CATHAY GENERAL BANCORP (CATY) FY 2022 MD&A

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

General

The following discussion is intended to provide information to facilitate the understanding and assessment of the consolidated financial condition and results of operations of the Bancorp and its subsidiaries. It should be read in conjunction with this Annual Report and the audited Consolidated Financial Statements and Notes appearing elsewhere in this Annual Report. The following discussion and analysis of our financial condition and results of operations contains forward-looking statements. These statements are based on current expectations and assumptions, which are subject to risks and uncertainties. See “Forward-Looking Statements” and “Risk Factors Summary.” Actual results could differ materially because of various factors, including but not limited to those discussed in “Risk Factors,” under Part I, Item 1A of this Annual Report.

The Bank offers a wide range of financial services. As of the filing date of this report, the Bank operates 25 branches in Southern California, 19 branches in Northern California, 9 branches in New York State, four branches in Washington State, two branches in Illinois, two branches in Texas, one branch in each of Maryland, Massachusetts, Nevada, and New Jersey, one branch in Hong Kong, and a representative office in Beijing, in Shanghai, and in Taipei. The Bank is a commercial bank, servicing primarily individuals, professionals, and small to medium-sized businesses in the local markets in which its branches are located.

The financial information presented herein includes the accounts of the Bancorp, its subsidiaries, including the Bank, and the Bank’s consolidated subsidiaries. All material transactions between these entities are eliminated.

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Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of the Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our Consolidated Financial Statements. Actual results may differ from these estimates under different assumptions or conditions.

Certain accounting policies that are fundamental to understanding our financial condition and results of operations involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. Management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors that are believed to be reasonable under the circumstances.

Management believes the following are critical accounting policies that require the most significant judgments and estimates used in the preparation of the Consolidated Financial Statements:

Allowance for Credit Losses (“ACL”) on Loans Held for Investment

The Bank maintains the allowance for credit losses at a level that the Bank considers appropriate to absorb the estimated and known risks in the loan portfolio and off-balance sheet unfunded credit commitments. Allowance for credit losses is comprised of the allowance for loan losses and the reserve for off-balance sheet unfunded credit commitments. With this risk management objective, the Bank’s management has an established monitoring system that it believes is designed to identify individually evaluated and potential problem loans, and to permit periodic evaluation of impairment and the appropriate level of the allowance for credit losses in a timely manner.

In addition, the Company’s Board of Directors has established a written credit policy that includes a credit review and control system that the Board of Directors believes should be effective in ensuring that the Bank maintains an appropriate allowance for credit losses. The Board of Directors provides oversight for the allowance evaluation process, including quarterly evaluations, and determines whether the allowance is appropriate to absorb losses in the credit portfolio. The determination of the amount of the allowance for credit losses and the provision for credit losses are based on management’s current judgment about the credit quality of the loan portfolio and takes into consideration known relevant internal and external factors that affect collectability when determining the appropriate level for the allowance for credit losses. The nature of the process by which the Bank determines the appropriate allowance for credit losses requires the exercise of considerable judgment. Additions to the allowance for credit losses are made by charges to the provision for credit losses. While management utilizes its business judgment based on the information available, the ultimate appropriateness of the allowance is dependent upon a variety of factors, many of which are beyond the Bank’s control, including but not limited to the performance of the Bank’s loan portfolio, the economy and market conditions, changes in interest rates, and the view of the regulatory authorities toward loan classifications. Identified credit exposures that are determined to be uncollectible are charged against the allowance for credit losses. Recoveries of previously charged off amounts, if any, are credited to the allowance for credit losses. A weakening of the economy or other factors that adversely affect asset quality could result in an increase in the number of delinquencies, bankruptcies, or defaults, and a higher level of non-performing assets, net charge-offs, and provision for credit losses in future periods.

The allowance for loan losses was $146.5 million and the allowance for off-balance sheet unfunded credit commitments was $8.7 million at December 31, 2022, which represented the amount believed by management to be appropriate to absorb lifetime credit losses in the loan portfolio, including unfunded credit commitments. The allowance for loan losses represented 0.80% of period-end gross loans and 182.12% of non-performing loans at December 31, 2022. The comparable ratios were 0.83% of period-end gross loans and 202.36% of non-performing loans at December 31, 2021.

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The allowance for credit losses is discussed in more detail in “Risk Elements of the Loan Portfolio — Allowance for Credit Losses” below. Management has reviewed the foregoing critical accounting policies and related disclosures with the Audit Committee of the Company’s Board of Directors.

Loan modifications

We began receiving requests from our borrowers for loan deferrals in March 2020 following the onset of the pandemic. Modifications include the deferral of principal payments or the deferral of principal and interest payments for terms generally 90 - 180 days. Requests are evaluated individually, and approved modifications are based on the unique circumstances of each borrower. At December 31, 2022 and 2021, $40.3 million and $70.0 million, respectively, of loans remain under loan modifications.

The CARES Act, as extended by the CAA, permits financial institutions to suspend requirements under GAAP for loan modifications to borrowers affected by COVID-19 and is intended to provide interpretive guidance as to conditions that would constitute a short-term modification that would not meet the definition of a troubled debt restructuring (“TDR”). Such conditions include the following (i) the loan modification is made between March 1, 2020, and January 1, 2022, and (ii) the applicable loan was not more than 30 days past due as of December 31, 2019. The Company is applying this guidance to qualifying loan modifications.

Paycheck Protection Program (PPP)

As part of the CARES Act, the Small Business Administration (SBA) has been authorized to guarantee loans under the PPP through December 31, 2021 for small businesses who meet the necessary eligibility requirements in order to keep their workers on the payroll. One of the notable features of the PPP is that borrowers are eligible for loan forgiveness if borrowers, among other conditions, maintain their staff and payroll and if loan amounts are used to cover payroll, mortgage interest, rents and utilities payments. PPP loans have a two to five year term and earn interest at a rate of 1%. We began accepting applications on April 3, 2020. As of December 31, 2022 and 2021, our outstanding PPP loans had a current balance of $2.6 million and $90.5 million, respectively. PPP loans are guaranteed by the SBA and therefore we believe PPP loans generally do not represent a material credit risk.

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Results of Operations

Overview

For the year ended December 31, 2022, we reported net income of $360.6 million, or $4.83 per diluted share, compared to net income of $298.3 million, or $3.80 per diluted share, in 2021, and net income of $228.9 million, or $2.87 per diluted share, in 2020. The $62.3 million increase in net income from 2021 to 2022 was primarily the result of increases in net interest income partially offset by increases in provision for credit losses, and increases in income taxes. The return on average assets in 2022 was 1.69%, compared to 1.52% in 2021, and to 1.22% in 2020. The return on average stockholders’ equity was 14.70% in 2022, compared to 12.11% in 2021, and to 9.70% in 2020.

Highlights

Net income available to common stockholders and key financial performance ratios are presented below for the three years indicated:

Net Interest Income

Comparison of 2022 with 2021

Net interest income increased $135.9 million, or 22.7%, from $597.8 million in 2021 to $733.7 million in 2022. The increase in net interest income was due primarily to the increase in interest income from loans offset by an increase in interest expense from time deposits.

Average loans for 2022 were $17.6 billion, a $1.8 billion, or an 11.4% increase from $15.8 billion in 2021. Compared with 2021, average residential mortgage loans increased $825.8 million, or 20.1%, average commercial mortgage loans increased $786.9 million, or 10.2%, and average commercial loans increased $307.3 million, or 10.6%. Average investment securities were $1.3 billion in 2022, an increase of $275.2 million, or 26.3%, from 2021. Average interest-bearing cash on deposits with financial institutions decreased $387.7 million, or 23.5%, to $1.3 billion in 2022 from $1.6 billion in 2021.

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Average interest-bearing deposits were $13.9 billion in 2022, an increase of $933.1 million, or 7.2%, from $13.0 billion in 2021, primarily due to increases of $868.1 million, or 21.5%, in money market accounts, $424.1 million, or 20.7%, in interest bearing demand deposits, and $221.3 million, or 24.7%, in savings accounts, offset by decreases of $580.4 million, or 9.7%, in time deposits.

Interest income increased $184.8 million, or 27.7%, from $666.5 million in 2021 to $851.3 million in 2022 primarily due to increases in loan rates:

Interest expense increased by $48.8 million, or 71.0%, to $117.6 million in 2022, compared with $68.8 million in 2021, primarily due to increased average interest-bearing deposits, and FHLB advances. The overall increase in interest expense was primarily due to increases in rates on interest bearing deposits, and volume and rate increases in other borrowings as discussed below:

Net interest margin, defined as net interest income to average interest-earning assets, was 3.63% in 2022 compared to 3.22% in 2021.

Comparison of 2021 with 2020

Net interest income increased $45.6 million, or 8.3%, from $552.1 million in 2020 to $597.8 million in 2021. The increase in net interest income was due primarily to the decrease in interest expense from time deposits partially offset by lower interest income from loans.

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Average loans for 2021 were $15.8 billion, a $326.6 million, or 2.1% increase from $15.5 billion in 2020. Compared with 2020, average commercial mortgage loans increased $304.1 million, or 4.1%, and average real estate construction loans increased $39.8 million, or 6.3%. Average investment securities were $1.0 billion in 2021, a decrease of $169.8 million, or 14.0%, from 2020. Average interest-bearing cash on deposits with financial institutions increased $689.3 million, or 71.8%, to $1.6 billion in 2021 from $960.3 million in 2020.

Average interest-bearing deposits were $13.0 billion in 2021, an increase of $434.2 million, or 3.5%, from $12.5 billion in 2020, primarily due to increases of $1.1 billion, or 38.9%, in money market accounts, $455.3 million, or 28.6%, in interest bearing demand deposits, and $138.1 million, or 18.2%, in savings accounts, offset by decreases of $1.3 billion, or 17.7%, in time deposits.

Interest income decreased $34.1 million, or 4.9%, from $700.6 million in 2020 to $666.5 million in 2021 primarily due to decreases in the rate of loans:

Interest expense decreased by $79.7 million, or 53.7%, to $68.8 million in 2021, compared with $148.5 million in 2020, primarily due to decreased cost from time deposits, FHLB advances, and long-term debt. The overall decrease in interest expense was primarily due to decreases in rates on interest bearing deposits, volume decreases in long term debts and volume and rate decreases in other borrowings as discussed below:

Net interest margin, defined as net interest income to average interest-earning assets, was 3.22% in 2021 compared to 3.12% in 2020.

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The following table sets forth information concerning average interest-earning assets, average interest-bearing liabilities, and the average yields and rates paid on those assets and liabilities in 2022, 2021 and 2020. Average outstanding amounts included in the table are daily averages.

(1)  Yields and amounts of interest earned include loan fees.  Non-accrual loans are included in the average balance.

(2)   Calculated by dividing net interest income by average outstanding interest-earning assets

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Net Interest Income — Changes Due to Rate and Volume (1)

Provision for Credit Losses

The provision for credit losses represents the charge against current earnings that is determined by management, through a credit review process, as the amount needed to maintain an allowance for loan losses and an allowance for off-balance sheet unfunded credit commitments that management believes to be sufficient to absorb credit losses inherent in the Bank’s loan portfolio and credit commitments. The Bank recorded a provision for credit losses of $14.5 million in 2022 compared with a reversal for credit losses of $16.0 million in 2021, and a provision for credit losses of $57.5 million in 2020. Net charge-offs for 2022 were $2.6 million, or 0.01% of average loans, compared to net charge-offs of $17.6 million for 2021, or 0.11% of average loans, and net recoveries of $14.2 million for 2020, or 0.09% of average loans.

Non-interest Income

Non-interest income increased $2.2 million, or 4.0%, to $56.8 million for 2022, from $54.6 million for 2021, compared to $42.8 million for 2020.  Non-interest income includes depository service fees, letters of credit commissions, securities gains (losses), gains (losses) from loan sales, gains from sale of premises and equipment, gains on acquisition, and other sources of fee income. These other fee-based services include wire transfer fees, safe deposit fees, fees on loan-related activities, fee income from our Wealth Management division, and foreign exchange fees.

Comparison of 2022 with 2021

The increase in non-interest income from 2021 to 2022 was primarily due to a $1.4 million increase in wealth management fees, and a $1.8 million decrease in loss on equity securities.

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Comparison of 2021 with 2020

The increase in non-interest income from 2020 to 2021 was primarily due to a $4.5 million increase in wealth management fees, $4.3 million increase in derivative fees and $1.3 million increase in the Bank Owned Life Insurance death benefit income.

Non-interest Expense

Non-interest expense includes expenses related to salaries and benefits of employees, occupancy expenses, marketing expenses, computer and equipment expenses, amortization of core deposit intangibles, amortization of investment is affordable housing and alternative energy partnerships, and other operating expenses.

Comparison of 2022 with 2021

Non-interest expense totaled $303.4 million in 2022 compared to $286.5 million in 2021. The increase of $16.9 million, or 5.9%, in non-interest expense in 2022 compared to 2021 was primarily due to a combination of the following:

The efficiency ratio, defined as non-interest expense divided by the sum of net interest income before provision for loan losses plus non-interest income, decreased to 38.38% in 2022 compared to 43.92% in 2021 due primarily to higher net interest income offset by an increase in non-interest expense as explained above.

Comparison of 2021 with 2020

Non-interest expense totaled $286.5 million in 2021 compared to $283.5 million in 2020. The increase of $3.1 million, or 1.1%, in non-interest expense in 2021 compared to 2020 was primarily due to a combination of the following:

The efficiency ratio, defined as non-interest expense divided by the sum of net interest income before provision for loan losses plus non-interest income, decreased to 43.92% in 2021 compared to 47.65% in 2020 due primarily to an increase in non-interest expense and higher net interest income as explained above.

Income Tax Expense

Income tax expense was $111.9 million in 2022, compared to $83.5 million in 2021, and $25.1 million in 2020. The effective tax rate was 23.7% for 2022, 21.9% for 2021, and 9.9% for 2020. The effective tax rate includes the impact of low-income housing and alternative energy investments.

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Our tax returns are open for audits by the Internal Revenue Service back to 2019 and by the California Franchise Tax Board back to 2018. The audit by the Internal Revenue Service for 2017 was completed in July 2020 and did not have an impact on income tax expense. From time to time, there may be differences of opinion with respect to the tax treatment accorded transactions. When, and if, such differences occur, and the related tax effects become probable and estimable, such amounts will be recognized.

Financial Condition

Total assets were $22.0 billion at December 31, 2022, an increase of $1.1 billion, or 5.3%, from $20.9 billion at December 31, 2021, primarily due to an increase of $1.9 billion in net loans, an increase of $345.9 million in investment securities offset by a decrease of $1.4 billion in short-term investments and interest-bearing deposits.

Investment Securities

Investment securities were $1.5 billion and represented 6.8% of total assets at December 31, 2022, compared with $1.1 billion and 5.5% of total assets at December 31, 2021. The following table summarizes the carrying value of our portfolio of securities for each of the past two years:

Effective January 1, 2021, upon the adoption of ASU 2016-13, Financial Instruments - Credit Losses, debt securities available-for-sale are measured at fair value and subject to impairment testing. When an available-for-sale debt security is considered impaired, the Company must determine if the decline in fair value has resulted from a credit-related loss or other factors and then, (1) recognize an allowance for credit losses by a charge to earnings for the credit-related component (if any) of the decline in fair value, and (2) recognize in other comprehensive income (loss) any non-credit related components of the fair value change. If the amount of the amortized cost basis expected to be recovered increases in a future period, the valuation reserve would be reduced, but not more than the amount of the current existing reserve for that security.

For available-for-sale (“AFS”) debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value with the credit component of the unrealized loss of the impaired AFS debt security recognized as an allowance for credit losses, and a corresponding provision for credit losses on the consolidated statement of income. For AFS debt securities that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors.

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In making this assessment, management considers the extent to which fair value is less than amortized cost, the payment structure of the security, failure of the issuer of the security to make scheduled interest or principal payments, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. Any fair value changes that have not been recorded through an allowance for credit losses is recognized in other comprehensive income. In the current period, management evaluated the securities in an unrealized loss position and determined that their unrealized losses were a result of the level of market interest rates relative to the types of securities and pricing changes caused by shifting supply and demand dynamics and not a result of downgraded credit ratings or other indicators of deterioration of the underlying issuers' ability to repay. Accordingly, we determined the unrealized losses were not credit-related and recognized the unrealized losses in "other comprehensive income/(loss)" in stockholders' equity. Although we periodically sell securities for portfolio for management purposes, we do not foresee having to sell any impaired securities strictly for liquidity needs and believe that it is more likely than not we would not be required to sell any impaired securities before recovery of their amortized cost.

The tables below show the related fair value and the gross unrealized losses of the Company’s investment portfolio, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position, as of December 31, 2022, and December 31, 2021:

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The scheduled maturities and taxable-equivalent yields by security type are presented in the following table:

Equity Securities

For the year ended December 31, 2022, the Company recognized a net gain of $392 thousand due to the increase in fair value of equity investments with readily determinable fair values during the year, compared to a net loss of $1.4 million in 2021. Equity securities were $22.2 million as of December 31, 2022, compared to $22.3 million as of December 31, 2021.

Loans

Loans represented 90.2% of average interest-earning assets during 2022, compared with 85.4% during 2021. Gross loans increased by $1.9 billion, or 11.7%, to $18.3 billion at December 31, 2022, compared with $16.3 billion at December 31, 2021. The increase in gross loans was primarily attributable to the following:

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Our lending relates predominantly to activities in the states of California, New York, Texas, Washington, Massachusetts, Illinois, New Jersey, Maryland, and Nevada. We also lend to domestic clients who are engaged in international trade. Loans outstanding in our branch in Hong Kong were $324.3 million as of December 31, 2022, compared to $275.6 million as of December 31, 2021.

The classification of loans by type and amount outstanding as of December 31 for each of the past five years is presented below:

The loan maturities in the table below are based on contractual maturities as of December 31, 2022. As is customary in the banking industry, loans that meet underwriting criteria can be renewed by mutual agreement between us and the borrower. Because we are unable to estimate the extent to which our borrowers will renew their loans, the table is based on contractual maturities. As a result, the data shown below should not be viewed as an indication of future cash flows.

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Deposits

The Bank primarily uses client deposits to fund its operations, and to a lesser extent advances from the Federal Home Loan Bank (“FHLB”), and other borrowings. The Bank’s deposits are generally obtained from the Bank’s geographic market area. The Bank utilizes traditional marketing methods to attract new clients and deposits, by offering a wide variety of products and services and utilizing various forms of advertising media. Although the vast majority of the Bank’s deposits are retail in nature, the Bank does engage in certain wholesale activities, primarily accepting deposits generated by brokers. The Bank considers wholesale deposits to be an alternative borrowing source rather than a client relationship and, as such, their levels are determined by management’s decisions as to the most economic funding sources. Brokered-deposits totaled $1.2 billion, or 6.2%, of total deposits, at December 31, 2022, compared to $394.0 million, or 2.2%, at December 31, 2021.

The Bank’s total deposits increased $446.4 million, or 2.5%, to $18.5 billion at December 31, 2022, from $18.1 billion at December 31, 2021, primarily due to a $1.5 billion, or 27.1%, increase in time deposits offset, in part, by a $798.9 million decrease in money market deposits, a $323.1 million, or 7.2%, decrease in Non-interest-bearing demand deposits. The following table displays the deposit mix balances as of the end of the past three years:

Average total deposits increased $1.6 billion, or 9.5%, to $18.3 billion in 2022, compared with average total deposits of $16.7 billion in 2021.

The following table displays average deposits and rates for the past five years:

Management considers the Bank’s time deposits of $250 thousand or more, which totaled $4.2 billion at December 31, 2022, to be generally less volatile than other wholesale funding sources primarily because approximately 84.7% of the Bank’s CDs of $250 thousand or more have been on deposit with the Bank for two years or more.  Management monitors the CDs of $250 thousand or more portfolio to help identify any changes in the deposit behavior in the market and of the Bank’s clients.

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Approximately 98.8% of the Bank’s CDs mature within one year as of December 31, 2022. The following tables display time deposits by maturity:

The following table displays time deposits with a remaining term of more than one year at December 31, 2022:

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Borrowings

Borrowings include securities sold under agreements to repurchase, Federal funds purchased, funds obtained as advances from the FHLB of San Francisco, and borrowings from other financial institutions.

As of December 31, 2022, there was $150.0 million in over-night borrowings from the FHLB at a rate of 4.65% in 2022 and no over-night borrowings from the FHLB in 2021. As of December 31, 2022, the advances from the FHLB were $335.0 million at a weighted average rate of 4.54% compared to $20.0 million at a weighted average rate of 2.89% as of December 31, 2021. As of December 31, 2022, final maturity for the FHLB advances were $300.0 million in January 2023, $20.0 million in May 2023, and $15.0 million in September 2024.

Long-term Debt

We established three special purpose trusts in 2003 and two in 2007 for the purpose of issuing Guaranteed Preferred Beneficial Interests in their Subordinated Debentures to outside investors (“Capital Securities”). The proceeds from the issuance of the Capital Securities as well as our purchase of the common stock of the special purpose trusts were invested in Junior Subordinated Notes of the Company (“Junior Subordinated Notes”). The trusts exist for the purpose of issuing the Capital Securities and investing in Junior Subordinated Notes. Subject to some limitations, payment of distributions out of the monies held by the trusts and payments on liquidation of the trusts, or the redemption of the Capital Securities, are guaranteed by the Company to the extent the trusts have funds on hand at such time. The obligations of the Company under the guarantees and the Junior Subordinated Notes are subordinate and junior in right of payment to all indebtedness of the Company and will be structurally subordinated to all liabilities and obligations of the Company’s subsidiaries. The Company has the right to defer payments of interest on the Junior Subordinated Notes at any time or from time to time for a period of up to twenty consecutive quarterly periods with respect to each deferral period. Under the terms of the Junior Subordinated Notes, the Company may not, with certain exceptions, declare or pay any dividends or distributions on its capital stock or purchase or acquire any of its capital stock if it has deferred payment of interest on any Junior Subordinated Notes.

As of December 31, 2022, Junior Subordinated Notes totaled $119.1 million with a weighted average interest rate of 4.01%, compared to $119.1 million with a weighted average rate of 2.38% as of December 31, 2021. The Junior Subordinated Notes have a stated maturity term of 30 years and qualify as Total Capital for these periods.

Off-Balance-Sheet Arrangements, Commitments, Guarantees, and Contractual Obligations

In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in the Consolidated Balance Sheets. We enter into these transactions to meet the financing needs of our clients. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the Consolidated Balance Sheets.

Loan Commitments. We enter into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon clients maintaining specific credit standards at the time of loan funding. We minimize our exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for credit losses.

Standby Letters of Credit. Standby letters of credit are written conditional commitments issued by us to secure the obligations of a client to a third party. In the event the client does not perform in accordance with the terms of an agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek reimbursement from the client. Our policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.

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Capital Resources

Stockholders’ Equity

Total equity was $2.5 billion at December 31, 2022, an increase of $27.8 million, or 1.1%, from $2.4 billion at December 31, 2021, primarily due to net income of $360.6 million, proceeds from dividend reinvestment of $3.7 million, and stock based compensation of $7.0 million, offset by other comprehensive income/(loss) of $99.2 million, shares withheld related to net share settlement of RSUs of $2.9 million, purchase of treasury stock of $141.3 million, and common stock cash dividends of $101.0 million. The Company paid cash dividends of $1.36 per common share in 2022, $1.27 per common share in 2021, and $1.24 per common share in 2020.

On September 2, 2021, the Board of Directors approved a stock repurchase program to buy back up to $125.0 million of the Bancorp’s common stock. The $125.0 million share repurchase program was completed on February 18, 2022, with the repurchased of 2,858,503 shares for a total of $125.0 million, at an average cost of $43.73 per share.

On May 26, 2022, the Board of Directors approved a new stock repurchase program to buy back up to $125.0 million of the Bancorp’s common stock. As of December 31, 2022, the Company repurchased 2,522,538 shares of common stock for a total of $108.4 million, at an average cost of $42.98 per share.

Capital Adequacy

Management seeks to retain our capital at a level sufficient to support future growth, protect depositors and stockholders, and comply with various regulatory requirements. The primary measure of capital adequacy is based on the ratio of risk-based capital to risk-weighted assets. At December 31, 2022, the Company’s Tier 1 risk-based capital ratio of 12.21%, total risk-based capital ratio of 13.73%, and Tier 1 leverage capital ratio of 10.08%, calculated under the Basel III Capital Rules, continue to place the Company in the “well capitalized” category for regulatory purposes, which is defined as institutions with a Tier 1 risk-based capital ratio equal to or greater than 8%, a total risk-based capital ratio equal to or greater than 10%, and a Tier 1 leverage capital ratio equal to or greater than 5%. At December 31, 2021, the Company’s Tier 1 risk-based capital ratio was 12.80%, total risk-based capital ratio was 14.41%, and Tier 1 leverage capital ratio was 10.40%.

A table displaying the Bancorp’s and the Bank’s capital and leverage ratios at December 31, 2022, and 2021, is included in Note 23 to the Consolidated Financial Statements.

Dividend Policy

Holders of common stock are entitled to dividends as and when declared by our Board of Directors out of funds legally available for the payment of dividends. Although we have historically paid cash dividends on our common stock, we are not required to do so. We increased the common stock dividend from $0.24 per share in the fourth quarter of 2017, to $0.31 per share in the fourth quarter of 2018, to $0.34 per share in the fourth quarter of 2021. The amount of future dividends will depend on our earnings, financial condition, capital requirements and other factors, and will be determined by our Board of Directors. The terms of our Junior Subordinated Notes also limit our ability to pay dividends. If we are not current in our payment of dividends on our Junior Subordinated Notes, we may not pay dividends on our common stock.

Substantially all of the revenues of the Company available for payment of dividends derive from amounts paid to it by the Bank. The Bank paid dividends to the Bancorp totaling $232.8 million during 2022, $230.0 million during 2021, and $146.0 million during 2020.

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The Federal Reserve Board issued Federal Reserve Supervision and Regulation Letter SR-09-4 that states that bank holding companies are expected to inform and consult with the Federal Reserve supervisory staff prior to declaring and paying a dividend that exceeds earnings for the period for which the dividend is being paid.

Under California State banking law, the Bank may not without regulatory approval pay a cash dividend which exceeds the lesser of the Bank’s retained earnings or its net income for the last three fiscal years, less any cash distributions made during that period. Under this regulation, the amount of retained earnings available for cash dividends to the Company immediately after December 31, 2022, was restricted to approximately $296.2 million. For additional information on statutory and regulatory limitations on the ability of Bancorp to pay dividends to its shareholders and on the Bank to pay dividends to Bancorp, see “Item 1. Business-Regulation and Supervision — Dividends.”

Risk Elements of the Loan Portfolio

Non-performing Assets

Non-performing assets include loans past due 90 days or more and still accruing interest, non-accrual loans, and OREO. Our policy is to place loans on non-accrual status if interest and principal or either interest or principal is past due 90 days or more, or in cases where management deems the full collection of principal and interest unlikely. After a loan is placed on non-accrual status, any previously accrued but unpaid interest is reversed and charged against current income and subsequent payments received are generally first applied towards the outstanding principal balance of the loan. Depending on the circumstances, management may elect to continue the accrual of interest on certain past due loans if partial payment is received and/or the loan is well collateralized and in the process of collection. The loan is generally returned to accrual status when the borrower has brought the past due principal and interest payments current and, in the opinion of management, the borrower has demonstrated the ability to make future payments of principal and interest as scheduled.

Management reviews the loan portfolio regularly to identify problem loans. During the ordinary course of business, management may become aware of borrowers that may not be able to meet the contractual requirements of their loan agreements. Such loans are placed under closer supervision with consideration given to placing the loan on non-accrual status, the need for an additional allowance for loan losses, and (if appropriate) partial or full charge-off.

Total non-performing portfolio assets increased $12.8 million, or 17.9%, to $84.5 million at December 31, 2022, compared to $71.7 million at December 31, 2021, primarily due to an increase of $10.1 million, and $3.0 million in accruing loans past due 90 days or more and nonaccrual loans, respectively.

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As a percentage of gross loans, excluding loans held for sale, plus OREO, our non-performing assets increased to 0.46% at December 31, 2022, from 0.44% at December 31, 2021. The non-performing portfolio loan, excluding loans held for sale, coverage ratio, defined as the allowance for credit losses to non-performing loans, excluding loans held for sale, decreased to 193.0% at December 31, 2022, from 212.9% at December 31, 2021. The following table presents the breakdown of total non-accrual, past due, and restructured loans for the past five years:

Non-accrual, Past Due and Restructured Loans

The effect of non-accrual loans on interest income for the past five years is presented below:

As of December 31, 2022, there were no commitments to lend additional funds to those borrowers whose loans had been restructured, were considered impaired, or were on non-accrual status.

Non-accrual Loans

Total non-accrual portfolio loans were $68.9 million at December 31, 2022, increased $3.0 million, or 4.6%, from $65.8 million at December 31, 2021. The allowance for the collateral-dependent loans is calculated based on the difference between the outstanding loan balance and the value of the collateral as determined by recent appraisals, sales contracts, or other available market price information, less cost to sell. The allowance for collateral-dependent loans varies from loan to loan based on the collateral coverage of the loan at the time of designation as non-performing. We continue to monitor the collateral coverage of these loans, based on recent appraisals, on a quarterly basis and adjust the allowance accordingly.

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The following tables present the type of properties securing the non-accrual portfolio loans and the type of businesses the borrowers engaged in as of the dates indicated:

(1) Real estate includes commercial mortgage loans, real estate construction loans, and residential mortgage loans, equity lines and installment & other loans.

(1)  Real estate includes commercial mortgage loans, real estate construction loans, and residential mortgage loans, equity lines and installment & other loans.

Troubled Debt Restructurings

A troubled debt restructuring (“TDR”) is a formal modification of the terms of a loan when the Bank, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower. The concessions may be granted in various forms, including reduction of the stated interest rate, reduction of the amount of principal amortization, forgiveness of a portion of a loan balance or accrued interest, or an extension of the maturity date. Although these loan modifications are considered under ASC Subtopic 310-40 to be TDRs, the loans must have, pursuant to the Bank’s policy, performed under the restructured terms and have demonstrated sustained performance under the modified terms for six months before being returned to accrual status. The sustained performance considered by management pursuant to its policy includes the periods prior to the modification if the prior performance met or exceeded the modified terms. This would include cash paid by the borrower prior to the restructure to set up interest reserves. Loans classified as TDRs are reported as individually evaluated loans.

The allowance for credit loss on a TDR is measured using the same method as all other loans held for investment, except when the value of a concession cannot be measured using a method other than the discounted cash flow method. When the value of a concession is measured using the discounted cash flow method, the allowance for credit loss is determined by discounting the expected future cash flows at the original interest rate of the loan.

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The CARES Act, signed into law on March 27, 2020, and as extended by the CAA permits financial institutions to suspend requirements under GAAP for loan modifications to borrowers affected by COVID-19 that would otherwise be characterized as TDRs and suspend any determination related thereto if (i) the loan modification is made between March 1, 2020, and January 1, 2022 and (ii) the applicable loan was not more than 30 days past due as of December 31, 2019. In addition, federal bank regulatory authorities have issued guidance to encourage financial institutions to make loan modifications for borrowers affected by COVID-19 and have assured financial institutions that they will neither receive supervisory criticism for such prudent loan modifications, nor be required by examiners to automatically categorize COVID-19-related loan modifications as TDRs. The Company is applied this guidance to qualifying loan modifications.

A summary of TDRs by type of loan and by accrual/non-accrual status as of the dates indicated is shown below:

As of December 31, 2022, recorded investment in non-accrual loans was $68.9 million compared to $65.8 million as of December 31, 2021. For non-accrual loans, the amounts previously charged off represent 14.1% of the contractual balances for non-accrual loans as of December 31, 2022. As of December 31, 2022, $43.1 million, or 62.6%, of the $68.9 million of non-accrual loans were secured by real estate compared to $49.3 million, or 74.9% of the $65.8 million of non-accrual loans that were secured by real estate as of December 31, 2021. The Bank generally seeks to obtain current appraisals, sales contracts, or other available market price information intended to provide updated factors in evaluating potential loss.

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The allowance for loan losses to non-performing loans was 182.1% at December 31, 2022, compared to 202.4% at December 31, 2021, primarily due to an increase in the non-accrual loans. Non-accrual loans also include those TDRs that do not qualify for accrual status.

The following table presents non-accrual loans and the related allowance as of December 31, 2022 and 2021:

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Loan Interest Reserves

In accordance with customary banking practice, construction loans and land development loans generally are originated where interest on the loan is disbursed from pre-established interest reserves included in the total original loan commitment. Our construction and land development loans generally include optional renewal terms after the maturity of the initial loan term. New appraisals are obtained prior to extension or renewal of these loans in part to determine the appropriate interest reserve to be established for the new loan term. Loans with interest reserves are generally underwritten to the same criteria, including loan to value and, if applicable, pro forma debt service coverage ratios, as loans without interest reserves. Construction loans with interest reserves are monitored on a periodic basis to gauge progress towards completion. Interest reserves are frozen if it is determined that additional draws would result in a loan to value ratio that exceeds policy maximums based on collateral property type. Our policy limits in this regard are consistent with supervisory limits and range from 50% in the case of land to 85% in the case of one to four family residential construction projects.

As of December 31, 2022, construction loans of $443.9 million were disbursed with pre-established interest reserves of $54.5 million compared to $520.5 million of such loans disbursed with pre-established interest reserves of $51.1 million at December 31, 2021.  The balance for construction loans with interest reserves which have been extended was $34.4 million with pre-established interest reserves of $1.0 million at December 31, 2022, compared to $20.4 million with pre-established interest reserves of $0.4 million at December 31, 2021.  Land loans of $48.6 million were disbursed with pre-established interest reserves of $1.6 million at December 31, 2022, compared to $46.2 million of land loans disbursed with pre-established interest reserves of $0.6 million at December 31, 2021.  The balance for land loans with interest reserves which have been extended was $0.9 million, with pre-established interest reserves of $58 thousand for December 31, 2022 and 2021..

At December 31, 2022 and December 31, 2021, the Bank had no loans on non-accrual status with available interest reserves.  At December 31, 2022 and 2021, there were no non-accrual residential loans, non-accrual non-residential construction loans and non-accrual land loans that were originated with pre-established interest reserves, respectively.  While we typically expect loans with interest reserves to be repaid in full according to the original contractual terms, some loans may require one or more extensions beyond the original maturity before full repayment.  Typically, these extensions are required due to construction delays, delays in the sale or lease of property, or some combination of these two factors.

Loan Concentration

Most of the Company’s business activities are with clients located in the high-density Asian-populated areas of Southern and Northern California; New York City; New York; Dallas and Houston, Texas; Seattle, Washington; Boston, Massachusetts; Chicago, Illinois; Nevada; New Jersey; Rockville, Maryland and Las Vegas, Nevada. The Company also has loan clients in Hong Kong. The Company has no specific industry concentration, and generally our loans are collateralized with real property or other pledged collateral of the borrowers. The Company generally expects our loans to be paid off from the operating profits of the borrowers, refinancing by another lender, or through sale by the borrowers of the collateral.  There are no loan concentrations to multiple borrowers in similar activities that exceeded 10% of total loans as of December 31,2022 or as of December 31, 2021.

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The Federal banking regulatory agencies issued final guidance on December 6, 2006, regarding risk management practices for financial institutions with high or increasing concentrations of commercial real estate ("CRE") loans on their balance sheets. The regulatory guidance reiterates the need for sound internal risk management practices for those institutions that have experienced rapid growth in CRE lending, have notable exposure to specific types of CRE, or are approaching or exceeding the supervisory criteria used to evaluate the CRE concentration risk, but the guidance is not to be construed as a limit for CRE exposure. The supervisory criteria are: (1) total reported loans for construction, land development, and other land represent 100% of the institution's total risk-based capital, and (2) both total CRE loans represent 300% or more of the institution's total risk-based capital and the institution's CRE loan portfolio has increased 50% or more within the last thirty-six months. The Bank’s loans for construction, land development, and other land represented 27% of total risk-based capital as of December 31, 2022, and 31% as of December 31, 2021. Total CRE loans represented 287% of total risk-based capital as of December 31, 2022, and 285% as of December 31, 2021, which were within the Bank’s internal limit of 400%, of total capital. See Part I — Item 1A — “Risk Factors” for a discussion of some of the factors that may affect us.

Allowance for Credit Losses

The Bank maintains the allowance for credit losses at a level that the Bank’s management considers appropriate to cover the estimated and known inherent risks in the loan portfolio and off-balance sheet unfunded credit commitments. Allowance for credit losses is comprised of allowances for loan losses and for off-balance sheet unfunded credit commitments. With this risk management objective, the Bank’s management has an established monitoring system that is designed to identify individually evaluated and potential problem loans, and to permit periodic evaluation of impairment and the appropriate level of the allowance for credit losses in a timely manner.

In addition, the Board of Directors of the Bank has established a written credit policy that includes a credit review and control system that it believes should be effective in ensuring that the Bank maintains an appropriate allowance for credit losses. The Board of Directors provides oversight for the allowance evaluation process, including quarterly evaluations, and determines whether the allowance is appropriate to absorb losses in the credit portfolio. The determination of the amount of the allowance for credit losses and the provision for credit losses is based on management’s current judgment about the credit quality of the loan portfolio and takes into consideration known relevant internal and external factors that affect collectability when determining the appropriate level for the allowance for credit losses. The nature of the process by which the Bank determines the appropriate allowance for credit losses requires the exercise of considerable judgment. Additions or reductions to the allowance for credit losses are made by charges or credits to the provision for credit losses. While management utilizes its business judgment based on the information available, the ultimate appropriateness of the allowance is dependent upon a variety of factors, many of which are beyond the Bank’s control, including but not limited to the performance of the Bank’s loan portfolio, the economy and market conditions, changes in interest rates, and the view of the regulatory authorities toward loan classifications. Identified credit exposures that are determined to be uncollectible are charged against the allowance for credit losses. Recoveries of previously charged off amounts, if any, are credited to the allowance for credit losses. A weakening of the economy or other factors that adversely affect asset quality can result in an increase in the number of delinquencies, bankruptcies, and defaults, and a higher level of non-performing assets, net charge-offs, and provision for loan losses. See Part I — Item 1A — “Risk Factors” for additional factors that could cause actual results to differ materially from forward-looking statements or historical performance.

The allowance for loan losses was $146.5 million and the allowance for off-balance sheet unfunded credit commitments was $8.7 million at December 31, 2022, which represented the amount believed by management to be appropriate to absorb credit losses inherent in the loan portfolio. The allowance for credit losses, which is the sum of the allowances for loan losses and for off-balance sheet unfunded credit commitments, was $155.2 million at December 31, 2022, compared to $143.3 million at December 31, 2021, an increase of $12.0 million, or 8.4%. The allowance for credit losses represented 0.9% of period-end gross loans and 193.0% of non-performing loans at December 31, 2022. The comparable ratios were 0.9% of period-end gross loans and 212.9% of non-performing loans at December 31, 2021.

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Critical Accounting Policies and Estimates

Our accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. We identify critical policies and estimates as those that require management to make particularly difficult, subjective, and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. We have identified the policy and estimate related to the allowance for credit losses on loans as a critical accounting policy.

Our critical accounting policies and estimates are described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report Form 10-K. For more information, please also see Note 1, Summary of Significant Accounting Policies contained in Item 8, Financial Statements and Supplementary Data.

Expected Credit Losses Estimate for Loans

In January 2021, we adopted ASC 326, which replaces the incurred loss methodology with an expected loss methodology. The allowance for credit losses is the combination of the allowance for loan losses and the reserve for unfunded loan commitments. The allowance for loan losses is reported as a reduction of the amortized cost basis of loans, while the reserve for unfunded loan commitments is included within “Other liabilities” on the Consolidated Balance Sheets. The amortized cost basis of loans does not include interest receivable, which is included in “Other assets” on the Consolidated Balance Sheets. The “Provision for credit losses” on the Consolidated Statement of Operations and Comprehensive Income is a combination of the provision for loan losses and the provision for unfunded loan commitments.

Under the CECL methodology, expected credit losses reflect losses over the remaining contractual life of an asset, considering the effect of prepayments and available information about the collectability of cash flows, including information about relevant historical experience, current conditions, and reasonable and supportable forecasts of future events and circumstances. Thus, the CECL methodology incorporates a broad range of information in developing credit loss estimates. For further information regarding the calculation of the allowance for credit losses on loans held for investment using the CECL methodology effective January 1, 2021, see Notes 1 and 5 to the Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data.”

In calculating our allowance for credit losses for the year ended 2022, the change in Moody’s forecast of future GDP, unemployment rates, CRE and home price indexes, resulted in an increase in the allowance for credit losses. Our methodology and framework along with the 8-quarter reasonable and supportable forecast period and the 4-quarter reversion period have remained consistent since the implementation of CECL on January 1, 2021. Certain management assumptions are reassessed every quarter based on current expectations for credit losses, while other assumptions are assessed and updated on at least an annual basis.

The use of different economic forecasts, whether based on different scenarios, the use of multiple or single scenarios, or updated economic forecasts and scenarios, can change the outcome of the calculations. In addition to the economic forecasts, there are numerous components and assumptions that are integral to the overall estimation of allowance for credit losses.

The determination of the allowance for credit losses is complex and dependent on numerous models, assumptions, and judgments made by management. Management's current expectation for credit losses as quantified in the allowance for credit losses, considers the impact of assumptions and is reflective of historical credit experience, economic forecasts viewed to be reasonable and supportable, current loan composition, and relative credit risks known as of the balance sheet date.

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Under the Company’s CECL methodology, nine portfolio segments with similar risk characteristics are evaluated for expected loss. Six portfolios are modeled using econometric models and three smaller portfolios are evaluated using a simplified loss-rate method that calculates lifetime expected credit losses for the respective pools (simplified approach). The six portfolios subject to econometric modeling include residential mortgages; commercial and industrial loans (“C&I”); construction loans; commercial real estate (“CRE”) for multifamily loans; CRE for owner-occupied loans; and other CRE loans. We estimate the probability of default during the reasonable and supportable forecast period using separate econometric regression models developed to correlate macroeconomic variables, (GDP, unemployment, CRE prices and residential mortgage prices) to historical credit performance for each of the six loan portfolios from 2007 to the fourth quarter of 2020. Loss given default rates would be computed based on the net charge-offs recognized and then applied to the expected exposure at default of defaulted loans starting with the fourth quarter of 2007 through the fourth quarter of 2020. The probability of default and the loss given default rates are applied to the expected amount at default at the loan level based on contractual scheduled payments and estimated prepayments. The amounts so calculated comprise the quantitative portion of the allowance for credit losses.

The Company’s CECL methodology utilizes an eight-quarter reasonable and supportable (“R&S”) forecast period, and a four-quarter reversion period. Management relies on multiple forecasts, blending them into a single loss estimate. Generally speaking, the blended scenario approach would include the Baseline, the Alternative Scenario 1 – Upside – 10th Percentile and the Alternative Scenario 3 – Downside – 90th Percentile forecasts. After the R&S period, the Company will revert straight-line for the four-quarter reversion period to the long-term loss rates for each of the six portfolios of loans. The contractual term excludes renewals and modifications but includes pre-approved extensions and prepayment assumptions where applicable.

Our allowance for credit losses is sensitive to a number of inputs, including macroeconomic forecast assumptions and credit rating migrations during the period. Our macroeconomic forecasts used in determining the December 31, 2022, allowance for credit losses consisted of three scenarios as provided by an outside forecaster. Because the December 2022 baseline scenario did not forecast a recession in the forecast period, we increased the weighing of the downside scenario to reflect our expectations that a recession in the forecast period was more likely than not. The baseline scenario reflects modest ongoing GDP growth and a modest increase in the unemployment rate peaking at 4.2% in the fourth quarter of 2023. The upside scenario reflects a faster decline in the inflation rate and the Federal Reserve cutting the Fed funds rate starting in the first quarter of 2024 and stronger GDP growth and lower unemployment rates relative to the baseline scenario. The downside scenario contemplates a recession due to continued high inflation rates and an increase in the Fed funds rate to 5.2% in the second quarter of 2023 that results in negative GDP growth for three quarters peaking at 3.6% in the second quarter of 2023, rising unemployment that peaks at 7.8% in the first quarter of 2024, and a decline in CRE prices and residential home prices of over 20% and 15%, respectively, during the forecast period. We placed the most weight on our downside scenario, with the remaining weighting mainly on the baseline scenario and a small weighting on the upside scenario. As of December 31, 2021, we placed the most weight on our baseline scenario, with the remaining weighting split equally between the update and the downside scenarios.

Keeping all other factors constant, we estimate that if we had applied 100% weighting to the downside scenario, the allowance for credit losses as of December 31, 2022, would have been approximately $45.4 million higher. This estimate is intended to reflect the sensitivity of the allowance for credit losses to changes in our scenario weights and is not intended to be indicative of future changes in the allowance for credit losses.

Management believes the allowance for credit losses is appropriate for the current expected credit losses in our loan portfolio and associated unfunded commitments, and the credit risk ratings and loss rates currently assigned are reasonable and appropriate as of the reporting date. It is possible that others, given the same information, may at any point in time reach different conclusions that could result in a significant impact to the Company's financial statements.

Prior to January 1, 2021, our allowance for loan losses consisted of the following:

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The following table sets forth the information relating to the allowance for loan losses, charge-offs, recoveries, and the reserve for off-balance sheet credit commitments for the past five years: