BANNER CORP (BANR) FY 2022 MD&A

Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding our financial condition and results of operations. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to the Consolidated Financial Statements contained in Item IV of this Form 10-K.

Executive Overview

Banner’s successful execution of its super community bank model and strategic initiatives has delivered solid core operating results and profitability over the last several years. The Company’s longer term strategic initiatives continue to focus on originating high quality assets and client acquisition, which we believe will continue to generate strong revenue while maintaining the Company’s moderate risk profile.

2022 Financial Highlights

•Revenues increased 6%, to $628.4 million, compared to $593.3 million for the prior year.

•Net income decreased to $195.4 million, or $5.67 per diluted share, compared to net income of $201.0 million, or $5.76 per diluted share for the prior year.

•Net interest income increased 11% to $553.2 million, compared to $496.9 million for the prior year.

•Net interest margin, on a tax equivalent basis, was 3.68% compared to 3.39% in the prior year.

•Non-interest income decreased to $75.3 million, compared to $96.4 million for the prior year.

•Non-interest expense decreased to $377.3 million, compared to $380.1 million for the prior year.

•Return on average assets was 1.18%, compared to 1.24% in the prior year.

•Efficiency ratio was 60.04%, compared to 64.06% in the prior year.

•Net loans receivable increased 12% to $10.01 billion at December 31, 2022, compared to $8.95 billion a year ago.

•Non-performing assets decreased to $23.4 million, or 0.15% of total assets, at December 31, 2022, compared to $23.7 million, or 0.14% of total assets, a year ago.

•The allowance for credit losses - loans was $141.5 million, or 1.39% of total loans receivable, at December 31, 2022, compared to $132.1 million, or 1.45% of total loans receivable a year ago.

•Core deposits (non-interest-bearing and interest-bearing transaction and savings accounts) decreased to $12.90 billion at December 31, 2022, compared to $13.49 billion a year ago. Core deposits represented 95% of total deposits at December 31, 2022.

•Cash dividends paid to shareholders were $1.76 per share, compared to $1.64 for the prior year.

•Common shareholders’ equity per share decreased to $42.59 at December 31, 2022, compared to $49.35 a year ago.

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Selected Financial Data: The following condensed consolidated statements of financial condition and operations and selected performance ratios as of December 31, 2022, 2021, and 2020 and for the years then ended have been derived from our audited consolidated financial statements.

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(1)Includes securities available-for-sale and held-to-maturity.

(2)Calculated using shares outstanding.

(3)Net income divided by average assets.

(4)Net income divided by average common equity.

(5)Net interest income as a percent of average interest-earning assets.

(6)Non-interest expenses divided by the total of net interest income and non-interest income.

(7)Non-performing loans consist of nonaccrual and 90 days past due loans still accruing interest.

(8)Represent non-GAAP financial measures.*

*Non-GAAP financial measures: To calculate the adjusted revenue, the diluted adjusted earnings per share and the adjusted efficiency ratio, we make adjustments to our GAAP revenues and expenses as reported on our Consolidated Statements of Operations, which results in non-GAAP financial measures. To calculate tangible equity per share and the ratio of tangible common shareholders’ equity to tangible assets, we make adjustments to our GAAP assets and shareholders’ equity as reported on our Consolidated Statements of Financial Condition, which results in non-GAAP financial measures. Management has presented non-GAAP financial measures in this discussion and analysis because it believes that they provide useful and comparative information to assess trends in our core operations and to facilitate the comparison of our performance with the performance of our peers. However, these non-GAAP financial measures are supplemental and are not a substitute for any analysis based on GAAP. Where applicable, we have also presented comparable earnings information using GAAP financial measures. For a reconciliation of these non-GAAP financial measures, see the tables below. Because not all companies use the same calculations, our presentation may not be comparable to other similarly titled measures as calculated by other companies.

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The following tables set forth reconciliations of non-GAAP financial measures discussed in this report (dollars in thousands, except share and per share data):

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We calculate tangible common equity by excluding goodwill and other intangible assets from shareholders’ equity. We calculate tangible assets by excluding the balance of goodwill and other intangible assets from total assets. We believe that this is consistent with the treatment by our bank regulatory agencies, which exclude goodwill and other intangible assets from the calculation of risk-based capital ratios. Management believes that this non-GAAP financial measure provides information to investors that is useful in understanding the basis of our capital position (dollars in thousands).

Critical Accounting Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates, assumptions and judgements that affect amounts reported in the consolidated financial statements. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Management believes the following estimates require difficult, subjective or complex judgments and, therefore, management considers the following to be critical accounting estimates.

Allowance for Credit Losses: The allowance for credit losses reflects management's evaluation of our loans and their estimated loss potential, as well as the risk inherent in various components of the portfolio. There is significant judgment and assumptions applied in estimating the allowance for credit losses. These judgements, assumptions and estimates are susceptible to significant changes based on the current environment. Among the material estimates required to establish the allowance for credit losses are a reasonable and supportable forecast; a reasonable and supportable forecast period and the reversion period; value of collateral; strength of guarantors; the amount and timing of future cash flows for loans individually evaluated; and determination of the qualitative loss factors.

Management estimates the allowance for credit losses using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The allowance for credit losses is maintained at a level sufficient to provide for expected credit losses over the life of the asset based on evaluating historical credit loss experience and making adjustments to historical loss information for differences in the specific risk characteristics in the current portfolio. These factors include, among others, changes in the size and composition of the portfolio, differences in underwriting standards, delinquency rates, actual loss experience and current economic conditions.

Management considers various economic scenarios and forecasts to arrive at the estimate that most reflects management’s expectations of future conditions. The selection of a more optimistic or pessimistic economic forecast would result in a lower or higher allowance for credit losses. The use of a protracted slump economic forecast would have increased the allowance for credit losses - loans by approximately 28% as of December 31, 2022, where the use of a stronger near-term growth economic forecast would result in a negligible decrease in the allowance for credit losses - loans as of December 31, 2022.

Management uses a scale to assign qualitative and environmental (QE) factor adjustments based on the level of estimated impact which requires a significant amount of judgment. Some QE factors impact all loan segments equally while others may impact some loan segments more or less than others. If management’s judgment were different for a QE factor that impacts all loan segments equally, a five basis-point change in this QE factor would increase or decrease the allowance for credit losses by 3.7% as of December 31, 2022.

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Fair Value Accounting and Measurement: We use fair value measurements to record fair value adjustments to certain financial assets and liabilities. A hierarchical disclosure framework associated with the level of pricing observability is utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Determining the fair value of financial instruments with unobservable inputs requires a significant amount of judgment. This includes the discount rate used to fair value our trust preferred securities and junior subordinated debentures. A 25 basis-point increase or decrease in the discount rate used to calculate the fair value of our trust preferred securities would result in a $643,000 decrease or increase in the reported fair value as of December 31, 2022, with an offsetting adjustment to our non-interest income. A 25 basis-point increase or decrease in the discount rate used to calculate the fair value of our junior subordinated debentures would result in a $1.6 million decrease or increase in the reported fair value as of December 31, 2022, with an offsetting adjustment to our accumulated other comprehensive income.

Goodwill: An assessment of qualitative factors is completed to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The qualitative assessment involves judgment by management on determining whether there have been any triggering events that have occurred which would indicate potential impairment. If the qualitative analysis concludes that further analysis is required, then a quantitative impairment test would be completed. Various valuation methodologies are considered when estimating the reporting unit’s fair value. The specific factors used in these various valuation methodologies that require judgment include the selection of comparable market transactions, discount rates, earnings capitalization rates and the future projected earnings of the reporting unit. Changes in these assumptions could result in changes to the estimated fair value of the reporting unit. The Company completed an assessment of qualitative factors as of December 31, 2022, and concluded that no further analysis was required as it is more likely than not that the fair value of the Bank, the reporting unit, exceeds the carrying value.

Income Taxes and Deferred Taxes:  The Company determines its deferred tax assets and liabilities based on the enacted tax rates that are expected to be in effect when the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in the Company’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. A 1% change in tax rates would result in a $7.3 million increase or decrease in our net deferred tax asset as of December 31, 2022. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by the tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, when they occur, impact accrued taxes and can materially affect our operating results. The evaluation pertaining to the tax expense and related deferred tax asset and liability balances involves a high degree of judgment and subjectivity around the measurement and resolution of these matters. This includes an evaluation of our ability to use our net operating loss carryforwards. The ultimate realization of the deferred tax assets is dependent upon the existence, or generation, of taxable income in the periods when those temporary differences and net operating loss and credit carryforwards are deductible.

Legal Contingencies: In the normal course of our business, we have various legal proceedings and other contingent matters pending. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. The estimated losses often involve a level of subjectivity and usually are a range of reasonable losses and not an exact number, in those situations we accrue the best estimate within the range or the low end of the range if no estimate within the range is better than another.

Comparison of Financial Condition at December 31, 2022 and 2021

General. Total assets decreased to $15.83 billion at December 31, 2022, compared to $16.80 billion at December 31, 2021.  The decrease in assets in 2022 was largely the result of a decrease in cash held and interest-bearing deposits, partially offset by loan growth.

Total loans receivable (gross loans less deferred fees and discounts and excluding loans held for sale) increased $1.06 billion, or 12%, to $10.15 billion at December 31, 2022, from $9.08 billion at December 31, 2021.  The increase in total loans receivable primarily reflects increased one-to-four family residential, multifamily real estate, commercial business, construction, land and land development, and consumer loan balances, partially offset by decreased commercial real estate loan balances. Excluding SBA PPP loans, total loans receivable increased $1.19 billion during the year ended December 31, 2022.

Loans held for sale decreased to $56.9 million at December 31, 2022, compared to $96.5 million at December 31, 2021, principally as a result of a decrease in one- to four-family held for sale loan originations and the transfer of $54.0 million of multifamily held for sale loans to held for investment during the fourth quarter of 2022. Loans held for sale at December 31, 2022 included $49.5 million of multifamily loans and $7.4 million of one- to four-family loans, compared to $49.9 million of multifamily loans and $46.6 million of one- to four-family loans at December 31, 2021.

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The aggregate of securities and interest-bearing deposits decreased $1.98 billion, or 32%, to $4.28 billion at December 31, 2022, compared to $6.26 billion a year earlier, primarily due to a decrease in interest-bearing deposits.  Securities decreased to $3.94 billion at December 31, 2022, from $4.19 billion at December 31, 2021, as the fair value of securities available-for-sale declined as a result of an increase in interest rates during 2022. Fair value adjustments for securities designated as available-for-sale reflected a decrease of $418.8 million for the year ended December 31, 2022, which was included net of the associated tax benefit as a component of other comprehensive income, and largely occurred as a result of increases in market interest rates during 2022. Securities which are designated as held-to-maturity increased by $596.7 million from the prior year-end balance. This increase was primarily due to the transfer of $462.2 million of securities from available for sale to held to maturity during the first quarter of 2022 to limit the impact that potential future interest rates changes would have on AOCI. The average effective duration of our securities portfolio was approximately 6.5 years at December 31, 2022, compared to 4.6 years at December 31, 2021.

Deposits decreased $706.9 million, or 5%, to $13.62 billion at December 31, 2022, from $14.33 billion at December 31, 2021. The decrease in deposits reflects the sale of four branches, which included the transfer of $178.2 million of related deposits, as well as an overall decline in market liquidity.  Core deposits were 95% of total deposits at December 31, 2022, compared to 94% of total deposits one year earlier. Non-interest-bearing deposits decreased by $208.2 million, or 3%, to $6.18 billion from $6.39 billion at December 31, 2021; interest-bearing transaction and savings accounts decreased by $383.6 million or 5%, to $6.72 billion at December 31, 2022 from $7.10 billion at December 31, 2021; and certificates of deposit decreased $115.1 million, or 14%, to $723.5 million at December 31, 2022 from $838.6 million at December 31, 2021.

We had $50.0 million of FHLB advances at both December 31, 2022 and December 31, 2021, as core deposits were a sufficient source of funding. Other borrowings, consisting of retail repurchase agreements primarily related to client cash management accounts, decreased $31.7 million to $232.8 million at December 31, 2022, compared to $264.5 million at December 31, 2021. Junior subordinated debentures totaled $74.9 million at December 31, 2022 compared to $119.8 million at December 31, 2021, as we redeemed $50.5 million of junior subordinated debentures during the first quarter of 2022. Subordinated notes, net of issuance costs, were $98.9 million at December 31, 2022 compared to $98.6 million at December 31, 2021.

Total shareholders’ equity decreased $233.9 million, to $1.46 billion at December 31, 2022, compared to $1.69 billion at December 31, 2021. The decrease in shareholders’ equity is primarily due to the $363.0 million decrease in AOCI, primarily due to an increase in the unrealized loss and related decrease in the fair value of securities available-for-sale, net of tax, as a result of an increase in interest rates during 2022, the accrual of $60.9 million of cash dividends to common shareholders, and the repurchase of 200,000 shares of common stock at a total cost of $11.0 million, partially offset by the $195.4 million of year-to-date net income. Common shareholder’s equity to total assets was 9.20% and 10.06% at December 31, 2022 and 2021, respectively. Tangible common shareholders’ equity (a non-GAAP financial measure), which excludes goodwill and other intangible assets was $1.07 billion, or 6.95% of tangible assets at December 31, 2022, compared to $1.30 billion, or 7.93% at December 31, 2021. The decrease in tangible common shareholders’ equity as a percentage of tangible assets was primarily due to the previously mentioned decrease in AOCI. The Company’s book value per share was $42.59 at December 31, 2022, compared to $49.35 per share a year ago, and its tangible book value per share (a non-GAAP financial measure) was $31.41 at December 31, 2022, compared to $38.02 per share a year ago. See, “Executive Overview” above for a reconciliation of these non-GAAP financial measures.

Investments.  At December 31, 2022, our consolidated investment securities portfolio totaled $3.94 billion and consisted principally of mortgage-backed and mortgage-related securities and municipal bonds and to a lesser extent U.S. Government and agency obligations, corporate debt obligations, and asset-backed securities.  Our investment levels may be increased or decreased depending upon management’s projections as to the demand for funds to be used in our loan origination, deposit and other activities and upon yields available on investment alternatives.  During the year ended December 31, 2022, our aggregate investment in securities decreased $251.6 million primarily due to a decrease in the fair value of securities available-for-sale as a result of an increase in interest rates during 2022. Holdings of mortgage-backed securities decreased $151.7 million and U.S. Government and agency obligations decreased $146.2 million, while municipal bonds increased $35.2 million, corporate debt obligations increased $8.1 million and asset-backed securities increased $5.1 million.

U.S. Government and Agency Obligations:  Our portfolio of U.S. Government and agency obligations had a carrying value of $55.4 million (with an amortized cost of $56.7 million) at December 31, 2022, a weighted average contractual maturity of 10.3 years and a weighted average coupon rate of 4.84%.  Many of the U.S. Government and agency obligations we own include call features which allow the issuing agency the right to call the securities at various dates prior to the final maturity.

Mortgage-Backed Obligations:  At December 31, 2022, our mortgage-backed and mortgage-related securities had a carrying value of $2.75 billion ($3.12 billion at amortized cost, with a net fair value adjustment of $365.8 million).  The weighted average coupon rate of these securities was 2.62% and the weighted average contractual maturity was 24.9 years, although we receive principal payments on these securities each month resulting in a much shorter expected average life.  As of December 31, 2022, 98% of the mortgage-backed and mortgage-related securities pay interest at a fixed rate.

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Municipal Bonds:  The carrying value of our tax-exempt bonds at December 31, 2022 was $653.1 million ($678.9 million at amortized cost), comprised of general obligation bonds (i.e., backed by the general credit of the issuer) and, to a lesser extent, revenue bonds (i.e., backed by revenues from the specific project being financed) issued by cities and counties and various housing authorities, and hospital, school, water and sanitation districts.  We also had taxable bonds in our municipal bond portfolio, which at December 31, 2022 had a carrying value of $111.2 million ($125.6 million at amortized cost).  Many of our qualifying municipal bonds are not rated by a nationally recognized credit rating agency due to the smaller size of the total issuance and a portion of these bonds have been acquired through direct private placement by the issuers. We have not experienced any defaults or payment deferrals on our current portfolio of municipal bonds.  Our combined municipal bond portfolio is geographically diverse, with the majority within the states of Washington, Oregon, Texas and California. At December 31, 2022, our municipal bond portfolio, including taxable and tax-exempt, had a weighted average maturity of approximately 20.5 years and a weighted average coupon rate of 3.44%.

Corporate Bonds:  Our corporate bond portfolio had a carrying value of $153.5 million ($163.5 million at amortized cost, with a net fair value adjustment of $10.0 million) at December 31, 2022.  At December 31, 2022, the portfolio had a weighted average maturity of 9.9 years and a weighted average coupon rate of 4.30%.

Asset-Backed Securities:  At December 31, 2022, our asset-backed securities portfolio had a carrying value of $211.5 million (with an amortized cost of $222.5 million), and was comprised of collateralized loan obligations.  The weighted average coupon rate of these securities was 5.93% and the weighted average contractual maturity was 12.9 years. At December 31, 2022, 100% of these securities had adjustable interest rates tied to three-month LIBOR.

The following tables set forth certain information regarding carrying values and percentage of total carrying values of our portfolio of securities—trading and securities—available-for-sale, both carried at estimated fair market value, and securities—held-to-maturity, carried at amortized cost as of December 31, 2022, 2021 and 2020 (dollars in thousands):

Table 1: Securities

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The following table shows the maturity or period to repricing of our consolidated portfolio of available-for-sale and held-to-maturity securities as of December 31, 2022 (dollars in thousands):

Table 2: Securities Available-for-Sale and Held-to-Maturity —Maturity/Repricing and Rates

(1)Tax-exempt weighted average yield is calculated on a tax equivalent basis using a federal tax rate of 21% and a tax disallowance of 10%.

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Loans and Lending.  Loans are our most significant and generally highest yielding earning assets. We attempt to maintain a portfolio of loans to total deposits ratio at a level designed to enhance our revenues, while adhering to sound underwriting practices and appropriate diversification guidelines in order to maintain a moderate risk profile. Our loan to deposit ratio typically ranges from 90% to 95%. Our loan to deposit ratio at December 31, 2022 was 75%. During the most recent quarters our loan to deposit ratio has begun to trend upward as the unprecedented level of market liquidity begins to contract. We offer a wide range of loan products to meet the demands of our clients. Our lending activities are primarily directed toward the origination of real estate and commercial loans. Total loans receivable increased $1.06 billion, or 12%, to $10.15 billion at December 31, 2022, from $9.08 billion at December 31, 2021. The increase in total loans receivable for the year ended December 31, 2022 primarily reflects increased one-to-four family residential, multifamily real estate, commercial business, construction, land and land development, and consumer loan balances, partially offset by decreased commercial real estate loan balances. While we originate a variety of loans, our ability to originate each type of loan is dependent upon the relative client demand and competition in each market we serve.  We continue to implement strategies designed to capture more market share and achieve increases in targeted loans. New loan originations and portfolio balances will continue to be significantly affected by economic activity and changes in interest rates.

The following table shows loan originations (excluding loans held for sale) activity for the years ended December 31, 2022, 2021, and 2020 (in thousands):

Table 3: Loan Originations

One- to Four-Family Residential Real Estate Lending:  At December 31, 2022, $1.17 billion, or 12% of our loan portfolio, consisted of permanent loans on one- to four-family residences.  We are active originators of one- to four-family residential loans in most communities where we have established offices in Washington, Oregon, California and Idaho. Originations of portfolio one- to four-family residential loans have recently been relatively strong, despite increases in interest rates during the current year. Our balance of loans for one- to four-family residences increased by $515.6 million in 2022, compared to the prior year. The increase in one-to-four family real estate loans during 2022 was primarily the result of one- to four-family construction loans converting to one- to four-family residential portfolio loans and a higher percentage of new production originated as held for investment during the year due to the higher interest rate environment.

Construction and Land Lending:   Our construction loan originations have been relatively strong in recent years as builders have expanded production and experienced strong home sales in many markets where we operate.  At December 31, 2022, construction, land and land development loans totaled $1.49 billion, or 15% of total loans, compared to $1.31 billion, or 14%, at December 31, 2021. One-to four-family construction loans increased by $78.6 million in 2022, as builders have expanded production and experienced strong home sales during the year. During the year ended December 31, 2022, land and land development loans (both residential and commercial) increased by $15.0 million, primarily reflecting increased residential land and land development loans also due to the strong housing market.

Commercial and Multifamily Real Estate Lending:  We also originate loans secured by commercial and multifamily real estate.  Commercial and multifamily real estate loans originated by us include both fixed- and adjustable-rate loans with intermediate terms of generally five to ten years.  Our commercial real estate portfolio consists of loans on a variety of property types with no significant concentrations by property type, borrowers or locations.  At December 31, 2022, our loan portfolio included $3.64 billion of commercial real estate loans, or 36% of the total loan portfolio, and $645.1 million of multifamily real estate loans, or 6% of the total loan portfolio, compared to $3.79 billion, or 42%, and $530.9 million, or 6%, at December 31, 2021, respectively.

Commercial Business Lending:  Our commercial business lending is directed toward meeting the credit and related deposit needs of various small- to medium-sized business and agribusiness borrowers operating in our primary market areas.  In addition to providing earning assets, this type of lending has helped increase our deposit base. At December 31, 2022, commercial business loans totaled $1.28 billion, or 13% of total loans, compared to $1.17 billion, or 13%, at December 31, 2021. SBA PPP loans decreased 94% to $7.9 million at December 31, 2022, compared to $133.9 million at December 31, 2021. Our commercial business lending, to a lesser extent, includes participation in certain syndicated loans, including shared national credits that totaled $234.1 million at December 31, 2022.

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Agricultural Lending:  Agriculture is a major industry in many Washington, Oregon, California and Idaho locations in our service area.  While agricultural loans are not a large part of our portfolio, we routinely make agricultural loans to borrowers with a strong capital base, sufficient management depth, proven ability to operate through agricultural cycles, reliable cash flows and adequate financial reporting.  Payments on agricultural loans depend, to a large degree, on the results of operation of the related farm entity.  The repayment is also subject to other economic and weather conditions as well as market prices for agricultural products, which can be highly volatile at times.  At December 31, 2022, agricultural loans totaled $295.1 million, or 3% of the loan portfolio, compared to $280.6 million, or 3%, at December 31, 2021.

Consumer and Other Lending:  Consumer lending has traditionally been a modest part of our business with loans made primarily to accommodate our existing client base. At December 31, 2022, our consumer loans increased $125.0 million to $680.9 million, or 7% of our loan portfolio, compared to $555.9 million, or 6%, at December 31, 2021.  The increase from December 31, 2021 was primarily due to a home equity loan marketing campaign during the second and third quarters of 2022. As of December 31, 2022, 83% of our consumer loans were secured by one- to four-family residences, including home equity lines of credit.  Credit card balances totaled $42.9 million at December 31, 2022 compared to $37.8 million a year earlier.

Loan Servicing Portfolio:  At December 31, 2022, we were servicing $3.01 billion of loans for others and held $11.4 million in escrow for our portfolio of loans serviced for others.  The loan servicing portfolio at December 31, 2022 was comprised of $1.35 billion of Freddie Mac residential mortgage loans, $1.09 billion of Fannie Mae residential mortgage loans, $328.5 million of Oregon Housing residential mortgage loans, $69.9 million of SBA loans and $171.4 million of other loans serviced for a variety of investors.  The portfolio included loans secured by property located primarily in the states of Washington, Oregon, Idaho and California.  For the years ended December 31, 2022 and 2021, we recognized $7.5 million and $7.7 million of loan servicing income in our results of operations, respectively. For the years ended December 31, 2022 and 2021, we recognized $4.2 million and $6.6 million of amortization for MSRs and SBA servicing rights, respectively.

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The following table sets forth the composition of the Company’s loan portfolio, net of discounts and deferred fees and costs, by type of loan as of the dates indicated (dollars in thousands):

Table 4: Loan Portfolio Analysis

During the first quarter of 2022, the Company changed the segmentation of its Small Balance CRE loan category based on the common risk characteristics used to measure the allowance for credit losses.  The following table presents the loans receivable at December 31, 2022, 2021 and 2020 by class (dollars in thousands). The presentation of loans receivable at December 31, 2021 and 2020 has been revised to match the segmentation used in the current period presentation.

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The following table sets forth the Company’s loans by geographic concentration at December 31, 2022, 2021 and 2020 (dollars in thousands):

Table 5: Loans by Geographic Concentration

The following table sets forth certain information at December 31, 2022 regarding the dollar amount of loans maturing in our portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments.  Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Loan balances are net of unamortized premiums and discounts and exclude loans held for sale (in thousands):

Table 6: Loans by Maturity

Contractual maturities of loans do not necessarily reflect the actual life of such assets.  The average life of loans typically is substantially less than their contractual maturities because of principal repayments and prepayments.  In addition, due-on-sale clauses on certain mortgage loans generally give us the right to declare loans immediately due and payable in the event that the borrower sells the real property subject to the mortgage and the loan is not repaid.  The average life of mortgage loans tends to increase however when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decreases when rates on existing mortgage loans are substantially higher than current mortgage loan market rates.

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The following table sets forth the dollar amount of all loans maturing after December 31, 2023 which have fixed interest rates and floating or adjustable interest rates (in thousands):

Table 7: Loans Maturing after One Year

Deposits. We compete with other financial institutions and financial intermediaries in attracting deposits and we generally attract deposits within our primary market areas. Much of the focus of our expansion and current marketing efforts have been directed toward attracting additional deposit client relationships and balances.  The long-term success of our deposit gathering activities is reflected not only in the growth of core deposit balances, but also in the level of deposit fees, service charges and other payment processing revenues compared to prior periods.

One of our key strategies is to strengthen our franchise by emphasizing core deposit activity in non-interest-bearing and other transaction and savings accounts with less reliance on higher cost certificates of deposit.  Increasing core deposits is a fundamental element of our business strategy. This strategy continues to help control our cost of funds and increase the opportunity for deposit fee revenues, while stabilizing our funding base.  Total deposits decreased $706.9 million, or 5%, to $13.62 billion at December 31, 2022 from $14.33 billion at December 31, 2021. The decrease in total deposits from the prior year end reflects the sale of four branches during 2022, which included the transfer of $178.2 million of related deposits as well as an overall decrease in market liquidity. Non-interest-bearing deposits decreased by $208.2 million, or 3%, to $6.18 billion at year end from $6.39 billion at December 31, 2021. Interest-bearing transaction and savings accounts decreased by $383.6 million, or 5%, to $6.72 billion at December 31, 2022 compared to $7.10 billion a year earlier.  Certificates of deposit decreased $115.1 million, or 14%, to $723.5 million at December 31, 2022 from $838.6 million at December 31, 2021. Core deposits were 95% of total deposits at December 31, 2022, compared to 94% a year earlier.

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The following table sets forth the balances of deposits in the various types of accounts offered by the Bank at the dates indicated (dollars in thousands):

Table 8: Deposits

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The following table indicates the amount of the Bank’s certificates of deposit with balances in excess of the FDIC insurance limit by time remaining until maturity as of December 31, 2022 (in thousands):

Table 9: Maturity Period— Certificates of Deposit in excess of the FDIC insurance limit

The following table provides additional detail on geographic concentrations of our deposits at December 31, 2022, 2021, and 2020 (in thousands):

Table 10: Geographic Concentration of Deposits

Borrowings.  We had $50.0 million FHLB advances at both December 31, 2022 and December 31, 2021, as core deposits were a sufficient source of funding. At that date, based on pledged collateral, the Bank had $2.99 billion of available credit capacity with the FHLB. At December 31, 2022, based upon our available unencumbered collateral, the Bank was eligible to borrow $1.19 billion from the Federal Reserve Bank, however, at that date we had no funds borrowed under this arrangement.

At December 31, 2022, retail repurchase agreements totaled $232.8 million, had a weighted average rate of 0.35%, and were secured by pledges of certain mortgage-backed securities and agency securities.  Retail repurchase agreement balances, which are primarily associated with client sweep account arrangements, decreased $31.7 million, from the 2021 year-end balance.  We had no borrowings under wholesale repurchase agreements at December 31, 2022 or December 31, 2021.

At December 31, 2022, we had an aggregate of $86.5 million of TPS.  This includes $75.0 million issued by us and $11.5 million acquired in our bank acquisitions. The junior subordinated debentures are carried at their estimated fair value of $74.9 million at December 31, 2022. Banner redeemed $50.5 million of junior subordinated debentures during the first quarter of 2022 and redeemed $8.2 million of junior subordinated debentures during the fourth quarter of 2021. At December 31, 2022, the TPS had a weighted average rate of 5.99%.  At December 31, 2022, subordinated notes, net of issuance costs were $98.9 million and had a weighted average interest rate of 5.00%.

Asset Quality.  Maintaining a moderate risk profile by employing appropriate underwriting standards, avoiding excessive asset concentrations and aggressively managing troubled assets has been and will continue to be a primary focus for us.

Non-performing assets decreased to $23.4 million, or 0.15% of total assets, at December 31, 2022, from $23.7 million, or 0.14% of total assets, at December 31, 2021.  At December 31, 2022, our allowance for credit losses - loans was $141.5 million, or 615% of non-performing loans, compared to $132.1 million, or 578% of non-performing loans at December 31, 2021.

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The following table sets forth information with respect to our non-performing assets and restructured loans, at the dates indicated (dollars in thousands):

Table 11: Non-Performing Assets

(1)    Includes $44,000 of nonaccrual TDR loans as of December 31, 2022. For the year ended December 31, 2022, interest income was reduced by $725,000 as a result of nonaccrual loan activity, which includes the reversal of $322,000 of accrued interest as of the date the loan was placed on nonaccrual. There was no interest income recognized on nonaccrual loans during the year ended December 31, 2022.

(2)    These loans were performing under their restructured repayment terms at the dates indicated.

The following table presents the Company’s portfolio of risk-rated loans and non-risk-rated loans by grade at the dates indicated (in thousands):

Table 12: Loans by Grade

The decrease in substandard loans during the year ended December 31, 2022 primarily reflects the payoff of substandard loans as well as risk rating upgrades.

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Comparison of Results of Operations for the Years Ended December 31, 2022 and 2021

For the year ended December 31, 2022, our net income was $195.4 million, or $5.67 per diluted share, compared to net income of $201.0 million, or $5.76 per diluted share for the year ended December 31, 2021. Current year results were positively impacted by increased interest income, decreased funding costs and a $7.8 million gain recognized on the branch sale completed during the second quarter of 2022, partially offset by a $23.1 million decrease in mortgage banking income and a provision for credit losses of $10.4 million.

Our operating results depend largely on our net interest income which increased $56.3 million to $553.2 million, primarily reflecting increased yields on loans and investment securities due to rising interest rates during the year as well as an increase in average interest-earning assets, particularly growth in investment securities balances. Revenues (net interest income and non-interest income) increased $35.1 million, or 6%, to $628.4 million for the year ended December 31, 2022, compared to $593.3 million for the year ended December 31, 2021, which also reflected a $21.2 million decrease in non-interest income primarily as a result of lower income from mortgage banking operations, partially offset by the gain recognized on the branch sale. The decrease in mortgage banking income reflects a reduction in the volume and a decrease in the gain on sale margin for one- to four-family loans sold during the year along with a negative fair market adjustment on multifamily held for sale loans. Non-interest expense decreased to $377.3 million for the year ended December 31, 2022 compared with $380.1 million for the year ended December 31, 2021, largely as a result of a decrease in professional and legal expenses, a decrease in salary and employee benefits expense, and a decrease in advertising and marketing expense, partially offset by a decrease in capitalized loan origination costs.

Net Interest Income.  Net interest income increased by $56.3 million, or 11%, to $553.2 million for the year ended December 31, 2022, compared to $496.9 million for the year ended December 31, 2021, primarily due to an increase in the average balance of interest-earning assets, increased yields on average interest-earning assets and decreased funding costs, partially offset by a decline in the recognition of deferred loan fee income due to SBA PPP loan repayments from SBA loan forgiveness. The higher average yield on interest-earning assets compared to same prior year period reflects rising market interest rates during the year ended December 31, 2022.

The net interest margin on a tax equivalent basis of 3.68% for the year ended December 31, 2022 was 29 basis points higher than the prior year. The increase in net interest margin compared to a year earlier primarily reflects a 25 basis-point increase in yields on average interest-earning assets and a three basis-point decrease in the cost of funding liabilities. The increase in average yields on interest-earning assets during the current year reflects the benefit of variable rate interest-earning assets repricing higher due to rising interest rates, as well as new loans being originated at higher interest rates, partially offset by a higher percentage of assets being invested in low yielding short term investments and interest-bearing deposits. Since March 2022, in response to inflation, the FOMC of the Federal Reserve System has increased the target range for the federal funds rate by 425 basis points, including 125 basis points during the fourth quarter of 2022, to a range of 4.25% to 4.50%. The decrease in the overall cost of funding liabilities compared to a year earlier was largely due to an increase in the average balance of low-cost core deposits, including non-interest-bearing transaction and savings accounts

Interest Income.  Interest income for the year ended December 31, 2022 was $572.6 million, compared to $520.5 million for the prior year, an increase of $52.1 million.  The increase in interest income occurred as a result of the yields on interest-earnings assets increasing the 25 basis points to 3.80% and the average balance of interest-earning assets increasing $424.6 million to $15.33 billion. The increased yield on interest-earning assets reflects increases in the average yields on loans and securities.

Interest income on loans increased by $5.2 million to $450.9 million for the year ended December 31, 2022, from the prior year. The increased interest income on loans is primarily due to the average loan yields increasing 12 basis points to 4.76%, reflecting the impact of rising interest rates. The acquisition accounting loan discount accretion and related balance sheet impact added four basis points to the loan yield for the year ended December 31, 2022, compared to seven basis points for the year ended December 31, 2021.  Average loans receivable decreased $116.2 million to $9.60 billion, principally as a result of the forgiveness of SBA PPP loans.

The combined average balance of mortgage-backed securities, other investment securities, equity securities, daily interest-bearing deposits and FHLB stock increased $540.9 million to $5.74 billion (excluding the effect of fair value adjustments), contributing to the $47.6 million increase in interest and dividend income compared to the prior year.  The average yield on the combined portfolio increased 68 basis points to 2.20%, reflecting a 30 basis-point increase in the average yield on mortgage-backed securities and a 72 basis-point increase in the yield on other securities.

Interest Expense.  Interest expense for the year ended December 31, 2022 was $19.4 million, compared to $23.6 million for the prior year, a decrease of $4.2 million, or 18%.  The decrease in interest expense occurred as a result of a three basis-point decrease in the average cost of all funding liabilities to 0.13%, partially offset by the average balance of funding liabilities increasing $410.2 million to $14.40 billion. The increase in average balance of funding liabilities reflects increases in low-cost core deposits, including non-interest-bearing deposits and interest-bearing transaction and savings accounts, partially offset by lower average balances of certificates of deposit, FHLB advances and subordinated debt.

Deposit interest expense decreased $1.6 million, or 14%, to $10.1 million for the year ended December 31, 2022 compared to $11.8 million for the prior year as a result of the average cost of deposits, including non-interest bearing deposits, decreasing two basis points to 0.07%, partially offset by the average balance of interest-bearing deposits increasing $239.9 million to $7.83 billion. The decrease in the average cost of deposits between the periods was primarily due to a $301.8 million increase in the average balance of non-interest-bearing accounts, a higher percentage of our interest-bearing deposits being lower-cost core deposits and a 25 basis-point decrease in the average rate paid on certificates of deposit.

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The average rate paid on total borrowings increased two basis points to 2.04%, reflecting the 87 basis-point increase in the average cost of our subordinated debt and the 55 basis-point increase in the average cost of FHLB advances, partially offset by the $131.5 million decrease in average balance of total borrowings. The decrease in average total borrowings was largely due to a $82.7 million decrease in average balance of FHLB advances and a $57.7 million decrease in the average balance of subordinated debt. The decrease in average total borrowings was the primary reason for the $2.6 million decrease in the related interest expense to $9.3 million for the year ended December 31, 2022, from $11.8 million in the prior year.

Table 13, Analysis of Net Interest Spread, presents, for the periods indicated, our condensed average balance sheet information, together with interest income and yields earned on average interest-earning assets and interest expense and rates paid on average interest-bearing liabilities.  Average balances are computed using daily average balances.

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The following table provides an analysis of our net interest spread for the last three years (dollars in thousands):

Table 13: Analysis of Net Interest Spread

(footnotes follow)

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(1)Average balances include loans accounted for on a nonaccrual basis and loans 90 days or more past due.  Amortization of net deferred loan fees/costs is included with interest on loans.

(2)Average other non-interest-bearing liabilities include fair value adjustments related to junior subordinated debentures.

(3)Tax-exempt income is calculated on a tax equivalent basis. The tax equivalent yield adjustment to interest earned on loans was $5.9 million, $5.1 million, and $4.9 million for the years ended December 31, 2022, December 31, 2021, and December 31, 2020, respectively. The tax equivalent yield adjustment to interest earned on tax exempt securities was $4.8 million, $4.1 million, and $3.5 million for the years ended December 31, 2022, December 31, 2021, and December 31, 2020, respectively.

The following table sets forth the effects of changing rates and volumes on our net interest income during the periods shown (in thousands).  Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume).  Effects on interest income attributable to changes in rate and volume (changes in rate multiplied by changes in volume) have been allocated between changes in rate and changes in volume (in thousands):

Table 14: Rate/Volume Analysis

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Provision and Allowance for Credit Losses.  We recorded an $8.2 million provision for credit losses - loans in the year ended December 31, 2022, compared to a $33.1 million recapture of provision for credit losses - loans recorded in 2021. The provision and allowance for credit losses is one of the most critical accounting estimates included in our Consolidated Financial Statements.

The provision for credit losses - loans reflects the amount required to maintain the allowance for credit losses - loans at an appropriate level based upon management’s evaluation of the adequacy of collective and individual loss reserves. The provision for credit losses - loans for the current year primarily reflects loan growth and, to a lesser extent, a deterioration in forecasted economic conditions and indicators utilized to estimate credit losses, partially offset by an improvement in the level of adversely classified loans. The prior year recapture of provision for credit losses - loans primarily reflected an improvement in forecasted economic indicators and a decrease in adversely classified loans. Future assessments of the expected credit losses will not only be impacted by changes to the reasonable and supportable forecast, but will also include an updated assessment of qualitative factors, as well as consideration of any required changes in the reasonable and supportable forecast reversion period.

We recorded net recoveries of $1.2 million for the year ended December 31, 2022, compared to net charge-offs of $2.1 million for the prior year. The reduction in net charge-offs in 2022 reflects the improvement in overall loan portfolio performance during 2022. A comparison of the allowance for credit losses - loans at December 31, 2022 and 2021 reflects an increase of $9.4 million, or 7%, to $141.5 million at December 31, 2022, from $132.1 million at December 31, 2021.  The allowance for credit losses - loans as a percentage of total loans (loans receivable excluding allowance for credit losses) decreased to 1.39% at December 31, 2022, compared to 1.45% at December 31, 2021.  The decrease in the allowance for credit losses - loans as a percentage of loans reflects an improvement in the level of adversely classified loans during 2022.

The following table sets forth an analysis of our allowance for credit losses - loans for the periods indicated (dollars in thousands):

Table 15: Changes in Allowance for Credit Losses - Loans