lending program (including paycheck protection program ("PPP") loans); residential real estate loans; and consumer loans, including home equity loans, automobile loans and credit card services. We target our services to owner-managed businesses, professional firms, real estate professionals, not-for-profit businesses and consumers within our geographic markets who meet our underwriting standards.
Our commercial lending focuses primarily on originating commercial and industrial loans, owner occupied commercial real estate loans and, non-owner occupied commercial real estate loans in our primary market areas, which include Oakland County, the Detroit metropolitan area, the Grand Rapids metropolitan area, and the Ann Arbor metropolitan area. We have lenders dedicated to targeting mid-sized businesses with between $5.0 million and $50.0 million of annual revenue, but we also target small businesses with annual revenue of less than $5.0 million.
Commercial Loans. The commercial loans offered by the Bank include (i) commercial mortgages, (ii) commercial and industrial loans consisting of operating lines of credit, term loans, SBA-guaranteed loans (including PPP loans) and loans guaranteed by other loan programs such as the Michigan Economic Development Corporation (MEDC) collateral support program and, in the past, the U.S. Department of Agriculture (USDA) Business and Industry program; and (iii) commercial real estate construction and land development loans. Targeted customer groups include small and mid-sized business owners and operators. Another target group is professionals who are likely to build and occupy facilities at their principal employment locations.
The Bank’s commercial mortgages are used to provide construction and permanent financing for owner-occupied, retail and office buildings, and multi-family buildings. Commercial real estate secured loans are generally written on a five-year term, with amortizing periods ranging up to twenty years. Interest rates may be fixed for three to seven years, or adjustable. The Bank generally charges an origination fee for its services. We generally require personal guarantees from the principal owners of the property supported by a review of the principal owners’ personal financial statements. We attempt to limit our risk by analyzing the borrowers’ cash flow and collateral value on an ongoing basis and by an annual review of rent rolls and financial statements. The conventional loan-to-value ratio as established by an independent appraisal typically will not exceed 80% for these loans. Owner-occupied commercial real estate loans were $283.4 million, or 17.1% of the Company’s loan portfolio, and non-owner occupied commercial real estate/multi-family loans were $467.4 million, or 28.3% of the Company’s loan portfolio, as of December 31, 2021.
Commercial and industrial loans are generally made to small to mid-sized businesses for business purposes and are supported by the cash flow of the underlying business as well as collateral of accounts receivable, inventory and/or equipment and personal guaranties from the business owners. SBA, MEDC, and USDA lending programs are utilized to enhance the credit quality of loans that already meet the requirements of the Company’s rigorous credit underwriting policies and procedures. These programs have a further benefit to the Company in terms of liquidity and potential fee income, since there is an active secondary market that will purchase the guaranteed portion of these loans at a premium. Our operating lines of credit typically are limited to a percentage of the value of the assets securing the line. Lines of credit and term loans typically are reviewed annually. Commercial and industrial loans are primarily underwritten on the basis of the borrower’s ability to service the loan from operating income. The terms of these loans vary by purpose and by type of underlying collateral. We typically make equipment loans for a term of five years or less at fixed or adjustable rates, with the loan fully amortized over the term. Loans to support working capital typically have terms not exceeding one year and are usually secured by accounts receivable, inventory and personal guarantees of the principals of the business. The interest rates charged on loans vary with the degree of risk and loan amount and are further subject to competitive pressures, money market rates, the availability of funds and government regulations. For loans secured by accounts receivable and inventory, principal is typically repaid as the assets securing the loan are converted into cash (monitored on a monthly, quarterly or more frequent basis as determined necessary in the underwriting process), and for loans secured with other types of collateral, principal is typically due at maturity. As of December 31, 2021,
commercial and industrial loans (including PPP loans) totaled approximately $460.5 million, or 27.9% of the Company’s loan portfolio.
Construction loans include commercial projects (such as multi-family housing, industrial, office and retail centers). Permanent financing is typically offered for commercial properties under construction. These loans typically have a term of less than 18 months, floating interest rates and commitment fees. Construction loans for investment real estate are made to developers who have an established record of successful project completion and loan repayment. Loan repayment for owner occupied transactions is generally from permanent financing with either the Bank or a qualified mortgage lender. The conventional loan-to-value ratio as established by independent appraisal typically is limited to 80% or less for owner occupied and 75% or less for non-owner occupied real estate. Loan proceeds are disbursed based on the percentage of completion and only after an experienced construction lender or third-party inspector has inspected the project, with construction monitoring handled by the Bank’s Credit Administration department, which ensures title policies are updated for each construction draw. At December 31, 2021, we had in $76.4 million construction loans outstanding, representing 4.6% of the Company’s loan portfolio, with $71.3 million in undisbursed commitments.
Residential Real Estate. We originate both fixed-rate loans and adjustable-rate loans in our residential lending program. Generally, these loans are originated to meet the requirements of the Federal National Mortgage Association ("Fannie Mae"), the Federal Home Loan Mortgage Corporation ("Freddie Mac"), Federal Housing Administration ("FHA"), Veterans Affairs ("VA") and jumbo loans for sale in the secondary market to investors. We typically sell our long term fixed rate and retain our adjustable loan originations. We generally underwrite our one- to four-family loans based on the applicant’s employment, debt to income levels, credit history and the appraised value of the subject property. Generally, we lend up to 80% of the lesser of the appraised value or purchase price for one- to four-family conforming residential loans. In situations where we grant a residential first mortgage loan with a loan-to-value ratio in excess of 80%, we generally require private mortgage insurance in order to reduce our exposure to 80% or less. Properties securing our one- to four-family loans are generally appraised by independent appraisers selected by our appraisal management companies conforming with appraisal independent compliance guidelines. We require our borrowers to obtain title and hazard insurance, and flood insurance, if necessary, in an amount equal to the regulatory maximum. Fixed rate loans generally are offered on a fully amortizing basis for terms ranging from 10 to 30 years at interest rates and fees that reflect current secondary market pricing. Most adjustable rate mortgage (ARM) products offered adjust annually after an initial period ranging from one to ten years, subject to a limitation on the annual change of 1.0% to 2.0% and a lifetime limitation of 5.0% to 6.0%. Beginning in 2021, these ARM products most frequently adjust based upon the 30-day average yield of the SOFR index adjusted to a constant maturity of six months plus a margin or spread above the index. Generally, ARM loans held in our portfolio do not allow for interest-only payments nor negative amortization of principal and carry allowable prepayment restrictions. The Bank also makes a limited amount of loans secured by second mortgages on residential real estate. Second residential mortgages may have a loan to value of up 80% when combined with the first mortgage; however exceptions can be made based on credit capacity, collateral and the banking relationship. Also included in residential real estate loans are home equity lines of credit. Home equity lines of credit generally have a loan to value ratio of up to 90% at the time of origination when combined with the first mortgage. In 2020, the Bank temporarily restricted the loan to value ratio to 80% at the time of origination when combined with a first mortgage due to the uncertainty related to COVID-19. The majority of these loans are secured by a first or second mortgage on residential property. Home equity lines of credit allow for a 10-year draw period, followed by a 10-year repayment period, and the interest rate is generally tied to the prime rate as published by the Wall Street Journal and may include a margin. As of December 31, 2021, residential loans totaled approximately $440.6 million, or 26.7% of the Company’s loan portfolio, of which $35.2 million were home equity lines of credit.
Consumer Loans. Consumer loans offered by the Bank include personal installment and auto loans and credit cards through a third-party provider. Personal lines of credit generally have maturities from one to five years and variable interest rates. Personal unsecured loans are available to creditworthy bank customers with limits determined on a loan by loan basis. Credit reports and industry standard debt-to-income ratios or less are used to qualify borrowers. As of December 31, 2021, consumer loans totaled approximately $837 thousand, or 0.1% of the Company’s loan portfolio.
Loan Policy and Approval. Loan authority is delegated by the Directors Loan Committee. The Bank does not provide loan authority to any one individual, but takes a risk management approach based on aggregate credit exposure and risk grading. Aggregate exposure less than $2.0 million requires multi-signature approval. The Management Loan Committee has approval authority up to $6.0 million. All other loans require approval by the Directors Loan Committee. Each loan request requires some level of credit approval. Under applicable federal and state law, the Bank’s permissible loans to one borrower are limited to $65.1 million in the aggregate as of December 31, 2021, subject to two-thirds board approval.
Deposit Services. The Bank offers a full range of deposit services insured by the Federal Deposit Insurance Corporation (FDIC), including (i) commercial checking and small business checking products, (ii) retirement accounts such as Individual Retirement Accounts (IRAs), and (iii) retail deposit services such as certificates of deposits, money market accounts, savings
accounts, checking account products and Automated Teller Machines (ATMs). The Bank also offers debit cards and internet banking as well commercial depository (treasury management) services.
The Bank’s business strategy concentrates heavily on the generation of “core” deposits, which are generally defined as demand deposit accounts, money market accounts, negotiable order of withdrawal (NOW) accounts, and time deposit accounts of less than $250 thousand. The Bank focuses its deposit efforts on cash rich businesses such as insurance companies, insurance agents, trade associations, title and escrow companies, real estate offices, churches and professionals such as physicians, attorneys and other services providers. The Bank has implemented deposit gathering strategies and tactics to attract and retain deposits utilizing technology to deliver treasury management services (e.g. remote deposit capture, lock box, and electronic bill payments) in addition to the traditional generation of deposit relationships in conjunction with its lending activities.
As of December 31, 2021, the Bank had $23.1 million of brokered deposits and deposits obtained through the use of internet listing services (approximately 1.1% of total deposits).
In addition, we generate fee income through our money services business clients (MSB), which provide cash management services for small, locally-owned cash intensive businesses. We intend to continue to grow this line of business, which we acquired in 2016 through our Bank of Michigan acquisition.
Competition
The financial services industry is highly competitive as we compete for loans, deposits and customer relationships in our market. Competition involves efforts to retain current clients, make new loans and obtain new deposits, increase the scope and sophistication of services offered and offer competitive interest rates paid on deposits and charged on loans. Within our branch footprint, we primarily face competition from national, regional and other local financial institutions that have established branch networks throughout our market areas, giving them visible retail presence to customers.
In mortgage banking, we face competition from a wide range of national financial institutions, regional and local community banks, as well as credit unions and national mortgage companies. In commercial banking, we face competition to underwrite loans to sound, stable businesses and real estate projects at competitive price levels that make sense for our business and risk profile. Our major commercial bank competitors include larger national, regional and local financial institutions that may have the ability to make loans on larger projects than we can or provide a larger mix of product offerings. We also compete with smaller local financial institutions that may have aggressive pricing and unique terms on various types of loans and, increasingly, financial technology platforms that offer their products exclusively through web-based portals.
In retail banking, we primarily compete with national, regional, and local banks that have visible retail presence and personnel in our market areas. The primary factors driving competition in consumer banking are customer service, interest rates, fees charged, branch locations and hours of operation and the range of products offered. We compete for deposits by advertising, offering competitive interest rates and seeking to provide a higher level of personal service. We also face competition from non-traditional alternatives to banks such as credit unions, money centers, money market mutual funds and cash management accounts.
We believe our ability to provide a flexible, sophisticated product offering and an efficient process to our customers allows us to stay competitive in the financial services environment. We believe our local presence and hands-on approach enables us to provide a high level of service that our customers value.
Our Market Areas
We believe the demographics of our market areas provide strong growth opportunities for our loan portfolio and deposits. The following chart, which is based on data from S&P Global Market Intelligence, shows our share of the deposits in our market areas as of June 30, 2021, which is the most recent data available.
Deposits Level One
(Dollars in millions) in Market Deposits Market Share
Market Area by County
Oakland County $ 82,923.0 $ 1,609.0 1.94 %
Washtenaw County 12,654.5 276.4 2.18
Wayne County 90,258.1 77.4 0.09
Macomb County 20,970.0 43.1 0.21
Kent County 22,909.4 29.4 0.13
Jackson County 2,808.0 23.0 0.82
Human Capital Resources
Level One’s community banking strategy relies heavily on the personal relationships and the quality of service provided by team members. Accordingly, Level One aims to attract, develop and retain team members who can drive financial and strategic growth objectives and build long-term shareholder value. Key items related to Level One’s human capital resources are described below.
Structure. As of December 31, 2021, Level One had 291 full-time equivalent team members, primarily located in Michigan. Level One’s Chief Human Resources Officer reports directly to the Chairman and CEO and manages all aspects of the team member experience, including talent acquisition, education and development, talent management, and compensation and benefits. None of Level One's team members are a party to a collective bargaining agreement. We consider Level One's relationship with its team members to be strong.
The Board of Directors and the Compensation Committee are updated on Level One’s talent development and human capital management strategies, with a focus on providing competitive compensation and benefit plans. Additionally, in 2021, the Board of Directors selected a new President of Level One Bank after a rigorous selection process facilitated by Kaplan Partners, an outside firm specializing in talent selection. A special committee of the Board was formed to evaluate two internal candidates, one of which was selected into the position. Selecting an internal candidate for the important position of President is evidence that Level One has invested in talent development.
Productivity. Level One carefully manages the size of its workforce and reallocates resources as needed. As of December 31, 2021, Level One’s total headcount was 11% higher than the preceding year-end due to the growth of Level One's mortgage division and acquisition of high performing mortgage professionals. Level One team members continued to produce record high mortgage volumes in 2021.
Diversity. Level One is committed to providing a safe and engaging environment for all team members. Level One has been recognized for nine years in a row as one of Metro Detroit's Best and Brightest Companies to Work for by MichBusiness. Level One believes this was driven largely by the commitment of its diverse talent who have ready access to decision makers. Level One believes that it meets all the requirements for a diverse workforce as evidenced by a strong Affirmative Action Plan and its retention of diverse talent.
Compensation and Benefits. Level One strives to provide pay, benefits, and services that help meet the varying needs of its team members. Compensation and benefits include market-competitive pay, retirement programs, broad-based bonuses, health and welfare benefits, financial counseling, paid time off, family leave and flexible work schedules. Level One periodically reviews compensation and benefits by grade level and position to ensure similar positions are paid comparatively and to ensure that Level One has a competitive and valuable offering to meet the well-being and needs of its team members.
Development and Retention. Level One measures the success of its talent acquisition strategy on speed and quality of acquisition, retention, and overall performance metrics. Sourcing strategies are reviewed to ensure that the best talent is attracted to Level One.
Level One has also created internal programs to support the development and retention of its team members, including an internal leadership development program designed to train emerging leaders, enhanced training for retail bank team members, and personality-type training for all team members to better understand themselves and others. Level One’s executives and managers participated in a conflict management course (Crucial Conversations) in 2021 as well as a course to enhance a leader’s ability to understand others (Emotional Intelligence). Additionally, specially focused development plans were created for high potential and key talent to ensure learning through a variety of experiences. Level One also supports its team members’ involvement in external development programs. For example, each year, women are sponsored to attend the MBA Women’s Forum and others are supported through attendance in webinars and conferences. A special accelerated program for emerging
leaders was provided to eight new managers in 2021, facilitated by ICC (Innovate. Coach. Consult). The program was well received by participants and their managers.
Team member turnover for 2021 was 16.7%. Like many other companies, Level One Bank experienced elements of the Great Resignation as the labor market was rich with opportunities. While Level One’s turnover was higher than in the past, it was not considered to threaten Level One’s ability to meet customer needs in a safe and sound manner.
Culture and Core Values. Level One leadership believes the foundation of its culture is built on six core values: Passion, Relationship Focused, Humble Yet Confident, Hardest Job You’ll Ever Love, Do What’s Best, and Results Matter. These core values are embedded in all team members’ performance reviews and talent discussions and are present in all interviews, selection decisions and promotions. The energy and dedication to Level One’s entrepreneurial spirit are driven by these core values and are evidenced by positive engagement survey results.
Corporate Information
Our principal executive office is located at 32991 Hamilton Court, Farmington Hills, Michigan, and our telephone number is (248) 737-0300. Our website address is www.levelonebank.com. Through our website, under “Investor Relations - Financials,” we make available, free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (the “SEC”). The contents of our website are not incorporated by reference into this report.
Supervision and Regulation
General
FDIC-insured institutions, 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 the Michigan Department of Insurance and Financial Services (the “DIFS”), the FDIC, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), and the Consumer Financial Protection Bureau (the “CFPB”). Furthermore, taxation laws administered by the Internal Revenue Service and state taxing authorities, accounting rules developed by the 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 Company and the Bank may make, 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 Company’s and the Bank’s insiders and affiliates and our payment of dividends. In reaction to the global financial crisis and particularly following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “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. Then, in May 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (“Regulatory Relief Act”) was enacted by Congress in part to provide regulatory relief for community banks and their holding companies. To that end, the law eliminated questions about the applicability of certain Dodd-Frank Act reforms to community bank systems, including relieving us of any requirement to engage in mandatory stress tests, maintain a risk committee or comply with the Volcker Rule’s complicated prohibitions on proprietary trading and ownership of private funds. We believe these reforms are favorable to our 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 that 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, 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 Company and the Bank, beginning with a discussion of the impact of the COVID-19 pandemic on the banking industry. 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.
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”. The capital guidelines for U.S. banks beginning in 1989 have been based upon international capital accords (known as “Basel” rules) adopted by the 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 accords recognized that bank assets for the purpose of the capital ratio calculations needed to be risk weighted (the theory being that riskier assets should require more capital) and that off-balance sheet exposures needed to be factored in the calculations. Following the global financial crisis, 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.
The Basel III Rule. 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 binding regulations by each of the regulatory agencies. The Basel III Rule increased the required quantity and quality of capital and required more detailed categories of risk weighting of riskier, more opaque assets. For nearly every class of assets, the Basel III Rule requires a more complex, detailed and calibrated assessment of risk in the calculation of risk weightings. 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” (generally certain holding companies with consolidated assets of less than $3 billion, like the Company) and certain qualifying banking organizations that may elect a simplified framework (which we have not done). Thus, the Bank is currently subject to the Basel III Rule as described below.
Not only did the Basel III Rule increase most of the required minimum capital ratios in effect prior to January 1, 2015, but, in requiring that forms of capital be of higher quality to absorb loss, 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). The Basel III Rule also constrained the inclusion of minority interests, mortgage-servicing assets, and deferred tax assets in capital and required deductions from Common Equity Tier 1 Capital in the event that such assets exceeded a 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;
•A ratio of minimum Tier 1 Capital equal 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. 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. The federal bank regulators released a joint statement in response to the COVID-19 pandemic reminding the industry that capital and liquidity buffers were meant to give banks the means to support the economy in adverse situations, and that the agencies would support banks that use the buffers for that purpose if undertaken in a safe and sound manner.
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 Federal Reserve for the Company and the FDIC for the Bank, in order to be well-capitalized, we 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;
•A ratio of Total Capital to total risk-weighted assets of 10% or more; and
•A leverage ratio of Tier 1 Capital to total adjusted average quarterly assets of 5% or greater.
It is possible under the Basel III Rule to be well-capitalized while remaining out of compliance with the capital conservation buffer discussed above.
As of December 31, 2021: (i) the Bank was not subject to a directive from DIFS or FDIC to increase its capital and (ii) the Bank was well-capitalized, as defined by FDIC regulations. As of December 31, 2021, the Company had regulatory capital in excess of the Federal Reserve’s requirements and met the Basel III Rule requirements to be well-capitalized. We are also in compliance with the capital conservation buffer.
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 an “off-ramp” for institutions, like us, with total consolidated assets of less than $10 billion. Section 201 of the Regulatory Relief Act instructed the federal banking regulators to establish a single “Community Bank Leverage Ratio” (“CBLR”) of between 8 and 10%. Under the final rule, a community banking organization is eligible to elect the new framework if it has: less than $10 billion in total consolidated assets, limited amounts of certain assets and off-balance sheet exposures, and a CBLR greater than 9%. The bank regulatory agencies temporarily lowered the CBLR to 8% as a result of the COVID-19 pandemic. We may elect the CBLR framework at any time but have not currently determined to do so.
Regulation and Supervision of the Company
General. As the sole shareholder of the Bank, we are a bank holding company. As a bank holding company, we are registered with, and is subject to regulation supervision and enforcement by, the Federal Reserve under the 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 us and our subsidiaries as the Federal Reserve may require.
Acquisitions, Activities and Financial Holding Company Election. 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 have 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 us 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 us 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 nonbank 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 nonbanking 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. We have elected to operate as a financial holding company. In order to maintain our status as a financial holding company, the Company and the Bank must be well-capitalized, well-managed, and the Bank must have a least a satisfactory Community Reinvestment Act ("CRA") rating. If the Federal Reserve determines that either the Company or the Bank is not well-capitalized or well-managed, the Federal Reserve will provide a period of time in which to achieve compliance, but during the period of noncompliance, the Federal Reserve may place any additional limitations on us that it deems appropriate. Furthermore, if non-compliance is based on the failure of the Bank to achieve a satisfactory CRA rating, we would not be able to commence any new financial activities or acquire a company that engages in such activities.
Change in Control. Federal law 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.
Capital Requirements. As of the date of this filing, the Federal Reserve has not requested that the Company report consolidated regulatory capital, recognizing the exemption under the Federal Reserve’s Small Bank Holding Company Policy Statement applicable to holding companies with less than $3 billion in total assets (as long as they do not: engage in significant nonbanking activities, conduct significant off-balance sheet activities or have a material amount of debt or equity securities registered with the SEC). Unless the Federal Reserve determines otherwise, we are considered well-capitalized, as long as the Bank is well-capitalized. 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 Michigan corporation, we are subject to the Michigan Business Corporation Act, as amended, which prohibits us from paying a dividend if, after giving effect to the dividend we would not be able to pay our debts as the debts become due in the usual course of business, or our total assets would be less than the sum of its total liabilities plus, the amount that would be needed, if we were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those 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. These factors have come into consideration in the industry as a result of the COVID-19 pandemic. The Federal Reserve also possesses enforcement powers over bank holding companies and their nonbank 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.
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, and this is evidenced in its reaction to the COVID-19 pandemic. Among the tools available to the Federal Reserve to affect the money supply are open market transactions in U.S. government securities and changes in the discount rate on bank borrowings. 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. Our 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 will 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 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.
Supervision and Regulation of the Bank
General. The Bank is a Michigan-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 Michigan-chartered FDIC-insured bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the DIFS, the chartering authority for Michigan 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.
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 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. The reserve ratio reached 1.36% as of September 30, 2018, exceeding the statutory required minimum. As a result, the FDIC provided assessment credits 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 applied the small bank credits for quarterly assessment periods beginning July 1, 2019. However, the reserve ratio then fell to 1.30% in 2020 as a result of extraordinary insured deposit growth caused by an unprecedented inflow of more than $1 trillion in estimated insured deposits in the first half of 2020, stemming mainly from the COVID-19 pandemic. Although the FDIC could have ceased the small bank credits, it waived the requirement that the reserve ratio be at least 1.35% for full remittance of the remaining assessment credits, and it refunded all small bank credits as of September 30, 2020.
Supervisory Assessments. All Michigan-chartered banks are required to pay supervisory assessments to the DIFS to fund the operations of that agency. The amount of the assessment is calculated on the basis of the Bank’s total assets. During the year ended December 31, 2021, the Bank paid supervisory assessments to the DIFS totaling approximately $243 thousand.
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).
In addition to liquidity guidelines already in place, the federal bank regulatory agencies implemented the Basel III LCR in September 2014, which requires large financial firms to hold levels of liquid assets sufficient to protect against constraints on their funding during times of financial turmoil, and in 2016 proposed implementation of the NSFR. While these rules do not, and will not, apply to the Bank, it continues to review its liquidity risk management policies in light of developments.
Dividend Payments. The primary source of funds for the Company is dividends from the Bank. Under the Michigan Banking Code, the Bank cannot declare or pay a cash dividend or dividend in kind unless it will have a surplus amounting to not less than 20% of its capital after payment of the dividend. In addition, the Bank may pay dividends only out of net income then on hand, after deducting its bad debts. Further, the Bank may not declare or pay a dividend until cumulative dividends on preferred stock, if any, are paid in full.
The payment of dividends by any FDIC-insured institution is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a FDIC-insured institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its capital requirements under applicable guidelines as of December 31, 2021. Notwithstanding the availability of funds for dividends, however, the FDIC and the DIFS 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 have to maintain 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 Michigan 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 Company, investments in the stock or other securities of the Company and the acceptance of the stock or other securities of the Company 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 Company and our subsidiaries, to our principal shareholders 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 Company or the Bank, or a principal shareholder of the Company, 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, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, 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 decade, 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, legal and reputational risk. The federal bank regulators have identified key risk themes for 2021 as: credit risk management given projected weaker economic conditions and commercial and residential real estate concentration risk management. The agencies will also be monitoring banks for their transition away from LIBOR as a reference rate, compliance risk management related to COVID-19 pandemic-related activities, Bank Secrecy Act/anti-money laundering compliance, cybersecurity, planning for and implementation of the Current Expected Credit Loss (CECL) accounting standard, and CRA performance. 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.
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 confidential information of their customers. These laws require the Bank to periodically disclose its 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 customers with marketing offers. In addition, as a part of its operational risk mitigation, 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 and to require the same of its service providers. These security and privacy policies and procedures are in effect across all business lines and geographic locations.
Branching Authority. Michigan banks, such as the Bank, have the authority under Michigan law to establish branches anywhere in the State of Michigan, 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 de novo interstate branches 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. Federal law requires FDIC-insured institutions to maintain reserves against their transaction accounts (primarily NOW and regular checking accounts) to provide liquidity. Reserves are maintained on deposit at the Federal Reserve Banks. The reserve requirements are subject to annual adjustment by the Federal Reserve, and, for 2020, the Federal Reserve had determined that the first $16.9 million of otherwise reservable balances had a zero percent reserve requirement; for transaction accounts aggregating between $16.9 million to $127.5 million, the reserve requirement was 3% of those transaction account balances; and for net transaction accounts in excess of $127.5 million, the reserve requirement was 10% of the aggregate amount of total transaction account balances in excess of $127.5 million. However, in March 2020, in an unprecedented move, the Federal Reserve announced that the banking system had ample reserves, and, as reserve requirements no longer played a significant role in this regime, it reduced all reserve tranches to zero percent, thereby freeing banks from the reserve maintenance requirement. The action permits the Bank to loan or invest funds that were previously unavailable. The Federal Reserve has indicated that it expects to continue to operate in an ample reserves regime for the foreseeable future.
Community Reinvestment Act 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. Applications for additional acquisitions would be affected by the evaluation of the Bank’s effectiveness in meeting its CRA requirements.
Anti-Money Laundering. The USA PATRIOT Act is designed to deny terrorists and criminals the ability to obtain access to the U.S. financial system and has significant implications for FDIC-insured institutions, brokers, dealers and other businesses involved in the transfer of money. The USA PATRIOT Act, along with other legal authority, mandates financial services companies to have policies and procedures with respect to measures designed to address any or all of the following matters: (i) customer identification programs; (ii) money laundering; (iii) terrorist financing; (iv) identifying and reporting suspicious
activities and currency transactions; (v) currency crimes; and (vi) cooperation between FDIC-insured institutions and law enforcement authorities.
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.
As of December 31, 2021, the Bank did not exceed these guidelines.
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 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 CFPB has from time to time released additional rules as to qualified mortgages and the borrower’s ability to repay, most recently in October of 2020.
The CFPB’s rules have not had a significant impact on the Bank’s operations, except for higher compliance costs.

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ITEM 1A. RISK FACTORS
Item 1A - Risk Factors
The material risks that management believes affect the Company are described below. You should carefully consider the risks, together with all of the other information included herein. The risks described below are not the only risks the Company faces. Additional risks not presently known or that the Company believes are immaterial also may have a material adverse effect on the Company’s results of operations and financial condition.
Risks Related to Our Pending Merger Transaction
Failure to complete our proposed Merger with First Merchants could negatively impact our business, financial results and stock price.
If the Merger is not completed for any reason, our ongoing business may be adversely affected, and, without realizing any of the benefits of having completed the Merger, we will be subject to a number of risks, including the following:
•we may experience negative reactions from the financial markets, including negative impacts on our stock price;
•the market price of our common stock could decline to the extent that the current market prices reflect a market assumption that the Merger will be completed;
•we may experience negative reactions from our customers, vendors and team members;
•we will have incurred substantial expenses and will be required to pay certain costs relating to the Merger, whether or not the Merger is completed, such as legal, accounting, investment banking and advisory and printing fees;
•the Merger Agreement places certain restrictions on the conduct of our business prior to completion of the Merger, such restrictions, the waiver of which is subject to the consent of First Merchants, may adversely affect our ability to execute certain of our business strategies; and
•matters relating to the Merger may require substantial commitments of time and resources by our management (including integration planning), which could otherwise have been devoted to other opportunities that may have been beneficial to us, as an independent company.
In addition to the above risks, if the Merger Agreement is terminated and our board of directors seeks another merger or business combination, the market price of our common stock could decline, which could make it more difficult to find a party willing to offer equivalent or more attractive consideration than the consideration First Merchants has agreed to provide. If the Merger Agreement is terminated under certain circumstances, we may be required to pay a termination fee of $11.13 million to First Merchants, which may adversely affect the price of our common stock. Any of the above risks could materially affect our business, financial results and stock price.
We face risks and uncertainties related to our proposed Merger with First Merchants.
Uncertainty about the effect of the Merger on our team members and customers may have an adverse effect on us. These uncertainties may impair our ability to attract, retain and motivate key personnel until the Merger is consummated and for a period of time thereafter, and could cause customers and others that deal with us to seek to change their existing business relationships with us. Team member retention may be particularly challenging during the pendency of the Merger, as team members may experience uncertainty about their roles with the surviving corporation following the Merger.
In addition, the Merger Agreement contains provisions that restrict our ability to, among other things, solicit, knowingly encourage or facilitate inquiries or proposals or enter into any agreement with respect to, or initiate or participate in any negotiations or discussions with any person concerning any alternative business combination proposals, subject to certain exceptions generally related to our board of directors’ exercise of its fiduciary duties. These provisions, which include a $11.13 million termination fee payable under certain circumstances, might discourage a potential competing acquirer that might have an interest in engaging in a superior transaction from considering or proposing that acquisition, or might result in lower value received by our shareholders than would have otherwise been received.
The Company and First Merchants have operated and, until the completion of the Merger, will continue to operate, independently. The success of the Merger, including anticipated benefits and cost savings among other things, will depend, in part, on our and First Merchants’ ability to successfully combine and integrate our and First Merchants’ businesses in a manner that facilitates growth opportunities and realizes cost savings. It is possible that the integration process could result in the loss of key employees, the loss of customers, the disruption of either company’s or both companies’ ongoing business, inconsistencies in standards, controls, procedures and policies, unexpected integration issues, higher than expected integration costs and an overall post-completion integration process that takes longer than originally anticipated. If the combined companies experience difficulties with the integration process, the anticipated benefits of the Merger may not be realized fully or at all, or may take longer to realize than expected.
The Merger Agreement may be terminated in accordance with its terms and the Merger may not be completed.
The Merger Agreement is subject to a number of conditions which must be fulfilled in order to complete the Merger. Those conditions include: the approval of the Merger by our shareholders; the effectiveness of the registration statement on Form S-4 for the shares of First Merchants common stock and preferred stock (or depositary shares in respect thereof) to be issued in the Merger; the receipt of authorization for listing on Nasdaq of the shares of First Merchants common stock and preferred stock (or depositary shares in respect thereof) to be issued in the Merger; the receipt of all required regulatory approvals; the absence of any order, decree or injunction enjoining or prohibiting the Merger; the receipt of a fairness opinion by the Company’s financial advisor; subject to certain exceptions, the accuracy of representations and warranties under the Merger Agreement; our and First Merchants’ performance of our and their respective obligations under the Merger Agreement in all material respects; and each of our and First Merchants’ receipt of a tax opinion to the effect that the Merger will be treated as a “reorganization” within the meaning of Section 368(a) of the Internal Revenue Code of 1986, as amended. These conditions to the closing of the Merger may not be fulfilled in a timely manner or at all, and, accordingly, the Merger may be delayed or may not be completed.
We and First Merchants may elect to terminate the Merger Agreement under certain circumstances. Among other situations, if the Merger is not completed by July 31, 2022 (or if the sole impediment to closing is the lack of regulatory approval, September 30, 2022), either we or First Merchants may choose not to proceed with the Merger, subject to certain exceptions. We and First Merchants can also mutually decide to terminate the Merger Agreement at any time. If the Merger Agreement is terminated, under certain limited circumstances, we may be required to pay a termination fee of $11.13 million to First Merchants, or First Merchants may be required to pay a termination fee of $10.0 million to us.
Our ability to complete the Merger is subject to the receipt of approval from various regulatory agencies, which may impose conditions that could adversely affect us or cause the Merger to be abandoned.
Before the transactions contemplated in the Merger Agreement can be completed, the Company and First Merchants must obtain various regulatory approvals. The terms and conditions of the approvals that are granted may impose conditions, limitations, obligations or costs, or place restrictions on the conduct of the combined company’s business or require changes to the terms of the transactions contemplated by the Merger Agreement. Although the Company and First Merchants do not currently expect that any such conditions or changes would be imposed, there can be no assurance that the regulators will not impose any such conditions, obligations or restrictions, and that such conditions, limitations, obligations or restrictions will not have the effect of delaying or preventing completion of any of the transactions contemplated by the Merger Agreement, imposing additional material costs on or materially limiting the revenues of the combined company following the Merger or otherwise reduce the anticipated benefits of the Merger if the Merger were consummated successfully within the expected timeframe, any of which might have an adverse effect on the combined company following the Merger.
Because the market price of First Merchants common stock may fluctuate, our shareholders cannot be certain of the precise value of the Merger consideration they may receive in the Merger.
At the time the Merger is completed, each issued and outstanding share of our common stock will be converted into the right to receive 0.7167 of a share of First Merchants common stock and $10.17 in cash.
The market value of First Merchants common stock may fluctuate prior to closing of the Merger as a result of a variety of factors, including general market and economic conditions, changes in First Merchants’ businesses, operations and prospects, and regulatory considerations. Many of these factors are outside of our and First Merchants’ control. Consequently, your shareholders will not know the actual market value of the shares of First Merchants common stock that they will receive when the Merger is completed. The actual value of the shares of First Merchants common stock received by our shareholders will depend on the market value of shares of First Merchants common stock at the time the Merger is completed. This market value may be less or more than the value used to determine the exchange ratio stated in the Merger Agreement.
Shareholder litigation could prevent or delay the closing of the proposed Merger or otherwise negatively impact our business and operations.
In connection with the Merger, lawsuits have and may in the future be filed against us, First Merchants, or the directors and officers of either company in connection with the Merger. Litigation filed against us, our board of directors or First Merchants and its board of directors could prevent or delay the completion of the Merger or result in the payment of damages following completion of the Merger. The defense or settlement of any lawsuit or claim that remains unresolved at the effective time of the Merger may adversely affect the combined company’s business, financial condition, results of operations, cash flows and market price.
COVID-19 Risks
The outbreak of COVID-19 and related developments have led to an economic recession, increased inflation, disruptions in labor markets and had other severe effects on the U.S. economy. The pandemic has also adversely impacted certain industries in which our clients operate and impaired their ability to fulfill their financial obligations to us. The ultimate impact of the COVID-19 pandemic on our business remains uncertain but may have a material and adverse effect on our business, financial condition, results of operations and growth prospects.
The COVID-19 pandemic continues to negatively impact the United States and the world. The spread of COVID-19 has negatively impacted the U.S. economy at large, and small businesses in particular, and has disrupted our operations. The pandemic and responses on the part of the U.S. and local governments and populations have inhibited growth in economic activity and resulted in increased inflation, labor market and supply chain disruptions, a rising interest rate environment, and had other severe effects on the U.S. economy. We expect increased interest rates will adversely affect mortgage originations and mortgage banking revenue in future periods. The ultimate impact of the COVID-19 pandemic on our business remains uncertain but may have a material and adverse effect on our business, financial condition, results of operations and growth prospects.
The outbreak of COVID-19 has resulted in a decline in the businesses of certain of our clients, a decrease in consumer confidence and a disruption in the services provided by our vendors. Continued disruptions to our clients’ businesses could result in increased risk of delinquencies, defaults, foreclosures, and losses on our loans and could harm local loan demand, liquidity of loan guarantors, the value of loan collateral (particularly in real estate), and deposit availability and negatively impact the implementation of our growth strategy. Although the U.S. government introduced a number of programs designed to soften the impact of COVID-19 on small businesses, our borrowers may still not be able to satisfy their financial obligations to us.
In addition, COVID-19 has impacted and likely will continue to impact the financial ability of businesses and consumers to borrow money, which would negatively impact loan volumes. Certain of our borrowers are in, or have exposure to, the restaurant and hospitality industries and are located in areas that are, or were, quarantined or under stay-at-home orders. COVID-19 may also have an adverse effect on our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, and our consumer loan portfolios.
The ultimate extent of the COVID-19 pandemic’s effect on our business will depend on many factors, primarily including the speed and extent of any recovery from the related economic recession. Among other things, this will depend on the duration of the COVID-19 pandemic, particularly in our markets, the distribution, supply, and adoption of vaccines, therapies and other public health initiatives to control the spread of the disease, the nature and size of federal economic stimulus and other governmental efforts, and the possibility of additional state lockdown or stay-at-home orders in our markets.
Credit Risks
A decline in general business and economic conditions and any regulatory responses to such conditions could have a material adverse effect on our business, financial position, results of operations and growth prospects.
Our business and operations are sensitive to general business and economic conditions in the United States, generally, and particularly in our market areas in the state of Michigan. If the national, regional and local economies experience worsening economic conditions, including high levels of unemployment, our growth and profitability could be constrained. A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose loan portfolios are geographically diverse. Weak economic conditions are characterized by, among other indicators, deflation, elevated levels of unemployment, fluctuations in debt and equity capital markets, increased delinquencies on mortgage, commercial and consumer loans, residential and commercial real estate price declines, and lower home sales and commercial activity. In addition, unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; uncertainty in U.S. trade policies, legislation, treaties and tariffs; natural disasters; acts of war or terrorism; widespread disease or pandemics; or a combination of these or other factors. All of these factors are generally detrimental to our business. Our business is significantly affected by monetary, trade and other regulatory policies of the U.S. federal government, its agencies and government-sponsored entities. Changes in any of these policies are influenced by macroeconomic conditions and other factors that are beyond our control, are difficult to predict and could have a material adverse effect on our business, financial position, results of operations and growth prospects.
If we do not effectively manage our credit risk, we may experience increased levels of delinquencies, nonaccrual loans and charge-offs, which could require increases in our provision for loan losses.
There are risks inherent in making any loan, 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 guarantee that our credit underwriting and monitoring procedures will reduce these credit risks, and they cannot be expected to completely eliminate our credit risks. If the overall economic climate in the United States, generally, or our market areas, specifically, declines, our borrowers may experience difficulties in repaying their loans, and the level of nonaccrual loans, charge-offs and delinquencies could rise and require further increases in the provision for loan losses, which would cause our net income, return on equity and capital to decrease.
Our allowance for loan losses may prove to be insufficient to absorb potential losses in our loan portfolio.
If there are slow economic conditions or real estate values and sales deteriorate, we may experience higher delinquencies and credit losses. As a result, we could be required to increase our provision for loan losses and to charge-off additional loans in the future. If charge-offs in future periods exceed the allowance for loan losses, we may need additional provisions to replenish the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, most likely, capital, and may have a material negative effect on our financial condition and results of operations.
In addition, in June 2016, the FASB issued a new accounting standard that will replace the current approach under U.S. generally accepted accounting principles (GAAP) for establishing the allowance for loan losses. Under this standard, referred to as CECL, credit losses will be measured based on past events, current conditions and reasonable and supportable forecasts of future conditions that affect the collectability of financial assets. The new standard is expected to generally result in increases to allowance levels and will require the application of the revised methodology to existing financial assets through a one-time adjustment to retained earnings upon initial effectiveness, which may be material. As a smaller reporting company, this standard will be effective for us on January 1, 2023. In addition, this change may require us to increase our allowance for loan losses rapidly in future periods, and greatly increases the types of data we need to collect and review to determine the appropriate level of the allowance for loan losses. It may also result in even small changes to future forecasts having a significant impact on the allowance, which could make the allowance more volatile, and regulators may impose additional capital buffers to absorb this volatility.
Because a significant portion of our loan portfolio is comprised of real estate loans, a decline in real estate values and liquidity could impair the value of collateral securing our real estate loans and result in loan and other losses.
Adverse developments affecting real estate values in our market areas could increase the credit risk associated with our real estate loan portfolio. The market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the area in which the real estate is located. Adverse changes affecting real estate values and the liquidity of real estate in one or more of our markets could increase the credit risk associated with our loan portfolio, significantly impair the value of property pledged as collateral on loans and affect our ability to sell the collateral upon foreclosure without a loss or additional losses, which could result in losses that would adversely affect profitability. Such declines and losses would have a material adverse impact on our business, results of operations and growth prospects.
Many of our loans are to commercial borrowers, which have a higher degree of risk than other types of loans.
Commercial loans typically involve higher principal amounts than other types of loans, and some of our commercial borrowers have more than one loan outstanding with us. Because payments on such loans are often dependent on the cash flow of the commercial venture and the successful operation or development of the property or business involved, repayment of such loans is often more sensitive than other types of loans to adverse conditions in the real estate market or the general business climate and economy. Repayments of loans secured by non-owner occupied properties depend primarily on the tenant’s continuing ability to pay rent to the property owner, who is our borrower, or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. Accordingly, a downturn in the real estate market or a challenging business and economic environment may increase our risk related to commercial loans. In addition, many of our commercial real estate loans are not fully amortizing and require large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. Our commercial and industrial loans are primarily made based on the identified cash flow of the borrower and secondarily on the collateral underlying the loans. The borrowers’ cash flow may prove to be unpredictable, and collateral securing these loans may fluctuate in value. Most often, this collateral consists of accounts receivable, inventory and equipment. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Inventory and equipment may depreciate over time, may be difficult to appraise, may be illiquid and may fluctuate in value based on the success of the business. If the cash flow from business operations is reduced, the borrower’s ability to repay the loan may be impaired.
The level of our commercial real estate loan portfolio may subject us to additional regulatory scrutiny.
The regulatory agencies have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under the CRE Guidance, a financial institution that, like us, is actively involved in commercial real estate lending should perform a risk assessment to identify concentrations in commercial real estate lending. The purpose of the guidance is to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance states that management should employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing. We have concluded that we have a concentration in commercial real estate lending under the foregoing standards because our balance in commercial real estate loans at December 31, 2021 represents greater than 100% but less than 300% of total capital. While we believe we have implemented policies and procedures with respect to our commercial real estate loan portfolio consistent with this guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance that may result in additional costs to us.
Our high concentration of large loans to certain borrowers may increase our credit risk.
Our growth over the last several years has been partially attributable to our ability to originate and retain large loans. We have established an informal, internal limit on loans to one borrower, principal or guarantor. Our limit is based on “total exposure,” which represents the aggregate exposure of economically related borrowers for approval purposes. However, we may, under certain circumstances, consider going above this internal limit in situations where management’s understanding of the industry and the credit quality of the borrower are commensurate with the increased size of the loan. Many of these loans have been made to a small number of borrowers, resulting in a high concentration of large loans to certain borrowers. As of December 31, 2021, our 20 largest borrowing relationships accounted for approximately 13.0% of our total loan portfolio, the largest of which totaled $19.5 million. Along with other risks inherent in these loans, such as the deterioration of the underlying businesses or property securing these loans, this high concentration of borrowers presents a risk to our lending operations. If any one of these borrowers becomes unable to repay its loan obligations as a result of economic or market conditions, or personal circumstances, such as divorce or death, our nonaccruing loans and our provision for loan losses could increase significantly, which could have a material adverse effect on our business, financial condition, results of operations and prospects.
Construction loans are based upon estimates of costs and values associated with the complete project. These estimates may be inaccurate, and we may be exposed to significant losses on loans for these projects.
Construction and land development loans involve additional risks because funds are advanced upon the security of the project, which is of uncertain value 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 and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. Changes in demand for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and may be concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of the builders we deal with have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss. For certain construction loans, repayment is 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 our appraisal of the value of the completed project proves to be overstated or market values or rental rates decline, we may have inadequate security for the repayment of the loan upon completion of construction of the project. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. 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 as well as 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. Loans on land under development or held for future construction also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral.
Our business may be adversely affected by credit risk associated with residential property.
One- to four-family residential loans are generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. A decline in residential real estate values resulting from a downturn in the housing market in our market areas may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans. Recessionary conditions or declines in the volume of real estate sales and/or the sales prices coupled with elevated unemployment rates may result in higher than expected loan delinquencies or problem assets, and a decline in demand for our products and services. These potential negative events may cause us to incur losses, adversely affect our capital and liquidity and damage our financial condition and business operations.
Operational, Strategic and Reputational Risks
The occurrence of fraudulent activity, breaches or failures of our information security controls or cybersecurity-related incidents could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
As a bank, we are susceptible to fraudulent activity, information security breaches and cybersecurity-related incidents that may be committed against us or our clients, which may result in financial losses or increased costs to us or our clients, disclosure or misuse of our information or our client information, misappropriation of assets, privacy breaches against our clients, litigation or damage to our reputation. Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Information security breaches and cybersecurity-related incidents may include fraudulent or unauthorized access to systems used by us or our clients, denial or degradation of service attacks and malware or other cyber-attacks.
In recent periods, there continues to be a rise in electronic fraudulent activity, security breaches and cyber-attacks within the financial services industry, especially in the commercial banking sector due to cyber criminals targeting commercial bank accounts. Moreover, large corporations, including financial institutions and retail companies, have suffered major data breaches, in some cases exposing not only confidential and proprietary corporate information, but also sensitive financial and other personal information of their customers and employees and subjecting them to potential fraudulent activity. Some of our clients may have been affected by such breaches, which could increase their risks of identity theft and other fraudulent activity that could involve their accounts with us.
Information pertaining to us and our clients is maintained, and transactions are executed, on networks and systems maintained by us and certain third-party partners, such as our online banking, mobile banking or accounting systems. The secure maintenance and transmission of confidential information, as well as execution of transactions over these systems, are
essential to protect us and our clients against fraud and security breaches and to maintain the confidence of our clients. Breaches of information security also may occur through intentional or unintentional acts by those having access to our systems or the confidential information of our clients, including employees. In addition, increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third-party technologies (including browsers and operating systems) or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions, as well as the technology used by our clients to access our systems. Our third-party partners’ inability to anticipate, or failure to adequately mitigate, breaches of security could result in a number of negative events, including losses to us or our clients, loss of business or clients, damage to our reputation, the incurrence of additional expenses, disruption to our business, additional regulatory scrutiny or penalties or our exposure to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
We depend on information technology and telecommunications systems of third parties, and any systems failures, interruptions or data breaches involving these systems could adversely affect our operations and financial condition.
Our business is highly dependent on the successful and uninterrupted functioning of our information technology and telecommunications systems, third-party servicers, accounting systems, mobile and online banking platforms and financial intermediaries. We outsource to third parties many of our major systems, such as data processing and mobile and online banking. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. A system failure or service denial could result in a deterioration of our ability to process loans or gather deposits and provide customer service, compromise our ability to operate effectively, result in potential noncompliance with applicable laws or regulations, damage our reputation, result in a loss of customer business or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on business, financial condition, results of operations and growth prospects. In addition, failures of third parties to comply with applicable laws and regulations, or fraud or misconduct on the part of employees of any of these third parties, could disrupt our operations or adversely affect our reputation.
It may be difficult for us to replace some of our third-party vendors, particularly vendors providing our core banking and information services, in a timely manner if they are unwilling or unable to provide us with these services in the future for any reason and even if we are able to replace them, it may be at higher cost or result in the loss of customers. Any such events could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
Our operations rely heavily on the secure processing, storage and transmission of information and the monitoring of a large number of transactions on a minute-by-minute basis, and even a short interruption in service could have significant consequences. We also interact with and rely on retailers, for whom we process transactions, as well as financial counterparties and regulators. Each of these third parties may be targets of the same types of fraudulent activity, computer break-ins and other cyber security breaches described above, and the cyber security measures that they maintain to mitigate the risk of such activity may be different than our own and may be inadequate.
As a result of financial entities and technology systems becoming more interdependent and complex, a cyber incident, information breach or loss, or technology failure that compromises the systems or data of one or more financial entities could have a material impact on counterparties or other market participants, including ourselves. As a result of the foregoing, our ability to conduct business may be adversely affected by any significant disruptions to us or to third parties with whom we interact.
We are subject to certain operational risks, including, but not limited to, customer or employee fraud and data processing system failures and errors.
Employee errors and employee and customer misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence.
Our branch network expansion strategy may negatively affect our financial performance.
Our branch expansion strategy may not generate earnings, or may not generate earnings within a reasonable period of time. Numerous factors contribute to the performance of a new or acquired branch, such as a suitable location, each market’s competitive environment, managerial resources, qualified personnel, and an effective marketing strategy. New branches require a significant investment of both financial and personnel resources. Additionally, it takes time for a new branch to generate sufficient favorably priced deposits to produce enough income, including funding loan growth generated by our organization, to offset expenses related to the branch, some of which, like salaries and occupancy expense, are considered fixed costs. Opening
new branches in existing markets or new market areas could also divert resources from current core operations and thereby further adversely affect our growth and profitability. Finally, there is a risk that our new branches will not be successful even after they have been established.
We are highly dependent on our management team, and the loss of our senior executive officers or other key employees could harm our ability to implement our strategic plan, impair our relationships with customers and adversely affect our business, results of operations and growth prospects.
Our business and growth strategies are built primarily upon our ability to retain employees with experience and business relationships within their respective market areas. The loss of any of our key personnel could have an adverse impact on our business and growth because of their skills, years of industry experience, knowledge of our market areas, the difficulty of finding qualified replacement personnel and any difficulties associated with transitioning of responsibilities to any new members of the executive management team. In addition, although we have non-competition agreements with each of our executive officers and with several others of our senior personnel, we do not have any such agreements with other employees who are important to our business, and the enforceability of non-competition agreements varies across the states in which we do business. While our mortgage originators and loan officers are generally subject to non-solicitation provisions as part of their employment, our ability to enforce such agreements may not fully mitigate the injury to our business from the breach of such agreements, as such employees could leave us and immediately begin soliciting our customers. The departure of any of our personnel who are not subject to enforceable non-competition agreements could have a material adverse impact on our business, results of operations and growth prospects.
Our mortgage banking profitability could significantly decline if we are not able to originate and resell a high volume of mortgage loans.
Mortgage production, especially refinancing activity, declines in rising interest rate environments. While we have been experiencing historically low interest rates over the last few years, interest rates have begun to rise in recent periods. Accordingly, there can be no assurance that our mortgage production will continue at recent levels. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking business also depends in large part on our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. Thus, in addition to our dependence on the interest rate environment, we are dependent upon (i) the existence of an active secondary market and (ii) our ability to profitably sell loans or securities into that market. If our level of mortgage production declines, the profitability will depend upon our ability to reduce our costs commensurate with the reduction of revenue from our mortgage operations.
Our ability to maintain our reputation is critical to the success of our business, and the failure to do so may materially adversely affect our business and the value of our stock.
We are a community bank, and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected, by the actions of our employees or otherwise, our business and, therefore, our operating results and the value of our stock may be materially adversely affected.
We have a continuing need for technological change, and we may not have the resources to effectively implement new technology or we may experience operational challenges when implementing new technology.
The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our market area. We may experience operational challenges as we implement these new technology enhancements, or seek to implement them across all of our offices and business units, which could result in us not fully realizing the anticipated benefits from such new technology or require us to incur significant costs to remedy any such challenges in a timely manner.
Many of our larger competitors have substantially greater resources to invest in technological improvements. As a result, they may be able to offer additional or superior products to those that we will be able to offer, which would put us at a competitive disadvantage. Accordingly, a risk exists that we will not be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers.
In addition, the implementation of technological changes and upgrades to maintain current systems and integrate new ones may also cause service interruptions, transaction processing errors and system conversion delays and may cause us to fail to comply with applicable laws. We expect that new technologies and business processes applicable to the banking industry will continue to emerge, and these new technologies and business processes may be better than those we currently use. Because the
pace of technological change is high and our industry is intensely competitive, we may not be able to sustain our investment in new technology as critical systems and applications become obsolete or as better ones become available. A failure to successfully keep pace with technological change affecting the financial services industry and failure to avoid interruptions, errors and delays could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
Our real estate lending exposes us to the risk of environmental liabilities.
In the course of our business, we may foreclose and take title to real estate, and we could be subject to environmental liabilities with respect to these properties. We may be held liable by a governmental entity or by third persons for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition and results of operations could be materially and adversely affected.
We face strong competition from financial services companies and other companies that offer banking, mortgage, and leasing services and providers of SBA loans, which could harm our business.
Our operations consist of offering banking and mortgage services, and we also offer SBA lending, trust and leasing services to generate noninterest income. Many of our competitors offer the same, or a wider variety of, banking and related financial services within our market areas. These competitors include national banks, regional banks and other community banks. We also face competition from many other types of financial institutions. In addition, a number of out-of-state financial intermediaries have opened production offices or otherwise solicit deposits in our market areas. Additionally, we face growing competition from so-called “online businesses” with few or no physical locations, including online banks, lenders and consumer and commercial lending platforms, as well as automated retirement and investment service providers. Increased competition in our markets may result in reduced loans, deposits and commissions and brokers’ fees, as well as reduced net interest margin and profitability. Ultimately, we may not be able to compete successfully against current and future competitors. If we are unable to attract and retain banking, mortgage, and leasing customers, we may be unable to continue to grow our business, and our financial condition and results of operations may be adversely affected.
Our ability to compete successfully depends on a number of factors, including, among other things, the ability to develop, maintain and build long-term customer relationships based on top quality service, high ethical standards and safe, sound assets; the scope, relevance and pricing of products and services offered to meet customer needs and demands; the rate at which we introduce new products and services relative to our competitors; customer satisfaction with our level of service; the ability to expand our market position; and industry and general economic trends.
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could adversely affect our business, financial condition and results of operations.
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 and our ability to comply with applicable SBA lending requirements.
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 would 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.
Historically we have sold the guaranteed portion of our SBA 7(a) loans in the secondary market. These sales have resulted in our earning premium income and have created 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 portion of these loans. When we sell the guaranteed portion of our SBA 7(a) loans, we incur credit risk on the retained, non-guaranteed portion of the loans.
In order for a borrower to be eligible to receive an SBA loan, the lender must establish 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 deterioration in economic conditions or the borrower’s financial condition. 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 us, the SBA may require us 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 us.
We may be adversely affected by the soundness of other financial institutions.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies are interrelated as a result of trading, clearing, counterparty, and other relationships. We have exposure to different industries and counterparties, and through transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. These losses or defaults could have a material adverse effect on our business, financial condition, results of operations and growth prospects. Additionally, if our competitors were extending credit on terms we found to pose excessive risks, or at interest rates which we believed did not warrant the credit exposure, we may not be able to maintain our business volume and could experience deteriorating financial performance.
Legal, Accounting and Compliance Risks
We provide financial services to money services businesses and other cash-intensive businesses, which include, but are not limited to, check cashers, issuers/sellers of traveler’s checks, money orders and stored value cards, and money transmitters. Providing banking services to such businesses exposes us to enhanced risks from noncompliance with a variety of laws and regulations.
We provide financial services to the check cashing industry, offering currency, check clearing, monetary instrument, depository and credit services. We also provide treasury management services to money transmitters. Financial institutions that open and maintain accounts for money services businesses and other cash-intensive businesses are expected to apply the requirements of the USA Patriot Act and Bank Secrecy Act, as they do with all accountholders, on a risk-assessed basis. As with any category of accountholder, there will be money services businesses and other cash-intensive businesses that pose little risk of money laundering or lack of compliance with other laws and regulations and those that pose a significant risk. Providing treasury management services to money services businesses and other cash-intensive businesses represents a significant compliance and regulatory risk, and failure to comply with all statutory and regulatory requirements could result in fines or sanctions.
If the goodwill that we recorded in connection with a business acquisition becomes impaired, it could require charges to earnings, which would have a negative impact on our financial condition and results of operations.
Goodwill represents the amount by which the cost of an acquisition exceeded the fair value of net assets we acquired in connection with the purchase. We review goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the carrying value of the asset might be impaired.
We determine impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments are reflected in our results of operations in the periods in which they become known. As of December 31, 2021, our goodwill totaled $35.6 million. The Company conducted its annual goodwill impairment assessment as of October 1, 2021, and concluded that goodwill was not impaired as of such date. There can be no assurance that our future evaluations of goodwill will not result in findings of impairment and related write-downs, which may have a material adverse effect on our financial condition and results of operations.
Changes in accounting standards could materially impact our financial statements.
From time to time, the FASB or the SEC may change the financial accounting and reporting standards that govern the preparation of our financial statements, such as the implementation of the CECL accounting standard. Such changes may result in us being subject to new or changing accounting and reporting standards. In addition, the bodies that interpret the accounting standards (such as banking regulators or outside auditors) may change their interpretations or positions on how these standards should be applied. These changes may be beyond our control, can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retrospectively, or apply an existing standard differently, also retrospectively, in each case resulting in our needing to revise or restate prior period financial statements.
The Company and the Bank are subject to stringent capital and liquidity requirements.
Under the Basel III Rule, we are required to meet specified capital requirements. In addition, banking institutions that do not maintain a capital conservation buffer, comprised of Common Equity Tier 1 Capital, of 2.5% above the regulatory minimum capital requirements face constraints on the payment of dividends, stock repurchases and discretionary bonus
payments to executive officers based on the amount of the shortfall, unless prior regulatory approval is obtained. Accordingly, if the Bank or the Company fails to maintain the applicable minimum capital ratios and the capital conservation buffer, distributions by the Bank to the Company, or dividends or stock repurchases by the Company, may be prohibited or limited. Future increases in minimum capital requirements could adversely affect our net income. Furthermore, our failure to comply with the minimum capital requirements could result in our regulators taking formal or informal actions against us that could restrict our future growth or operations.
Litigation and regulatory actions, including possible enforcement actions, could subject us to significant fines, penalties, judgments or other requirements resulting in increased expenses or restrictions on our business activities.
Our business is subject to increased litigation and regulatory risks as a result of a number of factors, including the highly regulated nature of the financial services industry and the focus of state and federal prosecutors on banks and the financial services industry generally. In the normal course of business, from time to time, we have in the past and may in the future be named as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with our current or prior business activities. Any such legal or regulatory actions may subject us to substantial compensatory or punitive damages, significant fines, penalties, obligations to change our business practices or other requirements resulting in increased expenses, diminished income and damage to our reputation. Our involvement in any such matters, whether tangential or otherwise and even if the matters are ultimately determined in our favor, could also cause significant harm to our reputation and divert management attention from the operation of our business. Further, any settlement, consent order or adverse judgment in connection with any formal or informal proceeding or investigation by government agencies may result in litigation, investigations or proceedings as other litigants and government agencies begin independent reviews of the same activities. As a result, the outcome of legal and regulatory actions could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
For example, recent regulations require us to enhance our due diligence, ongoing monitoring and control over our third-party vendors and other ongoing third-party business relationships. As a result, if our regulators conclude that we have not exercised adequate oversight and control over our third-party vendors or other ongoing third-party business relationships or that such third parties have not performed appropriately, we could be subject to enforcement actions, including civil money penalties or other administrative or judicial penalties or fines, as well as requirements for customer remediation, any of which could have a material adverse effect our business, financial condition, results of operations and growth prospects.
Legislative and regulatory actions taken now or in the future may increase our costs and impact our business, governance structure, financial condition or results of operations.
New proposals for legislation continue to be introduced in the U.S. Congress that could substantially increase regulation of the bank and non-bank financial services industries and impose restrictions on the operations and general ability of firms within the industry to conduct business consistent with historical practices. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied. In addition, political developments, including possible changes in law introduced by the Biden administration or the appointment of new personnel in regulatory agencies, add uncertainty to the implementation, scope and timing of regulatory reforms. Certain aspects of current or proposed regulatory or legislative changes to laws applicable to the financial industry, if enacted or adopted, may impact the profitability of our business activities, require more oversight or change certain of our business practices, including the ability to offer new products, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads and could expose us to additional costs, including increased compliance costs. Changes in federal policy and at regulatory agencies are expected to occur over time through policy and personnel changes, which could lead to changes involving the level of oversight and focus on the financial services industry. Regulations and legislation may be impacted by the political ideologies of the executive and legislative branches of the U.S. government as well as the heads of regulatory and administrative agencies, which may change as a result of elections. The nature, timing and economic and political effects of potential changes to the current legal and regulatory framework affecting financial institutions remain highly uncertain. These changes also may require us to invest significant management attention and resources to make any necessary changes to operations to comply and could have an adverse effect on our business, financial condition and results of operations.
We are subject to numerous laws designed to protect consumers, including the CRA and fair lending laws, and failure to comply with these laws could lead to a wide variety of sanctions.
The CRA, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations prohibit discriminatory lending practices by financial institutions. The U.S. Department of Justice and federal and state banking and other agencies are responsible for enforcing these laws and regulations. A challenge to an institution’s compliance with fair lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions activity, restrictions on expansion, and restrictions on entering new business lines. Private parties may also challenge an institution’s performance under fair lending laws in private class action litigation. Such actions could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.
The Bank Secrecy Act, the USA Patriot Act and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and to file reports such as suspicious activity reports and currency transaction reports. We are required to comply with these and other anti-money laundering requirements. The federal banking agencies and Financial Crimes Enforcement Network are authorized to impose significant civil money penalties for violations of those requirements and have engaged in coordinated enforcement efforts against banks and other financial services providers with the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. We are also subject to increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
The Federal Reserve may require us to commit capital resources to support the Bank.
As a matter of policy, the Federal Reserve expects a bank holding company to act as a source of financial and managerial strength to a subsidiary bank and to commit resources to support such subsidiary bank. Under the “source of strength” doctrine, the Federal Reserve may require a bank holding company to make capital injections into a troubled subsidiary bank and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank. A capital injection may be required at times when the holding company may not have the resources to provide it and therefore may be required to borrow the funds or raise capital. Any loans by a holding company to its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the institution’s general unsecured creditors, including the holders of its note obligations. Thus, any borrowing that must be done by the Company to make a required capital injection becomes more difficult and expensive and could have an adverse effect on our business, financial condition and results of operations.
Market and Interest Rate Risks
Fluctuations in interest rates or an increase in inflation could 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. Interest rate increases often result in larger payment requirements for our borrowers, which increases the potential for default. At the same time, the marketability of the underlying property 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 loans as borrowers refinance their mortgages and other indebtedness at lower rates.
A sustained increase in market interest rates could adversely affect our earnings. A significant portion of our loans have fixed interest rates and longer terms than our deposits and borrowings. As a result of the relatively low interest rate environment, an increasing percentage of our deposits have been comprised of certificates of deposit and other deposits yielding no or a relatively low rate of interest having a shorter duration than our assets. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. Our net interest income could be adversely affected if the rates we pay on deposits and borrowings increase more rapidly than the rates we earn on loans. In addition, a substantial amount of our residential mortgage loans and home equity lines of credit have adjustable interest rates. As a result, these loans may experience a higher rate of default in a rising interest rate environment.
If short-term interest rates rise or remain at their low levels for a prolonged period, and longer term interest rates fall, we could experience further net interest margin compression as our interest earning assets would continue to reprice downward while our interest-bearing liability rates could fail to decline in tandem. This could have a material adverse effect on our net interest income and our results of operations.
In addition, any significant continued inflation could negatively impact our financial condition and results of operations, including by reducing the real value of our loan and securities portfolios, or by negatively impacting our economic environment and our borrowers’ business operations.
Changes to, or elimination of, LIBOR could adversely affect our financial instruments with interest rates currently indexed to LIBOR.
In 2017, the Financial Conduct Authority of the United Kingdom announced its intention to cease sustaining LIBOR. While there is no certainty on what rate or rates may become accepted alternatives to LIBOR, the Alternative Reference Rates Committee (“ARRC”), a steering committee comprised of U.S. financial market participants, selected by the Federal Reserve Bank of New York, began to publish SOFR as an alternative to LIBOR. SOFR is a broad measure of the cost of overnight borrowings collateralized by Treasury securities selected by the ARRC.
The market transition away from LIBOR to an alternative reference rate, such as SOFR, is complex and could have a range of adverse effects on our business, financial condition and results of operations. In particular, any such transition could:
•adversely affect the interest rates paid or received on, the revenue and expenses associated with, and the value of our floating-rate obligations, loans, deposits, subordinated debentures and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
•prompt inquiries or other actions from regulators in respect of our preparation and readiness for the replacement of LIBOR with an alternative reference rate;
•result in disputes, litigation or other actions with counterparties regarding the interpretation and enforceability of certain fallback language, or lack of fallback language, in LIBOR-based instruments; and
•require the transition to or development of appropriate systems and analytics to effectively transition our risk management processes from LIBOR-based products to those based on the applicable alternative pricing benchmark, such as SOFR.
We have floating rate loans and investment securities, interest rate swap agreements and subordinated debentures whose interest rates are indexed to LIBOR that mature after December 31, 2021. The transition from LIBOR could create additional costs as well as economic and reputation risk. We cannot predict any unfavorable effect the chosen alternative index may have on financial instruments currently indexed to LIBOR.
Our securities portfolio has and may continue to be negatively impacted by fluctuations in market value and interest rates.
Our securities portfolio has and may continue to be impacted by fluctuations in market value, which reduce accumulated other comprehensive income and/or earnings. 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. Changes in interest rates can have an adverse effect on our financial condition, as our available-for-sale securities are reported at their estimated fair value, and therefore are impacted by fluctuations in interest rates. 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 or our own analysis of the value of the security, defaults by the issuer or individual mortgagors with respect to the underlying securities, and limited investor demand. Our securities portfolio is evaluated quarterly for other-than-temporary impairment. 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. If this evaluation shows impairment to the actual or projected cash flows associated with one or more securities, a potential loss to earnings may occur. We increase or decrease our shareholders’ equity by the amount of change in the estimated fair value of the available-for-sale securities, net of taxes. There can be no assurance that the declines in market value will not result in other-than-temporary impairments of these assets, which would lead to accounting charges that could have a material adverse effect on our financial condition and results of operations.
Downgrades in the credit rating of one or more insurers that provide credit enhancement for our state and municipal securities portfolio may have an adverse impact on the market for and valuation of these types of securities.
We invest in tax-exempt state and local municipal securities, some of which are insured by monoline insurers. Several of these insurers have come under scrutiny by rating agencies. Even though management generally purchases municipal securities on the overall credit strength of the issuer, the reduction in the credit rating of an insurer may negatively impact the market for and valuation of our investment securities. Such downgrade could adversely affect our liquidity, financial condition and results of operations.
Monetary policies and regulations of the Federal Reserve could adversely affect our business, financial condition and results of operations.
In addition to being affected by general economic conditions, our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market purchases and sales of U.S. government securities, adjustments of the discount rate and changes in banks’ reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.
The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our business, financial condition and results of operations cannot be predicted.
Liquidity and Funding Risks
Liquidity risks could affect operations and jeopardize our business, financial condition, and results of operations.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and/or investment securities and from other sources could have a substantial negative effect on our liquidity. Our most important source of funds consists of our customer deposits, including escrow deposits held in connection with our commercial mortgage servicing business. Such deposit balances can decrease when customers perceive alternative investments, such as the stock market, as providing a better risk/return tradeoff, or, in connection with our commercial mortgage servicing business, third parties for whom we provide servicing choose to terminate that relationship with us. If customers move money out of bank deposits and into other investments, we could lose a relatively low cost source of funds, which would require us to seek wholesale funding alternatives in order to continue to grow, thereby increasing our funding costs and reducing our net interest income and net income.
Other primary sources of funds consist of cash from operations, investment security maturities and sales, and proceeds from the issuance and sale of our equity and debt securities to investors. Additional liquidity is provided by brokered deposits, repurchase agreements and the ability to borrow from the Federal Reserve Bank and the Federal Home Loan Bank of Indianapolis (FHLB). We also may borrow from third-party lenders from time to time. 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.
Any decline in available funding could adversely impact our ability to continue to implement our strategic plan, including originating loans, investing in securities, meeting our expenses, paying dividends to our shareholders or fulfilling obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, financial condition and results of operations.
We depend on non-core funding sources, which causes our cost of our funds to be higher when compared to other financial institutions.
We use certain non-core, wholesale funding sources, including brokered deposits and FHLB advances. Unlike traditional deposits from our local clients, there is a higher likelihood that the funds wholesale deposits provide will not remain with us after maturity. Although we are increasing our efforts to reduce our reliance on non-core funding sources, we may not be able to increase our market share of core-deposit funding in our highly competitive market area. If we are unable to do so, we may be forced to increase the amounts of wholesale funding sources. The cost of these funds can be volatile and may exceed the cost of core deposits in our market area, which could have a material adverse effect on our net interest income.
Municipal deposits are one important source of funds for us, and a reduced level of such deposits may hurt our profits.
Municipal deposits are an important source of funds for our lending and investment activities. Given our use of these high-average balance municipal deposits as a source of funds, our inability to retain such funds could have an adverse effect on our liquidity. In addition, our municipal deposits are primarily demand deposit accounts or short-term deposits and therefore are more sensitive to changes in interest rates. If we are forced to pay higher rates on our municipal deposits to retain those funds, or if we are unable to retain those funds and we are forced to turn to borrowing sources for our lending and investment activities, the interest expense associated with such borrowings may be higher than the rates we are paying on our municipal deposits, which could adversely affect our net income.
Our liquidity is dependent on dividends from the Bank.
The Company is a legal entity separate and distinct from the Bank. A substantial portion of our cash flow, including cash flow to pay principal and interest on any debt we may incur, comes from dividends the Company received from the Bank. Various federal and state laws and regulations limit the amount of dividends that the Bank may pay to the Company. In the event the Bank is unable to pay dividends to us, we may not be able to service any debt we may incur, which could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
We may need to raise additional capital in the future, and if we fail to maintain sufficient capital, whether due to losses, an inability to raise additional capital or otherwise, our financial condition, liquidity and results of operations, as well as our ability to maintain regulatory compliance, would be adversely affected.
We face significant capital and other regulatory requirements as a financial institution. We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs, which could include the possibility of financing acquisitions. In addition, the Company, on a consolidated basis, and the Bank,
on a stand-alone basis, must meet certain regulatory capital requirements and maintain sufficient liquidity. Importantly, regulatory capital requirements could increase from current levels, which could require us to raise additional capital or contract our operations. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions and governmental activities, and on our financial condition and performance. Accordingly, we cannot assure you that we will be able to raise additional capital if needed or on terms acceptable to us. If we fail to maintain capital to meet regulatory requirements, our financial condition, liquidity and results of operations would be materially and adversely affected.

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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
Our headquarters are located at 32991 Hamilton Court, Farmington Hills, Michigan. Including our headquarters building, we operate 17 offices, including 16 full-service banking centers located in southeastern and west Michigan, and one mortgage loan production office in Ann Arbor, Michigan. We own our headquarters building and our branch offices located in Novi and Bloomfield Hills as well as two of the branch offices in Ann Arbor, and lease the remainder of our locations.

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ITEM 3. LEGAL PROCEEDINGS
Item 3 - Legal Proceedings
In the normal course of business, we are named or threatened to be named as a defendant in various lawsuits, none of which we expect to have a material effect on the Company. However, given the nature, scope and complexity of the extensive legal and regulatory landscape applicable to our business (including laws and regulations governing consumer protection, fair lending, fair labor, privacy, information security, anti-money laundering and anti-terrorism), we, like all banking organizations, are subject to heightened legal and regulatory compliance and litigation risk. There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which we or any of our subsidiaries is a party or to which our
property is the subject.

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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 Stockholder Matters and Issuer of Purchases of Equity Securities
Market Information
Our common stock began trading on the Nasdaq Global Select Market (“Nasdaq”) under the symbol “LEVL” on April 20, 2018. Prior to that, there was no public market for our common stock. On August 10, 2020, our preferred stock began trading on Nasdaq under the symbol "LEVLP."
Unregistered Sales of Equity Securities
None.
Issuer Purchases of Equity Securities
Share Buyback Program. On January 23, 2019, the Company announced that its Board of Directors approved a repurchase program under which the Company is authorized to repurchase, from time to time as the Company deems appropriate, shares of the Company’s common stock with an aggregate purchase price of up to $5 million. The repurchase program began on January 23, 2019, and expired on December 31, 2020. The repurchase program did not obligate the Company to repurchase any dollar amount or number of shares, and the program could have been extended, modified, suspended or discontinued at any time.
On December 16, 2020, the Company announced that its Board of Directors approved a new share repurchase program that began on January 1, 2021 and expires on December 31, 2022 to replace the prior repurchase program. This repurchase program authorizes the repurchase shares of the Company's common stock with an aggregate purchase price of up to $10.0 million.
There were no repurchases of the Company's shares of its outstanding common stock during the three months ended December 31, 2021.
Under applicable state law, Michigan corporations are not permitted to retain treasury stock. As such, the price paid for the repurchased shares is recorded to common stock. As of December 31, 2021, the total shares repurchased in the amount of $6.2 million were redeemed but remain authorized, unissued shares.
As of March 4, 2022, the Company has not repurchased any shares during 2022.

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ITEM 6. SELECTED FINANCIAL DATA
Item 6 - [Reserved]

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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
The following discussion explains our financial condition as of December 31, 2021 and 2020 and results of operations for the years ended December 31, 2021, 2020 and 2019. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes presented in Item 8 of this report.
This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under "Forward-Looking Statements," "Risk Factors" and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements.
Selected Financial Data
As of and for the year ended December 31,
(Dollars in thousands, except per share data) 2021 2020 2019
Earnings Summary
Interest income $ 86,650 $ 82,639 $ 70,448
Interest expense 8,051 15,883 19,393
Net interest income 78,599 66,756 51,055
Provision for (recovery of) loan losses (725) 11,872 1,383
Noninterest income 22,372 29,714 14,211
Noninterest expense 61,839 60,232 44,369
Income before income taxes 39,857 24,366 19,514
Income tax provision 7,379 3,953 3,403
Net income 32,478 20,413 16,111
Preferred stock dividends 1,875 479 -
Net income available to common shareholders 30,603 19,934 16,111
Net income allocated to participating securities (1)
441 244 159
Net income attributable to common shareholders (1)
$ 30,162 $ 19,690 $ 15,952
Per Share Data
Basic earnings per common share $ 4.00 $ 2.58 $ 2.08
Diluted earnings per common share 3.95 2.57 2.05
Diluted earnings per common share, excluding acquisition and due diligence fees (2)
3.95 2.74 2.12
Book value per common share 28.02 25.14 22.13
Tangible book value per common share (2)
22.37 19.63 20.86
Preferred shares outstanding (in thousands) 10 10 -
Common shares outstanding (in thousands) 7,734 7,634 7,715
Average basic common shares (in thousands) 7,536 7,627 7,632
Average diluted common shares (in thousands) 7,650 7,686 7,747
Selected Period End Balances
Total assets $ 2,515,869 $ 2,442,982 $ 1,584,899
Securities available-for-sale 397,551 302,732 180,905
Total loans 1,652,771 1,723,537 1,227,609
Total deposits 2,040,082 1,963,312 1,135,428
Total liabilities 2,275,778 2,227,655 1,414,196
Total shareholders' equity 240,091 215,327 170,703
Total common shareholders' equity 216,719 191,955 170,703
Tangible common shareholders' equity (2)
173,033 149,844 160,940
Performance and Capital Ratios
Return on average assets 1.28 % 0.88 % 1.08 %
Return on average equity 14.24 10.61 9.90
Net interest margin (fully taxable equivalent) (3)
3.33 3.10 3.60
Efficiency ratio (noninterest expense/net interest income plus noninterest income) 61.24 62.44 67.98
Dividend payout ratio 5.74 7.37 7.20
Total shareholders' equity to total assets 9.54 8.81 10.77
Tangible common equity to tangible assets (2)
7.00 6.24 10.22
Common equity tier 1 to risk-weighted assets 10.37 9.30 11.72
Tier 1 capital to risk-weighted assets 11.75 10.80 11.72
Total capital to risk-weighted assets 14.76 14.91 15.99
Tier 1 capital to average assets (leverage ratio) 7.93 6.93 10.41
Asset Quality Ratios:
Net (recoveries) charge-offs to average loans 0.01 % 0.13 % 0.02 %
Nonperforming assets as a percentage of total assets 0.46 0.77 1.23
Nonaccrual loans as a percent of total loans 0.68 1.09 1.51
Allowance for loan losses as a percentage of total loans 1.30 1.29 1.03
Allowance for loan losses as a percentage of nonaccrual loans 189.79 118.50 68.40
Allowance for loan losses as a percentage of nonaccrual loans, excluding allowance allocated to loans accounted for under ASC 310-30 184.58 114.95 64.29
(1) Amounts presented are used in the two-class earnings per common share calculation. This method was adopted by the Company in the second quarter of 2019.
(2) See section entitled "GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures" below for a reconciliation to most comparable GAAP equivalent.
(3) Presented on a tax equivalent basis using a 21% tax rate for the 2019, 2020, and 2021 periods.
GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures
Some of the financial measures included in this report are not measures of financial condition or performance recognized by GAAP. These non-GAAP financial measures include tangible common shareholders' equity, tangible book value per common share, the ratio of tangible common equity to tangible assets, net income and diluted earnings per common share excluding acquisition and due diligence fees as well as allowance for loan loss as a percentage of total loans excluding PPP loans. Our management uses these non-GAAP financial measures in its analysis of our performance, and we believe that providing this information to financial analysts and investors allows them to evaluate capital adequacy, as well as better understand and evaluate the Company’s core financial results for the periods in question.
The following presents these non-GAAP financial measures along with their most directly comparable financial measures calculated in accordance with GAAP:
Tangible Common Shareholders' Equity, Tangible Common Equity to Tangible Assets Ratio and Tangible Book Value Per Share
As of and for the year ended December 31,
(Dollars in thousands, except per share data) 2021 2020 2019
Total shareholders' equity $ 240,091 $ 215,327 $ 170,703
Less:
Preferred stock 23,372 23,372 -
Total common shareholders' equity 216,719 191,955 170,703
Less:
Goodwill 35,554 35,554 9,387
Mortgage servicing rights, net 5,604 3,361 76
Other intangible assets, net 2,528 3,196 300
Tangible common shareholders' equity $ 173,033 $ 149,844 $ 160,940
Common shares outstanding (in thousands) 7,734 7,634 7,715
Tangible book value per common share $ 22.37 $ 19.63 $ 20.86
Total assets $ 2,515,869 $ 2,442,982 $ 1,584,899
Less:
Goodwill 35,554 35,554 9,387
Mortgage servicing rights, net 5,604 3,361 76
Other intangible assets, net 2,528 3,196 300
Tangible assets $ 2,472,183 $ 2,400,871 $ 1,575,136
Tangible common equity to tangible assets 7.00 % 6.24 % 10.22 %
Adjusted Income and Diluted Earnings Per Share
As of and for the year ended December 31,
(Dollars in thousands, except per share data) 2021 2020 2019
Net income, as reported $ 32,478 $ 20,413 $ 16,111
Acquisition and due diligence fees - 1,654 539
Income tax benefit (1)
- (331) (51)
Net income, excluding acquisition and due diligence fees $ 32,478 $ 21,736 $ 16,599
Diluted earnings per share, as reported $ 3.95 $ 2.57 $ 2.05
Effect of acquisition and due diligence fees, net of income tax benefit - 0.17 0.07
Diluted earnings per common share, excluding acquisition and due diligence fees $ 3.95 $ 2.74 $ 2.12
(1) Assumes income tax rate of 21% on deductible acquisition expenses for the 2019 and 2020 periods.
Allowance for Loan Loss as a Percentage of Total Loans, Excluding PPP Loans
As of and for the year ended December 31,
(Dollars in thousands, except per share data) 2021 2020 2019
Total loans $ 1,652,771 $ 1,723,537 $ 1,227,609
Less:
PPP loans 76,505 290,135 -
Total loans, excluding PPP loans $ 1,576,266 $ 1,433,402 $ 1,227,609
Allowance for loan loss $ 21,425 $ 22,297 $ 12,674
Allowance for loan loss as a percentage of total loans 1.30 % 1.29 % 1.03 %
Allowance for loan loss as a percentage of total loans excluding PPP loans 1.36 % 1.56 % 1.03 %
Critical Accounting Policies
Our consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States. Our significant accounting policies are set forth in Note 1 - Basis of Presentation and Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements in our consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this Form 10-K. Some of these policies require reliance on estimates and assumptions, which are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances, but may prove to be inaccurate or can be subject to variations. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations. At December 31, 2021, the most critical of these significant accounting policies in understanding the estimates and assumptions involved in preparing our consolidated financial statements were the policies related to the allowance for loan losses, fair value measurement, and goodwill, which are discussed more fully below.
Allowance for Loan Losses
The allowance for loan losses is calculated with the objective of maintaining a reserve sufficient to absorb estimated probable losses. Management's determination of the appropriateness of the allowance is based on periodic evaluations of the loan portfolio, lending-related commitments, and other relevant factors. This evaluation is inherently subjective as it requires numerous estimates, including the loss content for internal risk ratings, collateral values, and the amounts and timing of expected future cash flows. In addition, management may include qualitative adjustments intended to capture the impact of other uncertainties in the lending environment such as underwriting standards, current economic and political conditions, and other factors affecting the credit quality. Changes to one or more of the estimates used would result in a different estimated allowance for loan loss.
Fair Value Measurement
Investment securities available-for-sale, derivatives, loans held for sale, and certain other loans are recorded at fair value on a recurring basis. Additionally, from time to time, other assets and liabilities may be recorded at fair value on a nonrecurring basis, such as impaired loans, other real estate, and certain other assets and liabilities. Fair value is an estimate of the exchange
price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (i.e., not a forced transaction, such as a liquidation or distressed sale) between market participants at the measurement date and is based on the assumptions market participants would use when pricing an asset or liability. Fair value measurement and disclosure guidance establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value.
At December 31, 2021, assets and liabilities measured using observable inputs that are classified as Level 1 or Level 2 represented 97.45% and 100.00% of total assets and liabilities recorded at fair value, respectively. Valuations generated from model-based techniques that use at least one significant assumption not observable in the market are considered Level 3 and reflect estimates of assumptions market participants would use in pricing the asset or liability.
Valuation and Recoverability of Goodwill
Goodwill represents $35.6 million of our $2.52 billion in total assets as of December 31, 2021. We review goodwill for impairment annually as of October 1st and also test for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of our Company below its carrying amount. The accounting estimates related to our goodwill require us to make considerable assumptions about fair values. Our assumptions regarding fair values require significant judgment about economic and industry factors and the growth and earnings prospects of the Company. Changes in these judgements, either individually or collectively, may have a significant effect on the estimated fair values.
Overview
Level One Bancorp, Inc. is a financial holding company headquartered in Farmington Hills, Michigan, with its primary branch operations in southeastern and west Michigan. Through our wholly owned subsidiary, Level One Bank, we offer a broad range of loan products to the residential and commercial markets, as well as retail and business banking services. Hamilton Court Insurance Company, a wholly owned subsidiary of the Company, provided property and casualty insurance to the Company and the Bank and reinsurance to ten other third-party insurance captives for which insurance may not have been available or economically feasible in the insurance marketplace. Hamilton Court Insurance Company exited the pool resources relationship to which it was previously a member and was dissolved in January 2021.
Our principal business activities have been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We derive income principally from interest charged on loans and leases and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest sources, such as fees received in connection with various lending and deposit services and originations and sales of residential mortgage loans. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for loan losses and income tax expense.
Since 2007, we have grown substantially through organic growth and a series of five acquisitions, all of which have been fully integrated into our operations. We have made significant investments over the last several years in hiring additional staff and upgrading technology and system security. In 2016, we opened our first branch in the Grand Rapids, Michigan market. In the third quarter of 2017, we opened our second location in Bloomfield Township located in Oakland County. In the third quarter of 2018, we doubled the size of our mortgage division with the addition of new mortgage officers and support staff.
On January 2, 2020, the Company completed its acquisition of Ann Arbor Bancorp, Inc. (“AAB”) and its wholly owned
subsidiary, Ann Arbor State Bank. The transaction was completed pursuant to a merger of the Company’s wholly owned
merger subsidiary (“Merger Sub”) with and into AAB, pursuant to the Agreement and Plan of Merger, dated as of August 12,
2019, among the Company, Merger Sub and AAB. The Company paid aggregate consideration of approximately $67.9 million in cash.
Our results of operations for the years ended December 31, 2021 and 2020 include the results of operations of AAB on and after January 2, 2020, including $1.7 million of acquisition fees. Results for periods before January 2, 2020 reflect only those of Level One and do not include the results of operations of AAB. See "Note 2 - Business Combinations" for more information. In addition, all identifiable assets, including the intangible assets that consisted of $26.2 million in goodwill and $3.7 million in core deposit intangibles, and liabilities of AAB as of the merger date have been recorded at their estimated fair value and added to those of Level One.
Recent Developments
Fourth Quarter Common Stock Dividend. On December 15, 2021, Level One's Board of Directors declared a fourth quarter 2021 cash dividend of $0.06 per common share. The dividend was paid on January 14, 2022, to shareholders of record at the close of business on December 31, 2021.
First Quarter Preferred Stock Dividend. On January 19, 2022, Level One’s Board of Directors declared a quarterly cash dividend of $46.88 per share on its 7.50% Non-Cumulative Perpetual Preferred Stock, Series B. Holders of depositary shares will receive $0.4688 per depositary share. The dividend is payable on February 15, 2022, to shareholders of record at the close of business on January 31, 2022.
Impact of COVID-19 Pandemic. The COVID-19 pandemic in the United States has had, and is expected to continue to have, a complex and significant impact on the economy, the banking industry and the Company.
Effects on Our Business. We currently expect that the COVID-19 pandemic, federal, state and local government responses to the pandemic, supply disruptions, labor availability challenges, and the effects of existing and future variants of the disease, such as the Delta variant, may continue to have a significant impact on our business. A substantial portion of the Bank’s borrowers in the restaurant and hospitality industries have endured substantial economic distress, and while those challenges have been largely mitigated by the PPP and other governmental assistance, there is still some uncertainty about the ability of these clients to return to cash flow levels necessary to cover their debt service. These developments, together with economic conditions generally, are also expected to impact our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries and the value of certain collateral securing our loans.
Level One's Response to the COVID-19 Pandemic. Level One has taken comprehensive steps to help our customers, team members and communities during the COVID-19 pandemic. For our customers, we have provided loan payment deferrals and offered fee waivers, among other actions.
Level One was also a participating lender in both the first and second rounds of the PPP. In 2020, the Bank originated 2,208 PPP loans in the aggregate principal amount of $417.0 million. From January 18, 2021 through June 30, 2021, Level One funded 1,532 new PPP loan applications for $234.3 million, of which 1,187 were for loans $150,000 or below. As of December 31, 2021, $76.5 million of PPP loans were still outstanding. The Bank is actively working with the borrowers of PPP loans to obtain loan forgiveness from the SBA.
Level One also recognizes that some of the most impacted industries are the restaurant and hospitality industries. As of December 31, 2021, Level One had 3.9% and 0.3% of loan concentrations in the restaurant and hospitality industries, respectively.
Results of Operations
Net Income
We had net income of $32.5 million, or $3.95 per diluted common share, for the year ended December 31, 2021, compared to $20.4 million, or $2.57 per diluted common share, for the year ended December 31, 2020. The increase of $12.1 million in net income primarily reflected an increase of $11.8 million in net interest income, primarily due to higher interest income on loans due, in part, to the recognition of fees on PPP loans as they are forgiven. In addition, there was higher interest income on securities due to increased volumes of investment securities and lower interest expense on deposits, borrowed funds, and subordinated notes. The increase in net income also reflected a decrease of $12.6 million in provision for loan loss, primarily due to a decrease in general reserves resulting from an increase in the economic qualitative factors in the year ended December 31, 2020 and a reduction in qualitative factors in the third quarter of 2021. These were partially offset by a $7.3 million decrease in noninterest income primarily due to lower mortgage banking activities and net gain on sales of securities partially offset by an increase in service charges on deposits. In addition, there were increases of $3.4 million of income tax provision primarily due to higher income before taxes and $1.6 million of noninterest expense primarily due to higher salary and employee benefits, other expense, data processing expense, and professional services fees partially offset by lower acquisition and due diligence fees.
Net Interest Income
Our primary source of revenue is net interest income, which is the difference between interest income from interest-earning assets (primarily loans and securities) and interest expense of funding sources (primarily interest-bearing deposits and borrowings).
Net interest income of $78.6 million for the year ended December 31, 2021 was $11.8 million higher than the net interest income of $66.8 million for the year ended December 31, 2020. The year ended December 31, 2021 included a $4.0 million increase in interest income as well as a $7.8 million decrease in interest expense, compared to December 31, 2020. The increase in interest income was primarily driven by increases of $2.9 million in interest and fees on loans and $1.4 million in interest on investment securities. The increase in interest and fees on loans for the year ended December 31, 2021 compared to the same period in 2020 was mainly driven by the Bank earning $12.9 million of net SBA fees on PPP loans compared to $6.5 million for the year ended December 31, 2020. The increase in interest income on investment securities was mainly due to an increase of $123.7 million in average balances due to excess liquidity from PPP loan forgiveness and increased customer liquidity.
The decrease in interest expense was primarily driven by a decrease of $6.7 million in interest expense on deposits and a decrease of $1.2 million in interest expense on borrowed funds and subordinated notes. The decrease in deposit interest expense was primarily due to lower interest rates paid as a result of revised internal deposit rates and maturity of higher cost time deposits. The decrease in interest expense on borrowed funds and subordinated notes was primarily due to the redemption of $15.0 million of subordinated notes during the second quarter of 2021 and a decrease in FHLB borrowings.
Our net interest margin (FTE) for the year ended December 31, 2021 was 3.33%, compared to 3.10% for the same period in 2020. The increase of 23 basis points in the net interest margin year over year was primarily a result of a decrease in cost of funds, which declined 52 basis points to 0.53% in 2021, compared to 1.05% in 2020 primarily due to lower interest rates paid as a result of revised internal deposit rates and maturity of higher cost time deposits. The decrease in cost of funds was accompanied by a lower yields across most interest-earning assets, mostly reflecting the impact of lower market interest rates.
Our net interest margin benefits from discount accretion on our purchased credit impaired loan portfolios, a component of our accretable yield. The accretable yield represents the excess of the net present value of expected future cash flows over the acquisition date fair value and includes both the expected coupon of the loan and the discount accretion. The accretable yield is recognized as interest income over the expected remaining life of the purchased credit impaired loan. The difference between the actual yield earned on total loans and the yield generated based on the contractual coupon (not including any interest income for loans in nonaccrual status) represents excess accretable yield. The contractual coupon of the loan considers the contractual coupon rates of the loan and does not include any interest income for loans in nonaccrual status. For the years ended December 31, 2021 and 2020, the yield on total loans was impacted by 6 basis points and 7 basis points due to the accretable yield on purchased credit impaired loans. Our net interest margin for the years ended December 31, 2021 and 2020, benefited by 4 basis points and 8 basis points, respectively, as a result of the excess accretable yield. As of December 31, 2021 and December 31, 2020, our remaining accretable yield was $5.7 million and $7.1 million, respectively, and our nonaccretable difference was $1.4 million and $2.7 million, respectively.
The following table sets forth information related to our average balance sheet, average yields on assets, and average rates on liabilities for the periods indicated. We derived these yields by dividing income or expense by the average daily balance of the corresponding assets or liabilities. In this table, adjustments were made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis.
Analysis of Net Interest Income-Fully Taxable Equivalent
For the years ended December 31,
(Dollars in thousands) 2021 2020 2019
Average Balance Sheets:
Gross loans(1)
$ 1,791,671 $ 1,730,470 $ 1,169,486
Investment securities: (2)
Taxable 254,913 138,837 129,274
Tax-exempt 103,609 96,020 84,392
Interest-earning cash balances 218,931 194,545 38,268
Other investments 14,398 12,903 8,523
Total interest-earning assets $ 2,383,522 $ 2,172,775 $ 1,429,943
Non-earning assets: 145,990 135,229 68,015
Total assets $ 2,529,512 $ 2,308,004 $ 1,497,958
Interest-bearing demand deposits $ 162,405 $ 115,249 $ 57,480
Money market and savings deposits 613,883 496,827 314,918
Time deposits 519,447 573,823 527,605
Borrowings 183,503 279,949 79,864
Subordinated notes 36,376 44,490 16,061
Total interest-bearing liabilities 1,515,614 1,510,338 995,928
Noninterest-bearing demand deposits 754,376 574,537 321,487
Other liabilities 31,466 30,787 17,750
Shareholders' equity 228,056 192,342 162,793
Total liabilities and shareholders' equity $ 2,529,512 $ 2,308,004 $ 1,497,958
Yields: (3)
Earning Assets
Gross loans 4.43 % 4.42 % 5.42 %
Investment securities:
Taxable 1.58 % 1.93 % 2.71 %
Tax-exempt 3.02 % 3.19 % 3.27 %
Interest earning cash balances 0.13 % 0.24 % 2.23 %
Other investments 3.13 % 4.07 % 5.26 %
Total interest earning assets 3.66 % 3.83 % 4.96 %
Interest-bearing liabilities
Interest-bearing demand deposits 0.14 % 0.28 % 0.49 %
Money market and savings deposits 0.19 % 0.56 % 1.43 %
Time deposits 0.56 % 1.38 % 2.30 %
Borrowings 1.02 % 0.84 % 1.73 %
Subordinated notes 5.12 % 5.70 % 6.69 %
Total interest-bearing liabilities 0.53 % 1.05 % 1.95 %
Interest spread 3.13 % 2.78 % 3.01 %
Net interest margin(4)
3.30 % 3.07 % 3.57 %
Tax equivalent effect 0.03 % 0.03 % 0.03 %
Net interest margin on a fully tax equivalent basis 3.33 % 3.10 % 3.60 %
(1) Includes nonaccrual loans.
(2) For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.
(3) Average rates and yields are presented on an annual basis and include a taxable equivalent adjustment to interest income of $617 thousand, $574 thousand and $453 thousand on tax-exempt securities for the years ended December 31, 2021, 2020 and 2019, respectively, using the federal corporate tax rate of 21%.
(4) Net interest margin represents net interest income divided by average total interest-earning assets.
Rate/Volume Analysis
The table below presents the effect of volume and rate changes on interest income and expense for the periods indicated. Changes in volume are changes in the average balance multiplied by the previous period's average rate. Changes in rate are changes in the average rate multiplied by the average balance from the previous period. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate. The average rate for tax-exempt securities is reported on a fully taxable equivalent basis.
For the year ended December 31, 2021 vs. 2020
Increase
(Decrease) Due to:
(Dollars in thousands) Rate Volume Net Increase (Decrease)
Interest-earning assets
Gross loans $ 163 $ 2,711 $ 2,874
Investment securities:
Taxable (547) 1,906 1,359
Tax-exempt (210) 234 24
Interest-earning cash balances (225) 53 (172)
Other investments (130) 56 (74)
Total interest income (949) 4,960 4,011
Interest-bearing liabilities
Interest-bearing demand deposits (190) 102 (88)
Money market and savings deposits (2,128) 542 (1,586)
Time deposits (4,317) (689) (5,006)
Borrowings 439 (917) (478)
Subordinated debt (242) (432) (674)
Total interest expense (6,438) (1,394) (7,832)
Change in net interest income $ 5,489 $ 6,354 $ 11,843
For the year ended December 31, 2020 vs. 2019
Increase
(Decrease) Due to:
(Dollars in thousands) Rate Volume Net Increase (Decrease)
Interest-earning assets
Gross loans $ (13,194) $ 26,353 $ 13,159
Investment securities:
Taxable (1,076) 244 (832)
Tax-exempt (191) 372 181
Interest-earning cash balances (1,327) 933 (394)
Other investments (117) 194 77
Total interest income (15,905) 28,096 12,191
Interest-bearing liabilities
Interest-bearing demand deposits (157) 198 41
Money market and savings deposits (3,589) 1,830 (1,759)
Time deposits (5,217) 987 (4,230)
Borrowings (1,009) 1,984 975
Subordinated debt (180) 1,643 1,463
Total interest expense (10,152) 6,642 (3,510)
Change in net interest income $ (5,753) $ 21,454 $ 15,701
Provision for Loan Losses
We established an allowance for loan losses through a provision for loan losses charged as an expense in our consolidated statements of income. Management reviews the loan portfolio, consisting of originated loans and acquired loans, on a quarterly basis to evaluate the outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses.
Loans acquired in connection with acquisitions that have evidence of credit deterioration since origination and for which it is probable at the date of acquisition that we will not collect all contractually required principal and interest payments are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, or ASC 310-30. These credit-impaired loans have been recorded at their estimated fair value on the respective acquisition date, based on subjective determinations regarding risk ratings, expected future cash flows and fair value of the underlying collateral, without a carryover of the related allowance for loan losses. At the acquisition date, the Company recognizes the expected shortfall of expected future cash flows, as compared to the contractual amount due, as a nonaccretable discount. Any excess of the net present value of expected future cash flows over the acquisition date fair value is recognized as the accretable discount, or accretable yield. We evaluate these loans semi-annually to assess expected cash flows. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges or a reclassification of the difference from nonaccretable to accretable with a positive impact on interest income. As of December 31, 2021, and December 31, 2020, our remaining accretable yield was $5.7 million and $7.1 million, and our nonaccretable difference was $1.4 million and $2.7 million, respectively.
The provision for loan losses was a provision benefit of $725 thousand for the year ended December 31, 2021, compared to a provision expense of $11.9 million for the year ended December 31, 2020. The decrease of $12.6 million in the provision for loan losses was primarily due to a decrease in general reserves of $10.6 million due to a reduction in qualitative factors within the allowance for loan loss model as a result of improved credit quality while qualitative factors were increased during the year ended December 31, 2020 due to economic uncertainty regarding the impact of the COVID-19 pandemic on credit quality. In addition, there was a decrease of $2.1 million in net chargeoffs resulting from a $1.3 million chargeoff on a nonaccrual loan during the second quarter of 2020.
Noninterest Income
The following table presents noninterest income for the years ended December 31, 2021, 2020 and 2019.
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Noninterest income
Service charges on deposits $ 3,311 $ 2,446 $ 2,547
Net gain on sales of securities 21 1,862 1,174
Mortgage banking activities 15,843 22,190 7,880
Other charges and fees 3,197 3,216 2,610
Total noninterest income $ 22,372 $ 29,714 $ 14,211
Noninterest income decreased $7.3 million to $22.4 million for the year ended December 31, 2021, compared to $29.7 million for the same period in 2020. The decrease in noninterest income was primarily due to decreases of $6.3 million in mortgage banking activities and $1.8 million in net gain on sales of securities. These decreases were partially offset by an increase of $865 thousand in service charges on deposits. The decrease in mortgage banking activities was primarily due to $115.7 million lower residential loan originations held for sale and $56.0 million lower residential loans sold. The higher volumes in the year ended December 31, 2020 were primarily due to a decrease in interest rates during the first half of 2020 while interest rates have remained relatively stable in 2021. The decrease in net gains on sales of securities was primarily due to fewer securities sold during 2021 compared to 2020. The increase in service charges on deposits was due to higher transaction volumes and deposit balances.
Noninterest Expense
The following table presents noninterest expense for the years ended December 31, 2021, 2020 and 2019.
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Noninterest expense
Salary and employee benefits $ 39,353 $ 38,304 $ 28,775
Occupancy and equipment expense 6,631 6,549 4,939
Professional service fees 3,542 2,935 1,808
Acquisition and due diligence fees - 1,654 539
FDIC premium 1,027 1,119 310
Marketing expense 1,288 956 1,107
Loan processing expense 983 935 661
Data processing expense 4,125 3,460 2,374
Core deposit premium amortization 668 768 146
Other expense 4,222 3,552 3,710
Total noninterest expense $ 61,839 $ 60,232 $ 44,369
Noninterest expense increased $1.6 million to $61.8 million for the year ended December 31, 2021, compared to $60.2 million for the same period in 2020. The increase in noninterest expense was primarily due to increases in salary and employee benefits of $1.0 million, other expense of $670 thousand, data processing expense of $665 thousand, professional service fees of $607 thousand, and marketing expense of $332 thousand. These increases were partially offset by a decrease of $1.7 million in acquisition and due diligence fees. The increase in salary and employee benefits was primarily due to annual compensation increases and an increase of 8 full-time equivalent employees. The increase in other expenses was primarily due to an increase in fraud losses. The increase in data processing expense was primarily due to a new loan processing system used for PPP loans. The increase in professional fees was primarily due to fees related to the pending merger. The increase in marketing expense was primarily due to an increase in advertising efforts. The decrease in acquisition and due diligence fees was due to the acquisition of Ann Arbor State Bank in the first quarter of 2020.
Income Taxes and Tax-Related Items
During the year ended December 31, 2021, we recognized income tax expense of $7.4 million on $39.9 million of pre-tax income resulting in an effective tax rate of 18.5%, compared to the same period in 2020, in which we recognized an income tax expense of $4.0 million on $24.4 million of pre-tax income, resulting in an effective tax rate of 16.2%.
The increase in income tax provision for the year ended December 31, 2021 compared to the same period in 2020 was primarily as a result of higher income before taxes. Additionally, a $290 thousand tax benefit related to the Ann Arbor State Bank net operating loss (NOL) in the first quarter of 2020 resulting from the Coronavirus Aid, Relief and Economic Security Act ("CARES Act") provision that allows for NOLs generated in 2018 to 2020 to be carried back five years as well as disqualified dispositions of Ann Arbor State Bank’s stock options generated a $175 thousand tax benefit in the first quarter of 2020.
See "Note 11 - Income Taxes" of Notes to Consolidated Financial Statements for a reconciliation between expected and actual income tax expense for the years ended December 31, 2021 and 2020.
Financial Condition
Investment Securities
The following table presents the fair value of the Company's investment securities portfolio, all of which were classified as available-for-sale as of December 31, 2021, 2020 and 2019.
As of December 31,
(Dollars in thousands) 2021 2020 2019
Securities available-for-sale:
U.S. government sponsored entities and agencies $ 21,774 $ 26,358 $ -
State and political subdivision 148,276 132,723 93,747
Mortgage-backed securities: residential 22,211 26,081 10,565
Mortgage-backed securities: commercial 23,271 11,918 8,779
Collateralized mortgage obligations: residential 13,461 13,446 8,529
Collateralized mortgage obligations: commercial 51,183 58,512 23,181
U.S. Treasury 64,387 - 1,999
SBA 13,927 17,593 21,984
Asset backed securities 9,706 10,072 10,084
Corporate bonds 29,355 6,029 2,037
Total securities available-for-sale $ 397,551 $ 302,732 $ 180,905
The composition of our investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity for both normal operations and potential acquisitions, while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral. At December 31, 2021, total investment securities were $397.6 million, or 15.8% of total assets, compared to $302.7 million, or 12.4% of total assets, at December 31, 2020. The $94.8 million increase in securities available-for-sale from December 31, 2020 to December 31, 2021, was due to the purchase of securities using the excess cash balances generated by the payoffs and forgiveness of PPP loans. Securities with a carrying value of $88.6 million and $98.7 million were pledged at December 31, 2021 and December 31, 2020, respectively, to secure borrowings, deposits and mortgage derivatives.
As of December 31, 2021, the Company held 68 tax-exempt state and local municipal securities totaling $52.3 million backed by the Michigan School Bond Loan Fund. Other than the aforementioned investments and the U.S. government and its agencies, at December 31, 2021 and December 31, 2020, there were no holdings of securities of any one issuer in an amount greater than 10% of shareholders' equity.
The securities available-for-sale presented in the following tables are reported at amortized cost and by contractual maturity as of December 31, 2021 and December 31, 2020. Expected maturities may differ from contractual maturities as issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage-backed securities and collateralized mortgage obligations receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax equivalent basis.
December 31, 2021
One year or less One to five years Five to ten years After ten years
(Dollars in thousands) Amortized
Cost Average
Yield Amortized
Cost Average
Yield Amortized
Cost Average
Yield Amortized
Cost Average
Yield
Securities available-for-sale:
U.S. government sponsored agency obligations $ 2,522 1.61 % $ - - % $ 15,000 1.22 % $ 5,000 1.48 %
State and political subdivision 1,341 2.41 12,869 2.42 53,553 2.68 73,988 2.88
Mortgage-backed securities: residential - - 73 1.90 27 1.92 22,216 1.09
Mortgage-backed securities: commercial - - 5,090 2.44 16,534 1.27 1,787 3.63
Collateralized mortgage obligations: residential - - 326 2.91 163 1.20 13,068 1.21
Collateralized mortgage obligations: commercial 2,248 5.62 4,424 2.77 38,782 1.20 6,428 1.96
U.S. Treasury - - 35,705 0.87 29,393 1.34 - -
SBA - - - - 7,424 1.45 6,427 1.31
Asset backed securities - - - - - - 9,762 0.76
Corporate bonds - - - - 29,673 3.61 - -
Total securities available-for-sale $ 6,111 3.26 % $ 58,487 1.51 % $ 190,549 2.03 % $ 138,676 2.13 %
December 31, 2020
One year or less One to five years Five to ten years After ten years
(Dollars in thousands) Amortized
Cost Average
Yield Amortized
Cost Average
Yield Amortized
Cost Average
Yield Amortized
Cost Average
Yield
Securities available-for-sale:
U.S. government sponsored agency obligations $ 4,027 1.61 % $ 2,548 1.61 % $ 15,000 1.22 % $ 5,000 1.48 %
State and political subdivision 1,768 1.96 10,095 2.46 31,142 2.80 81,048 2.99
Mortgage-backed securities: residential - - 78 0.94 87 0.19 25,564 1.44
Mortgage-backed securities: commercial 847 1.36 3,795 2.46 4,985 1.69 1,807 3.64
Collateralized mortgage obligations: residential - - 46 4.02 559 2.11 12,715 1.25
Collateralized mortgage obligations: commercial 577 2.54 8,011 3.10 40,889 1.26 7,921 2.46
SBA - - - - 9,879 1.40 7,760 1.21
Asset backed securities - - - - - - 10,229 0.84
Corporate bonds 3,498 3.08 - - 2,500 4.38 - -
Total securities available-for-sale $ 10,717 2.18 % $ 24,573 2.58 % $ 105,041 1.82 % $ 152,044 2.28 %
Loans
Our loan portfolio represents a broad range of borrowers comprised of commercial real estate, commercial and industrial, residential real estate, and consumer financing loans.
Commercial real estate loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, retail shopping centers and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers. Commercial real estate loans are then segregated into two classes: non-owner occupied and owner occupied commercial real estate loans. Non-owner occupied loans, which include loans secured by non-owner occupied and nonresidential properties, generally have a greater risk profile than owner-occupied loans, which include loans secured by multifamily structures and owner-occupied commercial structures.
Commercial and industrial loans include financing for commercial purposes in various lines of business, including manufacturing, service industry and professional service areas. Commercial and industrial loans are generally secured with the assets of the company and/or the personal guarantee of the business owners. The PPP loans funded during the second and third quarters of 2020 and first and second quarters of 2021, which are guaranteed by the SBA, are reported within the commercial and industrial loan category.
Residential real estate loans represent loans to consumers for the purchase or refinance of a residence. These loans are generally financed over a 15- to 30-year term and, in most cases, are extended to borrowers to finance their primary residence with both fixed-rate and adjustable-rate terms. Real estate construction loans are also offered to consumers who wish to build their own homes and are often structured to be converted to permanent loans at the end of the construction phase, which is typically twelve months. Residential real estate loans also include home equity loans and lines of credit that are secured by a first- or second-lien on the borrower's residence. Home equity lines of credit consist mainly of revolving lines of credit secured by residential real estate.
Consumer loans include loans made to individuals not secured by real estate, including loans secured by automobiles or watercraft, and personal unsecured loans.
The following table details our loan portfolio by loan type at the dates presented:
As of December 31,
(Dollars in thousands) 2021 2020 2019 2018 2017
Commercial real estate:
Non-owner occupied $ 467,364 $ 445,810 $ 388,515 $ 367,671 $ 343,420
Owner occupied 283,400 275,022 216,131 194,422 168,342
Total commercial real estate 750,764 720,832 604,646 562,093 511,762
Commercial and industrial 460,530 685,504 410,228 383,455 377,686
Residential real estate 440,640 315,476 211,839 180,018 144,439
Consumer 837 1,725 896 999 1,036
Total loans $ 1,652,771 $ 1,723,537 $ 1,227,609 $ 1,126,565 $ 1,034,923
Total loans were $1.65 billion at December 31, 2021, a decrease of $70.8 million from December 31, 2020. The decline in our loan portfolio compared to December 31, 2020 was primarily due to a $225.0 million decrease in our commercial and industrial loan portfolio, $213.6 million of which was due to the net change in PPP loans. This was partially offset by an increase of $125.2 million in our residential real estate portfolio. In general, we target a loan portfolio mix of approximately one-half commercial real estate, approximately one-third commercial and industrial loans and one-sixth a mix of residential real estate and consumer loans. As of December 31, 2021, approximately 45.4% of our loans were commercial real estate, 27.9% were commercial and industrial, and 26.7% were residential real estate and consumer loans.
We originate both fixed and adjustable rate residential real estate loans conforming to the underwriting guidelines of Fannie Mae and Freddie Mac, as well as home equity loans and lines of credit that are secured by first or junior liens. Most of our fixed rate residential loans, along with some of our adjustable rate mortgages, are sold to Fannie Mae and other financial institutions with which we have established a correspondent lending relationship. The Company established a direct relationship with Fannie Mae and began locking and selling loans to Fannie Mae with servicing retained during the third quarter of 2019. Refer to Note 8 - Mortgage Servicing Rights, Net for further details on our mortgage servicing rights.
Loan Maturity/Rate Sensitivity
The following table shows the contractual maturities of our loans as of December 31, 2021.
(Dollars in thousands) One year or
less After one but
within five
years After five but
within fifteen
years After fifteen
years Total
December 31, 2021
Commercial real estate $ 90,512 $ 422,681 $ 228,432 $ 9,139 $ 750,764
Commercial and industrial 135,940 243,580 78,135 2,875 460,530
Residential real estate 25,846 8,366 39,740 366,688 440,640
Consumer 62 586 40 149 837
Total loans $ 252,360 $ 675,213 $ 346,347 $ 378,851 $ 1,652,771
Sensitivity of loans to changes in interest rates:
Fixed interest rates $ 576,033 $ 177,823 $ 148,970
Floating interest rates 99,180 168,524 229,881
Total $ 675,213 $ 346,347 $ 378,851
Summary of Impaired Assets and Past Due Loans
Nonperforming assets consist of nonaccrual loans and other real estate owned. We do not consider performing TDRs to be nonperforming assets, but they are included as part of impaired assets. The level of nonaccrual loans is an important element in assessing asset quality. Loans are classified as nonaccrual when, in the opinion of management, collection of principal or interest is not expected according to the terms of the agreement. Generally, loans are placed on nonaccrual status due to the continued failure by the borrower to adhere to contractual payment terms coupled with other pertinent factors, such as insufficient collateral value.
A loan is categorized as a troubled debt restructuring if a concession is granted, such as to provide for the reduction of either interest or principal, due to deterioration in the financial condition of the borrower. Typical concessions include reduction of the interest rate on the loan to a rate considered lower than the current market rate, forgiveness of a portion of the loan balance, extension of the maturity date, and/or modifications from principal and interest payments to interest-only payments for a certain period. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. In accordance with bank regulatory guidance, troubled debt restructurings do not include short-term modifications made on a good-faith basis in response to the COVID-19 pandemic to borrowers who were current prior to any relief. This includes short-term modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. As of December 31, 2021, there were no loans that remained on a COVID-related deferral compared to $20.1 million as of December 31, 2020.
Credit Quality Indicators:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes commercial and industrial and commercial real estate loans and is performed on an annual basis. The Company uses the following definitions for risk ratings:
Pass. Loans classified as pass are higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: cash/stock secured, excellent credit risk, superior credit risk, good credit risk, satisfactory credit risk, and marginal credit risk.
Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company's credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
For residential real estate loans and consumer loans, the Company evaluates credit quality based on the aging status of the loan and by payment activity. Residential real estate loans and consumer loans are considered nonperforming if they are 90 days or more past due. Consumer loan types are continuously monitored for changes in delinquency trends and other asset quality indicators.
Purchased credit impaired loans accounted for under ASC 310-30 are classified as performing, even though they may be contractually past due, as any nonpayment of contractual principal or interest is considered in the semi-annual re-estimation of expected cash flows and is included in the resulting recognition of current period loan loss provision or future period yield adjustments.
Total classified and criticized loans as of December 31, 2021 compared to December 31, 2020 were as follows:
(Dollars in thousands) December 31, 2021 December 31, 2020
Classified loans:
Substandard $ 24,866 $ 34,921
Doubtful 1,477 1,143
Total classified loans $ 26,343 $ 36,064
Special mention 74,254 47,297
Total classified and criticized loans $ 100,597 $ 83,361
A summary of nonperforming assets (defined as nonaccrual loans and other real estate owned), performing troubled debt restructurings and loans 90 days or more past due and still accruing, as of the dates indicated, are presented below.
As of December 31,
(Dollars in thousands) 2021 2020 2019
Nonaccrual loans
Commercial real estate $ 4,246 $ 7,320 $ 4,832
Commercial and industrial 4,208 7,490 11,112
Residential real estate 2,819 3,991 2,569
Consumer 16 15 16
Total nonaccrual loans(1)
11,289 18,816 18,529
Other real estate owned 201 - 921
Total nonperforming assets 11,490 18,816 19,450
Performing troubled debt restructurings
Commercial and industrial 334 546 547
Residential real estate 365 432 359
Total performing troubled debt restructurings 699 978 906
Total impaired assets, excluding ASC 310-30 loans $ 12,189 $ 19,794 $ 20,356
Loans 90 days or more past due and still accruing $ 162 $ 269 $ 157
(1)Nonaccrual loans include nonperforming troubled debt restructurings of $3.4 million, $3.8 million, $3.0 million, $5.0 million and $6.4 million at the respective dates indicated above.
During the years ended December 31, 2021 and 2020, the Company recorded $641 thousand and $234 thousand, respectively, of interest income on nonaccrual loans and performing TDRs excluding PCI loans.
In addition to nonperforming and impaired assets, the Company had purchased credit impaired loans accounted for under ASC 310-30 which amounted to $4.2 million, $5.0 million, $6.0 million, $7.9 million, and $9.7 million at the respective dates indicated in the table above.
Nonperforming assets decreased $7.3 million as of December 31, 2021 compared to December 31, 2020. The decrease in nonperforming assets was attributable to a decrease in nonaccrual loans primarily due to pay offs of four commercial loan relationships totaling $5.4 million, paydowns on four commercial loan relationships totaling $3.9 million, and one $759 thousand residential loan relationship moving back to accruing. This was partially offset by two commercial loan relationships moving to nonaccrual status totaling $2.6 million.
Allowance for Loan Losses
We maintain the allowance for loan losses at a level we believe is sufficient to absorb probable incurred losses in our loan portfolio given the conditions at the time. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio and other factors. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change. The allowance is increased by provisions charged to expense and decreased by actual charge-offs, net of recoveries.
Acquired Loans
The allowance for loan losses on acquired loans is based on credit deterioration subsequent to the acquisition date. In accordance with the accounting guidance for business combinations, there was no allowance brought forward on any of the acquired loans as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at
the acquisition date. For purchased credit impaired loans, accounted for under ASC 310-30, management establishes an allowance for credit deterioration subsequent to the date of acquisition by re-estimating expected cash flows on a semi-annual basis with any decline in expected cash flows recorded as provision for loan losses. Impairment is measured as the excess of the recorded investment in a loan over the present value of expected future cash flows discounted at the pre-impairment accounting yield of the loan. For increases in cash flows expected to be collected, we first reverse any previously recorded allowance for loan losses, then adjust the amount of accretable yield recognized on a prospective basis over the loan's remaining life. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. For non-purchased credit impaired loans acquired in our acquisitions that are accounted for under ASC 310-20, the historical loss estimates are based on the historical losses experienced since acquisition. We record an allowance for loan losses only when the calculated amount exceeds the discount remaining from acquisition that was established for the similar period covered in the allowance for loan loss calculation. For all other purchased loans, the allowance is calculated in accordance with the methods used to calculate the allowance for loan losses for originated loans, as described below.
Originated Loans
The allowance for loan losses represents management's assessment of probable credit losses inherent in the loan portfolio. The allowance for loan losses consists of specific components, based on individual evaluation of certain loans, and general components for homogeneous pools of loans with similar risk characteristics.
Impaired loans include loans placed on nonaccrual status and troubled debt restructurings. Loans are considered impaired when based on current information and events it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreements. When determining if we will be unable to collect all principal and interest payments due in accordance with the original contractual terms of the loan agreement, we consider the borrower's overall financial condition, resources and payment record, support from guarantors, and the realizable value of any collateral. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
All impaired loans are identified to be individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the discounted expected future cash flows or at the fair value of collateral if repayment is collateral dependent.
The allowance for our nonimpaired loans, which includes commercial real estate, commercial and industrial, residential real estate, and consumer loans that are not individually evaluated for impairment, begins with a process of estimating the probable incurred losses in the portfolio. These estimates are established based on our historical loss data. Additional allowance estimates for commercial and industrial and commercial real estate loans are based on internal credit risk ratings. Internal credit risk ratings are assigned to each business loan at the time of approval and are subjected to subsequent periodic reviews by senior management, at least annually or more frequently upon the occurrence of a circumstance that affects the credit risk of the loan. There is no allowance on PPP loans (included in the commercial and industrial loan category) since they are 100% guaranteed by the SBA.
The Company's current methodology on historical loss analysis incorporates and fully relies on the Company's own historical loss data. The historical loss estimates are established by loan type including commercial real estate, commercial and industrial, residential real estate, and consumer. In addition, consideration is given to the borrower’s rating for commercial and industrial and commercial real estate loans.
The following table presents, by loan type, the changes in the allowance for loan losses for the periods presented.
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Balance at beginning of period $ 22,297 $ 12,674 $ 11,566
Loan charge-offs:
Commercial real estate - - (92)
Commercial and industrial (31) (2,118) (438)
Residential real estate (242) (285) -
Consumer (33) (58) (106)
Total loan charge-offs (306) (2,461) (636)
Recoveries of loans previously charged-off:
Commercial real estate - 12 6
Commercial and industrial 53 87 246
Residential real estate 86 85 77
Consumer 20 28 32
Total loan recoveries 159 212 361
Net charge-offs (147) (2,249) (275)
Provision for (recovery of) loan losses (725) 11,872 1,383
Balance at end of period $ 21,425 $ 22,297 $ 12,674
Allowance for loan losses as a percentage of period-end loans 1.30 % 1.29 % 1.03 %
Net charge-offs to average loans 0.01 0.13 0.02
Our allowance for loan losses was $21.4 million, or 1.30% of loans, at December 31, 2021 compared to $22.3 million, or 1.29% of loans, at December 31, 2020. As of December 31, 2021 and December 31, 2020, the allowance for loan losses as a percentage of loans excluding PPP loans (a non-GAAP measure), was 1.36% and 1.56%, respectively. The $872 thousand decrease in the allowance for loan losses during the year ended December 31, 2021 was primarily due to a decrease in general reserves related to the reduction in qualitative factors within the allowance for loan loss model as a result of improved credit quality partially offset by loan growth..
The following table presents, by loan type, the allocation of the allowance for loan losses at the dates presented.
(Dollars in thousands) Allocated
Allowance Percentage of loans in each category
to total loans
December 31, 2021
Balance at end of period applicable to:
Commercial real estate $ 9,455 45.3 %
Commercial and industrial 7,799 27.9
Residential real estate 4,166 26.7
Consumer 5 0.1
Total loans $ 21,425 100.0 %
December 31, 2020
Balance at end of period applicable to:
Commercial real estate $ 9,975 41.8 %
Commercial and industrial 8,786 39.8
Residential real estate 3,527 18.3
Consumer 9 0.1
Total loans $ 22,297 100.0 %
December 31, 2019
Balance at end of period applicable to:
Commercial real estate $ 5,773 49.2 %
Commercial and industrial 5,515 33.4
Residential real estate 1,384 17.3
Consumer 2 0.1
Total loans $ 12,674 100.0 %
The following table presents, by loan type, the net loan charge-offs for the dates presented.
(Dollars in thousands) Net charge-offs (recoveries) Percentage of average loans
For the year ended December 31, 2021
Commercial and industrial $ (22) - %
Residential real estate 156 -
Consumer 13 1.1
Total net charge-offs (recoveries) $ 147 - %
For the year ended December 31, 2020
Commercial real estate $ (12) - %
Commercial and industrial 2,031 0.3
Residential real estate 200 0.1
Consumer 30 1.0
Total net charge-offs (recoveries) $ 2,249 0.1 %
Goodwill
The Company has acquired three banks, Lotus Bank in March 2015, Bank of Michigan in March 2016, and Ann Arbor State Bank in January 2020, which resulted in the recognition of goodwill. Total goodwill was $35.6 million at December 31, 2021 and December 31, 2020.
As a result of the unprecedented decline in economic conditions triggered by the COVID-19 pandemic, the market valuations, including our stock price, saw a significant decline in March 2020, which then continued into the second quarter of 2020. These events indicated that goodwill may be impaired and resulted in us performing a qualitative goodwill impairment assessment in the second quarter of 2020. As a result of the analysis, we concluded that it was more-likely-than-not that the fair value of the reporting unit could be greater than its carrying amount.
Since the price of our stock did not fully recover during the third quarter of 2020, the Company engaged a reputable, third-party valuation firm to perform a quantitative analysis of goodwill as of August 31, 2020 ("the valuation date"). In
deriving the fair value of the reporting unit (the Bank), the third-party firm assessed general economic conditions and outlook; industry and market considerations and outlook; the impact of recent events on financial performance; the market price of our common stock; and other relevant events. In addition, the valuation relied on financial projections through 2023 and growth rates prepared by management. Based on the valuation prepared, it was determined that the Company's estimated fair value of the reporting unit at August 31, 2020 was greater than its book value, and impairment of goodwill was not required.
The Company completed its annual goodwill impairment review as of October 1, 2021, noting strong financial indicators for the Bank, solid credit quality ratios, as well as the strong capital position of the Bank. Management determined that no triggering events have occurred that indicated impairment from the most recent valuation date through December 31, 2021, the stock was trading above book value as of December 31, 2021, and it is more likely than not that there was no goodwill impairment as of December 31, 2021.
Deposits
Total deposits were $2.04 billion at December 31, 2021 and $1.96 billion at December 31, 2020, representing 89.6% and 88.1% of total liabilities, respectively. The increase in deposits of $76.8 million was comprised of an increase of $291.0 million in demand deposits partially offset by decreases of $171.0 million in time deposits and $43.2 million in money market and savings deposits. The increase in deposits was primarily due to organic deposit growth during the year ended December 31, 2021 mainly as a result of increased customer liquidity and new customer growth. We had $1.16 billion and $1.13 billion at December 31, 2021 and 2020, respectively.
Our average interest-bearing deposit costs were 0.33% and 0.93% for the years ended December 31, 2021 and 2020, respectively. The decrease in interest-bearing deposit costs between the two periods was primarily due to lower interest rates paid as a result of revised internal deposit rates, mainly driven by the continuation of the low level of the target federal funds rate. The target federal funds interest rate decreased 150 basis points during March 2020.
Brokered deposits. Brokered deposits are marketed through national brokerage firms to their customers in $1,000 increments. For these brokered deposits, detailed records of owners are maintained by The Depository Trust Company under the name of CEDE & Co. This relationship provides a large source of deposits for the Company. Due to the competitive nature of the brokered deposit market, brokered deposits tend to bear higher rates of interest than non-brokered deposits. At December 31, 2021 and December 31, 2020, the Company had approximately $23.1 million and $29.3 million, respectively, of brokered deposits. The Company's ability to accept, roll-over or renew brokered deposits is contingent upon the Bank maintaining a capital level of "well-capitalized."
Included in the brokered deposits total at December 31, 2021 and December 31, 2020 was $690 thousand and $1.2 million, respectively, in Certificate of Deposit Account Registry Service ("CDARS") one-way buys that were acquired from Ann Arbor State Bank.
Management understands the importance of core deposits as a stable source of funding and may periodically implement various deposit promotion strategies to encourage core deposit growth. For periods of rising interest rates, management has modeled the aggregate yields for non-maturity deposits and time deposits to increase at a slower pace than the increase in underlying market rates, which is intended to result in net interest margin expansion and an increase in net interest income.
The following table sets forth the distribution of average deposits by account type for the periods indicated below.
Year Ended December 31, 2021
(Dollars in thousands) Average
Balance Percent Average
Rate
Noninterest-bearing demand deposits $ 754,376 36.9 % - %
Interest-bearing demand deposits 162,405 7.9 0.14
Money market and savings deposits 613,883 29.9 0.19
Time deposits 519,447 25.3 0.56
Total deposits $ 2,050,111 100.0 % 0.21 %
Year Ended December 31, 2020
(Dollars in thousands) Average
Balance Percent Average
Rate
Noninterest-bearing demand deposits $ 574,537 32.7 % - %
Interest-bearing demand deposits 115,249 6.5 0.28
Money market and savings deposits 496,827 28.2 0.56
Time deposits 573,823 32.6 1.38
Total deposits $ 1,760,436 100.0 % 0.62 %
Year Ended December 31, 2019
(Dollars in thousands) Average
Balance Percent Average
Rate
Noninterest-bearing demand deposits $ 321,487 26.3 % - %
Interest-bearing demand deposits 57,480 4.7 0.49
Money market and savings deposits 314,918 25.8 1.43
Time deposits 527,605 43.2 2.30
Total deposits $ 1,221,490 100.0 % 1.39 %
The following table shows the contractual maturity of time deposits, including CDARS and IRA deposits and other brokered funds, over $250 thousand that were outstanding as of the date presented.
(Dollars in thousands) December 31, 2021
Maturing in:
3 months or less $ 124,718
3 months to 6 months 60,458
6 months to 1 year 64,470
1 year or greater 17,668
Total $ 267,314
Borrowings
Total debt outstanding at December 31, 2021 was $208.4 million, a decrease of $21.9 million from $230.3 million at December 31, 2020. The decrease in total borrowings compared to December 31, 2020 was primarily due to the redemption of $15.0 million of subordinated notes as well as a decrease of $6.0 million in FHLB long term borrowings.
At December 31, 2021, FHLB advances were secured by a blanket lien on $580.6 million of real estate-related loans, and repurchase agreements were secured by securities with a fair value of $4.0 million. At December 31, 2020, FHLB advances were secured by a blanket lien on $512.3 million of real estate-related loans, and repurchase agreements were secured by securities with a fair value of $3.7 million.
As of December 31, 2021, the Company had $30.0 million of subordinated notes outstanding and debt issuance costs of $306 thousand related to these subordinated notes. As of December 31, 2020, the Company had $45.0 million of subordinated notes outstanding and debt issuance costs of $408 thousand related to these subordinated notes.
The $15.0 million of subordinated notes issued on December 21, 2015 had a fixed interest rate of 6.375% per annum, payable semiannually through December 15, 2020. From December 15, 2020, through maturity, the notes had a floating interest rate of three-month LIBOR plus 477 basis points payable quarterly through maturity. The notes were scheduled to mature on December 15, 2025, and the Company had the option to redeem or prepay any or all of the subordinated notes without premium or penalty any time after December 15, 2020 or upon an occurrence of a Tier 2 capital event or tax event. These subordinated notes were redeemed in June 2021.
The $30.0 million of subordinated notes issued on December 18, 2019 bear a fixed interest rate of 4.75% per annum, payable semiannually through December 18, 2024. The notes will bear a floating interest rate of three-month SOFR plus 311 basis points payable quarterly after December 18, 2024 through maturity. The notes mature on December 18, 2029, and the Company has the option to redeem any or all of the subordinated notes without premium or penalty any time after December 18, 2024 or upon the occurrence of a Tier 2 capital event or tax event. The issuance of the $30.0 million subordinated notes reflected management's efforts to fund the liquidity needs of the Company as well as pay the merger consideration to purchase Ann Arbor State Bank.
Selected financial information pertaining to the components of our short-term borrowings for the periods and as of the dates indicated is as follows:
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Securities sold under agreements to repurchase
Average daily balance $ 3,001 $ 730 $ 547
Weighted-average rate during period 0.25 % 0.30 % 0.30 %
Amount outstanding at period end $ 2,342 $ 3,204 $ 851
Weighted-average rate at period end 0.25 % 0.30 % 0.30 %
Maximum month-end balance $ 3,993 $ 3,204 $ 866
FHLB Advances
Average daily balance $ - $ 4,085 $ 26,952
Weighted-average rate during period - % 0.98 % 2.32 %
Amount outstanding at period end $ - $ - $ 60,000
Weighted-average rate at period end - % - % 1.61 %
Maximum month-end balance $ - $ 25,000 $ 95,000
FHLB Line of Credit
Average daily balance $ 5 $ 45 $ 93
Weighted-average rate during period 0.44 % 1.47 % 2.85 %
Amount outstanding at period end $ - $ - $ -
Weighted-average rate at period end - % - % - %
Maximum month-end balance $ - $ - $ 895
Federal funds purchased
Average daily balance $ - $ 148 $ 1,679
Weighted-average rate during period - % 1.79 % 2.75 %
Amount outstanding at period end $ - $ - $ 5,000
Weighted-average rate at period end - % - % 1.90 %
Maximum month-end balance $ - $ - $ 15,000
Capital Resources
Shareholders' equity is influenced primarily by earnings, dividends, the Company's sales and repurchases of its common stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized gains or losses, net of taxes, on available for sale securities.
Shareholders' equity increased $24.8 million to $240.1 million at December 31, 2021 compared to $215.3 million at December 31, 2020. The increase in shareholders' equity was primarily impacted by $32.5 million of net income generated during the year ended December 31, 2021 and $1.9 million of options exercised during the year, partially offset by decreases of
$5.2 million of accumulated other comprehensive income due to decreases in net unrealized gains on available-for-sale securities, $1.9 million of dividends declared on our preferred stock, $1.8 million of dividends declared on our common stock, and $1.4 million of stock repurchased through the share buyback program during the year ended December 31, 2021.
The following table summarizes the changes in our shareholders' equity for the periods indicated below:
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Balance at beginning of period $ 215,327 $ 170,703 $ 151,760
Net income 32,478 20,413 16,111
Other comprehensive income (loss) (5,237) 4,590 5,344
Preferred stock offering, net of issuance costs - 23,372 -
Redeemed stock (1,364) (2,648) (2,165)
Dividends on 7.50% Series B Preferred Stock (1,875) (479) -
Common stock dividends declared (1,838) (1,542) (1,236)
Exercise of stock options 1,920 95 219
Stock-based compensation expense 680 823 670
Balance at end of period $ 240,091 $ 215,327 $ 170,703
We strive to maintain an adequate capital base to support our activities in a safe and sound manner while at the same time attempting to maximize shareholder value. We assess capital adequacy against the risk inherent in our balance sheet, recognizing that unexpected loss is the common denominator of risk and that common equity has the greatest capacity to absorb unexpected loss.
We are subject to various regulatory capital requirements both at the Company level and at the Bank level. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. We have consistently maintained regulatory capital ratios at or above the well-capitalized standards.
A capital conservation buffer, comprised of common equity tier 1 capital, is established above the regulatory minimum capital requirements, and financial institutions that maintain a capital conservation buffer of 2.5% are generally not subject to the additional restrictions on dividends, share repurchases and discretionary bonus payments to executive officers under the Basel III Rule.
At December 31, 2021 and December 31, 2020, the Company's and the Bank's capital ratios were in excess of the requirement to be "well capitalized" under the regulatory guidelines.
The summary below compares the actual capital ratios with the minimum quantitative measures established by regulation to ensure capital adequacy:
Actual
Capital
Ratio Capital
Adequacy
Regulatory
Requirement Capital Adequacy
Regulatory Requirement +
Capital Conservation
Buffer(1)
Well
Capitalized
Regulatory
Requirement
December 31, 2021
Common equity tier 1 to risk-weighted assets:
Consolidated 10.37 % 4.50 % 7.00 %
Bank 13.12 % 4.50 % 7.00 % 6.50 %
Tier 1 capital to risk-weighted assets:
Consolidated 11.75 % 6.00 % 8.50 %
Bank 13.12 % 6.00 % 8.50 % 8.00 %
Total capital to risk-weighted assets:
Consolidated 14.76 % 8.00 % 10.50 %
Bank 14.37 % 8.00 % 10.50 % 10.00 %
Tier 1 capital to average assets (leverage ratio):
Consolidated 7.93 % 4.00 % 4.00 %
Bank 8.86 % 4.00 % 4.00 % 5.00 %
December 31, 2020
Common equity tier 1 to risk-weighted assets:
Consolidated 9.30 % 4.50 % 7.00 %
Bank 11.94 % 4.50 % 7.00 % 6.50 %
Tier 1 capital to risk-weighted assets:
Consolidated 10.80 % 6.00 % 8.50 %
Bank 11.94 % 6.00 % 8.50 % 8.00 %
Total capital to risk-weighted assets:
Consolidated 14.91 % 8.00 % 10.50 %
Bank 13.20 % 8.00 % 10.50 % 10.00 %
Tier 1 capital to average assets (leverage ratio):
Consolidated 6.93 % 4.00 % 4.00 %
Bank 7.67 % 4.00 % 4.00 % 5.00 %
(1) Reflects the capital conservation buffer of 2.5% for risk-weighted asset ratios.
Contractual Obligations
In the ordinary course of our operations, we enter into certain contractual obligations. Total contractual obligations at December 31, 2021 were $644.7 million, a decrease of $193.9 million from $838.6 million at December 31, 2020. The decrease of $193.9 million was primarily due to decreases of $171.0 million in time deposits and $14.9 million in subordinated notes.
The following tables present our contractual obligations as of December 31, 2021 and December 31, 2020.
Contractual Maturities as of December 31, 2021
(Dollars in thousands) Less Than
One Year One to
Three Years Three to
Five Years Over
Five Years Total
Operating lease obligations $ 1,833 $ 3,185 $ 2,391 $ 3,110 $ 10,519
Short-term borrowings 2,342 - - - 2,342
Long-term borrowings 11,254 33,039 2,047 130,000 176,340
Subordinated notes - - - 29,694 29,694
Time deposits 359,707 64,036 2,058 - 425,801
Total $ 375,136 $ 100,260 $ 6,496 $ 162,804 $ 644,696
Contractual Maturities as of December 31, 2020
(Dollars in thousands) Less Than
One Year One to
Three Years Three to
Five Years Over
Five Years Total
Operating lease obligations $ 1,731 $ 3,478 $ 2,509 $ 3,775 $ 11,493
Short-term borrowings 3,204 - - - 3,204
Long-term borrowings 6,176 14,304 32,000 130,000 182,480
Subordinated notes - - 15,000 29,592 44,592
Time deposits 437,211 153,759 5,845 - 596,815
Total $ 448,322 $ 171,541 $ 55,354 $ 163,367 $ 838,584
Off-Balance Sheet Arrangements
In the normal course of business, the Company offers a variety of financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments include outstanding commitments to extend credit, credit lines, commercial letters of credit and standby letters of credit. These are agreements to provide credit, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies used for loans are used to make such commitments, including obtaining collateral at exercise of the commitment.
We maintain an allowance to cover probable losses inherent in our financial instruments with off-balance sheet risk. At December 31, 2021, the allowance for off-balance sheet risk was $369 thousand, compared to $490 thousand at December 31, 2020, and was included in "Other liabilities" on our consolidated balance sheets.
A summary of the contractual amounts of our exposure to off-balance sheet risk is as follows.
December 31, 2021 December 31, 2020
(Dollars in thousands) Fixed Rate Variable Rate Fixed Rate Variable Rate
Commitments to make loans $ 13,532 $ 13,531 $ 18,269 $ 17,058
Unused lines of credit 49,841 392,186 28,898 385,307
Unused standby letters of credit and commercial letters of credit 2,145 - 2,340 1,992
Of the total unused lines of credit of $442.0 million at December 31, 2021, $71.3 million was comprised of undisbursed construction loan commitments. The Company expects to have sufficient access to liquidity to fund its off-balance sheet commitments.
Liquidity
Liquidity management is the process by which we manage the flow of funds necessary to meet our financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of our operations, and capital expenditures. Liquidity is monitored and closely managed by the Bank's Asset and Liability Committee (ALCO), a group of senior officers from the finance, enterprise risk management, treasury, and lending areas, as well as two board members. It is ALCO's responsibility to ensure we have the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for and quickly identified, and management has plans in place to respond. ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources. In addition, we have implemented modeling software that projects cash flows from the balance sheet under a broad range of potential scenarios, including severe changes in the economic environment.
At December 31, 2021, we had liquid assets of $639.1 million, compared to $455.4 million at December 31, 2020. Liquid assets include cash and due from banks, federal funds sold, interest-bearing deposits with banks and unencumbered securities available-for-sale. Cash and due from banks increased to $330.1 million, compared to $264.1 million at December 31, 2020 primarily as a result of forgiveness of PPP loans and new customer growth.
The Bank is a member of the FHLB, which provides short- and long-term funding to its members through advances collateralized by real estate-related assets and other select collateral, most typically in the form of debt securities. The actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As of December 31, 2021, we had $175.1 million of outstanding borrowings from the FHLB, and these advances were secured by a blanket lien on $580.6 million of real estate-related loans. Based on this collateral and the approved policy limits, the Company is eligible to borrow up to an additional $228.7 million from the FHLB. Additionally, the Bank can borrow up to $157.5 million through the unsecured lines of credit it has established with eight other banks, as well as $5.0 million through a secured line with the Federal Reserve Bank.
Further, because the Bank is "well capitalized," it can accept wholesale funding up to 40% of total assets, or approximately $1.01 billion, based on current policy limits at December 31, 2021. Management believed that as of December 31, 2021, we had adequate resources to fund all of our commitments.
The following liquidity ratios compare certain assets and liabilities to total deposits or total assets.
December 31, 2021 December 31, 2020
Investment securities available-for-sale to total assets 15.80 % 12.39 %
Loans to total deposits 81.01 87.79
Interest-earning assets to total assets 94.37 94.64
Interest-bearing deposits to total deposits 60.94 68.49

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 7A - Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates. Interest-rate risk is the risk to earnings and equity value arising from changes in market interest rates and arises in the normal course of business to the extent that there is a divergence between the amount of our interest-earning assets and the amount of interest-bearing liabilities that are prepaid/withdrawn, re-price, or mature in specified periods. We seek to achieve consistent growth in net interest income and equity while managing volatility arising from shifts in market interest rates. ALCO oversees market risk management, monitoring risk measures, limits, and policy guidelines for managing the amount of interest-rate risk and its effect on net interest income and capital. Our Board of Directors approves policy limits with respect to interest rate risk.
Interest Rate Risk
Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective interest rate risk management begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk position given business activities, management objectives, market expectations and ALCO policy limits and guidelines.
Interest rate risk can come in a variety of forms, including repricing risk, basis risk, yield curve risk and option risk. Repricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes impact our assets and liabilities. Basis risk is the risk of adverse consequence resulting from unequal change in the spread between two or more rates for different instruments with the same maturity. Yield curve risk is the risk of adverse consequence resulting from unequal changes in the spread between two or more rates for different maturities for the same or different instruments. Option risk in financial instruments arises from embedded options such as options provided to borrowers to make unscheduled loan prepayments, options provided to debt issuers to exercise call options prior to maturity, and depositor options to make withdrawals and early redemptions.
We regularly review our exposure to changes in interest rates. Among the factors we consider are changes in the mix of interest-earning assets and interest-bearing liabilities, interest rate spreads and repricing periods. ALCO reviews, on at least a quarterly basis, our interest rate risk position.
The interest rate risk position is measured and monitored at the Bank using net interest income simulation models and economic value of equity sensitivity analysis that capture both short-term and long-term interest-rate risk exposure.
Modeling the sensitivity of net interest income and the economic value of equity to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. The models used for these measurements rely on estimates of the potential impact that changes in interest rates may have on the value and prepayment speeds on all components of our loan portfolio, investment portfolio, as well as embedded options and cash flows of other assets and liabilities. Balance sheet growth assumptions are also included in the simulation modeling process. The analysis provides a framework as to what our overall sensitivity position is as of our most recent reported position and the impact that potential changes in interest rates may have on net interest income and the economic value of our equity.
Net interest income simulation involves forecasting net interest income under a variety of interest rate scenarios including instantaneous shocks.
The estimated impact on our net interest income as of December 31, 2021 and December 31, 2020, assuming immediate parallel moves in interest rates is presented in the table below.
December 31, 2021 December 31, 2020
Change in rates Following 12 months Following 24 months Following 12 months Following 24 months
+400 basis points (8.3) % (14.2) % 2.8 % 5.5 %
+300 basis points (2.3) (7.5) 5.5 7.6
+200 basis points 0.9 (1.7) 6.2 8.6
+100 basis points 3.3 2.6 5.7 8.2
-100 basis points (3.9) (6.8) (3.3) (5.2)
Management strategies may impact future reporting periods, as our actual results may differ from simulated results due to the timing, magnitude, and frequency of interest rate changes, the difference between actual experience and the characteristics assumed, as well as changes in market conditions. Market-based prepayment speeds are factored into the analysis for loan and
securities portfolios. Rate sensitivity for transactional deposit accounts is modeled based on both historical experience and external industry studies.
We use economic value of equity sensitivity analysis to understand the impact of interest rate changes on long-term cash flows, income, and capital. Economic value of equity is based on discounting the cash flows for all balance sheet instruments under different interest rate scenarios.
The table below presents the change in our economic value of equity as of December 31, 2021 and December 31, 2020, assuming immediate parallel shifts in interest rates. Changes noted between the two periods reflect recent enhancements in our asset/liability modeling, including projected values for non-maturity deposits in changing interest rate environments and limitations on lowering certain deposit rates below zero.
Change in rates December 31, 2021 December 31, 2020
+400 basis points (15.0) % 15.0 %
+300 basis points (8.0) 19.0
+200 basis points (2.0) 20.0
+100 basis points 2.0 15.0
-100 basis points (11.0) (26.0)

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Item 8 - Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors
Level One Bancorp, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheet of Level One Bancorp, Inc. (the “Company”) as of December 31, 2021 and 2020; the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2021; and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2021 and 2020 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2021 in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
The Company's management is responsible for these financial statements. Our responsibility is to express an opinion on the Company’s financial statements 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 Company 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting.
Accordingly, we express no such opinion.
Our audits 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. We believe that our audits provide a reasonable basis for our opinion.
We have served as the Company’s auditor since 2019.
Auburn Hills, Michigan
March 11, 2022
LEVEL ONE BANCORP, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2021 December 31, 2020
(Dollars in thousands, except per share data)
Assets
Cash and cash equivalents $ 330,146 $ 264,071
Securities available-for-sale 397,551 302,732
Other investments 14,398 14,398
Mortgage loans held for sale, at fair value 12,902 43,482
Loans:
Originated loans 1,486,969 1,498,458
Acquired loans 165,802 225,079
Total loans 1,652,771 1,723,537
Less: Allowance for loan losses (21,425) (22,297)
Net loans 1,631,346 1,701,240
Premises and equipment, net 14,903 15,834
Goodwill 35,554 35,554
Mortgage servicing rights, net 5,604 3,361
Core deposit intangibles, net 2,528 3,196
Other real estate owned 201 -
Bank-owned life insurance 29,960 18,200
Income tax benefit 4,829 3,686
Interest receivable and other assets 35,947 37,228
Total assets $ 2,515,869 $ 2,442,982
Liabilities
Deposits:
Noninterest-bearing demand deposits $ 796,782 $ 618,677
Interest-bearing demand deposits 240,781 127,920
Money market and savings deposits 576,718 619,900
Time deposits 425,801 596,815
Total deposits 2,040,082 1,963,312
Borrowings 178,682 185,684
Subordinated notes 29,694 44,592
Other liabilities 27,320 34,067
Total liabilities 2,275,778 2,227,655
Shareholders' equity
Preferred stock, no par value per share; authorized-50,000 shares; issued and outstanding-10,000 shares, with a liquidation preference of $2,500 per share, at December 31, 2021 and 2020
23,372 23,372
Common stock, no par value per share; authorized-20,000,000 shares; issued and outstanding-7,733,726 shares at December 31, 2021 and 7,633,780 shares at December 31, 2020
88,851 87,615
Retained earnings 124,923 96,158
Accumulated other comprehensive income, net of tax 2,945 8,182
Total shareholders' equity 240,091 215,327
Total liabilities and shareholders' equity $ 2,515,869 $ 2,442,982
See accompanying notes to the consolidated financial statements.
LEVEL ONE BANCORP, INC.
CONSOLIDATED STATEMENTS OF INCOME
For the year ended December 31,
(In thousands, except per share data) 2021 2020 2019
Interest income
Originated loans, including fees $ 68,555 $ 62,069 $ 56,956
Acquired loans, including fees 10,809 14,421 6,375
Securities:
Taxable 4,036 2,677 3,509
Tax-exempt 2,510 2,486 2,305
Federal funds sold and other investments 740 986 1,303
Total interest income 86,650 82,639 70,448
Interest Expense
Deposits 4,313 10,993 16,941
Borrowed funds 1,875 2,353 1,378
Subordinated notes 1,863 2,537 1,074
Total interest expense 8,051 15,883 19,393
Net interest income 78,599 66,756 51,055
Provision for (recovery of) loan losses (725) 11,872 1,383
Net interest income after provision for loan losses 79,324 54,884 49,672
Noninterest income
Service charges on deposits 3,311 2,446 2,547
Net gain on sales of securities 21 1,862 1,174
Mortgage banking activities 15,843 22,190 7,880
Other charges and fees 3,197 3,216 2,610
Total noninterest income 22,372 29,714 14,211
Noninterest expense
Salary and employee benefits 39,353 38,304 28,775
Occupancy and equipment expense 6,631 6,549 4,939
Professional service fees 3,542 2,935 1,808
Acquisition and due diligence fees - 1,654 539
FDIC premium expense 1,027 1,119 310
Marketing expense 1,288 956 1,107
Loan processing expense 983 935 661
Data processing expense 4,125 3,460 2,374
Core deposit premium amortization 668 768 146
Other expense 4,222 3,552 3,710
Total noninterest expense 61,839 60,232 44,369
Income before income taxes 39,857 24,366 19,514
Income tax provision 7,379 3,953 3,403
Net income $ 32,478 $ 20,413 $ 16,111
Preferred stock dividends 1,875 479 -
Net income attributable to common shareholders $ 30,603 $ 19,934 $ 16,111
Per common share data:
Basic earnings per common share $ 4.00 $ 2.58 $ 2.08
Diluted earnings per common share $ 3.95 $ 2.57 $ 2.05
Cash dividends declared per common share $ 0.24 $ 0.20 $ 0.16
Weighted average common shares outstanding-basic 7,536 7,627 7,655
Weighted average common shares outstanding-diluted 7,650 7,686 7,770
See accompanying notes to the consolidated financial statements.
LEVEL ONE BANCORP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Net income $ 32,478 $ 20,413 $ 16,111
Other comprehensive income:
Unrealized gains (losses) on securities available-for-sale (6,608) 7,673 7,939
Reclassification adjustment for gains included in income (21) (1,862) (1,174)
Tax effect(1)
1,392 (1,221) (1,421)
Net unrealized gains (losses) on securities available-for-sale, net of tax (5,237) 4,590 5,344
Total comprehensive income, net of tax $ 27,241 $ 25,003 $ 21,455
(1) Includes $4 thousand, $391 thousand and $247 thousand of tax expense related to the reclassification adjustment for gains included in income for the years ended December 31, 2021, 2020, and 2019, respectively.
See accompanying notes to the consolidated financial statements.
LEVEL ONE BANCORP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(In thousands, except per share data) Preferred Stock Common Stock Retained Earnings Accumulated Other Comprehensive Income Total Shareholders' Equity
Balance at January 1, 2019 $ - $ 90,621 $ 62,891 $ (1,752) $ 151,760
Net income - - 16,111 - 16,111
Other comprehensive income - - - 5,344 5,344
Redeemed Stock (90,816 shares)
- (2,165) - - (2,165)
Common stock dividends declared ($0.16 per share)
- - (1,236) - (1,236)
Exercise of stock options (21,550 shares)
- 219 - - 219
Stock-based compensation expense, net of tax impact - 670 - - 670
Balance at December 31, 2019 $ - $ 89,345 $ 77,766 $ 3,592 $ 170,703
Net income - - 20,413 - 20,413
Other comprehensive income - - - 4,590 4,590
Redeemed stock (125,798 shares)
- (2,648) - - (2,648)
Preferred stock offering, net of issuance costs 23,372 - - - 23,372
Dividends on 7.50% Series B Preferred Stock
- - (479) - (479)
Common stock dividends declared ($0.20 per share)
- - (1,542) - (1,542)
Exercise of stock options (10,000 shares)
- 95 - - 95
Stock-based compensation expense, net of tax impact (1)
- 823 - - 823
Balance at December 31, 2020 $ 23,372 $ 87,615 $ 96,158 $ 8,182 $ 215,327
Net income - - 32,478 - 32,478
Other comprehensive income - - - (5,237) (5,237)
Redeemed stock (59,645 shares)
- (1,364) - - (1,364)
Dividends on 7.50% Series B Preferred Stock
- - (1,875) - (1,875)
Common stock dividends declared ($0.24 per share)
- - (1,838) - (1,838)
Exercise of stock options (118,482 shares)
- 1,920 - - 1,920
Stock-based compensation expense, net of tax impact (1)
- 680 - - 680
Balance at December 31, 2021 $ 23,372 $ 88,851 $ 124,923 $ 2,945 $ 240,091
(1) Refer to "Note 12 - Stock based compensation" of Notes to Consolidated Financial Statements for a summary of our stock compensation activity and its effects on outstanding shares for the years ended December 31, 2021 and 2020.
See accompanying notes to the consolidated financial statements.
LEVEL ONE BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Cash flows from operating activities
Net income $ 32,478 $ 20,413 $ 16,111
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation of fixed assets 1,602 1,694 1,323
Amortization of core deposit intangibles 668 768 146
Stock-based compensation expense 817 887 713
Provision for (recovery of) loan losses (725) 11,872 1,383
Net securities premium amortization 3,039 2,149 1,735
Net gain on sales of securities (21) (1,862) (1,174)
Originations of loans held for sale (443,115) (557,078) (272,714)
Proceeds from sales of loans 482,028 545,581 270,363
Net gain on sales of loans (16,057) (22,191) (7,835)
Accretion on acquired purchase credit impaired loans (1,454) (1,760) (2,313)
Gain on sale of other real estate owned and repossessed assets - (316) -
Increase in cash surrender value of life insurance (660) (470) (301)
Amortization of debt issuance costs 102 152 62
Provision (benefit) for deferred income taxes 1,414 (3,315) (592)
Net change in accrued interest receivable and other assets 1,909 (10,751) (8,934)
Net change in accrued interest payable and other liabilities (7,717) 3,441 6,151
Net cash provided by (used in) operating activities 54,308 (10,786) 4,124
Cash flows from investing activities
Net change in loans 76,448 (271,648) (97,660)
Principal payments on securities available-for-sale 29,780 23,342 15,511
Purchases of securities available-for-sale (135,903) (140,078) (56,810)
Purchases of Bank Owned Life Insurance (11,100) - -
Purchases of other investments - (2,000) (3,150)
Additions to premises and equipment (671) (1,289) (2,019)
Proceeds from:
Sale and call of securities available-for-sale 1,657 47,849 70,856
Sale of other real estate owned and repossessed assets - 4,164 -
Net cash used in acquisition - (29,464) -
Net cash used in investing activities (39,789) (369,124) (73,272)
Cash flows from financing activities
Net change in deposits 76,770 563,064 793
Change in short-term borrowings (862) (62,647) (32,278)
Issuances of long-term borrowings - 291,334 145,000
Repayment of long-term borrowings (6,090) (270,437) -
Net proceeds from issuance of subordinated debt - - 29,487
Net proceeds from issuance of preferred stock - 23,372 -
Pay down of subordinated debt (15,000) - -
Change in secured borrowing (50) (70) (71)
Share buyback - redeemed stock (1,364) (2,648) (2,165)
Preferred stock dividends paid (1,875) (479) -
Common stock dividends paid (1,756) (1,469) (1,160)
Proceeds from exercised stock options 1,920 95 219
Payments related to tax-withholding for share based compensation awards (137) (64) (43)
Net cash provided by financing activities 51,556 540,051 139,782
Net change in cash and cash equivalents 66,075 160,141 70,634
Beginning cash and cash equivalents 264,071 103,930 33,296
Ending cash and cash equivalents $ 330,146 $ 264,071 $ 103,930
Supplemental disclosure of cash flow information:
Interest paid $ 8,366 $ 16,376 $ 19,493
Taxes paid 7,654 8,599 2,916
Transfer from loans held for sale to loans held for investment and repurchases 5,038 5,217 2,186
Transfer from loans to other real estate owned 201 2,927 921
Non-cash transactions:
Increase in assets and liabilities in acquisitions:
Assets acquired-Ann Arbor State Bank $ - $ 325,303 $ -
Liabilities assumed-Ann Arbor State Bank - 283,526 -
See accompanying notes to the consolidated financial statements.
LEVEL ONE BANCORP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1-BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Nature of Operations:
Level One Bancorp, Inc. (the “Company,” “Level One,” “we,” “our,” or “us”) is a financial holding company headquartered in Farmington Hills, Michigan. Including the Company headquarters, as of December 31, 2021, its wholly owned bank subsidiary, Level One Bank (the "Bank"), had 17 offices, including 11 banking centers (our full service branches) in Metro Detroit, one banking center in Grand Rapids, one banking center in Jackson, three banking centers in Ann Arbor and one mortgage loan production office in Ann Arbor.
The Bank is a Michigan banking corporation with depository accounts insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (the "FDIC"). The Bank provides a wide range of business and consumer financial services in southeastern Michigan and west Michigan. Its primary deposit products are checking, interest-bearing demand, money market and savings, and term certificate accounts, and its primary lending products are commercial real estate, commercial and industrial, residential real estate, and consumer loans. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Other financial instruments, which potentially represent concentrations of credit risk, include federal funds sold.
Hamilton Court Insurance Company ("Hamilton Court"), was a wholly owned insurance subsidiary of the Company that provided property and casualty insurance coverage to the Company and the Bank and reinsurance to ten other third party insurance captives for which insurance may not have been available or economically feasible in the insurance marketplace. Hamilton Court was designed to insure the risks of the Company and the Bank by providing additional insurance coverage for deductibles, excess limits and uninsured exposures. Hamilton Court was incorporated in Nevada. Hamilton Court Insurance Company exited the pool resources relationship to which it was previously a member and was dissolved in the first quarter of 2021.
Preferred Stock Public Offering:
On August 10, 2020, the Company sold 1,000,000 depositary shares, each representing 1/100th interest in a share of 7.50% Non-Cumulative Perpetual Preferred Stock, Series B, with a liquidation preference of $2,500 per share of Preferred Stock (equivalent to $25 per depositary share). The aggregate offering price for the shares sold by the Company was $25.0 million, and after deducting $1.6 million of underwriting discounts and offering expenses paid to third parties, the Company received total net proceeds of $23.4 million.
Merger with Ann Arbor Bancorp, Inc.:
On January 2, 2020, the Company completed its acquisition of Ann Arbor Bancorp, Inc. (“AAB”) and its wholly owned subsidiary, Ann Arbor State Bank. The Company paid aggregate consideration of approximately $67.9 million in cash. See "Note 2 - Business Combinations" for more information.
Merger with First Merchants Corporation:
On November 4, 2021, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with First Merchants Corporation., an Indiana corporation (“First Merchants”). The Merger Agreement provides that, upon the terms and subject to the conditions set forth therein, we will merge with and into First Merchants (the “Merger”), with First Merchants as the surviving corporation in the Merger. Immediately following the Merger, the Bank will consolidate with and into First Merchant’s’ wholly owned bank subsidiary, First Merchants Bank, with First Merchants Bank as the surviving entity.
Upon the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger, each share of our common stock outstanding immediately prior to the effective time of the Merger will be converted into the right to receive (i) 0.7167 shares of First Merchants common stock and (ii) $10.17 in cash. Each share of our 7.50% Non-Cumulative Perpetual Preferred Stock, Series B (“Level One Preferred Stock”) outstanding immediately prior to the effective time of the Merger will be converted into the right to receive a share of a newly created series of preferred stock of First Merchants having voting powers, preferences and special rights that are substantially identical to the Level One Preferred Stock (“First Merchants Preferred Stock”). Each depositary share issued pursuant to the Deposit Agreement, dated as of August 13, 2020, among Level One, Continental Stock Transfer & Trust Company, as depositary, and the holders from time to time of the depositary receipts described therein, representing one-hundredth of one share of the Level One Preferred Stock, shall thereupon represent one-hundredth of one share of the First Merchants Preferred Stock.
Basis of Presentation:
The accompanying consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to predominant practices within the banking industry. Management of the Company has made a number of estimates and assumptions related to the reporting of assets and liabilities to prepare the consolidated financial statements in conformity with GAAP. Actual results may differ from those estimates. In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of the results of operations for annual periods presented herein, have been included. Some items in the prior year financial statements were reclassified to conform to the current presentation. Such items had no impact on net income or shareholder’s equity.
Principles of Consolidation:
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, the Bank and Hamilton Court, after elimination of significant intercompany transactions and accounts.
Business Combinations
The Company accounts for business combinations under the acquisition method of accounting. Under the acquisition method, tangible and intangible identifiable assets acquired, liabilities assumed and any noncontrolling interests in the acquiree are recorded at fair value as of the acquisition date. The Company includes the results of operations of the acquired companies in the consolidated statements of income from the date of acquisition. Transaction costs and costs to restructure the acquired company are expensed as incurred. Goodwill is recognized as the excess of the acquisition price over the estimated fair value of the net assets acquired. If the fair value of the net assets acquired is greater than the acquisition price, a bargain purchase gain is recognized and recorded in noninterest income.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, amounts due from banks, which includes amounts on deposit with the Federal Reserve, interest-bearing deposits with banks or other financial institutions and federal funds sold. Generally, federal funds are sold for one-day periods, but not longer than 30 days.
Investment Securities
Investment securities consist of debt securities of the U.S. Treasury, government sponsored entities, states, counties, municipalities, corporations, agency mortgage-backed securities and non-agency mortgage-backed securities. Securities transactions are recorded on a trade date basis. Securities are classified as available for sale when the Company intends to sell them before maturity. Available-for-sale securities are recorded at fair value. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are included in other comprehensive income and the related accumulated unrealized holding gains and losses are reported as a separate component of shareholders’ equity until realized.
On a quarterly basis, the Company makes an assessment to determine whether there have been any events or circumstances to indicate that a security for which there is an unrealized loss is impaired on an other than temporary basis. This determination requires significant judgment. A decline in the fair value of any available-for-sale security below cost that is deemed other than temporary results in a charge to earnings and the establishment of a new cost basis for the security. In estimating other-than-temporary impairment (“OTTI”) losses, we consider the severity and duration of the impairment; the financial condition and near-term prospects of the issuer, which for debt securities considers external credit ratings and recent downgrades; projected cash flows on covered non-agency mortgage-backed securities; and the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value. Management evaluates securities for other-than-temporary impairment more frequently when economic or market conditions warrant such an evaluation.
Interest income includes amortization of purchase premiums or discounts. Premiums and discounts on securities are amortized on the level-yield method. Gains and losses on sales are recorded on the trade date and determined using the specific identification method. Also, when applicable, realized gains and losses are reported as a reclassification adjustment, net of tax, in other comprehensive income.
Other Investments
The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. The Bank also invests in an equity security that does not have a readily determinable fair value because its
ownership is restricted and lacks a market for trading. As a result, this security is carried at cost and is periodically evaluated for impairment.
Loans Held for Sale
Loans held for sale consist of loans originated with the intent to sell. Loans held for sale are carried at fair value, determined individually, as of the balance sheet date. The Company believes the fair value method reflects the economic risks associated with these loans. Fair value measurements on loans held for sale are based on quoted market prices for similar loans in the secondary market, market quotes from anticipated sales contracts and commitments, or contract prices from firm sales commitments. Fair value includes the servicing value of the loans as well as any accrued interest. The changes in the fair value of loans held for sale are reflected in mortgage banking activities on the consolidated statements of income.
Loans held for sale are sold with either servicing rights released or servicing rights retained. In addition to the Small Business Administration and United States Department of Agriculture guaranteed loans, which are sold with servicing retained, the Company starting selling loans held for sale with servicing retained directly to FNMA during the third quarter of 2019. Refer to the mortgage servicing rights section below for further discussion.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unamortized deferred loan fees and costs and net of any purchase premiums and discounts. Interest income is recorded on the accrual basis, in accordance with the terms of the respective loan. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income without anticipating prepayments.
Loans are considered delinquent when principal or interest payments are past due 30 days or more; delinquent loans may remain on accrual status between 30 days and 89 days past due. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Interest income on mortgage and commercial loans is discontinued when principal or interest payments are past due 90 days, unless the loan is well-secured and in process of collection. Consumer loans are typically charged off no later than 120 days past due. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Interest received on such loans is accounted for on the cash-basis or cost recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Certain Purchased Loans
The Company purchases individual loans and groups of loans, some of which have shown evidence of credit deterioration since origination. These purchased credit impaired (“PCI”) loans are recorded at the amount paid or at fair value at acquisition in a business combination, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the provision for loan losses.
These PCI loans are accounted for individually or aggregated into pools of loans based on common risk characteristics such as credit grade, loan type, and date of origination. The Company estimates the amount and timing of expected cash flows for each purchased loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).
Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, an impairment loss is recognized by establishing an allocation for the loan or pool in the allowance for loan losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized, prospectively, as loan interest income.
Allowance for Loan Losses
The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors considered by
management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
Loans over $250 thousand are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.
Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings, are classified as impaired, regardless of size, and are measured for impairment based upon the present value of estimated future cash flows using the loan’s effective rate at inception or, if considered collateral dependent, based upon the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
An allowance for loan losses for purchased credit impaired loans is recorded when projected future cash flows decrease. The measurement of impairment on these loans or pools of loans is based upon the excess of the loan or pool’s carrying value over the present value of the projected future cash flows, discounted at the last accounting yield applicable to the loan or pool of loans.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent 36 months. The historical loss analysis incorporates and fully relies on the Bank’s own historical loss data. The historical loss estimates are established by loan type including commercial and industrial and commercial real estate. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: local and national economic conditions; trends in underwriting standards and lending policies; trends in portfolio volume, maturity and composition (impact of credit concentrations); experience, ability and depth of lending management and staff; trends in delinquencies and nonaccruals; results of independent loan review; change in value for collateral dependent loans; high loan growth; unseasoned bank portfolio; specialized financing; and other factors (legal, regulatory, competition). The following portfolio segments have been identified:
Commercial real estate loans are secured by a mortgage lien on the real estate property. Owner-occupied real estate loans generally are considered to carry less risk than non-owner occupied real estate (properties) because the Company considers them to be less sensitive to the condition of the commercial real estate market. Repayment is based on the operations of the business. Investment real estate loans rely on rental income for loan repayment, which involves risk such as rent rollover, tenants going out of business, and competitive properties in the area. Construction and land development loans generally are considered the riskiest class of commercial real estate, due to possible cost overruns, contractor/lien issues, loss of tenant, etc. Risk of loss is managed by adherence to standard loan policies that establish certain levels of performance prior to the extension of a loan to the borrower.
Commercial and Industrial loans have varying degrees of risk, but overall are considered to have less risk than commercial real estate. These loans are generally short-term in nature and are almost always backed by collateral. Unsecured commercial loans are supported by strong borrower(s)/guarantor(s) in terms of liquidity, net worth, cash flow, etc. Collateral security of these loans is relatively liquid (i.e., accounts receivable, inventory, equipment) and readily available to cover potential loan loss. Credit risk is managed through standardized loan policies, established and authorized credit limits, portfolio management and the diversification of industries. The PPP loans funded during the second and third quarters of 2020, which are guaranteed by the SBA, are reported within this loan category.
Consumer and Residential Real Estate loan portfolios, unlike commercial, tend to be composed of many relatively homogeneous loans. Loan repayment is based on personal cash flow. To assess the risk of a consumer loan request, loan purpose, collateral, debt to income ratio, credit bureau report, and cash flow/employment verification are analyzed. A certain level of security is provided through liens on credits supported by collateral.
Economic conditions that affect consumers in the Bank’s market have a direct impact on the credit quality of these loans. Higher levels of unemployment, lower levels of income growth and weaker economic growth are factors that may adversely impact consumer loan credit quality.
The majority of residential real estate loans originated by the Bank conform to secondary market underwriting standards and are sold within a short timeframe to unaffiliated third parties, including the future servicing rights to the loans. The credit underwriting standards for these loans require a certain level of documentation, verifications, valuations, and overall credit performance of the borrower.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets. Leasehold improvements are amortized over the shorter of the life of the asset or the expected term of the lease.
We periodically review the carrying value of our long-lived assets to determine if impairment has occurred or whether changes in circumstances have occurred that would require a revision to the remaining useful life. In making such determination, we evaluate the performance, on an undiscounted basis, of the underlying operations or assets which give rise to such amount.
Other Real Estate Owned ("OREO") and Repossessed Assets
Other real estate owned and repossessed assets represent properties/assets acquired through acquisition, foreclosure, repossession process or other proceedings, and are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Fair value for OREO is based on an appraisal performed upon foreclosure. Property is evaluated regularly to ensure the recorded amount is supported by its fair value less estimated costs to dispose. After the initial foreclosure appraisal, fair value is generally determined by an annual appraisal unless known events warrant adjustments to the recorded value. Revenue from the operations of OREO is included in other income in the consolidated statements of income, and expense from the operations of OREO and decreases in valuations are included in other expense in the consolidated statements of income.
Goodwill and Core Deposit Intangible
Goodwill resulting from business combinations is generally determined as the excess of the fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet.
Core deposit intangible represents the value of the acquired customer core deposit bases and is included as an asset on the consolidated balance sheets. The core deposit intangible has an estimated finite life, is amortized on an accelerated basis over a 120-month period and is subject to periodic impairment evaluation. Management will periodically review the carrying value of its long-lived and intangible assets to determine if any impairment has occurred or whether changes in circumstances have occurred that would require a revision to the remaining useful life, in which case an impairment charge would be recorded as an expense in the period of impairment. In making such determination, management evaluates whether there are any adverse qualitative factors indicating that an impairment may exist, as well as the performance, on an undiscounted basis, of the underlying operations or assets which give rise to the intangible.
Mortgage Servicing Rights
When loans are sold with servicing retained, the servicing rights are carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value. The servicing rights are amortized in proportion to and over the period of estimated net servicing income.
Servicing rights are evaluated for impairment on a quarterly basis based upon the fair value obtained from an independent third party valuation model requiring the incorporation of assumptions that market participants would use in estimating future net servicing income, which include estimates of prepayment speeds, discount rate, cost to service, contractual servicing fee income, ancillary income, late fees, replacement reserves and other economic factors that are determined based on current market conditions.
Servicing fee income on residential mortgages totaled $1.2 million and $331 thousand for the years ended December 31, 2021 and 2020, respectively.
Bank-owned Life Insurance
The Bank has purchased life insurance policies on certain key executives and senior managers. Bank-owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Derivatives
All derivatives are recognized on the consolidated balance sheet as a component of other assets or other liabilities at their fair value.
Customer-initiated derivatives refer to the Company utilizing interest rate derivatives to provide a service to certain qualifying customers to help facilitate their respective risk management strategies. Therefore, these derivatives are not used to manage interest rate risk in the Company's assets or liabilities. The Company generally takes offsetting positions with dealer counterparties to mitigate the valuation risk of the customer-initiated derivatives. Income primarily results in the spread between the customer derivatives and offsetting dealer positions. The gains or losses derived from changes in fair value are recognized in current earnings during the period of change in other non-interest income on the consolidated statements of income. At December 31, 2021, the total notional amount of such agreements was $148.9 million and resulted in a derivative asset with a fair value of $5.4 million which was included in other assets and a derivative liability of $5.4 million which was included in other liabilities.
Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as freestanding derivatives. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked. The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into in order to hedge the change in interest rates resulting from its commitments to fund the loans. Changes in the fair values of these derivatives are included in mortgage banking activities in the consolidated statements of income.
Secured borrowing
Transfers of financial assets that do not qualify for sale accounting are reported as collateralized borrowings. Accordingly, the related assets remain on the Company’s balance sheet and continue to be reported and accounted for as if the transfer had not occurred. Cash proceeds from these transfers are reported as liabilities, with attributable interest expense recognized over the life of the related transactions.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are any matters at this time that will have a material effect on the consolidated financial statements.
Earnings per Share
The Company's restricted stock awards that pay non-forfeitable common stock dividends meet the criteria of a participating security. Accordingly, beginning in 2019, earnings per share is calculated using the two-class method under which earnings are allocated to both common shares and participating securities.
Debt Issuance Costs
Costs associated with the issuance of debt are presented in the consolidated balance sheet as a direct reduction from the carrying value of that debt liability. The deferred issuance costs are amortized over the life the related debt instrument, and included within the debt’s interest expense.
Stock-Based Compensation
Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards as there is no market or performance metrics that must be met. Compensation cost is recognized over the required service period, generally defined as
the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. Additionally, the Company accounts for forfeitures as they occur.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, net of taxes and reclassifications.
Income Taxes
Income tax expense or benefit is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Dividend Restriction
Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the holding company or by the holding company to shareholders. The total amount of dividends which may be paid out at any date is also generally limited to retained earnings.
Operating Segments
While chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating results are not reviewed by senior management to make resource allocation or performance decisions. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Emerging Growth Company Status:
We are an "emerging growth company," as defined in the Jumpstart Our Business Startups Act of 2012 (the JOBS Act). Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period when complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of this extended transition period, which means these financial statements, as well as financial statements we file in the future for as long as we remain an emerging growth company, will be subject to all new or revised accounting standards generally applicable to private companies.
Impact of Recently Issued Accounting Standards:
Leases
In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)," to improve transparency and comparability across entities regarding leasing arrangements. This ASU requires the recognition of a separate lease liability representing the required discounted lease payments over the lease term and a separate lease asset representing the right to use the underlying asset during the same lease term. Additionally, this ASU provides clarification regarding the identification of certain components of contracts that would represent a lease as well as requires additional disclosures to the notes of the financial statements.
The guidance is effective for the Company for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. In July 2018, the FASB issued ASU 2018-11, "Leases (Topic 842): Targeted Improvements" which provided additional guidance on the transition method, including application as a cumulative effect adjustment to equity and practical expedients to use when account for lease components. The Company adopted this standard as of January 1, 2022, and recorded right of use assets of $9.8 million with a like lease liability, recorded to other assets and liabilities, respectively.
Allowance for Credit Losses
In June 2016, the FASB issued ASU No. 2016-13, "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments," to replace the current incurred loss methodology for recognizing credit losses, which delays recognition until it is probable a loss has been incurred, with a methodology that reflects an estimate of all expected credit losses and considers additional reasonable and supportable forecasted information when determining credit loss estimates. This impacts the calculation of the allowance for credit losses for all financial assets measured under the amortized cost basis, including PCI loans at the time of and subsequent to acquisition. Additionally, credit losses related to available-for-sale debt securities would be recorded through the allowance for credit losses and not as a direct adjustment to the amortized cost of the securities.
The guidance is effective for the Company for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Once adopted, we expect our allowance for loan losses to increase through a one-time adjustment to retained earnings. The Company has reviewed potential methodologies for estimating expected credit losses, segmented the loan portfolio and established an implementation timeline. Our bank's merger with First Merchants Bank will be completed prior to the effective date, and First Merchants will complete the implementation.
Reference Rate Reform
In March 2020, the FASB issued ASU 2020-04, "Reference Rate Reform (Topic 848) : Facilitation of the Effects of Reference Rate Reform on Financial Reporting" to provide guidance to ease the potential burden in accounting for, or recognizing the effects of, reference rate reform on financial reporting. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met and only applies to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. In addition, the ASU provides optional expedients for applying the requirements of certain topics or industry subtopics in the Codification for contracts that are modified because of reference rate reform and contemporaneous modifications of other contract terms related to the replacement of the reference rate. The ASU allows companies to apply the standard as of the beginning of the interim period that includes March 12, 2020 through December 31, 2022. The Company is currently assessing the impact of this guidance to its financial statements; however, the impact is not expected to be material.
NOTE 2-BUSINESS COMBINATIONS
On January 2, 2020, the Company completed its previously announced acquisition of Ann Arbor Bancorp, Inc. and its wholly owned subsidiary, Ann Arbor State Bank. The Company paid an aggregate consideration of approximately $67.9 million in cash. The Company engaged in this transaction with the expectation that it would be accretive to income and expand our footprint in the Ann Arbor and Jackson markets.
AAB's results of operations were included in the Company’s results beginning January 2, 2020. Acquisition-related costs of $1.7 million are included in the Company’s income statement for the year ended December 31, 2020.
Goodwill of $26.2 million arising from the acquisition consisted largely of synergies and the cost savings resulting from the combining of the operations of the companies. The goodwill arising from the acquisition of AAB is not deductible for tax purposes.
The following table summarizes the amounts of assets acquired and liabilities assumed recognized at the acquisition date.
(Dollars in thousands)
Consideration paid:
Cash $ 67,944
Fair value of assets acquired:
Cash and cash equivalents 38,480
Investment securities 47,416
Federal Home Loan Bank stock 923
Loans held for sale 1,703
Loans held for investment 222,356
Premises and equipment 2,404
Core deposit intangibles 3,663
Other assets 8,358
Total assets acquired 325,303
Fair value of liabilities assumed:
Deposits 264,820
Federal Home Loan Bank advances 15,279
Other liabilities 3,427
Total liabilities assumed 283,526
Total identifiable net assets 41,777
Goodwill recognized in the acquisition $ 26,167
Core deposit intangibles of $3.7 million arising from the acquisition is being amortized over 10 years on an accelerated basis using the sum of the years digits method.
Loans acquired in the acquisition were initially recorded at fair value with no separate allowance for loan losses. The Company reviewed the loans at acquisition to determine which should be considered purchased credit impaired loans (i.e. loans accounted for under ASC 310-30), defining impaired loans as those that were either not accruing interest or exhibited credit risk factors consistent with nonaccrual loans at the acquisition date. Fair values for purchased loans are based on a discounted cash flow methodology that considers various factors including the type of loan and related collateral, classification status, fixed or variable interest rate, term of the loan and whether or not the loan was amortizing, and a discount rate reflecting the Company's assessment of risk inherent in the cash flow estimates. The Company accounts for purchased credit impaired loans in accordance with the provisions of ASC 310-30. The cash flows expected to be collected on purchased loans are estimated based upon the expected remaining life of the underlying loans, which includes the effects of estimated prepayments. Purchased loans are considered credit impaired if there is evidence of credit deterioration at the date of purchase and if it is probable that not all contractually required payments will be collected. Interest income, through accretion of the difference between the carrying value of the loans and the expected cash flows is recognized on the acquired loans accounted for under ASC 310-30.
Purchased loans outside the scope of ASC 310-30 are accounted for under ASC 310-20. Premiums and discounts created when the loans were recorded at their fair values at acquisition are amortized over the remaining terms of the loans as an adjustment to the related loan's yield.
(Dollars in thousands)
Accounted for under ASC 310-30:
Contractual cash flows $ 1,018
Contractual cash flows not expected to be collected (nonaccretable difference) 82
Expected cash flows 936
Interest component of expected cash flows (accretable yield) 35
Fair value at acquisition 901
Accounted for under ASC 310-20:
Unpaid principal and interest balance 221,061
Fair value premium 394
Fair value at acquisition 221,455
Total fair value at acquisition $ 222,356
The pro forma table below presents information as if the acquisition had occurred on January 1, 2019. The pro forma information includes adjustments to give the effects to any changes in interest income due to the accretion (amortization) of the discount (premium) associated with the fair value adjustments to acquired loans, any changes in interest expense due to estimated premium amortization/discount accretion associated with the fair value adjustments to acquired time deposits and borrowings and other debt, amortization of core deposit intangibles that would have resulted had the deposits been acquired as of January 1, 2019, and the related income tax effects. The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transaction been effected on the assumed date. Due diligence, professional fees, and other expenses related to the merger were incurred by the Company and AAB during the year ended December 31, 2020, but the pro forma condensed combined statement of income is not adjusted to exclude these costs.
For the year ended December 31,
(Dollars in thousands, except per share data) 2020 2019
Net interest income $ 66,796 $ 61,103
Noninterest income 29,714 17,206
Noninterest expense 60,300 53,174
Net income 20,433 17,647
Net income per diluted share 2.57 2.26
NOTE 3-SECURITIES
The following table summarizes the amortized cost and fair value of the available-for-sale securities portfolio at December 31, 2021 and December 31, 2020 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income.
(Dollars in thousands) Amortized
Cost Gross
Unrealized
Gains Gross
Unrealized
Losses Fair
Value
December 31, 2021
U.S. government sponsored entities & agencies $ 22,522 $ 21 $ (769) $ 21,774
State and political subdivision 141,751 6,972 (447) 148,276
Mortgage-backed securities: residential 22,316 97 (202) 22,211
Mortgage-backed securities: commercial 23,411 341 (481) 23,271
Collateralized mortgage obligations: residential 13,557 45 (141) 13,461
Collateralized mortgage obligations: commercial 51,882 444 (1,143) 51,183
U.S. Treasury 65,098 62 (773) 64,387
SBA 13,851 137 (61) 13,927
Asset backed securities 9,762 9 (65) 9,706
Corporate bonds 29,673 43 (361) 29,355
Total available-for-sale $ 393,823 $ 8,171 $ (4,443) $ 397,551
December 31, 2020
U.S. government sponsored entities & agencies $ 26,575 $ 103 $ (320) $ 26,358
State and political subdivision 124,053 8,751 (81) 132,723
Mortgage-backed securities: residential 25,729 352 - 26,081
Mortgage-backed securities: commercial 11,434 484 - 11,918
Collateralized mortgage obligations: residential 13,320 138 (12) 13,446
Collateralized mortgage obligations: commercial 57,398 1,206 (92) 58,512
SBA 17,639 61 (107) 17,593
Asset backed securities 10,229 - (157) 10,072
Corporate bonds 5,998 34 (3) 6,029
Total available-for-sale $ 292,375 $ 11,129 $ (772) $ 302,732
The proceeds from sales and calls of securities and the associated gains and losses for the periods below were as follows:
(Dollars in thousands) For the year ended December 31,
2021 2020 2019
Proceeds $ 1,657 $ 47,849 $ 70,856
Gross gains 21 1,871 1,566
Gross losses - (9) (392)
The amortized cost and fair value of securities are shown in the table below by contractual maturity. Expected maturities may differ from contractual maturities as issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
December 31, 2021
(Dollars in thousands) Amortized
Cost Fair
Value
Within one year $ 6,111 $ 6,151
One to five years 58,487 58,533
Five to ten years 190,549 190,429
Beyond ten years 138,676 142,438
Total $ 393,823 $ 397,551
Securities pledged at December 31, 2021 and December 31, 2020 had a carrying amount of $88.6 million and $98.7 million, respectively, and were pledged to secure Federal Home Loan Bank ("FHLB") advances, a Federal Reserve Bank line of credit, repurchase agreements, deposits and mortgage derivatives.
As of December 31, 2021, the Bank held 68 tax-exempt state and local municipal securities totaling $52.3 million backed by the Michigan School Bond Loan Fund. Other than the aforementioned investments and the U.S. government and its
agencies, at December 31, 2021 and December 31, 2020, there were no holdings of securities of any one issuer in an amount greater than 10% of shareholders' equity.
The following table summarizes securities with unrealized losses at December 31, 2021 and December 31, 2020 aggregated by security type and length of time in a continuous unrealized loss position:
Less than 12 Months 12 Months or Longer Total
(Dollars in thousands) Fair
value Unrealized
Losses Fair
value Unrealized
Losses Fair
value Unrealized
Losses
December 31, 2021
Available-for-sale
U.S. government sponsored entities & agencies $ - $ - $ 19,231 $ (769) $ 19,231 $ (769)
State and political subdivision 26,710 (364) 5,259 (83) 31,969 (447)
Mortgage-backed securities: residential 16,854 (202) 8 - 16,862 (202)
Mortgage-backed securities: commercial 12,621 (337) 3,431 (144) 16,052 (481)
Collateralized mortgage obligations: residential 10,713 (131) 885 (10) 11,598 (141)
Collateralized mortgage obligations: commercial 16,966 (567) 13,238 (576) 30,204 (1,143)
U.S. Treasury 54,671 (773) - - 54,671 (773)
SBA - - 5,183 (61) 5,183 (61)
Asset backed securities 4,703 (10) 2,411 (55) 7,114 (65)
Corporate bonds 21,871 (283) 2,422 (78) 24,293 (361)
Total available-for-sale $ 165,109 $ (2,667) $ 52,068 $ (1,776) $ 217,177 $ (4,443)
December 31, 2020
Available-for-sale
U.S. government sponsored entities & agencies $ 19,680 $ (320) $ - $ - $ 19,680 $ (320)
State and political subdivision 4,880 (81) - - 4,880 (81)
Collateralized mortgage obligations: residential - - 1,109 (12) 1,109 (12)
Collateralized mortgage obligations: commercial 26,477 (92) - - 26,477 (92)
SBA - - 12,209 (107) 12,209 (107)
Asset backed securities - - 10,072 (157) 10,072 (157)
Corporate bonds 2,497 (3) - - 2,497 (3)
Total available-for-sale $ 53,534 $ (496) $ 23,390 $ (276) $ 76,924 $ (772)
As of December 31, 2021, the Company's investment portfolio consisted of 332 securities, 82 of which were in an unrealized loss position. The unrealized losses for these securities resulted primarily from changes in interest rates since purchased. The Company expects full recovery of the carrying amount of these securities and does not intend to sell the securities in an unrealized loss position nor does it believe it will be required to sell securities in an unrealized loss position before the value is recovered. The Company did not consider these securities to be other-than-temporarily impaired at December 31, 2021.
NOTE 4-LOANS
The following table presents the recorded investment in loans at December 31, 2021 and December 31, 2020. The recorded investment in loans excludes accrued interest receivable.
(Dollars in thousands) Originated Acquired Total
December 31, 2021
Commercial real estate $ 644,337 $ 106,427 $ 750,764
Commercial and industrial 420,635 39,895 460,530
Residential real estate 421,226 19,414 440,640
Consumer 771 66 837
Total $ 1,486,969 $ 165,802 $ 1,652,771
December 31, 2020
Commercial real estate $ 587,631 $ 133,201 $ 720,832
Commercial and industrial 629,434 56,070 685,504
Residential real estate 280,645 34,831 315,476
Consumer 748 977 1,725
Total $ 1,498,458 $ 225,079 $ 1,723,537
At December 31, 2021 and December 31, 2020, the Company had residential loans held for sale, which were originated with the intent to sell, totaling $12.9 million and $43.5 million, respectively. During the years ended December 31, 2021 and 2020, the Company sold residential real estate loans with proceeds totaling $482.0 million and $545.6 million, respectively.
At December 31, 2021 and December 31, 2020, $76.5 million and $290.1 million, respectively, of PPP loans were included in the commercial and industrial loan balance.
The Bank was a participating lender in the Small Business Administration's (“SBA”) Paycheck Protection Program (“PPP”). PPP loans are forgivable, in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP. These loans carry a fixed rate of 1.00% and a term of two years (loans made before June 5, 2020) or five years (loans made on or after June 5, 2020), if not forgiven, in whole or in part. Payments are deferred until either the date on which the SBA remits the amount of forgiveness proceeds to the lender or the date that is 10 months after the last day of the covered period if the borrower does not apply for forgiveness within that 10 month period. Fees generated based on the origination of PPP loans are deferred and amortized into interest income over the contractual period of 24 months or 60 months, as applicable. Upon SBA forgiveness, unamortized fees are then recognized into interest income.
During 2020 and 2021, the bank originated 3,763 PPP loans with a total originated principal balance of $667.2 million generating net fee income of $20.6 million. Net fee income of $12.9 million and $6.5 million were recognized during the years ended December 31, 2021 and 2020, respectively. As of December 31, 2021, 3,260 of the 3,763 originated loans had been forgiven.
Nonperforming Assets
Nonperforming assets consist of loans for which the accrual of interest has been discontinued and other real estate owned obtained through foreclosure and other repossessed assets. Loans outside of those accounted for under ASC 310-30 are classified as nonaccrual when, in the opinion of management, it is probable that the Company will be unable to collect all the contractual interest and principal payments as scheduled in the loan agreement. The accrual of interest is discontinued when a loan is placed in nonaccrual status and any payments received reduce the carrying value of the loan. A loan may be placed back on accrual status if all contractual payments have been received and collection of future principal and interest payments is no longer doubtful. Acquired loans that are not performing in accordance with contractual terms are not reported as nonperforming because these loans are recorded at their net realizable value based on the principal and interest the Company expects to collect on these loans. There were $206 thousand and $12 thousand in commitments to lend additional funds to borrowers whose loans were classified as nonaccrual as of December 31, 2021 and December 31, 2020, respectively.
Information as to nonperforming assets was as follows:
(Dollars in thousands) December 31, 2021 December 31, 2020
Nonaccrual loans:
Commercial real estate $ 4,246 $ 7,320
Commercial and industrial 4,208 7,490
Residential real estate 2,819 3,991
Consumer 16 15
Total nonaccrual loans 11,289 18,816
Other real estate owned 201 -
Total nonperforming assets $ 11,490 $ 18,816
Loans 90 days or more past due and still accruing $ 162 $ 269
At December 31, 2021 and December 31, 2020, the loans that were 90 days or more past due and still accruing were PCI loans.
Loan delinquency as of the dates presented below was as follows:
(Dollars in thousands) Current 30 - 59 Days
Past Due 60 - 89 Days
Past Due 90+ Days
Past Due Total
December 31, 2021
Commercial real estate $ 750,666 $ 98 $ - $ - $ 750,764
Commercial and industrial 460,419 107 4 - 460,530
Residential real estate 436,009 2,443 851 1,337 440,640
Consumer 821 - 7 9 837
Total $ 1,647,915 $ 2,648 $ 862 $ 1,346 $ 1,652,771
December 31, 2020
Commercial real estate $ 714,196 $ 4,863 $ 1,773 $ - $ 720,832
Commercial and industrial 681,106 893 3,505 - 685,504
Residential real estate 305,800 5,420 1,110 3,146 315,476
Consumer 1,723 - - 2 1,725
Total $ 1,702,825 $ 11,176 $ 6,388 $ 3,148 $ 1,723,537
Impaired Loans:
Information as to impaired loans, excluding PCI loans, was as follows:
(Dollars in thousands) December 31, 2021 December 31, 2020
Nonaccrual loans $ 11,289 $ 18,816
Performing troubled debt restructurings:
Commercial and industrial 334 546
Residential real estate 365 432
Total performing troubled debt restructurings 699 978
Total impaired loans, excluding purchase credit impaired loans $ 11,988 $ 19,794
Troubled Debt Restructurings:
The Company assesses loan modifications to determine whether a modification constitutes a troubled debt restructuring ("TDR"). This applies to all loan modifications except for modifications to loans accounted for in pools under ASC 310-30, which are not subject to TDR accounting/classification. For loans excluded from ASC 310-30 accounting, a modification is considered a TDR when a borrower is experiencing financial difficulties and the Company grants a concession to the borrower. For loans accounted for individually under ASC 310-30, a modification is considered a TDR when a borrower is experiencing financial difficulties and the effective yield after the modification is less than the effective yield at the time the loan was acquired or less than the effective yield of any re-estimation of cash flows subsequent to acquisition in association with consideration of qualitative factors included within ASC 310-40. All TDRs are considered impaired loans. The nature and extent of impairment of TDRs, including those which have experienced a subsequent default, are considered in the determination of an appropriate level of allowance for loan losses.
The CARES Act was signed into law on March 27, 2020, which provides a variety of provisions, including, among other things, a small business lending program to originate paycheck protection loans, temporary relief for the community bank leverage ratio, and temporary relief for financial institutions related to troubled debt restructurings. On December 27, 2020, the Consolidated Appropriations Act, 2021 was signed into law and extends the relief related to troubled debt restructurings to the earlier of January 1, 2022 or 60 days after the national emergency termination date. As a result of the COVID-19 pandemic, the Company is currently working with borrowers to provide short-term payment modifications. Any short-term modifications made on a good-faith basis in response to the COVID-19 pandemic to borrowers who were current prior to any relief are not considered TDRs based on interagency guidance. This includes short-term modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program was implemented. The Company’s modification programs are designed to provide temporary relief for current borrowers affected by the COVID-19 pandemic. The Company has presumed that borrowers that are current on payments are not experiencing financial difficulties at the time of the modification for purposes of determining TDR status, and thus no further TDR analysis is required for each loan modification in the program.
As of December 31, 2021 and December 31, 2020, the Company had a recorded investment in troubled debt restructurings of $4.1 million and $4.8 million, respectively. The Company allocated a specific reserve of $314 thousand for those loans at December 31, 2021 and a specific reserve of $317 thousand for those loans at December 31, 2020. The Company had not committed to lend additional amounts to borrowers whose loans have been modified. As of December 31, 2021, there were $3.4 million of nonperforming TDRs and $699 thousand of performing TDRs included in impaired loans. As of December 31, 2020, there were $3.8 million of nonperforming TDRs and $978 thousand of performing TDRs included in impaired loans.
All TDRs are considered impaired loans in the calendar year of their restructuring. A loan that has been modified can return to performing status if it satisfies a six-month performance requirement; however, it will continue to be reported as a TDR and considered impaired.
The following table presents the recorded investment of loans modified as TDRs during the years ended December 31, 2020, and 2019 by type of concession granted. There were three loans modified as TDRs during the year ended December 31, 2021 which were subsequently paid off during the third quarter of 2021. In cases where more than one type of concession was granted, the loans were categorized based on the most significant concession.
Concession type Financial effects of
modification
(Dollars in thousands) Principal
deferral Interest
rate Forbearance
agreement Total
number of
loans Total
recorded
investment Net
charge-offs Provision
for loan
losses
For the year ended December 31, 2021
Commercial real estate $ - $ - $ - 1 $ - $ - $ -
Commercial and industrial - - - 2 - - -
Total $ - $ - $ - 3 $ - $ - $ -
For the year Ended December 31, 2020
Commercial real estate $ 1,654 $ - $ - 2 $ 1,654 $ - $ -
Residential real estate - 74 - 1 74 - -
Total $ 1,654 $ 74 $ - 3 $ 1,728 $ - $ -
For the year ended December 31, 2019
Commercial and industrial - - 332 2 332 - 174
Total $ - $ - $ 332 2 $ 332 $ - $ 174
On an ongoing basis, the Company monitors the performance of TDRs to their modified terms. The following table presents the number of loans modified as TDRs during the twelve months ended December 31, 2020 and 2019 for which there was a subsequent payment default including the recorded investment as of the period end. There were no loans modified as TDRs during the twelve months ended December 31, 2021 for which there was a subsequent payment default. A payment on a TDR is considered to be in default once it is greater than 30 days past due.
For the year ended December 31, 2020
(Dollars in thousands) Total number of
loans Total recorded
investment Provision for loan losses following a
subsequent default
Commercial real estate 1 $ 203 $ -
Total 1 $ 203 $ -
For the year ended December 31, 2019
(Dollars in thousands) Total number of
loans Total recorded
investment Provision for loan losses following a
subsequent default
Commercial and industrial 1 $ 42 $ 12
Total 1 $ 42 $ 12
Credit Quality Indicators:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes commercial and industrial and commercial real estate loans and is performed on an annual basis. The Company uses the following definitions for risk ratings:
Pass. Loans classified as pass are higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: cash/stock secured, excellent credit risk, superior credit risk, good credit risk, satisfactory credit risk, and marginal credit risk.
Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company's credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Based on the most recent analysis performed, the risk category of loans by class of loans was as follows:
(Dollars in thousands) Pass Special
Mention Substandard Doubtful Total
December 31, 2021
Commercial real estate $ 714,487 $ 25,282 $ 10,518 $ 477 $ 750,764
Commercial and industrial 396,210 48,972 14,348 1,000 460,530
Total $ 1,110,697 $ 74,254 $ 24,866 $ 1,477 $ 1,211,294
December 31, 2020
Commercial real estate $ 685,690 $ 21,570 $ 13,045 $ 527 $ 720,832
Commercial and industrial 637,285 25,727 21,876 616 685,504
Total $ 1,322,975 $ 47,297 $ 34,921 $ 1,143 $ 1,406,336
For residential real estate loans and consumer loans, the Company evaluates credit quality based on the aging status of the loan and by payment activity. Residential real estate loans and consumer loans are considered nonperforming if they are 90 days or more past due. Consumer loan types are continuously monitored for changes in delinquency trends and other asset quality indicators.
The following presents residential real estate and consumer loans by credit quality:
(Dollars in thousands) Performing Nonperforming Total
December 31, 2021
Residential real estate $ 437,821 $ 2,819 $ 440,640
Consumer 821 16 837
Total $ 438,642 $ 2,835 $ 441,477
December 31, 2020
Residential real estate $ 311,485 $ 3,991 $ 315,476
Consumer 1,710 15 1,725
Total $ 313,195 $ 4,006 $ 317,201
Purchased Credit Impaired Loans:
As part of the Company's previous five acquisitions, the Company acquired purchase credit impaired ("PCI") loans for which there was evidence of credit quality deterioration since origination, and we determined that it was probable that the Company would be unable to collect all contractually required principal and interest payments. The total balance of all PCI loans from these acquisitions was as follows:
(Dollars in thousand) Unpaid Principal Balance Recorded Investment
December 31, 2021
Commercial real estate $ 4,353 $ 1,597
Commercial and industrial 235 1
Residential real estate 3,416 2,577
Total PCI loans $ 8,004 $ 4,175
December 31, 2020
Commercial real estate $ 5,109 $ 1,773
Commercial and industrial 643 274
Residential real estate 4,017 2,949
Total PCI loans $ 9,769 $ 4,996
The following table reflects the activity in the accretable yield of PCI loans from past acquisitions, which includes total expected cash flows, including interest, in excess of the recorded investment.
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Accretable yield at beginning of period $ 7,097 $ 9,141 $ 10,947
Additions due to acquisitions - 35 -
Accretion of income (1,454) (1,760) (2,313)
Adjustments to accretable yield 29 (319) 507
Accretable yield at end of period $ 5,672 $ 7,097 $ 9,141
"Additions due to acquisitions" represents the accretable yield added as a result of the AAB acquisition. "Accretion of income" represents the income earned on these loans for the year.
For the years ended December 31, 2021 and 2020, allowance for loan losses on PCI loans decreased by $80 thousand and $95 thousand, respectively.
Related Party Loans:
We have extended loans to certain of our directors, executive officers, principal shareholders and their affiliates. The
aggregate loans outstanding to the directors, executive officers, principal shareholders and their affiliates as of December 31,
2021 and 2020 totaled approximately $1.3 million and $8.9 million, respectively. During 2021 and 2020, there were $684 thousand and $6.6 million, respectively, of new loans and other additions, while repayments and other reductions totaled $8.2 million and $1.8 million, respectively.
NOTE 5-ALLOWANCE FOR LOAN LOSSES
An allowance for loan losses is maintained to absorb probable incurred losses from the loan portfolio. The allowance for loan losses is based on management's continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of nonaccrual loans.
The Company established an allowance for loan losses associated with PCI loans (accounted for under ASC 310-30) based on credit deterioration subsequent to the acquisition date. As of December 31, 2021, the Company had 5 PCI loan pools and 9 non-pooled PCI loans. The Company re-estimates cash flows expected to be collected for PCI loans on a semi-annual basis, with any decline in expected cash flows recorded as provision for loan losses on a discounted basis during the period. For any increases in cash flows expected to be collected, the Company adjusts the amount of accretable yield to be recognized on a prospective basis over the loan's remaining life.
For loans not accounted for under ASC 310-30, the Company individually evaluates certain impaired loans on a quarterly basis and establishes specific allowances for such loans, if required. A loan is considered impaired when it is probable that interest or principal payments will not be made in accordance with the contractual terms of the loan agreement. Consistent with this definition, all loans for which the accrual of interest has been discontinued (nonaccrual loans) and all TDRs are considered impaired. The Company individually evaluates nonaccrual loans with book balances of $250 thousand or more, all loans whose terms have been modified in a TDR, and certain other loans. The threshold for individual evaluation is revised on an infrequent basis, generally when economic circumstances significantly change. Specific allowances for impaired loans are estimated using one of several methods, including the estimated fair value of underlying collateral, observable market value of similar debt or discounted expected future cash flows. All other impaired loans are individually evaluated by identifying its risk characteristics and applying the standard reserve factor for the corresponding loan pool.
Loans which do not meet the criteria to be individually evaluated are evaluated in pools of loans with similar risk characteristics. Business loans are assigned to pools based on the Company's internal risk rating system. Internal risk ratings are assigned to each business loan at the time of approval and are subjected to subsequent periodic reviews by the Company's senior management, generally at least annually or more frequently upon the occurrence of a circumstance that affects the credit risk of the loan. For business loans not individually evaluated, losses inherent to the pool are estimated by applying standard reserve factors to outstanding principal balances.
The allowance for loans not individually evaluated is determined by applying estimated loss rates to various pools of loans within the portfolios with similar risk characteristics. Estimated loss rates for all pools are updated quarterly, incorporating quantitative and qualitative factors such as recent charge-off experience, current economic conditions and trends, changes in collateral values of properties securing loans (using index-based estimates), and trends with respect to past due and nonaccrual amounts.
Loans acquired in business combinations are initially recorded at fair value, which includes an estimate of credit losses expected to be realized over the remaining lives of the loans, and therefore no corresponding allowance for loan losses is recorded for these loans at acquisition. Methods utilized to estimate any subsequently required allowance for loan losses for acquired loans not deemed credit-impaired at acquisition are similar to originated loans; however, the estimate of loss is based on the unpaid principal balance less any remaining purchase discount.
Loans individually evaluated for impairment are presented below.
(Dollars in thousands) Recorded investment with
no related
allowance Recorded investment
with related
allowance Total
recorded
investment Contractual
principal
balance Related
allowance
December 31, 2021
Individually evaluated impaired loans:
Commercial real estate $ 4,246 $ - $ 4,246 $ 4,636 $ -
Commercial and industrial 3,854 688 4,542 5,223 292
Residential real estate 802 136 938 1,264 29
Total $ 8,902 $ 824 $ 9,726 $ 11,123 $ 321
December 31, 2020
Individually evaluated impaired loans:
Commercial real estate $ 7,320 $ - $ 7,320 $ 7,720 $ -
Commercial and industrial 7,964 630 8,594 9,208 307
Residential real estate 2,153 192 2,345 2,447 25
Total $ 17,437 $ 822 $ 18,259 $ 19,375 $ 332
(Dollars in thousands) Average
Recorded
Investment Interest
Income
Recognized Cash Basis
Interest
Recognized
For the year ended December 31, 2021
Individually evaluated impaired loans:
Commercial real estate $ 5,018 $ - $ 345
Commercial and industrial 6,008 27 237
Residential real estate 1,287 22 10
Total $ 12,313 $ 49 $ 592
For the year ended December 31, 2020
Individually evaluated impaired loans:
Commercial real estate $ 7,981 $ - $ 10
Commercial and industrial 14,008 46 87
Residential real estate 3,304 36 55
Total $ 25,293 $ 82 $ 152
For the year ended December 31, 2019
Individually evaluated impaired loans:
Commercial real estate $ 4,233 $ 2 $ 209
Commercial and industrial 8,514 43 573
Residential real estate 1,904 29 9
Total $ 14,651 $ 74 $ 791
Activity in the allowance for loan losses is presented below:
(Dollars in thousands) Commercial
Real Estate Commercial
and Industrial Residential
Real Estate Consumer Total
For the year ended December 31, 2021
Allowance for loan losses:
Beginning balance $ 9,975 $ 8,786 $ 3,527 $ 9 $ 22,297
Provision for (recovery of) loan losses (520) (1,009) 795 9 (725)
Gross chargeoffs - (31) (242) (33) (306)
Recoveries - 53 86 20 159
Net (chargeoffs) recoveries - 22 (156) (13) (147)
Ending allowance for loan losses $ 9,455 $ 7,799 $ 4,166 $ 5 $ 21,425
For the year ended December 31, 2020
Allowance for loan losses:
Beginning balance $ 5,773 $ 5,515 $ 1,384 $ 2 $ 12,674
Provision for loan losses 4,190 5,302 2,343 37 11,872
Gross chargeoffs - (2,118) (285) (58) (2,461)
Recoveries 12 87 85 28 212
Net (chargeoffs) recoveries 12 (2,031) (200) (30) (2,249)
Ending Allowance for loan losses $ 9,975 $ 8,786 $ 3,527 $ 9 $ 22,297
For the year ended December 31, 2019
Allowance for loan losses:
Beginning balance $ 5,227 $ 5,174 $ 1,164 $ 1 $ 11,566
Provision for loan losses 632 533 143 75 1,383
Gross chargeoffs (92) (438) - (106) (636)
Recoveries 6 246 77 32 361
Net (chargeoffs) recoveries (86) (192) 77 (74) (275)
Ending Allowance for loan losses $ 5,773 $ 5,515 $ 1,384 $ 2 $ 12,674
Allocation of the allowance for loan losses is presented below:
(Dollars in thousands) Commercial
Real Estate Commercial
and Industrial Residential
Real Estate Consumer Total
December 31, 2021
Allowance for loan losses:
Individually evaluated for impairment $ - $ 292 $ 29 $ - $ 321
Collectively evaluated for impairment 9,088 7,506 3,917 5 20,516
Acquired with deteriorated credit quality 367 1 220 - 588
Ending allowance for loan losses $ 9,455 $ 7,799 $ 4,166 $ 5 $ 21,425
Balance of loans:
Individually evaluated for impairment $ 4,246 $ 4,542 $ 938 $ - $ 9,726
Collectively evaluated for impairment 744,921 455,987 437,125 837 1,638,870
Acquired with deteriorated credit quality 1,597 1 2,577 - 4,175
Total loans $ 750,764 $ 460,530 $ 440,640 $ 837 $ 1,652,771
December 31, 2020
Allowance for loan losses:
Individually evaluated for impairment $ - $ 307 $ 25 $ - $ 332
Collectively evaluated for impairment 9,550 8,465 3,273 9 21,297
Acquired with deteriorated credit quality 425 14 229 - 668
Ending allowance for loan losses $ 9,975 $ 8,786 $ 3,527 $ 9 $ 22,297
Balance of loans:
Individually evaluated for impairment $ 7,320 $ 8,594 $ 2,345 $ - $ 18,259
Collectively evaluated for impairment 711,739 676,636 310,182 1,725 1,700,282
Acquired with deteriorated credit quality 1,773 274 2,949 - 4,996
Total loans $ 720,832 $ 685,504 $ 315,476 $ 1,725 $ 1,723,537
NOTE 6-PREMISES AND EQUIPMENT
Premises and equipment were as follows at December 31, 2021 and December 31, 2020:
(Dollars in thousands) December 31, 2021 December 31, 2020
Land and land improvements $ 3,572 $ 3,514
Buildings 10,710 10,656
Leasehold improvements 3,027 3,017
Furniture, fixtures and equipment 8,254 7,786
Total premises and equipment $ 25,563 $ 24,973
Less: Accumulated depreciation 10,660 9,139
Net premises and equipment $ 14,903 $ 15,834
Depreciation expense was $1.6 million, $1.7 million and $1.3 million for the years ended December 31, 2021, 2020 and 2019, respectively.
Most of the Company's branch facilities are rented under non-cancelable operating lease agreements. Total rent expense was $1.8 million, $1.8 million, and $1.2 million for the years ended December 31, 2021, 2020 and 2019, respectively.
Rent commitments under non-cancelable operating leases (including renewal options that the Company will likely exercise) were as follows:
(Dollars in thousands) As of December 31, 2021
2022 $ 1,833
2023 1,792
2024 1,393
2025 1,268
2026 1,123
Thereafter 3,110
Total lease commitments $ 10,519
NOTE 7-GOODWILL AND INTANGIBLE ASSETS
Goodwill: The Company has acquired three banks, Lotus Bank in March 2015, Bank of Michigan in March 2016, and Ann Arbor State Bank in January 2020, which resulted in the recognition of goodwill of $4.6 million, $4.8 million, and $26.2 million, respectively. Total goodwill was $35.6 million at December 31, 2021 and December 31, 2020.
Goodwill is not amortized but is evaluated annually for impairment and on an interim basis if events or changes in circumstances indicate that goodwill might be impaired. The goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount, and an impairment charge would be recognized for any amount by which the carrying amount exceeds the reporting unit's fair value.
As a result of the unprecedented decline in economic conditions triggered by the COVID-19 pandemic, the market valuations, including our stock price, saw a significant decline in March 2020, which then continued into the second quarter of 2020. These events indicated that goodwill may be impaired and resulted in management performing a qualitative goodwill impairment assessment in the second quarter of 2020. As a result of the analysis, we concluded that it was more-likely-than-not that the fair value of the reporting unit could be greater than its carrying amount.
Since the price of our stock did not fully recover during the third quarter of 2020, the Company engaged a third-party valuation firm to perform a quantitative analysis of goodwill as of August 31, 2020 ("the valuation date"). In deriving the fair value of the reporting unit (the Bank), the third-party firm assessed general economic conditions and outlook; industry and market considerations and outlook; the impact of recent events on financial performance; the market price of our common stock and other relevant events. In addition, the valuation relied on financial projections through 2023 and growth rates prepared by management. Based on the valuation prepared, it was determined that the Company's estimated fair value of the reporting unit at August 31, 2020 was greater than its book value, and impairment of goodwill was not required.
The Company completed its annual goodwill impairment review as of October 1, 2021, noting strong financial indicators for the Bank, solid credit quality ratios, as well as the strong capital position of the Bank. Management also determined that no triggering events have occurred that indicated impairment from the most recent valuation date through December 31, 2021, the stock was trading above book value as of December 31, 2021, and it is more likely than not that there was no goodwill impairment as of December 31, 2021.
Intangible Assets: The Company recorded core deposit intangibles ("CDIs") associated with each of its acquisitions. CDIs are amortized on an accelerated basis over their estimated useful lives.
The table below presents the Company's net carrying amount of CDIs:
(Dollars in thousands) December 31, 2021 December 31, 2020
Gross carrying amount $ 5,708 $ 5,708
Accumulated amortization (3,180) (2,512)
Net Intangible $ 2,528 $ 3,196
Amortization expense for the CDIs was $668 thousand, $768 thousand and $146 thousand for the years ended December 31, 2021, 2020 and 2019, respectively.
As of December 31, 2021, estimated amortization expense for each of the next five years is as follows:
(Dollars in thousands)
2022 $ 586
2023 506
2024 425
2025 344
2026 268
NOTE 8-MORTGAGE SERVICING RIGHTS, NET
The Company has recorded a mortgage servicing rights asset for residential real estate mortgage loans that are sold to the secondary market for which servicing has been retained. Residential real estate mortgage loans serviced for others are not included in the consolidated balance sheets. Mortgage servicing rights are carried at the lower of the initial capitalized amount, net of accumulated amortization or estimated fair value. Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income. The unpaid principal balances of these loans at December 31, 2021 and December 31, 2020 were as follows:
(Dollars in thousands) December 31, 2021 December 31, 2020
Residential real estate mortgage loan portfolios serviced for:
FNMA $ 601,952 $ 320,467
Custodial escrow balances maintained with these serviced loans were $2.8 million and $1.9 million at December 31, 2021 and December 31, 2020, respectively.
Activity for mortgage servicing rights was as follows for the years ended December 31, 2021, 2020 and 2019:
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Mortgage servicing rights:
Balance, beginning of period $ 3,361 $ 76 $ -
Originated servicing 3,715 3,540 77
Amortization (1,472) (255) (1)
Balance, end of period $ 5,604 $ 3,361 $ 76
Servicing fee income, net of amortization of servicing rights and changes in the valuation allowance was $(322) thousand and $24 thousand for the years ended December 31, 2021 and 2020, respectively. There was no servicing fee income for the year ended December 31, 2019.
The Company recorded a valuation allowance of $17 thousand related to mortgage servicing rights during the first quarter of 2020, which was then reversed during the second quarter of 2020 as a result of the fair value at June 30, 2020 being higher than book value. The fair value remained higher than book value at December 31, 2021. There was no valuation allowance related to mortgage servicing rights during the year ended December 31, 2020.
The fair value of mortgage servicing rights was $8.3 million and $4.0 million at December 31, 2021 and December 31, 2020, respectively. The fair value of mortgage servicing rights is highly sensitive to changes in underlying assumptions. The fair value at December 31, 2021 was determined using a discount rate of 8.00% and prepayment speeds ranging from 5.65% to 7.20%, depending on the stratification of the specific rights. The fair value at December 31, 2020 was determined using a discount rate of 7.75% and prepayment speeds ranging from 8.44% to 10.41%, depending on the stratification of the specific right.
NOTE 9-DEPOSITS
Time deposits that met or exceeded the FDIC insurance limit of $250,000 were $267.3 million and $380.3 million at December 31, 2021 and 2020, respectively. At December 31, 2021, brokered deposits totaled $23.1 million, compared to $29.3 million at December 31, 2020.
As of December 31, 2021, the scheduled maturities of total time deposits were as follows:
(Dollars in thousands) December 31, 2021
Due in 2022 $ 359,707
Due in 2023 49,466
Due in 2024 14,570
Due in 2025 1,778
Due in 2026 280
Total $ 425,801
Related party deposits totaled $111.7 million and $112.0 million at December 31, 2021 and 2020, respectively.
NOTE 10-BORROWINGS AND SUBORDINATED DEBT
The following table presents the components of our short-term borrowings and long-term debt.
December 31, 2021 December 31, 2020
(Dollars in thousands) Amount Weighted
Average
Rate(1)
Amount Weighted
Average
Rate(1)
Short-term borrowings:
Securities sold under agreements to repurchase $ 2,342 0.25 % $ 3,204 0.30 %
Total short-term borrowings 2,342 0.25 3,204 0.30
Long-term debt:
Secured borrowing due in 2022 1,254 1.00 1,304 1.00
FHLB advances due in 2022 to 2029(2)
175,086 1.03 181,176 1.09
Subordinated notes due in 2025 and 2029(3)
29,694 4.75 44,592 5.29
Total long-term debt 206,034 1.57 227,072 1.91
Total short-term and long-term borrowings $ 208,376 1.56 % $ 230,276 1.89 %
(1) Weighted average rate presented is the contractual rate which excludes premiums and discounts related to purchase accounting.
(2) At December 31, 2021, the long-term FHLB advances consisted of 0.42% - 2.93% fixed rate notes and can be called through 2024 without penalty by the issuer. The December 31, 2021 balance includes FHLB advances of $175.0 million and purchase accounting premiums of $86 thousand. The December 31, 2020 balance includes FHLB advances of $181.0 million and purchase accounting premiums of $176 thousand.
(3) The December 31, 2021 balance includes subordinated notes of $30.0 million and debt issuance costs of $306 thousand. The December 31, 2020 balance includes subordinated notes of $45.0 million and debt issuance costs of $408 thousand.
The following table presents long-term borrowings by contractual maturity date:
(Dollars in thousands) As of December 31, 2021
2022 $ 11,254
2023 3,039
2024 30,000
2025 2,047
2026 -
Thereafter 159,694
Total long-term borrowings $ 206,034
The Bank is a member of the FHLB of Indianapolis, which provides short- and long-term funding collateralized by mortgage-related assets to its members. FHLB short-term borrowings bear interest at variable rates based on LIBOR. The $175.0 million of long-term FHLB advances as of December 31, 2021 were secured by a blanket lien on $580.6 million of real estate-related loans. Based on this collateral and the Company's holdings of FHLB stock, the Company was eligible to borrow up to an additional $228.7 million from the FHLB at December 31, 2021. In addition, the Bank can borrow up to $157.5 million through the unsecured lines of credit it has established with other correspondent banks, as well as $5.0 million through a secured line with the Federal Reserve Bank. The Bank had no outstanding federal funds purchased as of December 31, 2021 and December 31, 2020.
At December 31, 2021, the Company had $2.3 million of securities sold under agreements to repurchase with customers, which mature overnight. These borrowings were secured by residential collateralized mortgage obligation securities with a fair value of $4.0 million at December 31, 2021.
The Company had a secured borrowing of $1.3 million as of December 31, 2021 relating to certain loan participations sold by the Company that did not qualify for sales treatment. The secured borrowing bears a fixed rate of 1.00% and matures on September 15, 2022.
At December 31, 2021, the Company had $30.0 million outstanding subordinated notes and $306 thousand of debt issuance costs. The debt issuance costs are netted against the balance of the subordinated notes and recognized as expense over the expected term of the notes.
The $15.0 million of subordinated notes issued on December 21, 2015 had a fixed interest rate of 6.375% per annum, payable semiannually through December 15, 2020. As of December 15, 2020, the notes had a floating interest rate of three-month LIBOR plus 477 basis points payable quarterly through maturity. The notes were scheduled to mature on December 15, 2025, and the Company had the option to redeem or prepay any or all of the subordinated notes without premium or penalty any time after December 15, 2020 or upon an occurrence of a Tier 2 capital event or tax event. These subordinated notes were redeemed in June 2021.
The $30.0 million of subordinated notes issued on December 18, 2019 bear a fixed interest rate of 4.75% per annum, payable semiannually through December 18, 2024. The notes will bear a floating interest rate of three-month secured overnight financing rate (SOFR) plus 311 basis points payable quarterly after December 18, 2024 through maturity. The notes mature on December 18, 2029, and the Company has the option to redeem any or all of the subordinated notes without premium or penalty any time after December 18, 2024 or upon the occurrence of a Tier 2 capital event or tax event.
The Company has a short term line of credit of $30.0 million with Comerica Bank with a fixed interest rate of 4.05% per annum and a commitment fee of 0.20% on the average daily balance of the unused portion of the line of credit. As of December 31, 2021, the Company had no balance on the Comerica Bank line of credit. The Company participated in the PPP and also had the ability to borrow from the Federal Reserve's special purpose Paycheck Protection Program Liquidity Facility ("PPPLF") for additional funding. At December 31, 2021, the Company had no borrowings from the PPPLF.
NOTE 11-INCOME TAXES
The Company and its subsidiaries are subject to U.S. federal income tax. In the ordinary course of business, we are routinely subject to audit by Internal Revenue Service. Currently, the Company is subject to examination by taxing authorities for the 2017 tax return year and forward.
The current and deferred components of the provision for income taxes were as follows:
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Current expense $ 5,965 $ 7,268 $ 3,995
Deferred expense (benefit) 1,414 (3,315) (592)
Total $ 7,379 $ 3,953 $ 3,403
A reconciliation of expected income tax expense using the federal statutory rate of 21% as of December 31, 2021, 2020 and 2019 and actual income tax expense is as follows:
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Income tax expense based on federal corporate tax rate $ 8,370 $ 5,117 $ 4,098
Changes resulting from:
Tax-exempt income (634) (589) (538)
Captive insurance benefit (1) (156) (182)
Net operating loss carryback due to CARES Act - (290) -
Disqualified dispositions from stock options (4) (178) (13)
Other, net (352) 49 38
Income tax expense $ 7,379 $ 3,953 $ 3,403
In March 2020, the United States government approved the CARES Act, allowing companies to carryback net operating losses generated in 2018 through 2020 for five years to periods in which the tax rate was higher. Ann Arbor State Bank had a net operating loss ("NOL") of approximately $2.2 million generated on its 2020 short tax return which resulted in an increase in value of the NOL (which is part of the deferred tax assets) and therefore a $290 thousand tax benefit to be recognized during the first quarter of 2020. Additionally, disqualified dispositions of Ann Arbor State Bank’s stock options generated a $175 thousand tax benefit in the first quarter of 2020.
Upon exercise or vesting of a share-based award, if the tax deduction exceeds the compensation cost that was previously recorded for financial statement purposes, this will result in an excess tax benefit. A tax benefit of $187 thousand and $189 thousand was recorded during the years ended December 31, 2021 and 2020, respectively, as a result of share awards vesting/exercised during the year.
The tax effects of temporary differences that resulted in the significant components of deferred tax assets and liabilities at December 31, 2021 and 2020 are as follows:
For the years ended December 31,
(Dollars in thousands) 2021 2020
Deferred tax assets:
Allowance for loan losses $ 4,499 $ 4,682
Net operating loss - 757
Deferred compensation 280 215
Restricted stock awards 320 290
Stock options 91 126
Deferred loan fees 700 1,403
Nonaccrued interest 173 215
Accrued expenses 395 370
Other 35 63
Total gross deferred tax assets 6,493 8,121
Deferred tax liabilities:
Unrealized gain-available for sale securities (783) (2,175)
Depreciation (831) (914)
Prepaid expenses (215) (212)
Business combination adjustments (969) (1,080)
Partnership investments (362) (381)
Other (43) (47)
Total gross deferred tax liabilities (3,203) (4,809)
Net deferred tax assets $ 3,290 $ 3,312
Management has determined that a valuation allowance is not required for the deferred tax assets at December 31, 2021 because it is more likely than not that these assets could be realized through carry back to taxable income in prior years, future reversals of existing taxable temporary differences, tax planning strategies and future taxable income. This conclusion is based on the Company's historical earnings, its current level of earnings and prospects for continued growth and profitability.
There were no unrecognized tax benefits at December 31, 2021, and the Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months. The Company recognizes interest and/or penalties related to income tax matters in income tax expense when applicable. The Company did not record any interest and penalties for 2021, 2020, and 2019.
NOTE 12-STOCK BASED COMPENSATION
On March 15, 2018, the Company’s Board of Directors approved the 2018 Equity Incentive Plan ("2018 Plan"). The 2018 Plan became effective upon shareholder approval at the annual shareholders meeting held on April 17, 2018. Under the 2018 Plan, the Company can grant incentive and non-qualified stock options, stock awards, stock appreciation rights, and other incentive awards to directors and employees of, and certain service providers to, the Company and its subsidiaries. Once the 2018 Plan became effective, no further awards could be granted from the 2007 Stock Option Plan ("Stock Option Plan") or the
2014 Equity Incentive Plan ("2014 Plan"). However, any outstanding equity awards granted under the Stock Option Plan or the 2014 Plan will remain subject to the terms of such plans until the time such awards are no longer outstanding.
The Company reserved 250,000 shares of common stock for issuance under the 2018 Plan. During the years ended December 31, 2021 and 2020, the Company issued 55,320 and 38,170 restricted stock awards, respectively, under the 2018 Plan. There were 120,827 shares available for issuance as of December 31, 2021.
Stock Options
As of December 31, 2021, all of the Company's outstanding options were granted under the Stock Option Plan. The term of these options is ten years, and they vest one-third each year, over a three year period. The Company will use authorized but unissued shares to satisfy share option exercises. The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model.
Expected volatilities are based on historical volatilities of the Company's common stock. The Company assumes all awards will vest. The expected term of options granted represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. There were no stock options granted during the years ended December 31, 2021 or December 31, 2020.
The summary of our stock option activity for the years ended December 31, 2021 and 2020 is as follows:
2021 2020
Shares Weighted Average
Exercise Price Weighted Average Remaining Contractual
Term Shares Weighted Average
Exercise Price Weighted Average Remaining Contractual
Term
Options outstanding, beginning of period 345,218 $ 16.83 4.1 355,218 $ 16.63 5.0
Exercised (118,482) 16.21 (10,000) 9.57
Forfeited (2,175) 10.25 - -
Options outstanding, end of period 224,561 17.22 3.3 345,218 16.83 4.1
Options exercisable 224,561 $ 17.22 3.3 335,216 $ 16.59 4.0
The aggregate intrinsic value was $5.0 million for both options outstanding and exercisable as of December 31, 2021. The aggregate intrinsic value was $1.4 million for both options outstanding and exercisable as of December 31, 2020. As of December 31, 2021, there was no unrecognized compensation cost related to stock options granted under the Stock Option Plan.
The total intrinsic value and cash received from options exercised, including tax benefit, was $2.3 million and $1.9 million, respectively, for the year ended December 31, 2021, $130 thousand and $96 thousand, respectively for the year ended December 31, 2020, and $295 thousand and $232 thousand, respectively, for the year ended December 31, 2019.
Share-based compensation expense charged against income was $6 thousand, $45 thousand and $54 thousand for the years ended December 31, 2021, 2020 and 2019, respectively.
Restricted Stock Awards
A summary of changes in the Company's nonvested shares for the year ended December 31, 2021 is as follows:
Nonvested Shares Shares Weighted Average
Grant-Date Fair Value
Nonvested at January 1, 2021 93,270 $ 24.75
Granted 55,320 22.68
Vested (26,940) 24.78
Forfeited (8,500) 25.06
Nonvested at December 31, 2021 113,150 $ 23.71
As of December 31, 2021, there was $1.2 million of total unrecognized compensation cost related to nonvested shares granted under the 2018 Plan. The cost is expected to be recognized over a weighted average period of 1.9 years. The total fair value of shares vested during the year ended December 31, 2021 was $668 thousand compared to the fair value of $559 thousand for the year ended December 31, 2020.
Total expense for restricted stock awards totaled $811 thousand, $842 thousand and $659 thousand for the years ended December 31, 2021, 2020 and 2019, respectively. For the years ended December 31, 2021, 2020 and 2019 there was $137 thousand, $64 thousand and $43 thousand, respectively, of restricted stock redeemed to cover the payroll taxes due at the time of vesting.
A summary of our stock compensation activity and its effects on our outstanding common shares for the years ended December 31, 2021 is as follows.
2021 2020
Balance at Common shares outstanding, beginning of period 7,633,780 7,715,491
Redeemed stock (59,645) (125,798)
Exercise of stock options 118,482 10,000
Restricted stock grants 55,320 38,170
Restricted stock withheld for taxes (5,711) (2,683)
Cancellation of restricted stock (8,500) (1,400)
Balance at Common shares outstanding, end of period 7,733,726 7,633,780
NOTE 13 - OTHER BENEFIT PLANS
401(k) Plan: The Company sponsors a 401(k) plan in which substantially all employees are eligible to participate. The plan is a "safe harbor" plan in accordance with the Internal Revenue Code. In 2020, the Company updated the plan to provide a matching contribution equal to 100% of the first 3% and 50% of the next 2% of employee contributions for each eligible employee. In 2019 and earlier, the plan required the Company to make a 3% non-elective contribution for each eligible employee. Contributions to the plan were approximately $1.1 million, $1.1 million and $690 thousand for the years ended December 31, 2021, 2020 and 2019, respectively.
Deferred Compensation Plan: The Company's deferred compensation plan, established in 2015, covers all executive officers. Under the plan, the Company pays each participant, or his or her beneficiary, the amount of contributions deferred into the plan plus adjustments for deemed investment experience. The Company accrues a liability for the obligation under the plan. The expense incurred for deferred compensation was $310 thousand, $350 thousand and $261 thousand for the years ended December 31, 2021, 2020 and 2019, respectively, which resulted in a deferred compensation liability of $1.3 million, $1.0 million and $676 thousand as of December 31, 2021, 2020 and 2019, respectively.
NOTE 14-OFF-BALANCE SHEET ACTIVITIES
In the normal course of business, the Company offers a variety of financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments include outstanding commitments to extend credit, credit lines, commercial letters of credit and standby letters of credit. Commitments to extend credit are agreements to provide credit to a customer, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used and the total commitment amounts do not necessarily represent future cash flow requirements.
Standby letters of credit and commercial letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party, while commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party. These financial standby letters of credit irrevocably obligate the Company to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument.
Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies used for loans are used to make such commitments, including obtaining collateral at exercise of the commitment. We maintain an allowance to cover probable losses inherent in our financial instruments with off-balance sheet risk. At December 31, 2021, the allowance for off-balance sheet risk was $369 thousand, compared to $490 thousand at December 31, 2020, and was included in "Other liabilities" on our consolidated balance sheets.
A summary of the contractual amounts of the Company's exposure to off-balance sheet risk is as follows:
December 31, 2021 December 31, 2020
(Dollars in thousands) Fixed Variable Fixed Variable
Commitments to make loans $ 13,532 $ 13,531 $ 18,269 $ 17,058
Unused lines of credit 49,841 392,186 28,898 385,307
Unused standby letters of credit and commercial letters of credit 2,145 - 2,340 1,992
Commitments to make loans are generally made for periods of 90 days or less. The fixed rate loan commitments of $13.5 million as of December 31, 2021, had interest rates ranging from 2.89% to 5.25% and maturities ranging from 7 months to 18 years.
NOTE 15-REGULATORY CAPITAL MATTERS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Management believed that as of December 31, 2021, the Company and Bank met all capital adequacy requirements to which they were subject.
The Basel III rules require the Company and the Bank to maintain a capital conservation buffer of common equity Tier 1 capital of 2.5% above the minimum risk-weighted assets ratios.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.
At December 31, 2021 and December 31, 2020, the Company's and the Bank's capital ratios were in excess of the requirement to be "well capitalized" under regulatory guidelines. There are no conditions or events that management believes have changed the Company or the Bank's category.
Actual and required capital amounts and ratios are presented below:
Actual For Capital
Adequacy
Purposes For Capital Adequacy
Purposes + Capital
Conservation Buffer(1)
Well Capitalized Under Prompt Corrective
Action Provisions
(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio Amount Ratio
December 31, 2021
Common equity tier 1 to risk-weighted assets:
Consolidated $ 175,692 10.37 % $ 76,222 4.50 % $ 118,567 7.00 %
Bank 222,202 13.12 % 76,231 4.50 % 118,581 7.00 % $ 110,111 6.50 %
Tier 1 capital to risk-weighted assets:
Consolidated $ 199,064 11.75 % $ 101,629 6.00 % $ 143,975 8.50 %
Bank 222,202 13.12 % 101,641 6.00 % 143,991 8.50 % $ 135,521 8.00 %
Total capital to risk-weighted assets:
Consolidated $ 249,939 14.76 % $ 135,506 8.00 % $ 177,851 10.50 %
Bank 243,384 14.37 % 135,521 8.00 % 177,872 10.50 % $ 169,402 10.00 %
Tier 1 capital to average assets (leverage ratio):
Consolidated $ 199,064 7.93 % $ 100,392 4.00 % $ 100,392 4.00 %
Bank 222,202 8.86 % 100,272 4.00 % 100,272 4.00 % $ 125,339 5.00 %
December 31, 2020
Common equity tier 1 to risk-weighted assets:
Consolidated $ 144,938 9.30 % $ 70,141 4.50 % $ 109,108 7.00 %
Bank 185,655 11.94 % 69,950 4.50 % 108,812 7.00 % $ 101,040 6.50 %
Tier 1 capital to risk-weighted assets:
Consolidated $ 168,310 10.80 % $ 93,521 6.00 % $ 132,488 8.50 %
Bank 185,655 11.94 % 93,267 6.00 % 132,129 8.50 % $ 124,356 8.00 %
Total capital to risk-weighted assets:
Consolidated $ 232,386 14.91 % $ 124,695 8.00 % $ 163,662 10.50 %
Bank 205,127 13.20 % 124,356 8.00 % 163,218 10.50 % $ 155,446 10.00 %
Tier 1 capital to average assets (leverage ratio):
Consolidated $ 168,310 6.93 % $ 97,200 4.00 % $ 97,200 4.00 %
Bank 185,655 7.67 % 96,809 4.00 % 96,809 4.00 % $ 121,011 5.00 %
(1) Reflects the capital conservation buffer of 2.5% for risk-weighted asset ratios.
Dividend Restrictions - The Company’s primary source of cash is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. As of December 31, 2021, the Bank had the capacity to pay the Company a dividend of up to $65.5 million without the need to obtain prior regulatory approval.
NOTE 16-FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1-Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2-Significant other observable inputs other than Level 1 prices 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.
Level 3-Significant unobservable inputs that reflect a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:
Investment Securities: Securities available for sale are recorded at fair value on a recurring basis as follows: the fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where pricing on similar securities is not available, a third party is engaged to calculate the fair value using the Municipal Market Data curve (Level 3).
Loans Held for Sale, at Fair Value: The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan (Level 2).
Loans Measured at Fair Value: During the normal course of business, loans originated with the initial intention to sell, but not ultimately sold, are transferred from held for sale to our portfolio of loans held for investment at fair value as the Company adopted the fair value option at origination. The fair value of these loans is determined by obtaining fair value pricing from a third-party software, and then layering an additional adjustment, ranging from 5 to 75 basis points, as determined by management, depending on the reason for the transfer from loans held for sale. Loans are also evaluated for further credit deterioration and additional credit adjustments are applied to the loan as necessary. Due to the adjustments made, the Company classifies the loans transferred from loans held for sale as recurring Level 3.
Mortgage Servicing Rights ("MSRs"): In accordance with GAAP, the Company must record impairment charges on mortgage servicing rights on a non-recurring basis when the carrying value exceeds the estimated fair value. The fair value of our MSRs is obtained from a third-party valuation company that uses a discounted cash flow valuation model which calculates the present value of estimated future net servicing cash flows, taking into consideration expected mortgage loan prepayment rates, discount rates, costs to service, contractual servicing fee income, ancillary income, late fees, replacement reserves and other economic factors that are determined based on current market conditions. The reliance on Level 3 inputs to derive at the fair value of MSRs results in a Level 3 classification.
Impaired Loans: Impaired loans are measured and recorded at fair value on a non-recurring basis. All of our nonaccrual loans and trouble debt restructured loans are considered impaired and are reviewed individually for the amount of impairment, if any. The fair value of impaired loans is estimated using one of several methods, including the fair value of the collateral or the present value of the expected future cash flows discounted at the loan's effective interest rate. For loans that are collateral dependent, the fair value of each loan’s collateral is generally based on estimated market prices from an independently prepared appraisal. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Non-real estate collateral may be valued using an appraisal, net book value per the borrower's financial statements, or aging reports, adjusted or discounted based on management's historical knowledge, changes in market conditions from the time of the valuation, and management's expertise and knowledge of the client and client's business. Such adjustments are considered unobservable, and the fair value measurement is categorized as a Level 3 measurement.
Other Real Estate Owned: Other real estate owned assets are recorded at the lower of cost or fair value upon the transfer of a loan to other real estate owned and, subsequently, continue to be measured and carried at the lower of cost or fair value. The fair value of other real estate owned is based on recent real estate appraisals which are generally updated annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales, cost, and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Other real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Appraisals for both collateral-dependent impaired loans and real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and
licenses have been reviewed and verified by either the Company or the Company's appraisal services vendor. Once received, management reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. Management monitors the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.
Derivatives: Customer-initiated derivatives are traded in over-the counter markets where quoted market prices are not readily available. Fair value of customer-initiated derivatives is measured on a recurring basis using valuation models that use market observable inputs (Level 2).
Mortgage banking related derivatives including commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are recorded at fair value on a recurring basis. The fair value of these commitments is based on the fair value of related mortgage loans determined using observable market data (Level 2). Interest rate lock commitments are adjusted for expectations of exercise and funding. This adjustment is not considered to be a material input.
Assets and liabilities measured at fair value on a recurring basis are summarized below:
(Dollars in thousands) Total Quoted Prices
in Active Markets
for Identical Assets
(Level 1) Significant Other
Observable
Inputs
(Level 2) Significant
Unobservable
Inputs
(Level 3)
December 31, 2021
Securities available for sale:
U.S. government sponsored entities and agencies $ 21,774 $ - $ 21,774 $ -
State and political subdivision 148,276 - 147,406 870
Mortgage-backed securities: residential 22,211 - 22,211 -
Mortgage-backed securities: commercial 23,271 - 23,271 -
Collateralized mortgage obligations: residential 13,461 - 13,461 -
Collateralized mortgage obligations: commercial 51,183 - 51,183 -
U.S. Treasury 64,387 - 64,387 -
SBA 13,927 - 13,927 -
Asset backed securities 9,706 - 9,706 -
Corporate bonds 29,355 - 29,355 -
Total securities available for sale 397,551 - 396,681 870
Loans held for sale 12,902 - 12,902 -
Loans measured at fair value:
Residential real estate 10,000 - - 10,000
Derivative assets:
Customer-initiated derivatives 5,426 - 5,426 -
Forward contracts related to mortgage loans to be delivered for sale 29 - 29 -
Interest rate lock commitments 418 - 418 -
Total assets at fair value $ 426,326 $ - $ 415,456 $ 10,870
Derivative liabilities:
Customer-initiated derivatives 5,426 - 5,426 -
Forward contracts related to mortgage loans to be delivered for sale 49 - 49 -
Total liabilities at fair value $ 5,475 $ - $ 5,475 $ -
(Dollars in thousands) Total Quoted Prices
in Active Markets
for Identical Assets
(Level 1) Significant Other
Observable
Inputs
(Level 2) Significant
Unobservable
Inputs
(Level 3)
December 31, 2020
Securities available for sale:
U.S. government sponsored entities and agencies $ 26,358 $ - $ 26,358 $ -
State and political subdivision 132,723 - 131,259 1,464
Mortgage-backed securities: residential 26,081 - 26,081 -
Mortgage-backed securities: commercial 11,918 - 11,918 -
Collateralized mortgage obligations: residential 13,446 - 13,446 -
Collateralized mortgage obligations: commercial 58,512 - 58,512 -
SBA 17,593 - 17,593 -
Asset backed securities 10,072 - 10,072 -
Corporate bonds 6,029 - 6,029 -
Total securities available for sale $ 302,732 $ - $ 301,268 $ 1,464
Loans held for sale 43,482 - 43,482 -
Loans measured at fair value:
Residential real estate 8,037 - - 8,037
Derivative assets:
Customer-initiated derivatives 12,515 - 12,515 -
Forward contracts related to mortgage loans to be delivered for sale 46 - 46 -
Interest rate lock commitments 2,194 - 2,194 -
Total assets at fair value $ 369,006 $ - $ 359,505 $ 9,501
Derivative liabilities:
Customer-initiated derivatives 12,515 - 12,515 -
Forward contracts related to mortgage loans to be delivered for sale 423 - 423 -
Total liabilities at fair value $ 12,938 $ - $ 12,938 $ -
There were no transfers between levels within the fair value hierarchy, within a specific category, during the years ended December 31, 2021 or 2020. The Level 3 investment securities were acquired from Ann Arbor State Bank during the first quarter of 2020.
The following table summarizes the changes in Level 3 loans measured at fair value on a recurring basis.
For the year ended December 31,
(Dollars in thousands) 2021 2020
Loans held for investment
Beginning balance $ 8,037 $ 4,063
Transfers from loans held for sale 5,038 5,217
Gains (losses):
Recorded in "Mortgage banking activities" (462) 123
Repayments (2,613) (1,366)
Ending balance $ 10,000 $ 8,037
There were $98 thousand in loans held for investment measured at fair value that were on nonaccrual status or 90 days past due with a fair value of $93 thousand as of December 31, 2021. There were $105 thousand in loans held for investment measured at fair value that were on nonaccrual status or 90 days past due with a fair value of $109 thousand as of December 31, 2020.
The Company has elected the fair value option for loans held for sale. These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loan and in accordance with the Company's policy on loans held for investment.
As of December 31, 2021 and December 31, 2020, the aggregate fair value, contractual balance (including accrued interest), and gain or loss for loans held for sale carried at fair value was as follows:
(Dollars in thousands) December 31, 2021 December 31, 2020
Aggregate fair value $ 12,902 $ 43,482
Contractual balance 12,527 41,808
Unrealized gain 375 1,674
The total amount of gains as a result of changes in fair value of loans held for sale included in "Mortgage banking activities" for the years ended December 31, 2021, 2020 and 2019 were as follows:
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Change in fair value $ (1,299) $ 1,295 $ 296
Assets measured at fair value on a non-recurring basis are summarized below:
(Dollars in thousands) Significant Unobservable Inputs
(Level 3)
December 31, 2021
Impaired loans:
Commercial and industrial $ 272
Residential real estate 488
Mortgage servicing rights 8,279
Other real estate owned 201
Total $ 9,240
December 31, 2020
Impaired loans:
Commercial and industrial $ 1,270
Mortgage servicing rights 3,981
Total $ 5,251
The Company recorded specific reserves of $82 thousand and $95 thousand to reduce the value of the impaired loans noted above at December 31, 2021 and December 31, 2020, respectively, based on the estimated fair value of the underlying collateral. The Company also recorded $246 thousand of chargeoffs during the year ended December 31, 2021 related to the impaired loans at fair value. There were chargeoffs of $315 thousand related to impaired loans at fair value during the year ended December 31, 2020.
There were no write downs recorded in other real estate owned during the years ended December 31, 2021 or December 31, 2020.
The table below presents quantitative information about the significant unobservable inputs for assets measured at fair value on a nonrecurring basis at December 31, 2021 and December 31, 2020:
(Dollars in thousands) Fair Value at December 31, 2021 Valuation
Technique(s) Significant
Unobservable Input(s) Discount % Range/Amount
Impaired loans $ 760 Discounted appraisals; estimated net realizable value of collateral Collateral discounts 5.00-100.00%
Mortgage servicing rights 8,279 Discounted cash flow Prepayment speed 6.28 %
Discount rate 8.00 %
Other real estate owned 201 Appraisal of property Discounted appraisal value 11.00 %
(Dollars in thousands) Fair value at
December 31, 2020 Valuation
Technique(s) Significant
Unobservable Input(s) Discount % Range/Amount
Impaired loans $ 1,270 Discounted appraisals; estimated net realizable value of collateral Collateral discounts 10.00-90.00%
Mortgage servicing rights 3,981 Discounted cash flow Prepayment speed 8.71 %
Discount rate 7.75 %
The carrying amounts and estimated fair values of financial instruments, excluding those previously presented unless otherwise noted, at December 31, 2021 and December 31, 2020 are noted in the table below.
Estimated Fair Value
(Dollars in thousands) Carrying Value Quoted Prices in
Active Markets for
Identical Assets (Level 1) Significant
Other Observable
Inputs (Level 2) Significant
Unobservable
Inputs (Level 3) Total
December 31, 2021
Financial assets:
Cash and cash equivalents $ 330,146 $ 29,812 $ 300,334 $ - $ 330,146
Other investments 14,398 - - - N/A
Net loans 1,631,346 - - 1,648,443 1,648,443
Accrued interest receivable 6,398 - 1,886 4,512 6,398
Financial liabilities:
Deposits 2,040,082 - 2,061,670 - 2,061,670
Borrowings 178,682 - 181,306 - 181,306
Subordinated notes 29,694 - 31,314 - 31,314
Accrued interest payable 766 - 766 - 766
December 31, 2020
Financial assets:
Cash and cash equivalents $ 264,071 $ 25,245 $ 238,826 $ - $ 264,071
Other investments 14,398 N/A N/A N/A N/A
Net loans 1,701,240 - - 1,740,093 1,740,093
Accrued interest receivable 7,511 - 1,460 6,051 7,511
Financial liabilities:
Deposits 1,963,312 - 2,022,399 - 2,022,399
Borrowings 185,684 - 192,546 - 192,546
Subordinated notes 44,592 - 45,902 - 45,902
Accrued interest payable 1,081 - 1,081 - 1,081
The methods and assumptions, not previously presented, used to estimate fair value are described as follows:
(a)Cash and Cash Equivalents
The carrying amounts of cash on hand and non-interest due from bank accounts approximate fair values and are classified as Level 1. The carrying amounts of fed funds sold and interest bearing due from bank accounts approximate fair values and are classified as Level 2.
(b)Other Investments
It is not practical to determine the fair value of FHLB stock and Arctaris investment bond due to restrictions placed on their transferability.
(c)Loans
Fair value of loans, excluding loans held for sale, are estimated as follows: Fair values for all loans are estimated using present value of future estimated cash flows, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously.
(d)Deposits
The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 2 classification. Fair values for fixed and variable rate certificates of deposit are estimated using a present value of future estimated cash flows calculation that applies interest rates currently being offered on certificates of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.
(e) Borrowings
The fair values of the Company's short-term and long-term borrowings are estimated using present value of future estimated cash flows using current interest rates offered to the Company for similar types of borrowing arrangements, resulting in a Level 2 classification.
(f)Subordinated Notes
The fair value of the Company's subordinated notes is calculated based on present value of future estimated cash flows using current interest rates offered to the Company for similar types of borrowing arrangements, resulting in a Level 2 classification.
(g) Accrued Interest Receivable/Payable
The carrying amounts of accrued interest approximate fair value resulting in a Level 3 classification for receivable and a Level 2 classification for payable, consistent with their associated assets/liabilities.
NOTE 17-DERIVATIVES
The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. These interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions with approved, reputable, independent counterparties with substantially matching terms. The agreements are considered standalone derivatives, and changes in the fair value of derivatives are reported in earnings as non-interest income.
Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Company's exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. There are provisions in the agreements with the counterparties that allow for certain unsecured credit exposure up to an agreed threshold. Exposures in excess of the agreed thresholds are collateralized. In addition, the Company minimizes credit risk through credit approvals, limits, and monitoring procedures.
Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company's practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated in hedge relationships. Fair values were estimated based on changes in mortgage interest rates from the date of the commitments. Changes in the fair values of these mortgage-banking derivatives are included in mortgage banking activities.
The following table presents the notional amount and fair value of the Company's derivative instruments held or issued in connection with customer initiated and mortgage banking activities:
December 31, 2021 December 31, 2020
(Dollars in thousands) Notional Amount Fair Value Notional Amount Fair Value
Included in other assets:
Customer-initiated and mortgage banking derivatives:
Customer-initiated derivatives $ 148,862 $ 5,426 $ 136,023 $ 12,515
Forward contracts related to mortgage loans to be delivered for sale 6,199 29 10,191 46
Interest rate lock commitments 35,263 418 91,531 2,194
Total derivatives included in other assets $ 190,324 $ 5,873 $ 237,745 $ 14,755
Included in other liabilities:
Customer-initiated and mortgage banking derivatives:
Customer-initiated derivatives $ 148,862 $ 5,426 $ 136,023 $ 12,515
Forward contracts related to mortgage loans to be delivered for sale 29,767 49 92,899 423
Interest rate lock commitments 546 - - -
Total derivatives included in other liabilities $ 179,175 $ 5,475 $ 228,922 $ 12,938
In the normal course of business, the Company may decide to settle a forward contract rather than fulfill the contract. Cash received or paid in this settlement manner is included in "Mortgage banking activities" in the consolidated statements of income and is considered a cost of executing a forward contract. The following table presents the gains (losses) related to derivative instruments reflecting the changes in fair value:
For the year ended December 31,
(Dollars in thousands) Location of Gain (Loss) 2021 2020 2019
Forward contracts related to mortgage loans to be delivered for sale Mortgage banking activities $ 1,620 $ (5,011) $ (509)
Interest rate lock commitments Mortgage banking activities (1,776) 1,938 58
Total loss recognized in income $ (156) $ (3,073) $ (451)
Balance Sheet Offsetting:
Certain financial instruments, including customer-initiated derivatives and interest rate swaps, may be eligible for offset in the consolidated balance sheets and/or subject to master netting arrangements or similar agreements. The Company is a party to master netting arrangements with its financial institution counterparties; however, the Company does not offset assets and liabilities under these arrangements for financial statement presentation purposes based on an accounting policy election. The table below presents information about the Company's financial instruments that are eligible for offset.
Gross amounts not offset in the statements of financial position
(Dollars in thousands) Gross amounts recognized Gross amounts offset in the statements of financial condition Net amounts presented in the statements of financial condition Financial instruments Collateral (received)/posted Net amount
December 31, 2021
Offsetting derivative assets:
Customer initiated derivatives $ 5,426 $ - $ 5,426 $ - $ - $ 5,426
Offsetting derivative liabilities:
Customer initiated derivatives 5,426 - 5,426 - 10,383 (4,957)
December 31, 2020
Offsetting derivative assets:
Customer initiated derivatives $ 12,515 $ - $ 12,515 $ - $ - $ 12,515
Offsetting derivative liabilities:
Customer initiated derivatives 12,515 - 12,515 - 15,383 (2,868)
NOTE 18-PARENT COMPANY FINANCIAL STATEMENTS
Balance Sheets-Parent Company
(Dollars in thousands) December 31, 2021 December 31, 2020
Assets
Cash and cash equivalents $ 7,442 $ 25,779
Investment in banking subsidiary 263,229 232,671
Investment in captive insurance subsidiary - 1,625
Income tax benefit 59 355
Other assets 46 63
Total assets $ 270,776 $ 260,493
Liabilities
Subordinated notes $ 29,694 $ 44,592
Accrued expenses and other liabilities 991 574
Total liabilities 30,685 45,166
Shareholders' equity 240,091 215,327
Total liabilities and shareholders' equity $ 270,776 $ 260,493
Statements of Income and Comprehensive Income-Parent Company
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Income
Dividend income from bank subsidiary $ - $ 41,500 $ -
Dividend income from captive subsidiary 1,629 815 860
Total income $ 1,629 $ 42,315 $ 860
Expenses
Interest on borrowed funds - 40 4
Interest on subordinated notes 1,863 2,537 1,074
Other expenses 1,787 1,238 1,196
Total expenses $ 3,650 $ 3,815 $ 2,274
Income (loss) before income taxes and equity in undistributed net earnings of subsidiaries (2,021) 38,500 (1,414)
Income tax expense 909 781 427
Equity in (overdistributed) undistributed earnings of subsidiaries 33,590 (18,868) 17,098
Net income $ 32,478 $ 20,413 $ 16,111
Other comprehensive income (loss) (5,237) 4,590 5,344
Total comprehensive income, net of tax $ 27,241 $ 25,003 $ 21,455
Statements of Cash Flows-Parent Company
For the year ended December 31,
(Dollars in thousands) 2021 2020 2019
Cash flows from operating activities
Net income $ 32,478 $ 20,413 $ 16,111
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in over (under) distributed earnings of subsidiaries (33,590) 18,868 (17,098)
Stock based compensation expense 100 101 74
Net change in other assets, net 313 201 (205)
Net change in other liabilities, net 437 59 257
Net cash (used in) provided by operating activities (262) 39,642 (861)
Cash flows from investing activities
Cash used in acquisitions - (67,944) -
Net cash used in investing activities - (67,944) -
Cash flows from financing activities
Preferred stock offering, net of issuance costs - 23,372 -
Net proceeds from issuance of subordinated debt - - 29,487
Pay down of subordinated debt (15,000) - -
Share buyback - redeemed stock (1,364) (2,648) (2,165)
Preferred stock dividends paid (1,875) (479) -
Common stock dividends paid (1,756) (1,469) (1,160)
Proceeds from exercised stock options 1,920 95 219
Net cash (used in) provided by financing activities (18,075) 18,871 26,381
Net increase (decrease) in cash and cash equivalents (18,337) (9,431) 25,520
Beginning cash and cash equivalents 25,779 35,210 9,690
Ending cash and cash equivalents $ 7,442 $ 25,779 $ 35,210
NOTE 19-EARNINGS PER COMMON SHARE
The Company has elected to use the two-class method in calculating earnings per share due to the unvested restricted stock awards qualifying as participating securities. The two-class method is used in the calculation of basic and diluted earnings per common share. Under the two-class method, earnings available to common shareholders for the period are allocated between common shareholders and participating securities according to dividends declared (or accumulated) and participating rights in undistributed earnings.
Average shares of common stock for diluted net income per common share include shares to be issued upon the exercise of stock options granted under the Company's share-based compensation plans and restricted stock awards.
The calculation of basic and diluted earnings per share using the two-class method for the periods noted below was as follows:
For the year ended December 31,
(In thousands, except per share data) 2021 2020 2019
Net income $ 32,478 $ 20,413 $ 16,111
Preferred stock dividends 1,875 479 -
Net income available to common shareholders 30,603 19,934 16,111
Net income allocated to participating securities 441 244 159
Net income allocated to common shareholders (1)
$ 30,162 $ 19,690 $ 15,952
Weighted average common shares - issued 7,648 7,723 7,733
Average unvested restricted share awards (112) (96) (78)
Weighted average common shares outstanding - basic 7,536 7,627 7,655
Effect of dilutive securities:
Weighted average common stock equivalents 114 59 115
Weighted average common shares outstanding - diluted 7,650 7,686 7,770
EPS available to common shareholders
Basic earnings per common share $ 4.00 $ 2.58 $ 2.08
Diluted earnings per common share $ 3.95 $ 2.57 $ 2.05
(1) Net income allocated to common shareholders for basic and diluted earnings per share may differ under the two-class method as a result of adding common share equivalents for options to dilutive shares outstanding, which alters the ratio used to allocate net income to common shareholders and participating securities for the purposes of calculating diluted earnings per share.
There were no common stock options excluded in computing diluted earnings per share for the year ended December 31, 2021 compared to 117,334 and 30,000 shares of common stock options that were excluded in computing diluted earnings per common share for the years ended December 31, 2020 and 2019, respectively, because they were anti-dilutive.
NOTE 20-QUARTERLY FINANCIAL DATA (UNAUDITED)
The following tables present the unaudited quarterly financial data for the years ended December 31, 2021 and 2020:
For the year ended December 31, 2021
(In thousands, except per share data) First Quarter Second Quarter Third Quarter Fourth Quarter
Interest income $ 21,551 $ 21,737 $ 22,322 $ 21,040
Interest expense 2,394 2,121 1,807 1,729
Net interest income 19,157 19,616 20,515 19,311
Provision for (recovery of) loan losses 265 540 (1,189) (341)
Net interest income after provision for (recovery of) loan losses 18,892 19,076 21,704 19,652
Noninterest income 7,278 4,326 6,041 4,727
Noninterest expense 15,139 14,588 15,989 16,123
Income before income taxes 11,031 8,814 11,756 8,256
Income tax provision 2,072 1,835 2,291 1,181
Net income 8,959 6,979 9,465 7,075
Preferred stock dividends 469 469 468 469
Net income attributable to common shareholders $ 8,490 $ 6,510 $ 8,997 $ 6,606
Earnings per common share:
Basic $ 1.11 $ 0.85 $ 1.19 $ 0.85
Diluted 1.10 0.84 1.16 0.85
Cash dividends declared per common share 0.06 0.06 0.06 0.06
For the year ended December 31, 2020
(In thousands, except per share data) First Quarter Second Quarter Third Quarter Fourth Quarter
Interest income $ 19,817 $ 20,396 $ 20,245 $ 22,181
Interest expense 4,997 4,163 3,648 3,075
Net interest income 14,820 16,233 16,597 19,106
Provision for loan losses 489 5,575 4,270 1,538
Net interest income after provision for loan losses 14,331 10,658 12,327 17,568
Noninterest income 4,690 7,789 9,125 8,110
Noninterest expense 14,562 15,083 15,126 15,461
Income before income taxes 4,459 3,364 6,326 10,217
Income tax provision 349 643 1,117 1,844
Net income 4,110 2,721 5,209 8,373
Preferred stock dividends - - - 479
Net income attributable to common shareholders $ 4,110 $ 2,721 $ 5,209 $ 7,894
Earnings per common share:
Basic $ 0.53 $ 0.35 $ 0.68 $ 1.02
Diluted 0.53 0.35 0.67 1.02
Cash dividends declared per common share 0.05 0.05 0.05 0.05

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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
Evaluation of disclosure controls and procedures. The Company’s management, including our President and Chief Executive Officer and our Chief Financial Officer, have evaluated the effectiveness of our “disclosure controls and
procedures” (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, our President and Chief Executive Officer and our Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective as of that date to provide reasonable assurance that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its President and Chief Executive Officer and its Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management's annual report on internal control over financial reporting. Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act). Internal control over financial reporting is designed to provide a reasonable assurance of the Company's management and board of directors regarding the preparation of reliable published financial statements. Internal control over financial reporting includes self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Because of inherent limitations in any system of internal control, no matter how well designed, misstatements due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.
Management assessed the Company’s internal control over financial reporting as of December 31, 2021. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, Chief Executive Officer and our Chief Financial Officer assert that the Company maintained effective internal control over financial reporting as of December 31, 2021 based on the specified criteria. Our auditors will not be required to formally opine on the effectiveness of our internal control over financial reporting until we are no longer an “emerging growth company” as defined in the JOBS Act as we availed ourselves of the exemptions available to us under the JOBS Act.
Changes in internal control over financial reporting. There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the quarter ended December 31, 2021, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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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.
Information required by this item is set forth under the headings “Proposal 1 - Election of Directors,” “Delinquent Section 16(a) Reports,” and “Corporate Governance and the Board of Directors” appearing in the Company’s Proxy Statement for the 2022 annual meeting of shareholders to be filed within 120 days after December 31, 2021, which is incorporated herein by reference.

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ITEM 11. EXECUTIVE COMPENSATION
Item 11 - Executive Compensation
Information required by this item is set forth under the headings "Executive Compensation," "Corporate Governance and the Board of Directors - Director Compensation," and "Corporate Governance and the Board of Directors - Compensation
Committee Interlocks and Insider Participation" appearing in the Company's Proxy Statement for the 2022 annual meeting of
shareholders to be filed within 120 days after December 31, 2021, which 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 Stockholder Matters
Equity Compensation Plans. The following table discloses the number of outstanding options, warrants and rights granted to participants by the Company under our equity compensation plans, as well as the number of securities remaining available for future issuance under these plans as of December 31, 2021. Additional information regarding stock incentive plans is presented in Note 12 to the consolidated financial statements included pursuant to Item 8 to this Form 10-K.
Plan Category (a)
Number of securities to be issued upon exercise of outstanding options,
warrants and rights (b)
Weighted-average
exercise price of
outstanding options,
warrants and rights (c)
Number of securities
remaining available for
future issuance under
equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by shareholders (1)
224,561 $ 17.22 120,827
Equity compensation plans not approved by shareholders (2)
- - -
Total 224,561 $ 17.22 120,827
(1) Column (a) includes outstanding stock options granted from the Level One Bancorp, Inc. 2007 Stock Option Plan. Column (c) reflects the remaining share reserve under the Level One Bancorp, Inc. 2018 Equity Incentive Compensation Plan attributable to the initial 250,000 shares reserved for issuance.
(2) Reflects the Level One Bancorp, Inc. 2014 Equity Incentive Plan. As of December 31, 2021, there were no outstanding options, warrants or rights under the plan, and no additional awards may be granted under the plan.
Other information required by this item is set forth under the heading “Security Ownership of Certain Beneficial Owners” appearing in the Company’s Proxy Statement for the 2022 annual meeting of shareholders to be filed within 120 days after December 31, 2021, which is incorporated herein by reference.

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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Item 13 - Certain Relationships and Related Transactions, and Director Independence
Information required by this item is set forth under the headings “Certain Relationships and Related Party Transactions” and “Corporate Governance and the Board of Directors” appearing in the Company’s Proxy Statement for the 2022 annual meeting of shareholders to be filed within 120 days after December 31, 2021, which is incorporated herein by reference.

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ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Item 14 - Principal Accountant Fees and Services.
Plante & Moran, PLLC, Auburn Hills, Michigan (PCAOB ID 166) is the Company's independent registered public accounting firm.
Information required by this item is set forth under the heading "Proposal 2 - Ratification of the Appointment of Plante & Moran, PLLC as our Independent Registered Public Accounting Firm" appearing in the Company's Proxy Statement for the 2022 annual meeting of shareholders to be filed with the SEC within 120 days after December 31, 2021, which is incorporated herein by reference.
PART IV

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ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Item 15 - Exhibits
(a) The following documents are filed as part of this report:
(1) Financial Statements:
The following consolidated financial statements of the registrant and its subsidiaries are filed as part of this document under “Item 8. Financial Statements and Supplementary Data.”
Consolidated Balance Sheets -December 31, 2021 and 2020
Consolidated Statements of Income - Years Ended December 31, 2021, 2020, 2019
Consolidated Statements of Comprehensive Income - Years Ended December 31, 2021, 2020, 2019
Consolidated Statements of Shareholders’ Equity - Years Ended December 31, 2021, 2020, 2019
Consolidated Statements of Cash Flows - Years Ended December 31, 2021, 2020, 2019
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules:
All schedules are omitted as such information is inapplicable or is included in the financial statements.
(3) Exhibits:
The exhibits are filed as part of this report and exhibits incorporated herein by reference to other documents are as follows:
Exhibit No. Description
2.1 Agreement and Plan of Merger, dated as of November 4, 2021, between First Merchants Corporation and Level One Bancorp, Inc. (incorporated by reference to Exhibit 2.1 to the Company's current report on Form 8-K filed November 4, 2021.
3.1 Articles of Incorporation, as amended, of Level One Bancorp, Inc. (incorporated by reference to Exhibit 3.1 to the Company’s current report on Form 8-K filed August 13, 2020).
3.2 Amended and Restated Bylaws of Level One Bancorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
4.1 Description of the Company's Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934 - filed herewith.
4.2 Form of common stock certificate of Level One Bancorp, Inc. (incorporated by reference to Exhibit 4.1 the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
4.3 Indenture, dated as of December 18, 2019, between Level One Bancorp, Inc. and Wilmington Trust, National Association, as trustee (incorporated by reference to Exhibit 4.1 to the Company’s current report on Form 8-K filed December 19, 2019).
4.4 Form of 4.75% Fixed-to-Floating Rate Subordinated Notes due 2029 (incorporated by reference to Exhibit 4.2 to the Company’s current report on Form 8-K filed December 19, 2019).
4.5 Deposit Agreement, dated as of August 13, 2020, among Level One Bancorp, Inc., Continental Stock Transfer & Trust Company, as Depositary, and the holders from time to time of the Depositary Receipts issued thereunder (incorporated by reference to Exhibit 4.1 to the Company’s current report on Form 8-K filed August 13, 2020).
4.6 Form of Depositary Receipt (incorporated by reference to Exhibit 4.2 to the Company’s current report on Form 8-K filed August 13, 2020).
10.1* Employment Agreement, dated May 6, 2020, among Level One Bancorp, Inc., Level One Bank and Patrick Fehring (incorporated by reference to Exhibit 10.1 to the Company’s quarterly report on Form 10-Q filed May 8, 2020).
10.2* Employment Agreement, dated as of May 6, 2020, among Level One Bancorp, Inc., Level One Bank and Timothy Mackay (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on July 20, 2021)
10.3* Amendment to Employment Agreement, dated as of July 16, 2021, among the Company, the Bank and Timothy Mackay (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed on July 20, 2021)
10.4* Employment Agreement, dated May 6, 2020, among Level One Bancorp, Inc., Level One Bank and Gregory Wernette (incorporated by reference to Exhibit 10.2 to the Company’s quarterly report on Form 10-Q filed May 8, 2020).
10.5* Employment Agreement, dated May 6, 2020, among Level One Bancorp, Inc., Level One Bank and David Walker (incorporated by reference to Exhibit 10.3 to the Company’s quarterly report on Form 10-Q filed May 8, 2020).
10.6* Form of Level One Bank Supplemental Executive Retirement Plan, dated June 18, 2015 (incorporated by reference to Exhibit 10.4 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.7* Level One Bancorp, Inc. 2007 Stock Option Plan as amended and restated April 15, 2015 (incorporated by reference to Exhibit 10.5 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.8* Amendment to the Level One Bancorp, Inc. 2007 Stock Option Plan, dated August 29, 2017 (incorporated by reference to Exhibit 10.6 to the Company's registration on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.9* Form of Nonqualified Stock Option Agreement under the Level One Bancorp, Inc. 2007 Stock Option Plan (incorporated by reference to Exhibit 10.7 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.10* Level One Bancorp, Inc. 2014 Equity Incentive Plan (incorporated by reference to Exhibit 10.8 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.11* Form of Restricted Stock Award Agreement under the Level One Bancorp, Inc. 2014 Equity Incentive Plan (incorporated by reference to Exhibit 10.9 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.12* Form of Level One Executive Incentive Plan (incorporated by reference to Exhibit 10.10 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.13* Level One Bancorp, Inc. 2018 Equity Incentive Plan (incorporated by reference to Exhibit 10.11 to the Company's registration statement on Form S-1 (File no. 333-223866) filed March 23, 2018).
10.14* Form of Level One Bancorp, Inc. 2018 Equity Incentive Plan Stock Appreciation Right Award Agreement (incorporated by reference to Exhibit 4.7 to the Company’s registration statement on Form S-8 (File no. 333-224500) filed April 27, 2018).
10.15* Form of Level One Bancorp, Inc. 2018 Equity Incentive Plan Restricted Stock Award Agreement (incorporated by reference to Exhibit 4.8 to the Company’s registration statement on Form S-8 (File no. 333-224500) filed April 27, 2018).
10.16* Form of Level One Bancorp, Inc. 2018 Equity Incentive Plan Restricted Stock Unit Award Agreement (incorporated by reference to Exhibit 4.9 to the Company’s registration statement on Form S-8 (File no. 333-224500) filed April 27, 2018).
10.17* Form of Level One Bancorp, Inc. 2018 Equity Incentive Plan Nonqualified Stock Option Award Agreement (incorporated by reference to Exhibit 4.10 to the Company’s registration statement on Form S-8 (File no. 333-224500) filed April 27, 2018).
10.18* Form of Level One Bancorp, Inc. 2018 Equity Incentive Plan Incentive Stock Option Award Agreement (incorporated by reference to Exhibit 4.11 to the Company’s registration statement on Form S-8 (File no. 333-224500) filed April 27, 2018).
10.19* Form of Level One Bank Supplemental Executive Retirement Plan Amendment by Level One Bank and acknowledged by each of Patrick J. Fehring, David C. Walker, Gregory A. Wernette, Timothy R. Mackay, Eva D. Scurlock and Melanie C. Barrett (incorporated by reference to Exhibit 10.17 to the Company’s annual report on Form 10-K filed March 13, 2020).
21.1 Subsidiaries of Level One Bancorp, Inc. - filed herewith.
23.1 Consent of Plante & Moran, PLLC - filed herewith.
31.1 Principal Executive Officer’s Certifications required by Rule 13(a)-14(a) - filed herewith.
31.2 Principal Financial Officer’s Certifications required by Rule 13(a)-14(a) - filed herewith.
32.1 Principal Executive Officer Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - filed herewith.
32.2 Principal Financial Officer Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - filed herewith.
101 Financial information from the Company’s Annual Report on Form 10-K for the year ended
December 31, 2021, formatted in iXBRL interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Income; (iii) Consolidated Statements of
Comprehensive Income; (iv) Consolidated Statements of Shareholders’ Equity; (v)
Consolidated Statements of Cash Flows; and (vi) Notes to the Consolidated Financial Statements - filed
herewith.
104 Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)
*Indicates management contract or compensatory plan or arrangement.