FIVE STAR BANCORP (FSBC) FY 2022 MD&A

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

The following discussion and analysis presents management’s perspective on our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through Five Star

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Bank (“Five Star” or the “Bank”), the discussion and analysis relate to activities primarily conducted by the Bank. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and the accompanying notes presented elsewhere in this Annual Report on Form 10-K. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.

To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of our future financial outcomes. In addition to containing historical information, this discussion contains forward-looking statements that involve risks, uncertainties, and assumptions that could cause results to differ materially from management’s expectations. Factors that could cause such differences are discussed in the sections entitled “Cautionary Note Regarding Forward-Looking Statements” and “Part I, Item 1A. Risk Factors.” We assume no obligation to update any of these forward-looking statements, except to the extent required by law.

Company Overview

Headquartered in the greater Sacramento metropolitan area of California, Five Star Bancorp (“Bancorp” or the “Company”) is a bank holding company that operates through its wholly owned subsidiary, Five Star Bank (“Five Star” or the “Bank”), a California state-chartered non-member bank. We provide a broad range of banking products and services to small and medium-sized businesses, professionals, and individuals primarily in Northern California through seven branch offices and one loan production office. Our mission is to strive to become the top business bank in all markets we serve through exceptional service, deep connectivity, and customer empathy. We are dedicated to serving real estate, agricultural, faith-based, and small to medium-sized enterprises. We aim to consistently deliver value that meets or exceeds the expectations of our shareholders, customers, employees, business partners, and community. We refer to our mission as “purpose-driven and integrity-centered banking.” At December 31, 2022, we had total assets of $3.2 billion, total loans held for investment, net of allowance for loan losses, of $2.8 billion, and total deposits of $2.8 billion.

Key Factors Affecting our Business

Coronavirus (“COVID-19”)

The COVID-19 pandemic and the impact of actions to mitigate the spread of the virus affected our business, financial condition, and results of operations in the year ended December 31, 2022. During the year, we maintained our focus on relationship-based banking and made the health and safety of our customers and employees our priority. To help protect our customers and their finances during the pandemic, while all of our branches were open, we took into account guidelines from public health officials, and encouraged our customers to conduct business with us via phone, online banking, and mobile apps.

Our financial results for the year ended December 31, 2021 were also impacted by the COVID-19 pandemic. Beginning with the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) in March 2020, the federal government enacted a series of federal statutes creating, funding, and expanding wide-ranging economic relief for individuals and businesses impacted by COVID-19. Among other things, these statutes created and funded the Paycheck Protection Program (“PPP”), a loan program administered by the Small Business Administration (the “SBA”). Under the PPP, if a loan is fully forgiven, the SBA will repay the lending bank in full. If a loan is partially forgiven or not forgiven at all, a lender must look to the borrower for repayment of unforgiven principal and interest. If the borrower defaults, in part or in full, the loan is guaranteed by the SBA.

Our responsiveness and certainty of execution resulted in our ability to quickly provide 1,602 PPP loans to 1,239 customers nationwide, approximately 39% of which were new customers as of December 31, 2021. Because of our relationship-based banking approach, the influx of new customers contributed to a corresponding increase in deposits in the year ended December 31, 2020, which continued into the year ended December 31, 2021. There were no outstanding PPP loans at December 31, 2022.

Additionally, the uncertainty and economic downturn caused by the COVID-19 pandemic affected our overall existing loan portfolio. In 2020, our methodology for evaluating the allowance for loan losses was affected by the COVID-19 pandemic, resulting in higher reserve levels primarily related to our commercial secured portfolio. In 2021, reserve amounts were positively impacted by improved economic conditions and reductions to reserves required for classified and watch loans, which were offset by additional provisions required for loan growth during the year. In 2022, we continued to monitor higher risk concentrations identified in the loan portfolio for ongoing effects from COVID-19 and the impact on reserve requirements.

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Interest Rates

Net interest income is the most significant contributor to our net income and is the difference between the interest and fees earned on interest-earning assets and the interest expense incurred in connection with interest-bearing liabilities. Net interest income is primarily a function of the average balances and yields of these interest-earning assets and interest-bearing liabilities. These factors are influenced by internal considerations such as product mix and risk appetite as well as external influences such as economic conditions, competition for loans and deposits, and market interest rates.

The cost of our deposits and short-term borrowings is primarily based on short-term interest rates, which are largely driven by the Board of Governors of the Federal Reserve System’s (the “Federal Reserve’s”) actions and market competition. The yields generated by our loans and securities are typically affected by short-term and long-term interest rates, which are driven by market competition and market rates often impacted by the Federal Reserve’s actions. The level of net interest income is influenced by movements in such interest rates and the pace at which such movements occur.

Interest rates have risen significantly following the historically low levels during the COVID-19 pandemic. Due to elevated levels of inflation and corresponding pressure to raise interest rates, the Federal Reserve announced in January of 2022 that it would be slowing the pace of its bond purchasing and increasing the target range for the federal funds rate over time. The FOMC has since increased the target range seven times throughout 2022. As of December 31, 2022, the target range for the federal funds rate had been increased to 4.25% to 4.50%, and the FOMC signaled that future increases may be appropriate in order to attain a monetary policy sufficiently restrictive to return inflation to normalized levels.

We anticipate that interest rates may continue to rise over the next few years. Based on our asset sensitivity, a steepened yield curve could have a beneficial impact on our net interest income. Additionally, a continued flat yield curve would be expected to maintain our net interest income. An inverted yield curve, as was observed late in 2022, could have a negative impact on our net interest income.

Factors Affecting Comparability of Financial Results

S Corporation Status

Beginning at our inception, we elected to be taxed for U.S. federal income tax purposes as an S Corporation. In conjunction with our initial public offering (“IPO”), we filed consents from the requisite amount of our shareholders to revoke our S Corporation election with the Internal Revenue Service (the “IRS”), resulting in the commencement of our taxation as a C Corporation for U.S. federal and California state income tax purposes in the second quarter of fiscal year 2021. Prior to such revocation, our earnings were not subject to, and we did not pay, U.S. federal income tax, and we were not required to make any provision or recognize any liability for U.S. federal income tax in our consolidated financial statements. While we were not subject to, and did not pay, U.S. federal income tax, we were subject to, and paid, California S Corporation income tax at a current rate of 3.50%. Upon the termination of our status as an S Corporation, we commenced paying U.S. federal income tax and a higher California state income tax on our taxable earnings for each year (including the short year beginning on the date our status as an S Corporation terminated), and our consolidated financial statements reflect a provision for U.S. federal income tax and a higher California state income tax from that date forward. As a result of this change, the net income and earnings per share (“EPS”) data presented in our historical financial statements for periods prior to the termination of our S Corporation status and the other related financial information set forth in this filing, which (unless otherwise specified) do not include any provision for U.S. federal income tax or the higher California state income tax rate, will not be comparable with our net income and EPS in periods after we commenced being taxed as a C Corporation. As a C Corporation, our net income is calculated by including a provision for U.S. federal income tax and a higher California state income tax rate at a combined statutory rate of 29.56%.

The termination of our status as an S Corporation may also affect our financial condition and cash flows. Historically, we made quarterly cash distributions to our shareholders in amounts estimated by us to be sufficient for them to pay estimated individual U.S. federal and California state income tax liabilities resulting from our taxable income that was “passed through” to them. However, these distributions were not consistent, as sometimes the distributions were less than or in excess of the shareholders’ estimated U.S. federal and California state income tax liabilities resulting from their ownership of our stock. In addition, these estimates were based on individual income tax rates, which may differ from the rates imposed on the income of C Corporations. As a C Corporation, no income is “passed through” to any shareholders, but, as noted above, we commenced paying U.S. federal income tax and a higher California state income tax. However, in the event of an adjustment to our reported taxable income for periods prior to the termination of our S Corporation status, it is possible that our pre-IPO shareholders would be liable for additional income taxes for those prior periods. Pursuant to the

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Tax Sharing Agreement we entered into with such shareholders, upon our filing any tax return (amended or otherwise), in the event of any restatement of our taxable income or pursuant to a determination by, or a settlement with, a taxing authority, for any period during which we were an S Corporation, depending on the nature of the adjustment, we may be required to make a payment to such shareholders, who accepted distribution of the estimated balance of our federal Accumulated Adjustments Account (“AAA”) of $31.9 million under the Tax Sharing Agreement, in an amount equal to such shareholders’ incremental tax liability (including interest and penalties). In addition, the Tax Sharing Agreement provides that we will indemnify such shareholders with respect to unpaid income tax liabilities (including interest and penalties) to the extent that such unpaid income tax liabilities are attributable to an adjustment to our taxable income for any period after our S Corporation status terminated. The amounts that we have historically distributed to our shareholders may not be indicative of the amount of U.S. federal and California state income tax that we will be required to pay going forward. Depending on our effective tax rate and our future dividend rate, our future cash flows and financial condition could be positively or adversely affected compared to our historical cash flows and financial condition.

Furthermore, deferred tax assets and liabilities were recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of our existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of the change in tax rates resulting from becoming a C Corporation was recognized in net income in the year ended December 31, 2021.

Refer to the highlights of the financial results table within the section entitled “—Executive Summary” below for the impact of being taxed as a C Corporation on our net income, EPS, and various other financial measures for the years ended December 31, 2022 and 2021.

Public Company Costs

Following the completion of our IPO, we began to, and will continue to, incur additional costs associated with operating as a public company. These costs include additional personnel, legal, consulting, regulatory, insurance, accounting, investor relations, and other expenses that we did not incur as a private company.

The Sarbanes-Oxley Act, as well as rules adopted by the SEC, the FDIC, and national securities exchanges, require public companies to implement specified corporate governance practices that were inapplicable to us as a private company. These additional rules and regulations have increased, and are expected to continue to increase, our legal, regulatory, and financial compliance costs and will make some activities more time-consuming and costly.

Critical Accounting Estimates

Our consolidated financial statements are prepared in accordance with accounting principles that are generally accepted in the United States. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of our assets, liabilities, revenue, and expenses. We have identified certain policies and estimates as critical to our business operations and the understanding of our past or present consolidated financial condition and results of operations. These policies and estimates are considered critical because they have a material impact, or they have the potential to have a material impact, on our consolidated financial statements and because they require us to make significant judgments, assumptions, or estimates. We believe that the judgments, estimates, and assumptions used in the preparation of our financial statements are reasonable and appropriate, based on the information available at the time they were made. However, actual results may differ from those estimates, and these differences may be material.

Pursuant to the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), as an emerging growth company, we can elect to opt out of the extended transition period for adopting any new or revised accounting standards. We have elected not to opt out of the extended transition period, which means that when a standard is issued or revised and it has different application dates for public and private companies, we may adopt the standard on the application date for private companies.

We have elected to take advantage of the scaled disclosures and other relief under the JOBS Act, and we may take advantage of some or all of the reduced regulatory and reporting requirements that will be available to us under the JOBS Act, so long as we qualify as an emerging growth company.

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Provision and Allowance for Loan Losses

The allowance for loan losses represents the estimated probable incurred loan losses in our loan portfolio and is estimated as of December 31, 2022 using the incurred loss model. The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries of previously charged-off amounts, if any, are credited to the allowance for loan losses.

The allowance for loan losses is evaluated on a regular basis by management in consideration of optimistic, moderate, and pessimistic current conditions, and is based on management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions specifically impacting each loan type by purpose and by geography, and concentrations within the loan portfolio. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

A significant amount of the allowance for loan losses is measured on a collective (pool) basis by loan type when similar risk characteristics exist. For loans evaluated collectively, the allowance for loan losses is determined using historical losses adjusted for qualitative and environmental factors to reflect current conditions. The most significant components of qualitative and environmental factors used to estimate the allowance for loan losses are adjustments relating to prevailing economic conditions and volume of the loan portfolio. The prevailing economic conditions factor is estimated based on a range of potential economic conditions and is applied at both the portfolio and individual concentration level based on various factors. This estimate is subject to significant judgment and could potentially add $3.9 million based on existing loan balances, if not more, to the allowance for loan losses in pessimistic economic conditions. The volume of the loan portfolio is estimated based on growth rates in the prior year combined with an assessment of underwriting and credit standards. This estimate is subject to significant judgment and could potentially add $2.8 million based on existing loan balances, if not more, to the allowance for loan losses based on growth due to significant changes to underwriting standards. The concentrations estimate of qualitative and environmental factors is determined by the overall market outlook and is focused on significant concentrations within the loan portfolio. This estimate is subject to significant judgment and could potentially add $7.3 million based on existing loan balances, if not more, to the allowance for loan losses based on a pessimistic market outlook for the specifically identified concentration.

Income Taxes

Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. These estimates are determined using information available in the current year and are subject to change. As of December 31, 2022, the estimated net deferred tax asset was approximately $12.3 million and was estimated using an estimated blended statutory tax rate of 29.56%. Actual enacted tax rates upon recognition of the tax asset could vary significantly from our initial estimate.

Uncertain tax positions are recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that has a likelihood greater than 50% of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. As of December 31, 2022, the Company did not recognize any uncertain tax positions.

Executive Summary

Our strategic focus is to continue to grow organically by leveraging our existing core competencies and positioning our business for success in the evolving banking landscape. In leveraging our core competencies, we intend to:

•continue our organic lending growth in our market through our “purpose-driven and integrity-centered” approach to banking;

•continue to focus and grow each of the diverse industry clusters throughout our market areas;

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•build upon the strength of our brand to deepen and broaden client relationships and grow our deposit base;

•attract additional banking professionals with track records of driving revenue growth;

•maintain our disciplined credit underwriting and robust risk management;

•enhance our disciplined cost management culture;

•leverage our technology platforms to improve our efficiency; and

•further engage in the economic development of our communities and market areas.

Highlights of the financial results are presented in the following tables:

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1The allowance for loan losses to total loans held for investment, excluding PPP loans, is considered a non-GAAP financial measure. See the section entitled “Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to the most directly comparable GAAP financial measure. Allowance for loan losses to total loans held for investment, excluding PPP loans, is defined as allowance for loan losses, divided by total loans held for investment less PPP loans. The most directly comparable GAAP financial measure is allowance for loan losses to total loans held for investment.

2Tangible shareholders’ equity to tangible assets is considered a non-GAAP financial measure. See the section entitled “Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to the most directly comparable GAAP financial measure. Tangible shareholders’ equity to tangible assets is defined as total equity less goodwill and other intangible assets, divided by total assets less goodwill and other intangible assets. The most directly comparable GAAP financial measure is total shareholders’ equity to total assets. We had no goodwill or other intangible assets as of any of the dates indicated. As a result, tangible shareholders’ equity to tangible assets is the same as total shareholders’ equity to total assets as of each of the periods indicated.

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3Tangible book value per share is considered a non-GAAP financial measure. See the section entitled “Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to the most directly comparable GAAP financial measure. Tangible book value per share is defined as total shareholders’ equity less goodwill and other intangible assets, divided by the outstanding number of common shares at the end of the period. The most directly comparable GAAP financial measure is book value per share. We had no goodwill or other intangible assets at the end of any of the dates indicated. As a result, tangible book value per share is the same as book value per share at the end of each of the periods indicated.

4For the year ended December 31, 2022, our pro forma net income, provision for income taxes, earnings per common share, ROAA, and ROAE are our actual net income, provision for income taxes, earnings per common share, ROAA, and ROAE, respectively, given that the Company was a C Corporation for the entirety of the year. For the year ended December 31, 2021, we calculate our pro forma net income, provision for income taxes, earnings per common share, ROAA, and ROAE using an effective tax rate of 19.80%, which is the actual effective tax rate, excluding the effects of the discrete deferred tax adjustment of $4.6 million, discussed in the section entitled “Provision for Income Taxes” below.

5Cash dividend payout ratio on common stock is calculated as dividends on common shares divided by basic earnings per common share.

6Pro forma ROAA and ROAE are calculated using pro forma net income, with no adjustments to average assets and average equity balances.

RESULTS OF OPERATIONS

The following discussion of our results of operations compares the year ended December 31, 2022 to the year ended December 31, 2021.

Net Interest Income

Net interest income is the most significant contributor to our net income. Net interest income represents interest income from interest-earning assets, such as loans and investments, less interest expense on interest-bearing liabilities, such as deposits, FHLB advances, subordinated notes, and other borrowings, which are used to fund those assets. In evaluating our net interest income, we measure and monitor yields on our interest-earning assets and interest-bearing liabilities as well as trends in our net interest margin. Net interest margin is a ratio calculated as net interest income divided by average interest-earning assets for the same period. We manage our interest-earning assets and funding sources in order to maximize this margin while limiting credit risk and interest rate sensitivity to our established risk appetite levels. Changes in market interest rates and competition in our market typically have the largest impact on periodic changes in our net interest margin.

Our net interest margin of 3.75% for the year ended December 31, 2022 increased from 3.64% for the year ended December 31, 2021. This increase was primarily due to a 47 basis point increase in yields on interest-earning assets, which increased from 3.83% for the year ended December 31, 2021 to 4.30% for the year ended December 31, 2022, partially offset by a 60 basis point increase in rates paid on interest-bearing liabilities, which increased from 0.32% for the year ended December 31, 2021 to 0.92% for the year ended December 31, 2022.

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Average balance sheet, interest, and yield/rate analysis. The following table presents average balance sheet information, interest income, interest expense, and the corresponding average yield earned or rates paid for each period reported. The average balances are daily averages and include both performing and nonperforming loans.

1Interest income/expense is divided by the actual number of days in the period multiplied by the actual number of days in the year to correspond to stated interest rate terms, where applicable.

2Yields on available-for-sale securities are calculated based on fair value. Investment security interest is earned on 30/360 day basis monthly. Yields are not calculated on a tax-equivalent basis.

3Average loan balance includes both loans held for investment and loans held for sale. Non-accrual loans are included in total loan balances. No adjustment has been made for these loans in the yield calculations. Interest income on loans includes amortization of deferred loan fees, net of deferred loan costs.

4Net interest spread represents the average yield earned on interest-earning assets minus the average rate paid on interest-bearing liabilities.

5Net interest margin is computed by calculating the difference between interest income and interest expense, divided by the average balance of interest-earning assets, then annualized based on the number of days in the given period.

Analysis of changes in interest income and expenses. 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 rates. The following table shows the effect that these factors had on the interest earned from our interest-earning assets and interest incurred on our interest-bearing liabilities. The effect of changes in volume is determined by multiplying the change in volume by the current period’s average rate. The effect of rate changes is calculated by

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multiplying the change in average rate by the previous period’s volume. Changes not solely attributable to volume or rates have been allocated in proportion to the respective volume and rate components.

Factors affecting interest income and yields

Interest income increased during the year ended December 31, 2022, as compared to the year ended December 31, 2021, due to the following:

•Rates. The average yields on interest-earning assets were 4.30% and 3.83% for the years ended December 31, 2022 and December 31, 2021, respectively. The increase in yields period-over-period was primarily due to increases in yields earned on loans held for sale and interest-earning deposits with banks.

•Volume. Average interest-earning assets increased by approximately $613.9 million period-over-period, driven by new loan originations, which resulted in an increase in the average daily balance of loans for the year ended December 31, 2022 and contributed to the increase in interest income.

Factors affecting interest expense and rates

Interest expense increased during the year ended December 31, 2022, as compared to the year ended December 31, 2021, due to the following:

•Rates. The average costs of interest-bearing liabilities were 0.92% and 0.32% for the years ended December 31, 2022 and December 31, 2021, respectively. The increase in cost period-over-period was primarily due to increases in the rates paid on interest-bearing deposit accounts, with the most significant increases in interest paid on time and money market accounts, combined with an increase of 300 basis points in the rates paid on FHLB advances during the year ended December 31, 2022, as compared to the prior year. The rate paid on the new subordinated debt issuance remained relatively consistent with prior issuances. Additionally, the cost of funds increased from 0.19% for the year ended December 31, 2021 to 0.57% for the year ended December 31, 2022.

•Volume. Average interest-bearing liabilities increased by $362.6 million period-over-period, primarily driven by increases in average balances for all types of interest-bearing deposit accounts, with the most substantial increases in time, interest-bearing transaction, and money market accounts. Additionally, the issuance of $75.0 million of subordinated notes due September 1, 2032 on August 17, 2022 contributed to the increase in average interest-bearing liabilities period-over-period.

Provision for Loan Losses

The provision for loan losses is based on management’s assessment of the adequacy of our allowance for loan losses. Factors impacting the provision include inherent risk characteristics in our loan portfolio, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of the change in collateral values, and the funding probability on unfunded lending commitments. The provision for loan losses is charged against

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earnings in order to maintain our allowance for loan losses, which reflects management’s best estimate of probable losses inherent in our loan portfolio at the balance sheet date.

We recorded a $6.7 million provision for loan losses in the year ended December 31, 2022, compared to a $1.7 million provision for loan losses for the year ended December 31, 2021. The increase of $5.0 million for the provision year-over-year was primarily due to increased reserves based on loan growth and economic conditions during the year ended December 31, 2022, while improved economic conditions related to the impact of the COVID-19 pandemic during the year ended December 31, 2021 provided favorable economic conditions for our borrowers, which resulted in a less significant provision for the period.

We adopted the Current Expected Credit Loss (“CECL”) accounting standard effective January 1, 2023. The CECL allowance model calculates reserves over the life of the loan and is largely driven by portfolio characteristics, economic outlook, and other key methodology assumptions versus the current accounting practice that utilizes the incurred loss model. The adoption of this ASU will result in a one-time cumulative-effect adjustment to the allowance for loan losses as of the day of adoption. We currently estimate a combined increase to our allowance for credit losses and reserve for unfunded commitments totaling between $5.0 million to $7.0 million in the aggregate. This change, net of tax benefit, will decrease the opening retained earnings balance as of January 1, 2023. The above range is disclosed due to the fact that we are still in the process of finalizing the CECL allowance mode, including the review of assumptions related to qualitative adjustments and economic forecasts; finalizing the execution of internal controls; and evaluating the impact to our financial statement disclosures.

Non-interest Income

Non-interest income is a secondary contributor to our net income. Non-interest income consists of service charges on deposit accounts, net gain on sale of securities, gain on sale of loans, loan-related fees, FHLB stock dividends, earnings on BOLI, and other income.

The following table details the components of non-interest income for the periods indicated.

Net gain on sale of securities. The decrease in net gain on sale of securities resulted primarily from the sale of approximately $47.1 million of municipal securities, U.S. government agency securities, and U.S. Treasuries during the year ended December 31, 2021, resulting in a $0.7 million gain, compared to the sale of approximately $1.6 million of municipal securities, resulting in a gain of $5.0 thousand during the year ended December 31, 2022.

Gain on sale of loans. The decrease in gain on sale of loans related primarily to an overall decline in the effective yields on loans sold due to uncertainty of the timing and magnitude of rising interest rates during the year ended December 31, 2022 compared to the year ended December 31, 2021. During the year ended December 31, 2022, approximately $50.8 million of loans were sold with an effective yield of 5.78%, as compared to approximately $41.4 million of loans sold with an effective yield of 9.46% during the year ended December 31, 2021. Additionally, a $1.8 million consumer loan portfolio was sold for a net gain of approximately $0.2 million during the year ended December 31, 2021, which did not occur during the year ended December 31, 2022.

Loan-related fees. The increase in loan-related fees was primarily a result of: (i) an increase of $0.6 million in swap referral fees; (ii) an increase of $0.2 million in program fees earned for loans originated and serviced by a third party; and (iii) a $0.2 million increase in other fee income recognized in the year ended December 31, 2022 compared to the year ended

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December 31, 2021. These increases were partially offset by a decline of $0.1 million in loan referral income recognized during the year ended December 31, 2022 compared to the year ended December 31, 2021.

FHLB stock dividends. The increase in FHLB stock dividends primarily relates to an increase in FHLB Class B shares held for the year ended December 31, 2022 compared to the year ended December 31, 2021.

Earnings on BOLI. The increase in earnings on BOLI related primarily due to an additional BOLI policy purchased during the year ended December 31, 2022. Earnings on this policy were only recognized during the year ended December 31, 2022, and did not occur during the year ended December 31, 2021.

Other income. The increase in other income resulted primarily from a $0.4 million gain recorded on two distributions received on investments in two venture-backed funds during the year ended December 31, 2022, which did not occur during the year ended December 31, 2021.

Non-interest Expense

Non-interest expense includes salaries and employee benefits, occupancy and equipment, data processing and software, FDIC insurance, professional services, advertising and promotional, loan-related expenses, and other operating expenses. In evaluating our level of non-interest expense, we closely monitor our efficiency ratio. The efficiency ratio is calculated as non-interest expense divided by the sum of net interest income and non-interest income. We constantly seek to identify ways to streamline our business and operate more efficiently, which has enabled us to reduce our non-interest expense as a percentage of our revenue while continuing to achieve growth in total loans and assets.

Over the past several years, we have invested significant resources in personnel and infrastructure. Additionally, to support corporate organizational matters leading up to the IPO, we experienced increased audit, consulting, and legal costs, particularly during the year ended December 31, 2021. As a result, professional services expenses increased during the year ended December 31, 2021. We do not anticipate incurring significant costs of this type in future periods, and we expect our efficiency ratio will improve going forward due, in part, to our past investment in infrastructure.

The following table details the components of non-interest expense for the periods indicated.

Salaries and employee benefits. The increase in salaries and employee benefits was primarily a result of a $3.6 million increase in salaries, insurance, and benefits as a result of a 9.20% increase in headcount and a $0.2 million increase in commissions expense related to increased production during the year ended December 31, 2022, as compared to the year ended December 31, 2021. The increase was partially offset by an increase in loan origination costs of $1.0 million due to increased production during the year ended December 31, 2022, as compared to the year ended December 31, 2021.

Occupancy and equipment. The increase in occupancy and equipment was primarily the result of an overall increase in depreciation recognized for furniture, fixtures, and equipment that were purchased to support the 9.20% increase in headcount described above, combined with an overall increase in occupancy expenses period-over-period.

Data processing and software. The increase in data processing and software expenditures related primarily to: (i) increased usage of our digital banking platform; (ii) higher transaction volumes related to the increased number of loan and deposit accounts; and (iii) increased number of licenses required for new users on our loan origination and documentation system.

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FDIC insurance. The increase in FDIC insurance related primarily to an increase in the FDIC assessment base and asset growth for the year ended December 31, 2022 compared to the year ended December 31, 2021.

Professional services. Professional services decreased, primarily as a result of expenses recognized during the year ended December 31, 2021 related to the increased audit, consulting, and legal costs incurred to support corporate organizational matters leading up to the Company's IPO in May 2021, which did not recur during the year ended December 31, 2022.

Advertising and promotional. The increase in advertising and promotional costs was primarily related to increases in business development, marketing, and sponsorship expenses due to more in-person participation in events held during the year ended December 31, 2022, as compared to the year ended December 31, 2021.

Loan-related expenses. The increase in loan-related expenses related primarily to: (i) $0.1 million of increased UCC filing fees to support consumer loans originated; and (ii) an overall increase in expenses incurred for insurance and taxes, loan legal fees, environmental reports, and inspections to support loan production for the year ended December 31, 2022 compared to the year ended December 31, 2021.

Other operating expenses. The increase in other operating expenses includes a $0.3 million increase related to previously unamortized subordinated debt issuance costs recognized as an other expense upon redemption of the subordinated notes in December 2022. The remainder of the increase related to: (i) $0.7 million for expenses incurred for travel and fees paid for attendance of professional events, conferences, and other business-related events; (ii) $0.3 million of increased bank charges incurred related to correspondent bank and letter of credit fees incurred to support operations; and (iii) $0.2 million of increased insurance expenses during the year ended December 31, 2022, as compared to the year ended December 31, 2021. The remainder of the change related to an overall increase in expenses to support the growth in customers period-over-period.

Provision for Income Taxes

The Company terminated its status as a Subchapter S corporation as of May 5, 2021, in connection with its IPO, and became a C Corporation. Prior to that date, as an S Corporation, the Company had no U.S. federal income tax expense. The provision recorded for the year ended December 31, 2022 yielded an effective tax rate of 28.73%. Refer to the section entitled “Pro Forma C Corporation Income Tax Expense” below for a discussion on what the Company’s income tax expense and net income potentially could have been had the Company been taxed as a C Corporation for the year ended December 31, 2021.

In conjunction with the termination of the Subchapter S corporation status as of May 5, 2021, the C Corporation deferred tax assets and liabilities were estimated for future tax consequences attributable to differences between the financial statement carrying amounts of the Company’s existing assets and liabilities and their respective tax bases. The deferred tax assets and liabilities were measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of the change in tax rates resulting from becoming a C Corporation was recognized by increasing the net deferred tax asset to $5.4 million through a reduction to the provision for income taxes of $4.6 million during the year ended December 31, 2021.

Provision for income taxes increased by $13.4 million, or 283.62%, to $18.1 million for the year ended December 31, 2022, as compared to $4.7 million for the year ended December 31, 2021. This increase is due to an increase in taxable income, combined with an increase in the effective tax rate for each period, from 9.98% to 28.73% during the years ended December 31, 2021 and December 31, 2022, respectively. The lower tax rate used during the year ended December 31, 2021 was the result of the Company's termination of its Subchapter S Corporation status as of May 5, 2021.

Pro Forma C Corporation Income Tax Expense

Because of the Company’s status as a Subchapter S Corporation prior to May 5, 2021, no U.S. federal income tax expense was recorded for a portion of the year ended December 31, 2021. Had the Company been taxed as a C Corporation and paid U.S. federal income tax for the entirety of that period, the combined statutory income tax rate would have been 29.56%. For the year ended December 31, 2021, the pro forma statutory rate reflects a U.S. federal income tax rate of 21.00% and a California state income tax rate of 8.56%, after adjustment for the federal tax benefit, on corporate taxable income. The pro forma statutory rate for the year ended December 31, 2021 was calculated using an effective tax rate of 19.80%, which is the actual effective tax rate, excluding the effects of the discrete deferred tax adjustment of $4.6 million, discussed above. As a result, the Company’s pro forma provision for income taxes and pro forma net income for the year ended December 31, 2021 were $9.3 million and $37.8 million, respectively.

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FINANCIAL CONDITION SUMMARY

The following discussion compares our financial condition as of December 31, 2022 to our financial condition as of December 31, 2021. The following table summarizes selected components of our consolidated balance sheet as of December 31, 2022 and December 31, 2021.

Total Assets

At December 31, 2022, total assets were $3.2 billion, an increase of $670.4 million from $2.6 billion at December 31, 2021, primarily due to increases in total loans held for investment.

Cash and Cash Equivalents

Total cash and cash equivalents were $260.0 million at December 31, 2022, a decrease of $165.3 million, as compared to $425.3 million at December 31, 2021. The change primarily resulted from originations of loans held for investment, net of repayments, of $848.3 million, originations of loans held for sale of $60.2 million, the redemption of subordinated notes for $28.8 million, and dividend payments of $15.3 million. These outlays were partially offset by an increase in deposits of $496.1 million, FHLB borrowings of $100.0 million, an issuance of $75.0 million of subordinated notes in August 2022, proceeds from loans held for sale of $53.7 million, maturities, prepayments, calls of securities available-for-sale of $15.5 million, and net income of $44.8 million.

Investment Portfolio

Our investment portfolio is primarily comprised of U.S. government agencies, mortgage-backed securities, and obligations of states and political subdivisions, which are high-quality liquid investments. We manage our investment portfolio according to written investment policies approved by our board of directors. Our investment strategy aims to maximize earnings while maintaining liquidity in securities with minimal credit risk and interest rate risk that is reflective of the yields obtained on those securities. Most of our securities are classified as available-for-sale, although we have one long-term, fixed rate municipal security classified as held-to-maturity.

Our total securities available-for-sale and held to maturity amounted to $119.7 million at December 31, 2022 and $153.8 million at December 31, 2021, a decrease of $34.1 million year-over-year. The decrease was primarily due to an unrealized loss (tax-effected) on securities of $12.9 million, primarily in our mortgage-backed and municipal securities portfolios, resulting in tax-effected decreases to those portfolios of $7.6 million and $6.6 million, respectively. This unrealized loss was recognized as a result of interest rate increases that occurred during the period.

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The following table presents the carrying value of our securities by their stated maturities, as well as the weighted average yields for each maturity range, at December 31, 2022:

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The following table presents the carrying value of our securities by their stated maturities, as well as the weighted average yields for each maturity range, at December 31, 2021:

Weighted average yield for securities available-for-sale is the projected yield to maturity given current cash flow projections for U.S. government agencies, mortgage-backed securities, and collateralized mortgage obligations and is a yield to worst for callable municipal securities and corporate bonds. Weighted average yield for securities held-to-maturity is the stated coupon of the bond.

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Loan Portfolio

Our loan portfolio is our largest class of interest-earning assets and typically provides higher yields than other types of interest-earning assets. Associated with the higher yields is an inherent amount of credit risk, which we attempt to mitigate with strong underwriting. As of December 31, 2022 and December 31, 2021, our total loans amounted to $2.8 billion and $1.9 billion, respectively. The following table presents the balance and associated percentage of each major product type within our portfolio as of the dates indicated.

Commercial real estate loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, manufactured home communities, self-storage facilities, hospitality properties, faith-based properties, retail shopping centers, and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers.

Commercial land and development and commercial construction loans consist of loans made to fund commercial land acquisition and development and commercial construction. The real estate purchased with these loans is generally located in or near our market.

Commercial loans consist of financing for commercial purposes in various lines of business, including manufacturing, service industry, and professional service areas. Commercial loans can be secured or unsecured but are generally secured with the assets of the company and/or the personal guaranty of the business owners.

Residential real estate and construction real estate loans consist of loans secured by single-family and multifamily residential properties which are both owner-occupied and investor owned.

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The following tables present the commercial real estate loan balance, associated percentage of commercial real estate concentrations by collateral type, estimated collateral values, and related loan-to-value (“LTV”) ranges as of the dates indicated. Revolving lines of credit with zero balance and 0.00% LTV are excluded from this table. Collateral values are determined at origination using third-party real estate appraisals or evaluations. Updated appraisals, which are included in the table below, are obtained for loans that are downgraded to watch or substandard. Loans over $1.0 million are reviewed annually, at which time an internal assessment of collateral values is completed.

1Types of collateral in the “all other types” category are those that individually make up less than 5.00% commercial real estate concentration and include hospitality properties, auto dealerships, car washes, assisted living communities, country clubs, gas stations/convenience stores, medical offices, special purpose properties, mortuaries, restaurants, and schools.

Over the past few years, we have experienced significant growth in our loan portfolio, although the relative composition of the portfolio has not changed significantly (when PPP loans are excluded). Our primary focus remains commercial real estate lending (including commercial, commercial land and development, and commercial construction), which constitutes 88.87% of our portfolio at December 31, 2022. Commercial secured lending (consisting primarily of SBA 7(a) loans under $350,000) represents 5.89% of our portfolio at December 31, 2022. We sell the guaranteed portion of all SBA 7(a) loans, excluding PPP loans, in the secondary market and will continue to do so as long as market conditions continue to be favorable.

We recognize that our commercial real estate loan concentration is significant within our balance sheet. Commercial real estate loan balances as a percentage of risk-based capital were 680.34% and 577.92% as of December 31, 2022 and

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December 31, 2021, respectively. We have established internal concentration limits in the loan portfolio for commercial real estate loans by sector (i.e., manufactured home communities, self-storage, hospitality, etc.). All loan sectors were within our established limits as of December 31, 2022. Additionally, our loans are geographically concentrated with borrowers and collateral properties primarily in California.

We believe that our past success is attributable to focusing on products and markets where we have significant expertise. Given our concentrations, we have established strong risk management practices, including risk-based lending standards, self-established product and geographical limits, annual evaluations of income property loans, and semi-annual top-down and bottom-up stress testing. We expect to continue growing our loan portfolio. We do not expect our product or geographic concentrations to materially change.

The following table sets forth the contractual maturities of our loan portfolio at December 31, 2022:

The following table sets forth the contractual maturities of our loan portfolio at December 31, 2021:

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The following table sets forth the sensitivity to interest rate changes of our loan portfolio at December 31, 2022:

The following table sets forth the sensitivity to interest rate changes of our loan portfolio at December 31, 2021:

Asset Quality

We manage the quality of our loans based upon trends at the overall loan portfolio level as well as within each product type. We measure and monitor key factors that include the level and trend of classified, delinquent, non-accrual, and nonperforming assets, collateral coverage, credit scores, and debt service coverage, where applicable. These metrics directly impact our evaluation of the adequacy of our allowance for loan losses.

Our primary objective is to maintain a high level of asset quality in our loan portfolio. We believe our underwriting practices and policies, established by experienced professionals, appropriately govern the risk profile for our loan portfolio. These policies are continually evaluated and updated as necessary. All loans are assessed and assigned a risk classification at origination based on underlying characteristics of the transaction, such as collateral cash flow, collateral coverage, and borrower strength. We believe that we have a comprehensive methodology to proactively monitor our credit quality after the origination process. Particular emphasis is placed on our commercial portfolio, where risk assessments are reevaluated as a result of reviewing commercial property operating statements and borrower financials. On an ongoing basis, we also monitor payment performance, delinquencies, and tax and property insurance compliance. We design our practices to

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facilitate the early detection and remediation of problems within our loan portfolio. Assigned risk classifications are an integral part of management assessing the adequacy of our allowance for loan losses. We periodically employ the use of an independent consulting firm to evaluate our underwriting and risk assessment process. Like other financial institutions, we are subject to the risk that our loan portfolio will be exposed to increasing pressures from deteriorating borrower credit due to general economic conditions.

Nonperforming Assets

Our nonperforming assets consist of nonperforming loans and foreclosed real estate, if any. Nonperforming loans consist of non-accrual loans and loans contractually past due by 90 days or more and still accruing. Loans on which the accrual of interest has been discontinued are designated as non-accrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal or when a loan becomes contractually past due by 90 days or more with respect to interest or principal. When a loan is placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans only when they are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.

Troubled Debt Restructurings

We consider a loan to be a TDR when we have granted a concession and the borrower is experiencing financial difficulty. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under our internal underwriting policy. A TDR loan generally is kept on non-accrual status until, among other criteria, the borrower has paid for six consecutive months with no payment defaults, at which time the TDR may be placed back on accrual status.

PPP Loan Forgiveness

At December 31, 2021, there were 60 PPP loans outstanding totaling $22.1 million. All PPP loans had been forgiven or paid off by the borrower as of December 31, 2022.

SBA 7(a) Payments Made Under the CARES Act

Section 1112 of the CARES Act required the SBA to make payments on new and existing 7(a) loans for up to six months. The Consolidated Appropriations Act, 2021 amended this section of the CARES Act to extend the payment on 7(a) loans in existence on March 27, 2020, beginning on February 1, 2021, for up to eight or eleven months, depending on the borrower’s industry code, and to require the SBA to make up to three months of payments on new 7(a) loans approved between February 1, 2021 and September 30, 2021. These payments are not deferments but rather full payments of principal and interest that the borrower will not be responsible for in the future. In the year ended December 31, 2022, the SBA made payments under this program on 29 of our SBA 7(a) loans, totaling $161.0 thousand in principal and interest. No additional payments are expected.

SBA Loans

During 2022, the Company sold 172 SBA 7(a) loans with government-guaranteed portions totaling $50.8 million. Of the loans sold in 2022, the Company received gross proceeds of $53.7 million, resulting in a net gain on sale of $2.9 million.

During 2021, the Company sold 169 SBA 7(a) loans with government-guaranteed portions totaling $41.4 million. Of the loans sold in 2021, the Company received gross proceeds of $45.3 million, resulting in a net gain on sale of $3.9 million.

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Non-accrual Loans

The following table provides details of our nonperforming and restructured assets and certain other related information as of the dates presented:

The ratio of non-accrual loans to period end loans was 0.01% at December 31, 2022, decreasing from 0.03% as of December 31, 2021, partially due to a decline in our non-accrual loans.

The ratio of the allowance for loan losses to period end non-accrual loans increased from 3,954.30% as of December 31, 2021 to 7,026.98% as of December 31, 2022. The increase was primarily due to a 22.14% increase in the allowance for loan losses from December 31, 2021 to December 31, 2022, combined with a 31.29% reduction in period end non-accrual loans from December 31, 2021 to December 31, 2022, which was primarily due to a decrease of $0.2 million in commercial secured non-accrual loans from December 31, 2021 to December 31, 2022.

Potential Problem Loans

We utilize a risk grading system for our loans to aid us in evaluating the overall credit quality of our real estate loan portfolio and assessing the adequacy of our allowance for loan losses. All loans are grouped into a risk category at the time of origination. Commercial real estate loans over $1.0 million are reevaluated at least annually for proper classification in conjunction with our review of property and borrower financial information. All loans are reevaluated for proper risk grading as new information such as payment patterns, collateral condition, and other relevant information comes to our attention.

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The banking industry defines loans graded substandard or doubtful as “classified” loans. Loans by credit quality risk rating were as follows as of the periods indicated:

Loans designated as watch or substandard, which are not considered adversely classified, increased to $22.3 million at December 31, 2022 from $19.3 million at December 31, 2021. Loans designated as watch increased period-over-period, primarily due to an increase in commercial real estate loans designated as watch, resulting in a net increase in reserves related to watch loans. Loans designated substandard decreased period-over-period, primarily due to a payoff of commercial real estate loans designated as substandard, resulting in a net decrease in reserves related to substandard loans. In total, reserves related to classified and watch loans decreased by $12.0 thousand period-over-period, which was offset by additional provision for loan growth. There were no loans with doubtful risk grades at December 31, 2022 or December 31, 2021.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries of previously charged-off amounts, if any, are credited to the allowance for loan losses.

The allowance for loan losses is evaluated on a regular basis by management and is based on management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and

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prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

While the entire allowance for loan losses is available to absorb losses from any and all loans, the following table represents management’s allocation of our allowance for loan losses by loan category, and the percentage of the allowance for loan losses allocated to each category, for the periods indicated.

The allowance for loan losses was $28.4 million at December 31, 2022, as compared to $23.2 million at December 31, 2021. The $5.2 million increase is due to a $6.7 million provision for loan losses recorded during the year ended December 31, 2022, offset by net charge-offs of $1.5 million during the year ended December 31, 2022.

The following table is a summary of the allowance for loan losses by loan class as of the periods indicated:

The ratio of allowance for loan losses to total loans held for investment was 1.02% at December 31, 2022, compared to 1.20% at December 31, 2021. Excluding PPP loans, the ratio of the allowance for loan losses to total loans held for investment was 1.02% and 1.22% at December 31, 2022 and 2021, respectively. See the section entitled “Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to the most directly comparable GAAP financial measure. Non-accrual loans totaled $0.4 million, or 0.01% of total loans held for investment, at December 31, 2022, decreasing from $0.6 million, or 0.03% of total loans held for investment, at December 31, 2021.

Liabilities

During 2022, total liabilities increased by $652.6 million from $2.3 billion at December 31, 2021 to $3.0 billion at December 31, 2022. This increase was primarily due to an increase in total deposits of $496.1 million, comprised of increases of $69.1 million in non-interest-bearing deposits and $427.0 million in interest-bearing deposits, FHLB advances of $100.0 million, and subordinated notes issued of $75.0 million, partially offset by subordinated notes redeemed of $28.8 million.

Deposits

Representing 93.53% of our total liabilities as of December 31, 2022, deposits are our primary source of funding for our business operations.

Total deposits increased by $496.1 million, or 21.70%, to $2.8 billion at December 31, 2022 from $2.3 billion as of December 31, 2021. Deposit increases were attributed to an increase in the number of new relationships, as well as fluctuations in our existing accounts. Non-interest-bearing deposits increased by $69.1 million in 2022 to $1.0 billion, and

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represented 34.91% of total deposits at December 31, 2022, as compared to 39.46% of total deposits at December 31, 2021. Our loan to deposit ratio was 100.67% at December 31, 2022, as compared to 85.09% at December 31, 2021. The increase in the ratio coincided with growth in our business. We closely monitor the loan to deposit ratio for purposes of both operational objectives and regulatory capital compliance. We intend to continue to operate our business with a loan to deposit ratio within the range of these levels.

The following tables summarize our deposit composition by average deposits and average rates paid for the periods indicated:

Uninsured deposits, excluding time deposits, totaled $1.2 billion and $1.3 billion at December 31, 2022 and 2021, respectively.

As of December 31, 2022, our 40 largest deposit relationships, each accounting for more than $10.0 million, totaled $1.5 billion, or 52.15% of our total deposits. As of December 31, 2021, our 26 largest deposit relationships, each accounting for more than $10.0 million, totaled $912.7 million, or 39.93% of our total deposits. Overall, our large deposit relationships have been relatively consistent over time and have helped to continue to grow our deposit base. Our large deposit relationships are comprised of the following entity types as of the periods indicated:

Our largest single deposit relationship at December 31, 2022 related to a government agency. The balances for this customer were $180.0 million, or 6.47% of total deposits, as of that date. At December 31, 2021, our largest single deposit relationship related to a non-profit association that supports hospitals and health systems and had balances of $155.0 million, or 6.78% of total deposits, at that date. As our demand deposits fluctuate during a rising rate environment, we have purchased brokered deposits as needed to supplement liquidity. We do not consider brokered deposits as core deposits, but as another deposit funding source for our loan growth.

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The following table sets forth the maturity of time deposits as of December 31, 2022:

FHLB Advances and Other Borrowings

From time to time, we utilize short-term collateralized FHLB borrowings to maintain adequate liquidity. There was $100.0 million of borrowings outstanding as of December 31, 2022 and no borrowings outstanding as of December 31, 2021.

In 2022, we issued subordinated notes of $75.0 million. This debt was issued to investors in private placement transactions. See Note 9, Long Term Debt and Other Borrowings, in the notes to our consolidated financial statements included in this Annual Report on Form 10-K for additional information regarding these subordinated notes. The proceeds of the notes constitute Tier 2 capital under the regulatory capital rules of the federal banking agencies. The following table is a summary of our outstanding subordinated notes as of December 31, 2022:

On December 15, 2022, we redeemed $25.0 million and $3.8 million of subordinated notes issued on September 28, 2017 and November 8, 2019, respectively. Both subordinated notes were paid off using proceeds from the issuance of the subordinated notes of $75.0 million as discussed above.

Shareholders’ Equity

Shareholders’ equity totaled $252.8 million at December 31, 2022 and $235.0 million at December 31, 2021. The increase in shareholders’ equity was primarily attributable to net income recognized of $44.8 million, partially offset by a net decline of $12.9 million in other comprehensive income resulting from rising interest rates and $15.3 million in cash distributions paid during the year ended December 31, 2022.

Liquidity and Capital Resources

Liquidity Management

We manage liquidity based upon factors that include the level of diversification of our funding sources, the composition of our deposit types, the availability of unused funding sources, our off-balance sheet obligations, the amount of cash and liquid securities we hold, and the availability of assets to be readily converted into cash without undue loss. As the primary federal regulator of the Bank, the FDIC evaluates the liquidity of the Bank on a stand-alone basis pursuant to applicable guidance and policies.

Liquidity refers to our capacity to meet our cash obligations at a reasonable cost. Our cash obligations require us to have cash flow that is adequate to fund loan growth and maintain on-balance sheet liquidity while meeting present and future obligations of deposit withdrawals, borrowing maturities, and other contractual cash obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints in accessing sources of funds, and the ability to convert assets into cash. Changes in

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economic conditions or exposure to credit, market, operational, legal, or reputational risks could also affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity management.

The Company is a corporation separate and apart from the Bank and, therefore, must provide for its own liquidity, including liquidity required to meet its debt service requirements on its subordinated debt. The Company’s main source of cash flow is dividends declared and paid to it by the Bank. There are statutory and regulatory limitations that affect the ability of the Bank to pay dividends to the Company, including various legal and regulatory provisions that limit the amount of dividends the Bank can pay to the Company without regulatory approval. Under the California Financial Code, payment of a dividend from the Bank to Bancorp without advance regulatory approval is restricted to the lesser of the Bank’s retained earnings or the amount of the Bank’s net income from the previous three fiscal years less the amount of dividends paid during that period. We believe that these limitations will not impact our ability to meet our ongoing short-term cash obligations. For contingency purposes, the Company maintains a minimum level of cash to fund one year’s projected operating cash flow needs plus two years’ subordinated notes debt service. We continually monitor our liquidity position in order to meet all reasonably foreseeable short-term, long-term, and strategic liquidity demands. Management has established a comprehensive process for identifying, measuring, monitoring, and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include effective corporate governance, consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems, including stress tests, that are commensurate with the complexity of our business activities; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory, or operational impediments that can be used to meet liquidity needs in stress situations; comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the Bank’s liquidity risk management process.

Our liquidity position is supported by management of our liquid assets and liabilities and access to alternative sources of funds. Our liquidity requirements are met primarily through our deposits, FHLB advances, and the principal and interest payments we receive on loans and investment securities. Cash on hand, cash at third-party banks, investments available-for-sale, and maturing or prepaying balances in our investment and loan portfolios are our most liquid assets. Other sources of liquidity that are routinely available to us include funds from retail and wholesale deposits, advances from the FHLB, and proceeds from the sale of loans. Less commonly used sources of funding include borrowings from the Federal Reserve Bank of San Francisco discount window, draws on established federal funds lines from unaffiliated commercial banks, and the issuance of debt or equity securities. We believe that we have ample liquidity resources to fund future growth and meet other cash needs as necessary.

Sources and Uses of Cash

Our executive officers and board of directors review our sources and potential uses of cash in connection with our annual budgeting process. Generally speaking, our principal funding source is cash from gathering of deposits, and our principal uses of cash include funding of loans, operating expenses, income taxes, and dividend payments, as described below. We also had significant cash inflows as a result of our subordinated note issuance in 2022 and our IPO in 2021.

Based on our current capital allocation objectives, during 2023, we project spending $1.3 million related to continued build-out of our IT systems and processes and allocating $12.3 million of cash for dividends on our common stock.

For the 12-month period ending December 31, 2023, we project that our fixed commitments could potentially include: (i) approximately $329.1 million to fund off-balance sheet commitments outstanding at December 31, 2022; (ii) $5.8 million for IT services, IT support, and compliance expenditures; and (iii) $1.0 million for operating leases. In future years, we expect that our main sources and uses of cash will relate primarily to regular operating activities.

As of December 31, 2022, management believes the above-mentioned sources will provide adequate liquidity during the next twelve months for the Bank to meet its operating needs.

IPO

On May 7, 2021, we completed our IPO at a price of $20.00 per share. We raised approximately $111.2 million in net proceeds after deducting underwriting discounts and commissions of approximately $8.5 million and certain estimated

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offering expenses payable by us of approximately of $1.3 million. The net proceeds, less $2.1 million in other related expenses, including audit fees, legal fees, listing fees, and other expenses, totaled $109.1 million.

Loans

Loans are a significant use of cash in daily operations, and a source of cash as customers make payments on their loans or as loans are sold to other financial institutions. Cash flows from loans are affected by the timing and amount of customer payments and prepayments, changes in interest rates, the general economic environment, competition, and the political environment.

During the year ended December 31, 2022, we had cash outflows of $848.3 million in loan originations and advances, net of principal collected, and $60.2 million in loans originated for sale.

Additionally, we enter into commitments to extend credit in the ordinary course of business, such as commitments to fund new loans and undisbursed construction funds. While these commitments represent contractual cash requirements, a portion of these commitments to extend credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. At December 31, 2022, total off-balance sheet commitments totaled $329.1 million. We expect to fund these commitments to the extent utilized primarily through the repayment of existing loans, deposit growth, and liquid assets.

Deposits

Deposits are our primary source of funding for our business operations, and the cost of deposits has a significant impact on our net interest income and net interest margin.

Our deposits are made up of primarily money market and non-interest-bearing demand deposits. Aside from commercial and business clients, a significant portion of our deposits are from municipalities and non-profit organizations. Cash flows from deposits are impacted by the timing and amount of customer deposits, changes in market rates, and collateral availability.

During the year ended December 31, 2022, we had significant cash inflows related to an increase in deposits of $496.1 million, primarily as a result of an increase in the number of new relationships, fluctuations in existing accounts, and new certificates of deposit.

Over the next twelve months, approximately $339.3 million of time deposits are expected to mature. In addition, we expect $3.2 million of time deposits to mature through 2027. As these time deposits mature, some of these deposits may not renew due to the competition in the Bank's marketplace. However, based on our historical runoff experience, we expect the outflow will not be significant and can be replenished through our organic growth in deposits. We believe our emphasis on local deposits, combined with our third-party financing availability, as discussed below, provides a stable funding base.

Investment Securities

Our investment securities totaled $119.7 million at December 31, 2022. At December 31, 2022, 51.17% and 35.22% of our investment portfolio consisted of mortgage-backed securities and obligations of states and political subdivisions, respectively. Cash proceeds from mortgage-backed securities result from payments of principal and interest by borrowers. Cash proceeds from obligations of states and political subdivisions occur when these securities are called or mature. Assuming the current prepayment speed and interest rate environment, we expect to receive approximately $8.6 million from our securities over the next twelve months. In future periods, we expect to maintain approximately the same level of cash flows from our securities. Depending on market yield and our liquidity, we may purchase securities as a use of cash in our interest-earning asset portfolio.

During the year ended December 31, 2022, we had cash proceeds from sales, maturities, calls, and prepayments of securities of $17.1 million, partially offset by cash outflows of $2.6 million related to investment securities purchased. Additionally, at December 31, 2022, securities available-for-sale totaled $116.0 million, of which $40.5 million have been pledged as collateral for borrowings and other commitments.

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Future Contractual Obligations

Our estimated future obligations as of December 31, 2022 include both current and long-term obligations. Under our operating leases as discussed in Note 15, Commitments and Contingencies, we have a current obligation of $1.0 million and a long-term obligation of $3.5 million. We also have a current obligation of $339.3 million and a long-term obligation of $3.2 million related to time deposits, as discussed in Note 8, Interest-Bearing Deposits. We have net subordinated notes of $73.6 million, all of which are long-term obligations. Finally, we have one significant contract for core processing services. While the actual obligation is unknown and dependent on certain factors, including volume and activity, when using our 2022 average monthly expense extrapolated over the remaining life of the contract, we estimate that our current obligation under this contract is $0.5 million. We do not have a long-term obligation under this contract until it is renewed.

FHLB Financing

The Bank is a shareholder of the FHLB, which enables the Bank to have access to lower-cost FHLB financing when necessary. At December 31, 2022, the Bank had outstanding borrowings of $100.0 million and a total financing availability of $216.3 million, net of letters of credit issued of $686.5 million.

Impact of Inflation

Our consolidated financial statements and related notes have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of operations. Unlike most industrial companies, nearly all of our assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on our performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods or services.

Dividends

A use of liquidity for the Company is shareholder dividends. Bancorp paid dividends to its shareholders totaling $15.3 million during the year ended December 31, 2022, including a cash distribution in the amount of $5.0 million paid on March 17, 2022 to shareholders of record as of May 3, 2021, for the Company's final AAA payout, which was described in further detail in the Company’s Proxy Statement filed with the SEC and mailed to shareholders on April 6, 2022.

We expect to continue our current practice of paying quarterly cash dividends with respect to our common stock subject to our board of directors’ discretion to modify or terminate this practice at any time and for any reason without prior notice. We believe our quarterly dividend rate per share, as approved by our board of directors, enables us to balance our multiple objectives of managing our business and returning a portion of our earnings to our shareholders. Assuming continued payment during 2023 at a rate of $0.15 per share, which is the rate of each of our last five quarterly dividend payments, our average total dividend paid each quarter would be approximately $2.6 million based on the number of current outstanding shares if there are no increases or decreases in the number of shares, and given that unvested RSAs share equally in dividends with outstanding common stock.

Historical Information

The following table summarizes our consolidated cash flow activities:

Operating Activities

Net cash provided by operating activities increased by $17.3 million for the year ended December 31, 2022 as compared to the year ended December 31, 2021, primarily due to higher net income and an increase in loans originated for sale, partially offset by increases in the provision for loan losses and proceeds from sale of loans. Various other, less material items made

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up the remainder of the change. Cash provided by operating activities is subject to variability period-over-period as a result of timing differences, including with respect to the collection of receivables and payments of interest expense, accounts payable, and bonuses.

For additional information about our operating results, see “Results of Operations” above.

Investing Activities

Net cash used in investing activities increased by $381.9 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, primarily due to an increase in originations of loans held for investment, net of repayments, partially offset by a decrease in purchases of securities available-for-sale.

Financing Activities

Net cash provided by financing activities increased by $64.4 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, primarily due to issuance of subordinated notes, use of FHLB advances, and fewer cash dividends paid, partially offset by the redemption of subordinated notes and no issuance of common stock.

Capital Adequacy

We manage our capital by tracking our level and quality of capital with consideration given to our overall financial condition, our asset quality, our level of allowance for loan losses, our geographic and industry concentrations, and other risk factors on our balance sheet, including interest rate sensitivity.

Bancorp and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements as set forth in the following tables can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on our consolidated financial statements. The Bank and Bancorp are subject to minimum risk-based and leverage capital requirements under federal regulations implementing the Basel III framework, and the Bank is subject to regulatory thresholds that must be met for an insured depository institution to be classified as “well-capitalized” under the prompt corrective action framework. Under capital adequacy guidelines, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items, as calculated under regulatory accounting practices. Capital amounts for Bancorp and the Bank, as well as the Bank’s prompt corrective action classification, are also subject to qualitative judgments by the regulators about components of capital, risk weightings, and other factors. As of December 31, 2022, both Bancorp and the Bank were in compliance with all applicable regulatory capital requirements, and the Bank qualified as “well-capitalized” under the prompt corrective action framework.

Management reviews capital ratios on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet our anticipated future needs. For all periods presented, the Bank’s ratios exceed the regulatory definition of “well-capitalized” under the regulatory framework for prompt corrective action, and Bancorp’s ratios exceed the minimum ratios that would be required for it to be considered a well-capitalized bank holding company.

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The capital adequacy ratios as of December 31, 2022 and December 31, 2021 for Bancorp and the Bank are presented in the following tables. As of December 31, 2022 and December 31, 2021, Bancorp’s Tier 2 capital included subordinated debt, which was not included at the Bank level.

Recent Accounting Pronouncements

For a discussion of the expected impact of accounting pronouncements recently adopted and accounting pronouncements recently issued but not yet adopted by us as of December 31, 2022, see Note 2, Recently Issued Accounting Standards, of our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. On January 1, 2023, the Company will adopt ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the Current Expected Credit Loss model. The Company estimates the adoption of

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ASU No. 2016-13 will result in an increase to our allowance for credit losses and reserve for unfunded commitments totaling between $5.0 million to $7.0 million in the aggregate.

Non-GAAP Financial Measures

Some of the financial measures discussed herein are non-GAAP financial measures. In accordance with SEC rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP in our consolidated statements of income, balance sheets, statements of shareholders’ equity, or statements of cash flows.

Allowance for loan losses to total loans held for investment, excluding PPP loans, is defined as allowance for loan losses, divided by total loans held for investment less PPP loans. The most directly comparable GAAP financial measure is allowance for loan losses to total loans held for investment.

Tangible shareholders’ equity to tangible assets is defined as total equity less goodwill and other intangible assets, divided by total assets less goodwill and other intangible assets. The most directly comparable GAAP financial measure is total shareholders’ equity to total assets. We had no goodwill or other intangible assets at the end of any period indicated. As a result, tangible shareholders’ equity to tangible assets is the same as total shareholders’ equity to total assets at the end of each of the periods indicated.

Tangible book value per share is defined as total shareholders’ equity less goodwill and other intangible assets, divided by the outstanding number of common shares at the end of the period. The most directly comparable GAAP financial measure is book value per share. We had no goodwill or other intangible assets at the end of any period indicated. As a result, tangible book value per share is the same as book value per share at the end of each of the periods indicated.

We believe that these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition, results of operations, and cash flows computed in accordance with GAAP. However, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other banking companies use. Other banking companies may use names similar to those we use for the non-GAAP financial measures we disclose, but may calculate them differently. You should understand how we and other companies each calculate their non-GAAP financial measures when making comparisons.

The following reconciliation table provides a more detailed analysis of these non-GAAP financial measures along with their most directly comparable financial measures calculated in accordance with GAAP.