HAWTHORN BANCSHARES, INC. (HWBK) FY 2022 MD&A

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Crucial to the Company's community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, Hawthorn Bank (the "Bank"), the Company, with $1.9 billion in assets at December 31, 2022, provides a broad range of commercial and personal banking services. The Bank's specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration ("SBA") loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area.

The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and residential mortgage lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.

The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

The Company's subsidiary bank is a full-service bank that conducts general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust and brokerage services.

The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC") to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.

Significant Developments and Transactions

Each item listed below materially affects the comparability of our results of operations for each of the years in the three-years ended December 31, 2022, and our financial condition as of December 31 for each of the three-years ended, and may affect the comparability of financial information we report in future fiscal periods.

CRITICAL ACCOUNTING POLICIES

The following accounting policies are considered most critical to the understanding of the Company's financial condition and results of operations. These critical accounting policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the Company's critical accounting policies on its business operations are discussed throughout Management's

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Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.

Allowance for Loan Losses

Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the Company's results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. The Company’s allowance for loan losses represents management’s best estimate of losses inherent in the loan portfolio. The policy is designed to maintain the allowance at a level sufficient to absorb reasonably estimated and probable losses within the portfolio. A mathematical calculation of an estimate is made to assist in determining the adequacy and reasonableness of management’s recorded allowance for loan losses.

The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.

The ending result of this process is a recorded consolidated allowance for loan losses that represents management’s best estimate of the total incurred losses included in the loan portfolio considering available information, from internal and external sources, relevant to assessing exposure to credit loss over the contractual term of the instrument. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond the Company’s control, including the performance of its portfolios, the economy, and changes in interest rates. As such, significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on the Company’s Provision for credit losses and allowance for loan losses reported in its Consolidated Income Statements and Consolidated Balance Sheets, respectively.

Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company's business operations is provided in Note 1 to the Company's consolidated financial statements and is also discussed in the Lending and Credit Management section below.

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Consolidated Financial Highlights

The Company has prepared all of the consolidated financial information in this report in accordance with United States ("U.S.") generally accepted accounting principles ("GAAP"). In preparing the consolidated financial statements in accordance with GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

1.Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue includes net interest income and non-interest income.

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(1)Tier 1 leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets and still accruing interest.

Results of Operations Highlights

Consolidated net income decreased $1.8 million to $20.8 million, or $3.06 per diluted share, for the year ended December 31, 2022 compared to $22.5 million, or $3.27 per diluted share, for the year ended December 31, 2021. For the year ended December 31, 2022, the return on average assets ("ROA") was 1.16%, the return on average stockholders' equity ("ROE") was 15.94%, and the efficiency ratio was 66.7%.

Consolidated net income increased $8.2 million to $22.5 million, or $3.27 per diluted share, for the year ended December 31, 2021 compared to $14.3 million, or $2.04 per diluted share, for the year ended December 31, 2020. For the year ended December 31, 2021, the ROA was 1.30%, the ROE was 16.46%, and the efficiency ratio 65.0%.

Net interest income was $58.8 million for the year ended December 31, 2022 compared to $58.5 million and $53.3 million for the years ended December 31, 2021 and 2020, respectively. The net interest margin was 3.53% for the year ended December 31, 2022 compared to 3.62% and 3.48% for the years ended December 31, 2021 and 2020, respectively.

Provision expense. The Company recognized a negative provision expense for loan losses of $0.9 million for the year ended December 31, 2022 compared to a negative provision expense of $1.7 million and a provision expense of $5.8 million for the years ended December 31, 2021 and 2020, respectively. The negative provision expense in 2022 and 2021 primarily resulted from returning significant loan balances to accrual status from non-accrual status. Uncertain economic conditions resulting from the COVID-19 pandemic impacted the recognition of provision expense in 2020.

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Non-interest income decreased $2.8 million, or 16.7%, for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $1.8 million, or 12.1%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. These changes are discussed in greater detail below under the Non-interest Income and Expense section.

Non-interest expense decreased $0.4 million, or 0.9%, for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $3.9 million, or 8.8%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. These changes are discussed in greater detail below under the Non-interest Income and Expense section.

Balance Sheet Highlights

Loans – Loans held for investment increased $219.1 million, or 16.8%, to $1.5 billion as of December 31, 2022 compared to $1.3 billion as of December 31, 2021, and increased $15.2 million, or 1.2%, to $1.3 billion as of December 31, 2021 compared to $1.3 billion as of December 31, 2020.

Asset quality – Non-performing loans decreased $6.8 million to $18.7 million, or 1.23% of total loans, at December 31, 2022 compared to $25.5 million, or 1.96% of total loans, at December 31, 2021, and decreased $9.1 million to $25.5 million, or 1.96% of total loans, at December 31, 2021 compared to $34.6 million, or 2.69% of total loans, at December 31, 2020. The reduction in non-performing loans primarily resulted from non-accrual loan relationships returning to accrual status in both 2022 and 2021.

The allowance for loan losses to total loans was 1.02% at December 31, 2022, compared to 1.30% at December 31, 2021 and 1.41% at December 31, 2020. The Company's net charge-offs for the year ended December 31, 2022, were $0.4 million, or 0.03% of average loans compared to net recoveries of $0.5 million, or 0.04% of average loans for the year ended December 31, 2021, and net charge-offs of $0.2 million, or 0.01% of average loans for the year ended December 31, 2020. See the Lending and Credit Management section below for further discussion.

Deposits – Total deposits increased $115.3 million, or 7.6%, equal to $1.6 billion as of December 31, 2022 compared to $1.5 billion as of December 31, 2021, and increased $133.2 million, or 9.6%, to $1.5 billion as of December 31, 2021 compared to $1.4 billion as of December 31, 2020.

Capital – Total shareholder’s equity was $127.4 million and the common equity to assets ratio was 6.62% at December 31, 2022 as compared to 8.13% and 7.53% at December 31, 2021 and December 31, 2020, respectively. Regulatory capital ratios remain “well-capitalized,” with a tier 1 leverage ratio of 10.76% and a total risk-based capital ratio of 13.85% at December 31, 2022.

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Average Balance Sheets

Net interest income is the largest source of revenue resulting from the Company's lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest-earning assets and interest-bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest-bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the years in the three-year periods ended December 31, 2022, 2021, and 2020, respectively. The average balances used in this table and other statistical data were calculated using average daily balances.

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the years ended December 31, 2022, 2021 and 2020, respectively. Such adjustments totaled $2.1 million, $1.8 million and $1.0 million for the years ended December 31, 2022, 2021, and 2020, respectively.

(2)Non-accruing loans are included in the average amounts outstanding.

(3)Fees and costs on loans are included in interest income ($0.4 million, $5.4 million, and $1.8 million of PPP fees for the years ended December 31, 2022, 2021 and 2020, respectively, were included in commercial loan income).

Rate and Volume Analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest-earning assets and interest-bearing liabilities, identifying changes related to volumes and rates for the years ended December 31, 2022 compared to December 31, 2021, and for the years ended December 31, 2021 compared to December 31, 2020. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the years ended December 31, 2022, 2021 and 2020, respectively. Such adjustments totaled $2.1 million, $1.8 million and $1.0 million for the years ended December 31, 2022, 2021, and 2020, respectively.

(2)Non-accruing loans are included in the average amounts outstanding.

(3)Fees and costs on loans are included in interest income ($0.4 million, $5.4 million, and $1.8 million of PPP fees for the years ended December 31, 2022, 2021 and 2020, respectively, were included in commercial loan income).

Financial results for the year ended December 31, 2022 compared to the year ended December 31, 2021 reflected an increase in net interest income, on a tax equivalent basis, of $0.4 million, or 0.7%, and financial results for the year ended December 31, 2021 compared to the year ended December 31, 2020 reflected an increase of $6.1 million, or 11.2%.

Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) was 3.53% for the year ended December 31, 2022, compared to 3.62% and 3.48% for the years ended December 31, 2021 and 2020, respectively.

The increase in net interest income and decrease in net interest margin for 2022 compared to 2021 resulted from higher interest income from loan growth of 9.7% and a 4.1% increase in the investment portfolio, offset by higher interest expense for interest bearing liabilities and a reduction of fee income from loans under the SBA's Paycheck Protection Program ("PPP"). The increase in net interest income and net interest margin for 2021 over 2020 was primarily due to an increase in PPP income and a decrease in rates paid on average interest-bearing liabilities. The Company earned $0.4 million in 2022 compared to $5.4 million and $1.8 million in 2021 and 2020, respectively, in PPP fees.

Average interest-earning assets increased $52.2 million, or 3.1%, to $1.72 billion for the year ended December 31, 2022 compared to $1.67 billion for the year ended December 31, 2021, and average interest-bearing liabilities increased $50.7 million, or 4.4%, to $1.19 billion for the year ended December 31, 2022 compared to $1.14 billion for the year ended December 31, 2021.

Average interest-earning assets increased $107.9 million, or 6.9%, to $1.67 billion for the year ended December 31, 2021 compared to $1.56 billion for the year ended December 31, 2020, and average interest-bearing liabilities decreased $5.0 million, or 0.4%, to $1.14 billion for the year ended December 31, 2021 compared to $1.15 billion for the year ended December 31, 2020.

Total interest income (expressed on a fully taxable equivalent basis) increased to $71.3 million for the year ended December 31, 2022 compared to $66.3 million and $64.0 million for the years ended December 31, 2021 and 2020, respectively. The Company's rates earned on interest-earning assets were 4.14% for the year ended December 31, 2022 compared to 3.97% and 4.10% for the years ended December 31, 2021 and 2020, respectively.

Interest income on loans held for investment increased to $63.4 million for the year ended December 31, 2022 compared to $59.9 million and $58.6 million for the years ended December 31, 2021 and 2020, respectively.

Average loans outstanding increased $124.1 million, or 9.7%, to $1.41 billion for the year ended December 31, 2022 compared to $1.28 billion for the year ended December 31, 2021. The average yield on loans receivable decreased to 4.51% during the year ended December 31, 2022 compared to 4.67% for the year ended December 31, 2021.

Average loans outstanding increased $38.2 million, or 3.1%, to $1.28 billion for the year ended December 31, 2021 compared to $1.24 billion for the year ended December 31, 2020. The average yield on loans receivable decreased to 4.67% during the year ended December 31, 2021 compared to 4.71% for the year ended December 31, 2020. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Interest income on available-for-sale securities increased to $7.2 million for the year ended December 31, 2022 compared to $5.6 million and $4.2 million for the years ended December 31, 2021 and 2020, respectively.

Average securities increased $10.8 million, or 4.1%, to $273.3 million for the year ended December 31, 2022 compared to $262.5 million for the year ended December 31, 2021. The average yield on securities increased to 2.62% for the year ended December 31, 2022 compared to 2.15% for the year ended December 31, 2021.

Average securities increased $70.5 million, or 36.7%, to $262.5 million for the year ended December 31, 2021 compared to $192.0 million for the year ended December 31, 2020. The average yield on securities decreased to 2.15% for the year ended December 31, 2021 compared to 2.19% for the year ended December 31, 2020. See the Liquidity Management section for further discussion.

Total interest expense was $10.5 million for the year ended December 31, 2022 compared to $5.9 million and $9.7 million for the years ended December 31, 2021 and 2020, respectively. The Company's rate paid on interest-bearing liabilities was 0.88% for the year ended December 31, 2022 compared to 0.52% and 0.85% for the years ended December 31, 2021 and 2020, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits was $7.1 million for the year ended December 31, 2022 compared to $3.1 million and $5.9 million for the years ended December 31, 2021 and 2020, respectively.

Average interest-bearing deposits increased $88.5 million, or 9.1%, to $1.06 billion for the year ended December 31, 2022 compared to $967.9 million for the year ended December 31, 2021. The average cost of deposits increased to 0.68% during the year ended December 31, 2022 compared to 0.32% for the year ended December 31, 2021.

Average interest-bearing deposits increased $19.6 million, or 2.1%, to $967.9 million for the year ended December 31, 2021 compared to $948.3 million for the year ended December 31, 2020. The average cost of deposits decreased to 0.32% during the year ended December 31, 2021 compared to 0.62% for the year ended December 31, 2020.

Interest expense on borrowings was $3.4 million for the year ended December 31, 2022 compared to $2.8 million and $3.9 million for the years ended December 31, 2021 and 2020, respectively.

Average borrowings were $138.3 million for the year ended December 31, 2022 compared to $176.2 million and $200.7 million for the years ended December 31, 2021 and 2020, respectively. The average cost of borrowings increased to 2.45% for the year ended December 31, 2022 compared to 1.57% and 1.93% for the years ended December 31, 2021, and 2020, respectively. The increase in cost of funds is consistent with increases in prime resulting from higher market interest rates.

The decrease in average borrowings from 2021 compared to 2022 and 2021 compared to 2020 was primarily due to a decrease in advances from the Federal Home Loan Bank of Des Moines ("FHLB"). The Company will continue to use FHLB advances as a source of funding when conditions warrant. See the Liquidity Management section for further discussion.

Non-interest Income and Expense

Non-interest income for the years ended December 31, 2022, 2021, and 2020 was as follows:

*Total revenue is calculated as net interest income plus non-interest income.

Total non-interest income decreased $2.8 million, or (16.7)%, to $14.0 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $1.8 million, or 12.1%, to $16.8 million for the year ended December 31, 2021 compared to the year ended December 31, 2020.

Bank card income and fees increased $0.1 million, or 3.2%, to $4.1 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $0.8 million, or 23.6%, to $4.0 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The increases were primarily related to increases in debit card usage and interchange fees. As the economy began to recover from the COVID 19 pandemic, the Company began to see an increase in spending due to both stimulus income and a reduction of conservative savings due to the uncertainty of the pandemic.

Real estate servicing fees, net of the change in valuation of mortgage servicing rights was $1.0 million for the year ended December 31, 2022 compared to $0.6 million and $(0.05) million for the years ended December 31, 2021 and 2020, respectively. During 2022, mortgage rates significantly increased to over 6.0% for a new thirty-year conforming mortgage, and the discount rates used in the valuation of mortgage servicing rights increased as yields and risk increased contributing to increase in the valuation of mortgage servicing rights in 2022 compared to 2021. When comparing the change from 2021 to 2020, the dramatic drop in market interest rates in 2020 created an economic incentive for borrowers to refinance their existing home mortgage loans that slowed in 2021.

Mortgage loan servicing fees earned on loans sold were $0.8 million for the year ended December 31, 2022 compared to $0.8 million and $0.9 million for the years ended December 31, 2021 and 2020, respectively. The Company was servicing

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$240.5 million of mortgage loans at December 31, 2022, compared to $270.0 million and $292.7 million at December 31, 2021 and 2020, respectively.

Gain on sales of mortgage loans decreased $4.5 million to $2.7 million for the year ended December 31, 2022 compared to $7.2 million for the year ended December 31, 2021, and increased $0.1 million to $7.2 million for the year ended December 31, 2021 compared to $7.1 million for the year ended December 31, 2020. The Company sold loans totaling $87.2 million for the year ended December 31, 2022 compared to $206.6 million and $195.9 million for the years ended December 31, 2021 and 2020, respectively. The Company experienced strong sales in the secondary market in 2020 that slowed during the fourth quarter of 2021 as market rates continued to rise throughout 2022.

Other income increased $1.4 million to $2.0 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $0.1 million to $0.7 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The increase in the year ended December 31, 2022 over the year ended December 31, 2021 primarily resulted from an increase in the interest component of net pension cost and a decrease in the valuation allowance for other real estate owned, partially offset by a decrease in mortgage loan derivative income.

Investment Securities Gains (Losses), Net

The following table presents the gross unrealized gains and losses from sales and calls of available-for-sale securities, as well as gains and losses on equity securities from fair value adjustments which have been recognized in earnings for the years ended December 31, 2022, 2021, and 2020:

Non-interest expense for the years ended December 31, 2022, 2021, and 2020 was as follows:

*Efficiency ratio is calculated as non-interest expense as a percentage of total revenue. Total revenue includes net interest income and non-interest income.

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Total non-interest expense decreased $0.4 million, or 0.9%, to $48.5 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $3.9 million, or 8.8%, to $49.0 million for the year ended December 31, 2021 compared to the year ended December 31, 2020.

Salaries decreased $0.1 million, or 0.5%, to $20.6 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $1.0 million, or 4.8%, to $20.7 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The decrease for the year ended December 31, 2022 over the year ended December 31, 2021 was primarily due to decreases in incentive pay and deferred loan costs related to loan volume. The increase for the year ended December 31, 2021 over the year ended December 31, 2020 was primarily due to merit increases and incentive pay related to loan volume.

Employee benefits decreased $0.5 million, or 7.1%, to $6.4 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $0.6 million, or 8.7%, to $6.9 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The decrease for the year ended December 31, 2022 over the year ended December 31, 2021 was primarily due to a decrease in 401(k) plan contributions, medical premiums, and pension cost due to higher annual discount rate assumptions compared to the prior year's annual assumptions. The increase for the year ended December 31, 2021 over the year ended December 31, 2020 was primarily due to higher pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions, and an increase in 401(k) plan contributions.

Processing, network, and bank card expense increased $0.04 million, or 0.8%, to $4.8 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $0.9 million, or 23.0%, to $4.8 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The increase for the year ended December 31, 2022 over the year ended December 31, 2021 was primarily due to increases in credit card and ATM interchange fees partially offset by decreases in network expense. The increase for the year ended December 31, 2021 over the year ended December 31, 2020 was primarily due to increases in network, processing, and debit card processing expenses.

Legal, examination, and professional fees decreased $1.4 million, or 46.1%, to $1.6 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $1.6 million, or 107.4%, to $3.0 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The changes for the years ended 2022 over 2021 and 2021 over 2020 were related to $1.5 million in legal fees accrued as of December 31, 2021 for a lawsuit that was settled in January 2022.

Other non-interest expense increased $1.4 million, or 30.7%, to $5.9 million for the year ended December 31, 2022 compared to the year ended December 31, 2021, and increased $0.2 million, or 4.6%, to $4.5 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The increase for the year ended December 31, 2022 over the year ended December 31, 2021 was primarily related to the change in the fair value of mortgage banking derivatives, as well as increases in insurance expense, telephone, donations, and software expense related to network upgrades and maintenance agreements. The increase in the year ended December 31, 2021 over the year ended December 31, 2020 was primarily due to increases in FDIC assessment expense, deposit product expense, software expense related to new mortgage loan software, and telephone and internet expense related to a bank-wide telephone system upgrade and new system providers.

Income Taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 17.3% for the year ended December 31, 2022 compared to 20.2% and 18.2% for the years ended December 31, 2021 and 2020, respectively.

The decrease in the effective tax rate for the year ended December 31, 2022 compared to the year ended December 31, 2021 was primarily attributable to the decrease in earnings, increase in tax-exempt income, and the benefit recorded pertaining to the historical tax credit. The increase in the effective tax rate for the year ended December 31, 2021 compared to the year ended December 31, 2020 was primarily attributable to an increase in earnings and an increase in state taxes attributed to elevated earnings. The effective tax rate for each of the years ended December 31, 2022, 2021, and 2020, respectively, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free revenues.

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Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 78.3% of total assets as of December 31, 2022 compared to 70.2% as of December 31, 2021.

Lending activities are conducted pursuant to an established loan policy approved by the Bank's Board of Directors. The Bank's credit review process is overseen by regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.

A summary of loans, by major class within the Company's loan portfolio:

(a)Includes $0.01 million and $8.4 million SBA PPP loans, net at December 31, 2022 and 2021, respectively.

The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in credit extensions to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in non-accrual, past due, or restructured loans if such assets were loans.

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The contractual maturities of loan categories at December 31, 2022 and the composition of those loans between fixed rate and floating rate loans are as follows:

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. For the year ended December 31, 2022, the Company sold approximately $87.2 million of loans to investors compared to $206.6 million and $195.9 million for the years ended December 31, 2021 and 2020, respectively. At December 31, 2022, the Company was servicing approximately $240.5 million of loans sold to the secondary market compared to $270.0 million at December 31, 2021, and $292.7 million at December 31, 2020.

Risk Elements of the Loan Portfolio

Management, the senior loan committee, and the internal loan review department formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Loans in excess of $2.0 million in the aggregate and all adversely classified credits identified by management are reviewed by the senior loan committee. In addition, all other loans are reviewed on a risk weighted selection process. The senior loan committee reviews and reports to the Board of Directors, on a monthly basis, past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided by the Financial Accounting Standards Board ("FASB") under Accounting Standards Codification ("ASC") Topic 310-10-35 in identifying and measuring loan impairment. If

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management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below.

Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type; loss emergence factors; lending policies and procedures; economic conditions; the nature, volume and terms of the portfolio; lending staff and management; non-accrual loans; the loan review system; collateral values; concentrations of credit; and external factors. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.

Nonperforming Assets

The following table summarizes nonperforming assets:

(a)Non-performing loans include loans 90 days past due and accruing, non-accrual loans, and non-performing TDRs (defined below) included in non-accrual loans and 90 days past due.

(b)Non-performing assets include non-performing loans and other real estate owned and repossessed assets.

Total non-performing assets were $27.5 million, or 1.81% of total loans, at December 31, 2022 compared to $36.0 million, or 2.76% of total loans, at December 31, 2021.

Total non-accrual loans at December 31, 2022 decreased $6.8 million to $18.7 million compared to $25.5 million at December 31, 2021. The decrease in non-accrual loans was primarily due to three large non-accrual loan relationships returning to accrual status. The Company's asset quality continues to improve during a turbulent economic environment.

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Loans past due 90 days and still accruing interest at December 31, 2022, were $1,000 compared to $14,000 at December 31, 2021. Other real estate owned and repossessed assets at December 31, 2022 were $8.8 million compared to $10.5 million at December 31, 2021. During the year ended December 31, 2022, $0.2 million of non-accrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $0.7 million for the year ended December 31, 2021.

As of December 31, 2022, approximately $12.8 million compared to $13.8 million at December 31, 2021, of loans classified as substandard, which include loans classified as performing troubled debt restructurings ("TDRs") and are not included in the non-performing asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at December 31, 2022 and December 31, 2021, respectively.

The following table summarizes the Company's TDRs at the dates indicated:

At December 31, 2022, loans classified as TDRs totaled $1.9 million, with $0.2 million of specific reserves compared to $2.4 million of loans classified as TDRs, with $0.2 million of specific reserves at December 31, 2021. Both performing and non-performing TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan's effective interest rate, or the fair value of the underlying collateral less applicable selling costs if the loan is collateral dependent. The net decrease in total TDRs from December 31, 2021 to December 31, 2022 was primarily due to approximately $0.5 million of payments received on TDRs.

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Allowance for Loan Losses and Provision

Allowance for Loan Losses

The following table is a summary of the allocation of the allowance for loan losses:

The allowance for loan losses was $15.6 million, or 1.02%, of loans outstanding at December 31, 2022 compared to $16.9 million, or 1.30%, of loans outstanding at December 31, 2021. The ratio of the allowance for loan losses to non-performing loans was 83.35% at December 31, 2022, compared to 66.36% at December 31, 2021.

The following table is a summary of the general and specific allocations of the allowance for loan losses:

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At December 31, 2022, $0.3 million of the Company's allowance for loan losses was allocated to impaired loans totaling approximately $20.4 million, compared to $3.0 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $27.3 million at December 31, 2021. Management determined that $17.7 million, or 87%, of total impaired loans required no reserve allocation at December 31, 2022 compared to $16.6 million, or 61%, at December 31, 2021, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experienced by loan type. The look-back period begins with loss history in the first quarter of 2012 as the starting point through the current quarter. Management determined that the look-back period should be expanded until a loss producing downturn is recognized. This would be accomplished by allowing the look-back period to shift forward by eliminating the earliest loss period and replenishing it with losses from the most recent period. The look-back period is consistently evaluated for relevance given the current facts and circumstances.

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These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods, which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.

The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.

The specific and general reserve allocations represent management's best estimate of probable losses inherent in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

The decrease in the allowance for loan losses from December 31, 2021 to December 31, 2022 primarily resulted from transitioning loans impacted by COVID-19 from non-accrual status back to performing status, partially offset by additional loan growth. This transition was made according to the Company’s established internal loan policies regarding loan performance as well as outside consultation of industry experts. This transition back to performing status also reduced specific reserves based on the attributes of the individual loan collateral to the general allocations method described above. The Company continues to monitor the risks associated with its non-performing loans.

Provision

The Company recognized a negative provision expense for loan losses of $0.9 million for the year ended December 31, 2022 compared to a negative provision expense of $1.7 million and a provision expense of $5.8 million for the years ended December 31, 2021 and 2020, respectively. The negative provision expense in 2022 and 2021 primarily resulted from returning significant loan balances to accrual status from non-accrual status. Uncertain economic conditions resulting from the COVID-19 pandemic impacted the recognition of provision expense in 2020.

Net Loan Charge-offs (Recoveries)

The Company's net loan charge-offs were $0.4 million, or 0.03% of average loans, for the year ended December 31, 2022 compared to net recoveries of $0.5 million, or 0.04% of average loans, for the year ended December 31, 2021.

The following table is a summary of net charge-offs (recoveries) to average loans:

Loans Held For Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale. In the fourth quarter of 2021, the Company elected the fair value option for all newly originated long-term personal real estate loans held for sale.

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The loans are primarily sold to Freddie Mac, Fannie Mae, and PennyMac and other various secondary-market investors. At December 31, 2022, the carrying amount of these loans was $0.6 million compared to $2.2 million at December 31, 2021.

Investment Portfolio

The Company's investment portfolio consists of securities classified as available-for-sale, equity or other. Available-for-sale debt securities, the largest component, are carried at estimated fair value. Unrealized holding gains and losses from available-for-sale securities are excluded from earnings and reported, net of applicable taxes, as a separate component of stockholders' equity until realized.

The Company does not engage in trading activities and, accordingly, does not have any debt or equity securities classified as trading securities. Historically, the Company's practice was to purchase and hold debt instruments until maturity unless special circumstances existed. However, since the investment portfolio's major function is to provide liquidity and to balance the Company's interest rate sensitivity position, all debt securities are now classified as available-for-sale.

At December 31, 2022, the investment portfolio classified as available-for-sale represented 13.0% of total consolidated assets. Future levels of investment securities can be expected to vary depending upon liquidity and interest-sensitivity needs, as well as other factors.

Available-for-Sale Securities

The following table presents the composition of the investment portfolio and related fair value by major category:

(a)Certain hybrid instruments possessing characteristics typically associated with debt obligations.

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As of December 31, 2022, the expected maturity and tax-equivalent yield in the investment portfolio was as follows:

(1)Mortgage-backed securities have been included using historic repayment speeds. Repayment speeds were determined from actual portfolio experience during the 12 months ended December 31, 2022 calculated separately for each mortgage-backed security. These repayment speeds are not necessarily indicative of future repayment speeds and are subject to change based on changing mortgage interest rates. The tax equivalent yield is calculated on amortized cost using a level yield method and a 21% tax rate.

(2)Rates on obligations of states and political subdivisions have been adjusted to fully taxable equivalent rates using the statutory federal income tax rate of 21%.

At December 31, 2022, $12.2 million of debt securities classified as available-for-sale in the table above had variable rate provisions with adjustment periods ranging from one week to 12 months.

Other Investment Securities

Other investment securities include equity securities with readily determinable fair values and other investments securities that do not have readily determinable fair values. Investments in FHLB stock, and Midwest Independent BankersBank ("MIB") stock, that do not have readily determinable fair values, are required for membership in those organizations.

Liquidity and Capital Resources

Liquidity Management

The role of liquidity management is to ensure funds are available to meet depositors' withdrawal demands and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers.

The Company's Asset/Liability Committee, primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity.

The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company's most liquid assets are comprised of available-for-sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve Bank.

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $250.7 million at December 31, 2022 and included an unrealized net loss of $46.4 million. The portfolio includes projected maturities and mortgage-backed securities pay-downs of approximately $9.5 million over the next 12 months, which offer resources to meet either new loan demand or reductions in the Company's deposit base.

The Company pledges portions of its investment securities portfolio as collateral to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. The Company's unpledged securities in the available-for-sale portfolio totaled approximately $139.2 million and $35.5 million at December 31, 2022 and 2021, respectively.

Total investment securities pledged for these purposes were as follows:

Liquidity is available from the Company's base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. Such deposits totaled $1.5 billion and represented 91.7% of the Company's total deposits at December 31, 2022, compared to $1.4 billion and 94.1% of the Company's total deposits at December 31, 2021. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships.

Core deposits at December 31, 2022 and 2021 were as follows:

Maturities of uninsured time deposits with balances over $250,000 as of December 31, 2022 were as follows:

Estimated uninsured deposits totaled $420.3 million, including $94.9 million of certificates of deposit, at December 31, 2022, compared to $513.5 million, including $69.1 million of certificates of deposit, at December 31, 2021. The Company had brokered deposits totaling $40.1 million and $20.2 million at December 31, 2022 and 2021, respectively.

Other components of liquidity are the level of borrowings from third-party sources and the availability of future credit. The Company's outside borrowings are comprised of securities sold under agreements to repurchase, FHLB advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of December 31, 2022, under agreements with these unaffiliated banks, the Bank may borrow up to $60.0 million in federal funds on an unsecured basis and up to $8.1 million on a secured basis. There were no federal funds purchased outstanding at December 31, 2022. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company's investment portfolio. At December 31, 2022, there were $5.2 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at December 31, 2022.

As a member of the FHLB, the Bank has access to credit products of the FHLB. As of December 31, 2022, the Bank had $98.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million at December 31, 2022 in outstanding subordinated notes issued to wholly owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at December 31, 2022 and 2021 were as follows:

The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the Company may draw advances against this collateral.

The following table reflects the advance equivalent of the assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company.

At December 31, 2022, loans of $681.8 million were pledged to the FHLB as collateral for borrowings and letters of credit. At December 31, 2022, investments with a market value of $8.6 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Sources and Uses of Funds

Cash and cash equivalents were $83.7 million at December 31, 2022 compared to $159.9 million at December 31, 2021. The $76.2 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the year ended December 31, 2022. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $20.3 million for the year ended December 31, 2022.

Investing activities, consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio, used total cash of $206.5 million. The cash outflow primarily consisted of a net increase in loans held for investment of $219.6 million and $21.3 million in purchases of investment securities partially offset by $33.2 million from maturities and calls and sales of investment securities

Financing activities provided cash of $110.1 million, resulting primarily from a $105.2 million increase in interest-bearing transaction accounts, and a $20.6 million increase in net FHLB advances. This was partially offset by a $18.6 million decrease in securities sold under agreements to repurchase. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2023.

In the normal course of business, the Company enters into certain forms of off-balance-sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance-sheet transactions in its evaluation of the Company's liquidity. The Company had $444.9 million in unused loan commitments and standby letters of credit as of December 31, 2022. Although the Company's current liquidity sources are adequate to fund this commitment level, many of the unused commitments are expected to expire or be partially used, and does not necessarily represent future cash requirements.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company's ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its common shareholders totaling approximately $4.2 million and $3.6 million for the years ended December 31, 2022 and 2021, respectively. A large portion of the Company's liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $10.5 million and $7.5 million in dividends to the Company during the years ended December 31, 2022 and 2021, respectively. At December 31, 2022 and 2021, the Company had cash and cash equivalents totaling $2.5 million and $1.8 million, respectively.

Capital Management

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.

In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act (the "Basel III Rules"). The phase-in period for the Company began on January 1, 2015. The Federal Reserve System's capital adequacy guidelines require that bank holding companies maintain a common equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.

In addition to the higher requirements, the Basel III Rules established that bank holding companies are required to maintain a common equity Tier 1 capital conservation buffer of at least 2.5% of risk-weighted assets over and above the minimum risk-based capital requirements. Institutions that do not maintain the required capital buffer will become subject to

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progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement was phased in over four years beginning in 2016. On January 1, 2016, the first phase of the requirement went into effect at 0.625% of risk-weighted assets, and increased each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of risk-weighted assets on January 1, 2019. At December 31, 2019, the capital conservation buffer requirement of 2.5% effectively raised the minimum required risk-based capital ratios to 7% common equity Tier 1 capital, 8.5% Tier 1 capital and 10.5% total capital on a fully phased-in basis.

Under the Basel III Rules, at December 31, 2022, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of December 31, for the years indicated:

Stock Dividend

For the fourteenth consecutive year, on July 1, 2022, the Company distributed a four percent stock dividend to common shareholders of record at the close of business on June 15, 2022. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect the stock dividend.

Repurchase Program

The Company's 2019 Repurchase Plan was amended during the second quarter of 2021 to authorize the purchase of up to $5.0 million in market value of the Company's common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as the timing of any such purchases.

The Company repurchased 108,724 common shares under the plan during the year ended December 31, 2022, at an average cost of $26.60 per share totaling $2.9 million. As of December 31, 2022, $2.1 million remained for share repurchase pursuant to that authorization.

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

The required payments of time deposits and other borrowed money, not including interest, at December 31, 2022 are as follows:

In the normal course of business, the Company is party to activities that contain credit, market and operational risk that are not reflected in whole or in part in the Company's consolidated financial statements. Such activities include traditional off-balance-sheet credit related financial instruments.

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The Company provides customers with off-balance-sheet credit support through loan commitments and standby letters of credit. Summarized credit-related financial instruments, including both commitments to extend credit and letters of credit at December 31, 2022 are as follows:

Since many of the unused commitments are expected to expire or be only partially used, the total amount of commitments in the preceding table does not necessarily represent future cash requirements.