EQUITY BANCSHARES INC (EQBK) FY 2021 MD&A

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K.  The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs and expected performance.  We caution that assumptions, expectations, projections, intentions or beliefs about future events may, and often do, vary from actual results and the differences can be material. See “Cautionary Statement Regarding Forward-Looking Statements.” Also, see the risk factors and other cautionary statements described under the heading “Item 1A – Risk Factors” included in Item 1A of this Annual Report on Form 10-K.  We do not undertake any obligation to publicly update any forward-looking statements except as otherwise required by applicable law.

This discussion and analysis of our financial condition and results of operation includes the following sections:

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* Indicates non-GAAP financial measure. Please see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Non-GAAP Financial Measures” for reconciliation to the most directly comparable GAAP measure.

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Overview

We are a bank holding company headquartered in Wichita, Kansas.  Our wholly-owned banking subsidiary, Equity Bank, provides a broad range of financial services primarily to businesses and business owners as well as individuals through our network of 69 full-service branches located in Arkansas, Kansas, Missouri and Oklahoma.  As of December 31, 2021, we had, on a consolidated basis, total assets of $5.14 billion, total deposits of $4.42 billion, total loans held for investment, net of allowances, of $3.11 billion and total stockholders’ equity of $500.6 million.  Net income for the year ended December 31, 2021, was $52.5 million, compared to a net loss of $75.0 million for the year ended December 31, 2020, primarily due to a goodwill impairment charge of $104.8 million during the third quarter of 2020.

History and Background

From 2003 through 2021, we completed a series of twenty acquisitions and two charter consolidations.  We seek to integrate the banks we acquire into our existing operational platform and enhance stockholder value through the creation of efficiencies within the combined operations.  In conjunction with our strategic acquisition growth, we strive to reposition and improve the loan portfolio and deposit mix of the banks we acquire.  Following our acquisitions, we focus on identifying and disposing of problematic loans and replacing them with higher quality loans generated organically.  In addition, we concentrate on growth in our commercial loan portfolio, which we believe generally offers higher return opportunities than our consumer loan portfolio, primarily by hiring additional talented bankers, particularly in our metropolitan markets, and incentivizing our bankers to expand their commercial banking relationships.  We also seek to increase our most attractive deposit accounts primarily by growing deposits in our community markets and cross selling our depository products to our loan customers.

Our principal objective is to continually increase stockholder value and generate consistent earnings growth by expanding our commercial banking franchise both organically and through strategic acquisitions.  We believe our strategy of selectively acquiring and integrating community banks has provided us with economies of scale and improved our overall franchise efficiency.  We expect to continue to pursue strategic acquisitions and believe our targeted market areas present us with many and varied acquisition opportunities.  We are also focused on continuing to grow organically and believe the markets in which we operate currently provide meaningful opportunities to expand our commercial customer base and increase our current market share.  We believe our geographic footprint, which is strategically split between growing metropolitan markets, such as Kansas City, Tulsa and Wichita, and stable community markets within Western Kansas, Western Missouri, Topeka, Northern Arkansas and Northern Oklahoma, provides us with access to low cost stable core deposits in community markets that we can use to fund commercial loan growth in our metropolitan markets.  We strive to provide an enhanced banking experience for our customers by providing them with a comprehensive suite of sophisticated banking products and services tailored to meet their needs, while delivering the high-quality relationship-based customer service of a community bank.

Highlights for the Year Ended December 31, 2021

We completed our merger with ASBI of Wichita, Kansas on October 1, 2021. ASBI had total assets of $777.6 million, net loans of $441.9 million and total deposits of $668.8 million. Also, on December 3, 2021, we completed our purchase of assets and assumption of deposits and certain other liabilities of three branches in St. Joseph, Missouri, from Security Bank of Kansas City (“Security”). At closing, the Security branches had total assets of $75.8 million, net loans of $1.4 million and total deposits of $75.1 million.

The COVID-19 pandemic has caused economic and social disruption on an unprecedented scale.  While some industries have been impacted more severely than others, all businesses have been impacted to some degree.  This disruption resulted in the shuttering

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of businesses across the country, significant job loss and aggressive measures by federal, state and local government during the year ended December 31, 2020. Throughout the year ended December 31, 2021, the economy has opened significantly compared to 2020; however, certain measures from governing authorities are still in place and continue to impact operations.

Congress, the President and the Federal Reserve have taken several actions designed to cushion the economic fallout.  Most notably, the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) was signed into law on March 27, 2020, as a $2 trillion legislative package.  The goal of the CARES Act is to prevent a severe economic downturn through various measures, including direct financial aid to American families and economic stimulus to significantly impacted industry sectors.  The package also included extensive emergency funding for hospitals and medical providers.  In addition to the general impact of COVID-19, certain provisions of the CARES Act as well as other recent legislative and regulatory relief efforts have had or are expected to have a material impact on the Company’s operations.  As a result of the COVID-19 pandemic and the related adverse local and national economic consequences, the Company is subject to many risks, including but not limited to:

Financial Position and Results of Operations:  Given that economic scenarios had become less certain since the pandemic was declared in early March 2020, management added additional allowance for credit losses during the year ended December 31, 2020. During the year ended December 31, 2021, the allowance for credit losses was increased further, largely due to the adoption of ASU 2016-13 (CECL) and partially offset by a release of allowance due to decrease in reserves on specifically assessed assets and improving trends in the Company’s loss experience and economic conditions in the markets in which we operate. Should economic conditions worsen, the Company could experience further increases in the required allowance for credit losses and record additional provision for credit losses expense.  The execution of the payment deferral program discussed in the following commentary improved the ratio of past due loans to total loans.  It is possible that asset quality measures could worsen at future measurement periods if the effects of COVID-19 are prolonged. For additional information see “NOTE 4 – LOANS AND ALLOWANCE FOR CREDIT LOSSES” in the Notes to Consolidated Financial Statements.

Net interest income increased $9.9 million in 2021 as compared to 2020, largely due to increased volume in interest-earning assets, fees earned on the facilitation of government assistance programs and decreasing yields on interest-bearing liabilities. The Company’s interest and fee income could be reduced due to COVID-19.  In keeping with guidance from regulators, the Company is actively working with COVID-19 affected borrowers to defer their payments, interest and fees throughout 2020 and 2021.  While interest and fees will still accrue to income, through normal GAAP accounting, should eventual credit losses on these deferred payments emerge, interest income and fees accrued would need to be reversed.  In such a scenario, interest income in future periods could be negatively impacted.  At this time, the Company is unable to project the materiality of such an impact but recognizes the breadth of the economic impact may affect borrowers’ ability to repay in future periods.

Capital and Liquidity:  As of December 31, 2021, all the Company’s capital ratios and Equity Bank’s capital ratios were in excess of all regulatory requirements.  While currently classified as well capitalized, an extended economic recession brought about by COVID-19 could adversely impact reported and regulatory capital ratios.  The Company relies on cash on hand as well as dividends from Equity Bank to service our debt.  If Equity Bank’s capital deteriorates such that it is unable to pay dividends to the Company for an extended period, the Company may not be able service its debt.

The Company maintains access to multiple sources of liquidity.  Wholesale funding markets have remained open to the Company, but rates for short term funding may be volatile.  If funding costs are elevated for an extended period, it could have an adverse effect on net interest margin.  If an extended recession caused large numbers of deposit customers to withdraw their funds, the Company might become more reliant on volatile or more expensive sources of funding.

Our Processes, Controls and Business Continuity Plan:  In early March 2020, management successfully deployed a modified working strategy, including emphasis on social distancing and remote work as necessary to emphasize the safety of the Company’s teams and continuity of business processes.  Prior technology planning resulted in the successful deployment of a portion of the operational team to a remote environment, while the remainder of the team continued to work on location in a workspace emphasizing social distancing.  In 2021, the Company has returned to a predominantly in-person operating environment for our team.  In keeping

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with our efforts to protect the health our employees, the Company administered a vaccination clinic in each of our markets to provide team members an opportunity to be inoculated in line with CDC recommendations.

Since early May 2020, all the Company’s bank locations have been open to customers with appropriate safety measures in place.  The Company continues to serve customers curbside and drive-through while offering full lobby access during normal hours.  No material operational or internal control challenges or risks have been identified to date.  As of December 31, 2021, the Company does not anticipate significant challenges to our ability to maintain systems and controls considering the measures we have taken to prevent the spread of COVID-19.

Lending Operations and Accommodations to Borrowers:  During the year ended December 31, 2020, the Company executed a payment deferral program for our commercial lending clients that were adversely affected by the pandemic and keeping with the extension of associated provisions under the CARES Act, continued the program in 2021. The majority of these deferrals have qualified under section 4013 of the CARES Act and the CAA Act and, as such, were not classified as troubled debt restructurings.  Deferred loans are subject to ongoing monitoring and will be downgraded or placed on nonaccrual if noted repayment weaknesses exist.  At December 31, 2021, the Company has 20 loans, totaling $36.3 million, that have been granted a payment deferral, and remain on deferral, as part of our COVID-19 response.

We were an active participant in all phases of the Paycheck Protection Program (“PPP”), administered by the Small Business Administration (“SBA”), and we helped many of our customers obtain loans through the program.  PPP loans generally have a two-or five year term and earn interest at 1.0%.  As of December 31, 2021 and 2020, the Company had 144 and 1,612 loans, with outstanding balances of $44.8 million and $253.7 million that were originated under this program.  To date, the Company has been successful in obtaining forgiveness for these credits and it remains the Company’s understanding that the remaining loans funded through the program are fully guaranteed by the U.S. Government.  Should those circumstances change, the Company could be required to establish additional allowance for credit losses through additional provision for credit losses expense charged to earnings.

The Company also participated in the Main Street Lending Program (“MSL Program”), created by the Federal Reserve to support lending to small and medium-sized businesses and nonprofit organizations that were in sound financial condition before the onset of the COVID-19 pandemic.  There was a total of $14.3 million and $14.1 million outstanding under the MSL Program for the periods ended December 31, 2021 and 2020.

Critical Accounting Policies

The preparation of our financial statements in accordance with GAAP requires management to make a number of judgements and assumptions that affect our reported results and disclosures.  Several of our accounting policies are inherently subject to valuation assumptions and other subjective assessments and are more critical than others in terms of their importance to results.  Changes in any of the estimates and assumptions underlying critical accounting policies could have a material effect on our financial statements.  Our accounting policies are described in “NOTE 1 – NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES” in the Notes to Consolidated Financial Statements.

The accounting policies that management believes are the most critical to an understanding of our financial condition and results of operations and require complex management judgement are described below.

Allowance for Credit Losses:  We adopted FASB ASU 2016-13 effective January 1, 2021, which requires the estimation of an allowance for credit losses in accordance with the current expected credit loss (“CECL”) methodology.  The allowance for credit losses for loans represents management’s estimate of all expected credit losses over the expected contractual life of our loan portfolio.  This assessment includes procedures to estimate the allowance and test the adequacy and appropriateness of the resulting balance.  The level of the allowance is based upon management’s evaluation of historical default and loss experience, current and projected economic conditions, asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay a loan (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, industry and peer bank loan quality indications and other pertinent factors, including regulatory recommendations.  The level of the allowance for credit losses maintained by management is believed adequate to absorb all expected future losses inherent in the loan portfolio at the balance sheet date; however, determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain.  The actual realized facts and circumstances may be different than those currently estimated by management and may result in significant changes in the allowance for credit losses in future periods.  The allowance for credit losses for loans, as reported in our consolidated balance sheets, is adjusted by provision for credit losses, which is recognized in earnings and is reduced by the charge-off of loan amounts, net of recoveries.

The Company utilizes primarily two methods for estimating the allowance for credit losses and the method used depends on the status of the underlying loans.  Non-performing loans primarily utilize a collateral specific fair value impairment method and performing loans primarily utilize a historical loss method. The performing loan method utilizes a probability of default (PD) and loss given default (LGD) modeling approach for historical loss coupled with a macroeconomic factor analysis derived from a statistical

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regression of loss experience correlated to changes in economic factors for all commercial banks operating within our geographical footprint. The macroeconomic regression is based on a multivariate approach and includes key indicators that provide the highest cumulative adjusted R-square figure.  Economic factors include, but are not limited to, national unemployment, gross domestic product, market interest rates and property pricing indices.  To arrive at the most predictive calculation, a lag factor was applied to these inputs, resulting in current and historic economic inputs driving the projection of loss over our reasonable and supportable forecast period, which managements has defined as 12 months for all portfolio segments.  Following the reasonable and supportable forecast period, loss experience immediately reverts to the current historical loss experience of the Company.  The estimated loan losses for all loan segments are adjusted for changes in qualitative factors not inherently considered in the quantitative analyses.  The qualitative categories and the measurements used to quantify the risks within each of these categories are subjectively selected by management but measured by objective measurements period over period.  The current period measurements are evaluated and assigned a factor commensurate with the current level of risk relative to past measurements over time.  The resulting qualitative adjustments are applied to the relevant collectively evaluated loan portfolios.  These adjustments are based upon quarterly trend assessments in projective economic sentiment, portfolio concentrations, policy exceptions, personnel retention, independent loan review results, collateral considerations, risk ratings and competition.  The qualitative allowance allocation, as determined by the processes noted above, is increased or decreased for each loan segment based on the assessment of these various qualitative factors.  The resultant loss rates are applied to the estimated future exposure at default (EAD), as determined based on contractual amortization terms through an average default month and estimated prepayment experience in arriving at the quantitative reserve within our allowance for credit losses.

The allowance represents management’s best estimate, but significant changes in circumstances relating to loan quality and economic conditions could result in significantly different results than what is reflected in the consolidated balance sheet as of December 31, 2021.  Likewise, an improvement in loan quality or economic conditions may allow for a further reduction in the required allowance.  Changing credit conditions would be expected to impact realized losses driving variability in specifically assessed allowances, as well as calculated quantitative and more subjectively analyzed qualitative factors.  Depending on the volatility in these conditions, material impacts could be realized within the Company’s operations.  Likewise, changing economic conditions, both positive and negative, to the extent significant could result in unexpected realization of provision or reversal of allowance for credit losses due to its impact on the quantitative and qualitative inputs to the Company’s calculation.  Under the CECL methodology, the impact of these conditions has the potential to further exacerbate periodic differences due to its life of loan perspective.  The life of loans calculated under the methodology is based in contractual duration and modified for prepayment expectations, making significant variation in periodic results possible due to changing contractual or adjusted duration of the assets within the calculation

Goodwill:  Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets.  Goodwill is assessed at least annually for impairment and any such impairment is recognized and expensed in the period identified.  Goodwill will be assessed more frequently if a triggering event occurs which indicates that the carrying value of the asset might be impaired.  We have selected December 31 as the date to perform our annual goodwill impairment test. Goodwill is the only intangible asset with an indefinite useful life.  For the year ended December 31, 2021, following recognition of a material impairment in goodwill balances during 2020, based on the improving market conditions, strong earnings performance by the Company, and improvements in market value of our stock as well the broader industry, management has determined there was not evidence of a triggering event as of or during the period then ended.  Based on this qualitative analysis and conclusion, it was determined that a more robust quantitative assessment was not necessary at our measurement date.

When performing quantitative goodwill impairment assessments, management is required to estimate the fair value of the Company’s equity in a change in control transaction.  To complete this valuation, management is required to derive assumptions related to industry performance, reporting unit business performance, economic and market conditions and various other assumptions, many of which require significant management judgement.

For additional information see “NOTE 1 – NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES” and “NOTE 7 – GOODWILL AND CORE DEPOSIT INTANGIBLES” in the Notes to Consolidated Financial Statements.

Results of Operations

We generate most of our revenue from interest income and fees on loans, interest and dividends on investment securities and non-interest income, such as service charges and fees, debit card income and mortgage banking income.  We incur interest expense on deposits and other borrowed funds and non-interest expense, such as salaries and employee benefits and occupancy expenses.

Changes in interest rates earned on interest-earning assets or incurred on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and non-interest-bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic change in net interest income.  Fluctuations in interest rates are driven by many factors, including governmental

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monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international circumstances and domestic and foreign financial markets.  Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Arkansas, Kansas, Missouri and Oklahoma, as well as developments affecting the consumer, commercial and real estate sectors within these markets.

For information comparing our results of operations for the year ended December 31, 2020, to year ended December 31, 2019, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 9, 2021.

Net Income

Year ended December 31, 2021, compared with year ended December 31, 2020

For the year ended December 31, 2021, there was net income allocable to common stockholders of $52.5 million, compared to a net loss allocable to common stockholders of $75.0 million for the year ended December 31, 2020, an increase of $127.5 million.  This change was primarily driven by a goodwill impairment of $104.8 million during 2020, a decrease in provision for loan losses of $32.7 million, an increase in non-interest income of $6.8 million, and a decrease in interest expense on deposits of $8.3 million, partially offset by an increase in provision for income taxes of $11.6 million. The changes in the components of net income are discussed in more detail below in the following sections of “Results of Operations.”

Net Interest Income and Net Interest Margin Analysis

Net interest income is the difference between interest income on interest-earning assets, including loans and securities, and interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds.  To evaluate net interest income, management measures and monitors (1) yields on loans and other interest-earning assets, (2) the costs of deposits and other funding sources, (3) the net interest spread and (4) net interest margin.  Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities.  Net interest margin is calculated as net interest income divided by average interest-earning assets.  Because non-interest-bearing sources of funds, such as non-interest-bearing deposits and stockholders’ equity also fund interest-earning assets, net interest margin includes the benefit of these non-interest-bearing sources of funds.  Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change,” and it is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “yield/rate change.”

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The following table shows the average balance of each principal category of assets, liabilities, and stockholders’ equity and the average yields on interest-earning assets and average rates on interest-bearing liabilities for the years ended December 31, 2021, 2020 and 2019.  The yields and rates are calculated by dividing income or expense by the average daily balances of the associated assets or liabilities.

Average Balance Sheets and Net Interest Analysis

(1)Average loan balances include nonaccrual loans, hedge fair value adjustments and merger fair value adjustments.

(2)Net interest margin is calculated by dividing net interest income by average interest-earning assets for the period.

(3)Tax exempt income is not included in the above table on a tax equivalent basis.

(4)Actual unrounded values are used to calculate the reported yield or rate disclosed.  Accordingly, recalculations using the amounts in thousands as disclosed in this report may not produce the same amounts.

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Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest yields/rates.  The following table analyzes the change in volume variances and yield/rate variances for the year ended December 31, 2021, as compared to the year ended December 31, 2020, and the year ended December 31, 2020, as compared to the year ended December 31, 2019.

Analysis of Changes in Net Interest Income

(1)The effect of changes in volume is determined by multiplying the change in volume by the previous year’s average rate.  Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the prior year’s volume.  The changes attributable to both volume and rate, which cannot be segregated, have been allocated to the volume variance and the rate variance in proportion to the relationship of the absolute dollar amount of the change in each.

Year ended December 31, 2021, compared with year ended December 31, 2020

The increase in net interest income before the provision for credit losses is primarily due to the increase in the volume of interest-earnings assets and a 31 basis point decrease in average rates of interest bearing liabilities, partially offset by a 45 basis point decrease in yields on interest-earning assets. The increase in average volume of interest-earning assets was primarily due to increases in loans.

The increase in loan interest income was driven by the $184.8 million increase in average loan volume.  The impact to net interest income from loan fees for the year ended December 31, 2021, was $19.5 million compared to $10.4 million for the year ended December 31, 2020.

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Average balances of borrowings from the FHLB decreased by $196.4 million from an average balance of $213.2 million for the year ended December 31, 2020, to an average balance of $16.8 million for the year ended December 31, 2021, coupled with a 7 basis point decrease in average borrowing cost resulted in a decrease in interest expense of $2.1 million.  Interest expense on subordinated borrowings for the year ended December 31, 2021, was $6.3 million compared to $3.5 million for the year ended December 31, 2020, an increase of $2.8 million.  Total cost of interest-bearing liabilities decreased 31 basis points to 0.50% for the year ended December 31, 2021, from 0.81% for the year ended December 31, 2020.

The increase in net interest margin is largely due to the cost of interest-bearing liabilities decreasing at a faster rate than interest-earning assets.  The decrease in cost of funds is primarily from the overall decrease in rates on interest-bearing liabilities, partially due to an increase in non-interest-bearing checking accounts and a decrease in the volume of borrowings.

Provision for Credit Losses

We maintain an allowance for credit losses for estimated losses in our loan portfolio.  The allowance for credit losses is increased by a provision for loan losses, which is a charge to earnings, and subsequent recoveries of amounts previously charged-off, but is decreased by charge-offs when the collectability of a loan balance is unlikely.  Management estimates the allowance balance required using past loan loss experience within the Company’s portfolio.  This historical loss calculation is then modified to reflect quantitative economic circumstances based on evidenced economic conditions and regression formulas which incorporate of lag factors in identifying a sufficiently predictive adjusted-R square as well as qualitative factors not inherently reflected in our historical loss or quantitative economic inputs.  Included in our qualitative assessment is the consideration of a prospective economic conditions over the preceding 12 months, considered the Company’s reasonable, supportable forecast period. As these factors change, the amount of the credit loss provision changes.

Year ended December 31, 2021, compared with year ended December 31, 2020

There was an $8.5 million reversal of provision for credit losses for the period ended December 31, 2021, compared to a provision of $24.3 million for the period ended December 31, 2020.  The release of allowance was principally due to reductions in reserves on specifically assessed assets excluding PCD loans and decreases in the calculated allowance on collectively evaluated performing loans.  The decrease in impairments on specifically evaluated loans was due to resolution of a few larger relationships discussed below and general improvement in asset quality.  The change in the calculated allowance on collectively evaluated loans was primarily driven by the implementation of CECL effective January 1, 2021 resulting in the calculation of a life of loan estimate versus this historical single year approach as well as period over period growth in the portfolio partially offset by improving trends in historical loss experience and economic conditions in the markets in which the Company operates.  The provision was increased significantly during the period ended December 31, 2020, largely as the result of increases in qualitative loss factors brought on by the projected economic impact of COVID-19.

During the period ended December 31, 2021, there was a recovery of $1.9 million from a relationship previously disclosed in 2019 that also had a specific reserve of $1.9 million that was released, which resulted in a net provision reversal of $3.8 million.  Another large relationship that incurred a $5.5 million provision in 2021 was moved to repossessed assets and was partially sold in January 2022.  Two other separate credits resulted in a net provision increase of $1.2 million for the year ended December 31, 2021.   For additional detail see “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations – Allowance for Credit Losses.” Net charge-offs for the year ended December 31, 2021, were $8.7 million as compared to net charge-offs of $2.8 million for the year ended December 31, 2020.  For the year ended December 31, 2021, gross charge-offs were $11.4 million offset by gross recoveries of $2.7 million.  In comparison, gross charge-offs were $3.3 million for the year ended December 31, 2020, offset by gross recoveries of $544 thousand.

Non-Interest Income

The primary sources of non-interest income are service charges and fees, debit card income, mortgage banking income, increases in the value of bank-owned life insurance, investment referral income, the recovery of zero-basis purchased loans, net gains on the sale of available-for-sale securities and other securities transactions.  Non-interest income does not include loan origination or other loan fees which are recognized as an adjustment to yield using the interest method.

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The following table provides a comparison of the major components of non-interest income for the years ended December 31, 2021, 2020 and 2019.

Non-Interest Income

For the Years Ended December 31,

Year ended December 31, 2021, compared with year ended December 31, 2020

Non-interest income improved in 2021 by 26% driven by continued expansion of customer service charges led by deposit service fees, debit card and trust and wealth management income, as well as insurance commissions and fees, credit card fees, and loan servicing fees which are included in ‘Other non-interest income’ and collectively improved by $1.6 million reflecting the Company’s continued emphasis on offering innovative products to our customer base.  Income further improved due to increased earnings on bank owned life insurance due to an increasing asset base and the realization of benefits from utilization of the policies and improvement in the value of the Company’s derivative positions.  These improvement were partially offset by a decline in gain on acquisition which was driven by purchase of Almena in 2020.

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Non-Interest Expense

The following table provides a comparison of the major components of non-interest expense for the years ended December 31, 2021, 2020 and 2019.

Non-Interest Expense

For the Year Ended December 31,

Year ended December 31, 2021, compared with year ended December 31, 2020

The decrease in non-interest expense was primarily due to a $104.8 million goodwill impairment charge in 2020 and gains on other real estate owned properties of $2.5 million, offset by increases in occupancy of $1.4 million, data processing of $2.3 million, and other other non-interest expense of $3.4.  These items and other changes in the various components of non-interest expense are discussed in more detail below.

Salaries and employee benefits:  There was a $2.5 million increase in salaries for the year ended December 31, 2021, as compared to the year ended December 31, 2020.  This increase reflects the addition of staff related to the October 2021 ASBI acquisition, the December 2021 Security acquisition, and the full year effect of the addition of staff related to the October 2020 Almena acquisition. The total increase in salary expense was offset by an increase in deferred fees of $4.4 million for the period ended December 31, 2021, compared to the period ended December 31, 2020.  Additionally, for the year ended December 31, 2021, there was an increase in incentives and bonuses of $1.8 million and retirement plan expense of $127 thousand, offset by decreases in restricted stock unit expense of $365 thousand.  Included in salaries and employee benefits is share-based compensation expense of $2.6 million for the year ended December 31, 2021, and $3.2 million for the year ended December 31, 2020.

Net occupancy and equipment:  Net occupancy and equipment includes expenses related to the use of premises and equipment, such as depreciation, operating lease payments, repairs and maintenance, insurance, property taxes and utilities, net of incidental rental income of excess facilities.  The increase is primarily related to the October 2021 ASBI acquisition, the December 2021 Security acquisition, and the full year effect of the two additional locations related to the October 2020 Almena acquisition.

Data processing:  The increase was principally due to increased software license expenses of $1.1 million, $717 thousand in data processing/debit card expense and online account processing expenses of $417 thousand.

Professional fees:  The increase of $431 thousand was principally due to increases in attorney fees of $454 thousand and consulting services of $384 thousand, partially offset by a decrease in accounting fees of $353 thousand.

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Other real estate owned:  As detailed in “NOTE 5 – OTHER REAL ESTATE OWNED” in the Notes to Consolidated Financial Statements, other real estate owned expenses, including provision for unrealized losses, were $1.3 million, partially offset by gains on sale and transfer to other real estate of $1.0 million and income from other real estate owned properties of $473 thousand, for the year ended December 31, 2021. For the year ended December 31, 2020, other real estate owned expenses including provision for unrealized losses, were $3.3 million, partially offset by gains on the sale of other real estate of $835 thousand and income from other real estate owned properties of $201 thousand.

Other:  Other non-interest expenses consists of subscriptions, memberships and dues, employee expenses, including travel, meals, entertainment and education, supplies, printing, insurance, account related losses, correspondent bank fees, customer program expenses, losses net of gains on the sale of fixed assets, losses net of gains on the sale of repossessed assets other than real estate, other operating expenses, such as settlement of claims, limited partnership tax credits and provision for unfunded commitments.

Merger expenses:  Merger expenses include legal, advisory and accounting fees associated with services to facilitate the acquisition of other banks.  Merger expenses also include data processing conversion costs and costs associated with the integration of personnel, processes, facilities and employee bonuses.  During 2021, the company incurred merger expenses of $237 thousand related to the Almena acquisition, $8.7 million related to the ASBI acquisition and $289 thousand related to the Security acquisition.  For the year ended December 31, 2020, merger expenses of $299 thousand are related to the Almena acquisition.

Efficiency Ratio

The efficiency ratio is a supplemental financial measure utilized in the internal evaluation of our performance and is not defined under GAAP.  Our efficiency ratio is computed by dividing non-interest expense, excluding goodwill impairment, merger expenses and loss on debt extinguishment, by the sum of net interest income and non-interest income, excluding net gains on sales of and settlement of securities and gain on acquisition.  Generally, an increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources.  The ratio defined under GAAP that is most comparable to the efficiency ratio is non-interest expense to net interest income plus non-interest income which is discussed in “Results of Operations – Non-GAAP Financial Measures.”

The Company’s non-interest expense, less goodwill impairment, to net interest income plus non-interest income increased from the period ended December 31, 2020, to December 31, 2021, primarily due to net interest income plus non-interest income increasing at a lower rate than non-interest expense less goodwill impairment, as discussed in “Results of Operations – Non-GAAP Financial Measures.” The efficiency ratio decreased during the same time period due to non-interest expense, excluding goodwill impairment and merger expenses, increasing at a lower proportional rate than net interest income and non-interest income, excluding net gains on security transactions and gain on acquisition, as discussed in “Results of Operations – Net Interest Income and Net Interest Margin Analysis” and “Results of Operations – Non-Interest Income.”

Income Taxes

The amount of income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income, the amount of non-deductible expenses and available tax credits.

Year ended December 31, 2021, compared with year ended December 31, 2020

The effective income tax rate for the year ended December 31, 2021, was 18.5% as compared to the U.S. statutory rate of 21.0%.  The effective income tax rate for the year ended December 31, 2020, was (0.5)% as compared to the U.S. statutory rate of 21.0%.  As detailed in “NOTE 15 – INCOME TAXES” in the Notes to Consolidated Financial Statements, the income tax rates differed from the U.S. statutory rates primarily due to non-taxable income, non-deductible expenses, non-deductible goodwill and tax credits.  The Company made an investment in solar tax credits during the year ended December 31, 2021, which materially affected the effective income tax rate for the period.

Impact of Inflation

Our consolidated financial statements and related notes included elsewhere in this annual report have been prepared in accordance with GAAP.  These require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.

Unlike many industrial companies, substantially all our assets and liabilities are monetary in nature.  As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation.  Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services.  However, other operating expenses do reflect general levels of inflation.

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Financial Condition

Overview

Our total assets increased $1.12 billion, or 28.0%, from $4.01 billion at December 31, 2020, to $5.14 billion at December 31, 2021.  The increase in total assets was primarily from increases in securities of $455.6 million, loans of $549.3 million and other assets of $67.4 million. Our total liabilities increased $1.03 billion, or 28.6%, from $3.61 billion at December 31, 2020, to $4.64 billion at December 31, 2021.  The increase in total liabilities was from increases in total deposits of $972.4 million, other liabilities of $28.3 million and subordinated debt of $8.2 million, somewhat offset by decreases in FHLB advances of $10.1 million. Our total stockholders’ equity increased $93.0 million, or 22.8%, from $407.6 million at December 31, 2020, to $500.6 million at December 31, 2021.

Loan Portfolio

Loans are the largest category of earning assets and typically provide higher yields than other types of earning assets.  Excluding the acquired loan balances at year end, gross loans held for investment increased by $165.5 million, or 6.4%, compared with December 31, 2020.  Growth consisted of $133.3 million, or 11.2%, from commercial real estate, $10.4 million, or 11.0%, from agricultural, $219.9 million, or 57.6%, from residential real estate, $25.8 million, or 44.0%, from consumer, and $3.1 million, or 2.3%, from agricultural real estate, offset by a decrease of $227.0 million, or 30.9%, from commercial and industrial.  We also had a decrease in loans classified as held for sale of $8.2 million, or 66.0%, from December 31, 2020.

Our loan portfolio consists of various types of loans, most of which are made to borrowers located in the Wichita, Kansas City and Tulsa MSAs, as well as various community markets throughout Arkansas, Kansas, Missouri and Oklahoma.  Although the portfolio is diversified and generally secured by various types of collateral, the majority of our loan portfolio consists of commercial and industrial and commercial real estate loans and a substantial portion of our borrowers’ ability to honor their obligations is dependent on local economic conditions in Arkansas, Kansas, Missouri and Oklahoma.  As of December 31, 2021, the only industry with a concentration of loans in excess of 10% of total loans was the hospitality industry, comprising 11.5% of total loans excluding SBA PPP.

At December 31, 2021, gross total loans were 71.5% of deposits and 61.5% of total assets.  At December 31, 2020, gross total loans were 75.5% of deposits and 64.9% of total assets.

The organic, or non-acquired, growth in our loan portfolio is attributable to our ability to attract new customers from other financial institutions and overall growth in our markets.  Our lending staff has been successful in building banking relationships with new customers.  Several new lenders have been hired in our markets and these employees have been successful in transitioning their former clients and attracting new clients.  Lending activities originate from the efforts of our lenders with an emphasis on lending to individuals, professionals, small to medium-sized businesses and commercial companies located in the Wichita, Kansas City and Tulsa MSAs, as well as community markets in Arkansas, Kansas, Missouri and Oklahoma.

The following table summarizes our loan portfolio by type of loan as of the dates indicated.

Composition of Loan Portfolio

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Commercial and industrial:  Commercial and industrial loans include loans used to purchase fixed assets, to provide working capital or meet other financing needs of the business.

Commercial real estate:  Commercial real estate loans include all loans secured by nonfarm nonresidential properties and multifamily residential properties, as well as 1-4 family investment-purpose real estate loans.  Of the $297.5 million in growth during 2021, $164.1 million, or 55.2%, was a result of loans acquired through acquisitions.

Residential real estate:  Residential real estate loans include loans secured by primary or secondary personal residences.  Acquisitions added $36.3 million in residential real estate loans during the year ended December 31, 2021.  During 2021, we purchased six pools of residential real estate mortgage loans totaling $363.9 million.  Pools of mortgages are occasionally purchased to expand our loan portfolio and provide additional loan income.

Agricultural real estate, Agricultural, Consumer and other:  Agricultural real estate loans are loans related to farmland. Agricultural loans are primarily operating lines subject to annual farming revenues including productivity/yield of the agricultural commodities produced.  Consumer loans are generally secured by consumer assets but may be unsecured.  The ASBI and Security acquisitions added $62.2 million in agricultural, $61.5 million in agricultural real estate, and $14.3 million in consumer loans during the year ended December 31, 2021.  These three loan types represent 14.7% of our overall loan portfolio.

The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of December 31, 2021, and December 31, 2020, are summarized in the following tables.

Loan Maturity and Sensitivity to Changes in Interest Rates

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Nonperforming Assets

The following table presents information regarding nonperforming assets at the dates indicated.

Nonperforming Assets

Nonperforming assets (“NPAs”) include loans on nonaccrual status, accruing loans 90 or more days past due, restructured loans, other real estate acquired through foreclosure and other repossessed assets.

The nonperforming loans at December 31, 2021, consisted of 176 separate credits and 137 separate borrowers.  We had nine nonperforming loan relationships each with outstanding balances exceeding $1.0 million as of December 31, 2021.  Of the increase in nonperforming assets, $2.5 million was a result of the ASBI acquisition.  There are several procedures in place to assist us in maintaining the overall quality of our loan portfolio.  We have established underwriting guidelines to be followed by lenders and we also monitor delinquency levels for any negative or adverse trends.  There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.

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Regulatory Loan Classification

We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors.  Loans are analyzed individually and classified based on credit risk.  Consumer loans are considered pass credits unless downgraded due to payment status or reviewed as part of a larger credit relationship.  We use the following definitions for risk ratings:

Pass:  Loans classified as pass include all loans that do not fall under one of the three following categories.  These loans are considered unclassified.

Special Mention:  Loans classified as special mention have a potential weakness that deserves management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of our credit position at some future date.  These loans are considered classified.

Substandard:  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.  These loans are considered classified.

Doubtful:  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, based on currently existing facts, conditions and values, highly questionable and improbable.  These loans are considered classified.

Potential problem loans consist of loans that are performing in accordance with contractual terms, but for which management has concerns about the borrower’s ability to comply with repayment terms because of the borrower’s potential financial difficulties.  Potential problem loans are assigned a grade of special mention or substandard.  At December 31, 2021, the Company had $72.5 million in potential problem loans which were not included in either non-accrual or 90 days past due categories, compared to $52.3 million at December 31, 2020.

For additional information about the risk category by class of loans see “NOTE 4 – LOANS AND ALLOWANCE FOR CREDIT LOSSES” in the Notes to Consolidated Financial Statements. At December 31, 2021, loans considered unclassified increased to 96.8% of total loans from 96.3% of total loans at December 31, 2020.

Risk Category of Loans by Class

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At December 31, 2021, the Company had $36.3 million, or 1.2%, of total loans excluding PPP loans participating in the payment deferral program.  For additional information see “NOTE 4 – LOANS AND ALLOWANCE FOR CREDIT LOSSES” in the Notes to Consolidated Financial Statements.

In accordance with applicable regulation, appraisals or evaluations are required to independently value real estate and, as an important element, to consider when underwriting loans secured in part or in whole by real estate.  The value of real estate collateral provides additional support to the borrower’s credit capacity.

With respect to potential problem loans, all monitored and under-performing loans are reviewed and evaluated to determine if they are impaired.  If we determine that a loan is impaired, then we evaluate the borrower’s overall financial condition to determine the need, if any, for possible write downs or appropriate additions to the allowance for credit losses based on the unlikelihood of full repayment of principal and interest in accordance with the contractual terms or the net realizable value of the pledged collateral.

Allowance for credit losses

Please see “Critical Accounting Policies – Allowance for Credit Losses” for additional discussion of our allowance policy.

In connection with our review of the loan portfolio, risk elements attributable to particular loan types or categories are considered when assessing the quality of individual loans.  For additional information see “NOTE 1 – NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES” in the Notes to Consolidated Financial Statements.

Purchased credit deteriorated loans:  Please see “Critical Accounting Policies – Allowance for Credit Losses” for additional discussion of our purchased credit deteriorated loans policy.  In accordance with ASC 326, the credit impairment mark on acquired loans was reclassified from loans to the allowance for credit losses, effective January 1, 2021.  After adoption of the standard, the allowance for credit losses is increased by the reserve calculated on newly acquired purchased credit deteriorated assets at the date of acquisition.  Subsequent changes to the allowance on these loans are recorded through the provision for loan losses.  For additional information about our purchased credit deteriorated loans see “NOTE 4 – LOANS AND ALLOWANCE FOR CREDIT LOSSES” in the Notes to Consolidated Financial Statements.

Analysis of allowance for credit losses:  At December 31, 2021, the allowance for credit losses totaled $48.4 million, or 1.53% of total loans.  At December 31, 2020, the allowance for loan losses totaled $33.7 million, or 1.30% of total loans.

The Company adopted CECL effective January 1, 2021.  The adoption resulted in increases in the allowance for credit losses (“ACL”) on loans held for investment of $15,732, an ACL for unfunded commitments of $838, a deferred tax asset of $4,167, a reclassification of purchased-impaired discounts from loans to ACL of $10,438 and a decrease in retained earnings of $12,403.  For additional information about the adoption of CECL see “NOTE 1 – NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES” in the Notes to Consolidated Financial Statements.

The allowance for credit losses on loans collectively evaluated totaled $34.3 million, or 1.14%, of the $3.1 billion in loans collectively evaluated at December 31, 2021, compared to an allowance for loan losses of $23.2 million, or 0.92%, of the $2.54 billion in loans collectively evaluated at December 31, 2020, and an allowance for loan losses of $11.0 million, or 0.44%, of the $2.50 billion in loans collectively evaluated at December 31, 2019.  The increase in allowance as a percentage of total loans and of loans collectively evaluated from December 31, 2020, to December 31, 2021, was driven by the CECL which introduced a life of loan concept to the calculation and resulted in a significant increase in reserves as previously indicated.  Following adoption, the level of reserve has declined due primarily to improving economic circumstances in the markets in which the Company operates as we continue to move away from the peak of the pandemic partially offset by increasing estimated exposure at default, loss experience within our historical loss calculation and extension of expected life of the underlying portfolio.

Net losses as a percentage of average loans was 0.30% for the twelve months ended December 31, 2021, as compared to 0.10% for the twelve months ended December 31, 2020, and 0.68% for the twelve months ended December 31, 2019.

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The following table presents, as of and for the periods indicated, an analysis of the allowance for credit losses and other related data.

Allowance for Credit Losses

(Dollars in thousands)

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Management believes that the allowance for credit losses at December 31, 2021, is adequate to cover current expected losses in the loan portfolio as of such date.  There can be no assurance, however, that we will not sustain losses in future periods that could be substantial in relation to the size of the allowance at December 31, 2021.

Securities

We use our securities portfolio to provide a source of liquidity, to provide an appropriate return on funds invested, to manage interest rate risk, to meet pledging requirements and to meet regulatory capital requirements.  At December 31, 2021, securities represented 25.8% of total assets compared with 21.7% at December 31, 2020.

At the date of purchase, debt securities are classified into one of two categories, held-to-maturity or available-for-sale.  We do not purchase securities for trading purposes.  At each reporting date, the appropriateness of the classification is reassessed.  Investments in debt securities are classified as held-to-maturity and carried at cost, adjusted for the amortization of premiums and the accretion of discounts, in the financial statements only if management has the positive intent and ability to hold those securities to maturity.  Debt securities not classified as held-to-maturity are classified as available-for-sale and measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, as accumulated comprehensive income or loss until realized.  Interest earned on securities is included in total interest and dividend income.  Also included in total interest and dividend income are dividends received on stock investments in the Federal Reserve Bank of Kansas City and the FHLB of Topeka.  These stock investments are stated at cost.

The following table summarizes the amortized cost and fair value by classification of available-for-sale securities as of the dates shown.

Available-For-Sale Securities

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The following tables summarize the contractual maturity of debt securities and their weighted average yields as of December 31, 2021, and December 31, 2020.  Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.  Available-for-sale securities are shown at fair value and held-to-maturity securities are shown at cost, adjusted for the amortization of premiums and the accretion of discounts.