MERCANTILE BANK CORP (MBWM) FY 2021 MD&A

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

The following discussion and other portions of this Annual Report contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about our company. Words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “is likely,” “plans,” “projects,” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.

Future Factors include, among others, adverse changes in interest rates and interest rate relationships; increasing rates of inflation and slower growth rates; significant declines in the value of commercial real estate; market volatility; demand for products and services; the degree of competition by traditional and non-traditional financial service companies; changes in banking regulation or actions by bank regulators; changes in prices, levies, and assessments; the impact of technological advances; potential cyber-attacks, information security breaches and other criminal activities on our computer systems; litigation liabilities; governmental and regulatory policy changes; the outcomes of existing or future contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; damage to our reputation resulting from adverse publicity, regulatory actions, litigation, operational failures, and the failure to meet client expectations and other facts; adoption of SOFR and changes in the method of determining SOFR; direct and indirect climate change matters; changes in the national and local economies, including the ongoing disruption to financial market and other economic activity caused by the Coronavirus Pandemic; and other factors described in Item 1A of this Annual Report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.

Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“Management’s Discussion and Analysis”) is based on Mercantile Bank Corporation’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and actual results could differ from those estimates. We have reviewed the analyses with the Audit Committee of our Board of Directors.

Allowance For Loan Losses: The allowance for loan losses (“allowance”) is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Loan losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results. Loans made under the Paycheck Protection Program are fully guaranteed by the Small Business Administration; therefore, such loans do not have an associated allowance.

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We complete a migration analysis quarterly to assist us in determining appropriate reserve allocation factors for non-impaired loans. Our migration takes into account various time periods; however, at year-end 2021, we placed most weight on the period starting January 1, 2011 through December 31, 2021. We believe this period represents an appropriate range of economic conditions, and that it provides for an appropriate basis in determining reserve allocation factors given current economic conditions and the general market consensus of economic conditions in the near future. Although the migration analysis provides an accurate historical accounting of our net loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data. Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and the relative aggressiveness in assigning and revising commercial loan risk ratings, with the most significant external environmental factor being the assessment of the current economic environment and the resulting implications on our loan portfolio.

We established a Covid-19 reserve allocation factor to address the Coronavirus Pandemic and its potential impact on the collectability of the loan portfolio during the second quarter of 2020. The creation of this factor reflected our belief that the traditional nine environmental factors did not sufficiently capture and address the unique circumstances, challenges and uncertainties associated with the Coronavirus Pandemic, which included unprecedented federal government stimulus and interventions, statewide mandatory closures of nonessential businesses and periodic changes to such and our ability to provide payment deferral programs to commercial and retail borrowers without the interjection of troubled debt restructuring accounting rules. We review a myriad of items when assessing this new environmental factor, including virus infection rates, economic outlooks, employment data, business closures, foreclosures, payment deferments and government-sponsored stimulus programs. The Covid-19 reserve factor resulted in a $5.3 million increase to the allowance during 2020, which increased to $6.5 million as of December 31, 2021 given the significant core commercial loan and residential mortgage loan growth during the year.

The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual principal and interest payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Impairment is evaluated on an individual loan basis. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing interest rate or at the fair value of collateral if repayment is expected solely from the collateral. The timing of obtaining outside appraisals varies, generally depending on the nature and complexity of the property being evaluated, general breadth of activity within the marketplace and the age of the most recent appraisal. For collateral dependent impaired loans, in most cases we obtain and use the “as is” value as indicated in the appraisal report, adjusting for any expected selling costs. In certain circumstances, we may internally update outside appraisals based on recent information impacting a particular or similar property, or due to identifiable trends (e.g., recent sales of similar properties) within our markets. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors are able to provide repayments, a recovery would be recorded upon receipt. Loans are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. We put loans into nonaccrual status when the full collection of principal and interest is not expected.

Financial institutions were not required to comply with the Current Expected Credit Loss (“CECL”) methodology requirements from the enactment date of the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) until the earlier of the end of the President’s declaration of a National Emergency or December 31, 2020. The Consolidated Appropriations Act, 2021, that was enacted in December 2020, provided for a further extension of the required CECL adoption date to January 1, 2022. An economic forecast is a key component of the CECL methodology. As we continued to experience an unprecedented economic environment whereby a sizable portion of the economy had been significantly impacted by government-imposed activity limitations and similar reactions by businesses and individuals, substantial government stimulus was provided to businesses, individuals and state and local governments and financial institutions offered businesses and individuals payment relief options, economic forecasts were regularly revised with no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we elected to postpone the adoption of CECL until January 1, 2022, and continued to use our incurred loan loss reserve model as permitted through December 31, 2021.

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Income Tax Accounting: Current income tax assets and liabilities are established for the amount of taxes payable or refundable for the current year. In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws for which the outcome may be uncertain. We periodically review and evaluate the status of our tax positions and make adjustments as necessary. Deferred income tax assets and liabilities are also established for the future tax consequences of events that have been recognized in our financial statements or tax returns. A deferred income tax asset or liability is recognized for the estimated future tax effects attributable to temporary differences that can be carried forward (used) in future years. The valuation of our net deferred income tax asset is considered critical as it requires us to make estimates based on provisions of the enacted tax laws. The assessment of the realizability of the net deferred income tax asset involves the use of estimates, assumptions, interpretations and judgments concerning accounting pronouncements, federal and state tax codes and the extent of future taxable income. There can be no assurance that future events, such as court decisions, positions of federal and state taxing authorities, and the extent of future taxable income will not differ from our current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings.

Accounting guidance requires us to assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, we consider both positive and negative evidence and analyze changes in near-term market conditions as well as other factors that may impact future operating results. Significant weight is given to evidence that can be objectively verified.

Securities: Securities available for sale consist of bonds and notes which might be sold prior to maturity due to changes in interest rates, prepayment risks, yield and availability of alternative investments, liquidity needs and other factors. Securities classified as available for sale are reported at their fair value. Declines in the fair value of securities below their cost that are other-than-temporary are reflected as realized losses. In estimating other-than-temporary losses, we consider: (1) the length of time and extent that fair value has been less than carrying value; (2) the financial condition and near term prospects of the issuer; and (3) our ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Fair values for securities available for sale are generally obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the current fair value of securities is recorded as a valuation adjustment and reported in other comprehensive income.

Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage loan prepayment speeds, the remaining life of the mortgage loan pool, delinquency rates, our cost to service loans and other factors to determine the cash flow that we will receive from servicing each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance.

Goodwill: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified. A more frequent assessment is performed should events or changes in circumstances indicate the carrying value of the goodwill may not be recoverable. We may elect to perform a qualitative assessment for the annual impairment test. If the qualitative assessment indicates it is more likely than not that the fair value of a reporting unit is less than its carrying amount, or if we elect not to perform a qualitative assessment, then we would be required to perform a quantitative test for goodwill impairment. If the estimated fair value of the reporting unit is less than the carrying value, goodwill is impaired and is written down to its estimated fair value.

We performed a qualitative assessment as of October 1, 2021 for which we evaluated the macro and microeconomic conditions, industry and market conditions, financial performance, and our underlying stock performance. We concluded it was more likely than not our fair value was greater than its carrying amount at the end of the period; therefore, no further testing was required. Due to stressed economic and market conditions throughout 2020, we assessed goodwill for impairment as of March 31, 2020, June 30, 2020, September 30, 2020, and October 1, 2020. No impairments were recorded in 2021 or 2020.

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INTRODUCTION

This Management’s Discussion and Analysis should be read in conjunction with the consolidated financial statements contained in this Annual Report. This discussion provides information about the consolidated financial condition and results of operations of Mercantile Bank Corporation and its consolidated subsidiary, Mercantile Bank (“our bank”), and Mercantile Insurance Center, Inc. (“our insurance company”), a subsidiary of our bank. Unless the text clearly suggests otherwise, references to “us,” “we,” “our,” or “the company” include Mercantile Bank Corporation and its wholly-owned subsidiaries referred to above.

CORONAVIRUS PANDEMIC

There remains a significant amount of stress and uncertainty across national and global economies due to the ongoing pandemic of coronavirus disease 2019 (“Covid-19”) caused by severe acute respiratory syndrome coronavirus 2 (the “Coronavirus Pandemic”). This uncertainty is heightened as certain geographic areas continue to experience surges in Covid-19 cases and governments at all levels continue to react to changes in circumstances, including supply chain disruptions and inflationary pressures.

The Coronavirus Pandemic is a highly unusual, unprecedented and evolving public health and economic crisis and may have a material negative impact on our financial condition and results of operations. We continue to occupy an asset-sensitive position, whereby interest rate environments characterized by numerous and/or high magnitude interest rate reductions have had a negative impact on our net interest income and net income. Additionally, the consequences of the unprecedented economic impact of the Coronavirus Pandemic may produce declining asset quality, reflected by a higher level of loan delinquencies and loan charge-offs, as well as downgrades of commercial lending relationships, which may necessitate additional provisions for our allowance and reduced net income.

The following section summarizes the primary measures that directly impact us and our customers.

The Paycheck Protection Program (“PPP”) reflected a substantial expansion of the Small Business Administration’s 100% guaranteed 7(a) loan program. The CARES Act authorized up to $350 billion in loans to businesses with fewer than 500 employees, including non-profit organizations, tribal business concerns, self-employed and individual contractors. The PPP provided 100% guaranteed loans to cover specific operating costs. PPP loans are eligible to be forgiven based upon certain criteria. In general, the amount of the loan that is forgivable is the sum of the payroll costs, interest payments on mortgages, rent and utilities incurred or paid by the business during a prescribed period beginning on the loan origination date. Any remaining balance after forgiveness is maintained at the 100% guarantee for the duration of the loan. The interest rate on the loan is fixed at 1.00%, with the financial institution receiving a loan origination fee from the Small Business Administration. The loan origination fees, net of the direct origination costs, are accreted into interest income on loans using the level yield methodology. The program ended on August 8, 2020. We originated approximately 2,200 loans aggregating $554 million. As of December 31, 2021, we recorded forgiveness transactions on all but ten loans aggregating $1.3 million. Net loan origination fees of $3.7 million were recorded during 2021.

The Consolidated Appropriations Act, 2021 authorized an additional $284 billion in Second Draw PPP loans (“Second Draw”). The program ended on May 31, 2021. Under the Second Draw, we originated approximately 1,200 loans aggregating $208 million. As of December 31, 2021, we recorded forgiveness transactions on about 1,000 loans aggregating $169 million. Net loan origination fees of $7.1 million were recorded during 2021.

The Internal Revenue Service has made three rounds of Individual Economic Impact Payments via direct deposit or mailed checks. In general, and subject to adjusted gross income limitations, qualifying individuals have received payments of $1,200 in April 2020, $600 in January 2021 and $1,400 in March 2021.

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From March 1, 2020 through 60 days after the end of the National Emergency (or December 31, 2020 if earlier), a financial institution may elect to suspend GAAP principles and regulatory determinations with respect to loan modifications related to Covid-19 that would otherwise be categorized as troubled debt restructurings. Banking agencies must defer to the financial institution’s election. We elected to suspend GAAP principles and regulatory determinations as permitted. The Consolidated Appropriations Act, 2021 extended the suspension date to January 1, 2022.

Financial institutions are not required to comply with the CECL methodology requirements from the enactment date of the CARES Act until the earlier of the end of the National Emergency or December 31, 2020. We elected to postpone CECL adoption as permitted. The Consolidated Appropriations Act, 2021 extended the adoption deferral date to January 1, 2022.

In early April 2020, in response to the early stages of the Coronavirus Pandemic and its pervasive impact across the economy and financial markets, we developed internal programs of loan payment deferments for commercial and retail borrowers. For commercial borrowers, we offered 90-day (three payments) interest only amendments as well as 90-day (three payments) principal and interest payment deferments. Under the latter program, borrowers were extended a 12-month single payment note at 0% interest in an amount equal to three payments, with loan proceeds used to make the scheduled payments. The single payment notes received a loan grade equal to the loan grade of each respective borrowing relationship. Certain of our commercial loan borrowers subsequently requested and received an additional 90-day (three payments) interest only amendment or 90-day (three payments) principal and interest payment deferment. Under the latter program, the amount equal to the three payments was added to the original deferment note which had nine months remaining to maturity; however, the original 0% interest rate was modified to equal the rate associated with each borrower’s traditional lending relationship with us for the remainder of the term. At the peak of activity in mid-2020, nearly 750 borrowers with loan balances aggregating $719 million participated in the commercial loan deferment program. As of December 31, 2021, we had no loans in the commercial loan deferment program.

For retail borrowers, we offered 90-day (three payments) principal and interest payment deferments, with deferred amounts added to the end of the loan. As of September 30, 2020, we had processed 260 principal and interest payment deferments with loan balances totaling $23.8 million. As of December 31, 2021, only eight borrowers with loan balances aggregating $0.4 million remained in the retail loan payment deferment program.

FINANCIAL OVERVIEW

We recorded net income of $59.0 million, or $3.69 per basic and diluted share, for 2021, compared to net income of $44.1 million, or $2.71 per basic and diluted share, for 2020. Costs and a charitable contribution related to the formation and initial funding of The Mercantile Bank Foundation decreased net income during 2021 by $3.2 million, or $0.20 per diluted share. Excluding these costs, diluted earnings per share increased $1.18, or over 43%, during 2021 compared to 2020.

Commercial loans increased $156 million during 2021, reflecting the combined net growth of core commercial loans and net activity under the PPP. Core commercial loans increased $481 million, or almost 20% during 2021, while PPP loans declined $325 million, comprised of $209 million in Second Draw PPP loans extended and $534 million in forgiveness transactions. As a percentage of total core commercial loans, commercial and industrial loans and owner occupied commercial real estate (“CRE”) loans combined equaled 57.1% at December 31, 2021, compared to 53.9% at year-end 2020. The new commercial loan pipeline remains strong, and at December 31, 2021, we had $182 million in unfunded loan commitments on commercial construction and development loans that are in the construction phase.

The overall quality of our loan portfolio remains strong, with nonperforming loans equaling 0.07% of total loans as of December 31, 2021. Accruing loans past due 30 to 89 days remain very low, and we had no foreclosed properties at year-end 2021. Gross loan charge-offs totaled $1.0 million during 2021, while recoveries of prior period loan charge-offs totaled $2.7 million, providing for net loan recoveries of $1.7 million, or 0.05% for the year.

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We recorded a negative loan loss provision expense of $4.3 million during 2021, compared to a provision expense of $14.1 million during 2020. The negative provision expense recorded during 2021 primarily reflects reduced allowance allocations associated with the economic and business conditions environmental factor, depicting improvement in both current and forecasted economic conditions, and the recording of net loan recoveries, which combined more than offset required allowance allocations necessitated by the strong net core commercial loan growth. The economic and business conditions environmental factor was upgraded during both the second and fourth quarters of 2021, resulting in an aggregate allowance reduction of $7.3 million related to these factors. The relatively large provision expense recorded during 2020 primarily reflected the onset of stressed conditions related to the Coronavirus Pandemic, including two separate downgrades of the economic and business conditions environmental factor, the introduction of the Covid-19 pandemic environmental factor to address the unique challenges and uncertainties associated with the Coronavirus Pandemic, and certain commercial loan downgrades.

Interest-earning balances, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During 2021, the average balance of these funds equaled $671 million, or 14.9% of average earning assets, compared to $357 million, or 9.2% of average earning assets, during 2020. Typically, we maintain our interest-earning balances at approximately $75 million, or about 2% of average earning assets. The elevated levels during 2021 and 2020 primarily reflect increased local deposits stemming from federal government stimulus programs and reduced business and consumer investing and spending. The excess level of interest-earning balances had a negative impact of approximately 40 basis points on our 2021 net interest margin.

Total deposits increased $672 million during 2021, and are up $1.4 billion since year-end 2019, equating to growth rates of almost 20% and over 51%, respectively. Growth in noninterest-bearing checking accounts comprised about 38% of the growth in 2021, and approximately 54% of the growth since year-end 2019.

Net interest income increased $1.8 million during 2021 compared to 2020. Both interest income and interest expense were impacted during 2021 by the Federal Open Market Committee’s (“FOMC”) federal funds rate cuts totaling 150 basis points in March 2020 and a historically low interest rate environment since that time; however, growth in earning assets, especially core commercial loans, and income associated with the PPP, has provided for the increase in net interest income. Interest income declined $4.8 million during 2021 compared to 2020, while interest expense was down $6.6 million during the same time periods.

Noninterest income was $56.2 million during 2021, compared to $45.2 million during 2020. The improved level mainly resulted from ongoing strength in our mortgage banking function and fee income generated from a commercial lending interest rate swap program that was introduced in late 2020. In addition, a gain of $1.1 million was recognized from the sale of a branch during 2021.

Noninterest expense was $111 million during 2021, compared to $98.5 million during 2020. Growth in salary expense, in large part reflecting merit and market adjustments, totaled $2.4 million in 2021. Expense associated with our bonus and stock-based compensation programs increased $2.8 million in 2021, primarily reflecting the strong 2021 operating performance. Health insurance costs were up $1.1 million in 2021, generally reflecting the Coronavirus Pandemic environment.

FINANCIAL CONDITION

Our total assets increased $820 million during 2021, and totaled $5.26 billion as of December 31, 2021. Total loans increased $260 million, interest-earning deposits were up $353 million and securities available for sale increased $205 million. Total deposits increased $672 million, securities sold under agreements to repurchase (“sweep accounts”) were up $79.1 million, and net proceeds from the issuance of subordinated notes totaled $73.6 million. In large part, increased local deposits exceeded growth in the loan and securities portfolios, with the excess funds maintained with the Federal Reserve Bank of Chicago.

Earning Assets

Average earning assets equaled 93.9% of average total assets during 2021, compared to 93.5% during 2020. The loan portfolio continued to comprise a majority of earning assets, followed by interest-earning deposits and securities. Average total loans equaled 73.7% of average earning assets during 2021, compared to 81.9% in 2020, while average interest-earning deposits and average securities comprised 14.9% and 11.4% of average earning assets during 2021 and 9.2% and 8.9% during 2020, respectively.

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Our loan portfolio has historically been primarily comprised of commercial loans. Commercial loans increased $156 million during 2021, and at December 31, 2021 totaled $2.95 billion, or 85.4% of our loan portfolio. As of December 31, 2020, the commercial loan portfolio comprised 87.5% of total loans. The increase in commercial loans reflects the combined net growth of core commercial loans and net activity under the PPP. Core commercial loans increased $481 million, or almost 20% during 2021, while PPP loans declined $325 million, comprised of $209 million in Second Draw PPP loans extended and $534 million in forgiveness transactions. Core commercial and industrial loans increased $317 million, non-owner occupied CRE loans grew $110 million, owner occupied CRE loans were up $35.8 million and multi-family and residential rental loans increased $30.5 million, while vacant land, land development and residential construction loans declined $11.8 million. As a percentage of total core commercial loans, commercial and industrial loans and owner occupied CRE loans combined equaled 57.1% at December 31, 2021, compared to 53.9% at year-end 2020. We believe our commercial loan portfolio remains well diversified.

As of December 31, 2021, availability on commercial construction and development loans that are in the construction phase totaled $182 million, with most of the funds expected to be drawn over the next 12 to 18 months. Our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods, including $212 million in new lending commitments, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report additional opportunities they are currently discussing with existing borrowers and potential new customers. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship, as well as concentration limits we have established within our commercial loan portfolio. Usage of existing commercial lines of credit was relatively stable during 2021 at approximately 40%, compared to our historical average of about 50% prior to the Coronavirus Pandemic.

Residential mortgage loans increased $105 million during 2021, totaling $443 million, or 12.8% of total loans, at December 31, 2021. As of December 31, 2020, the residential mortgage portfolio comprised 10.6% of total loans. Activity within the residential mortgage loan function remained very active throughout 2021, primarily reflecting refinance transactions spurred by low residential mortgage loan rates, strength in home purchase activity, and the continuing success of strategic initiatives that have been implemented over the past several years to gain market share and increase production. We originated $952 million in residential mortgage loans during 2021, compared to $864 million in 2020, an increase of over 10%. The production composition during 2021 was split almost evenly between refinance and purchase transactions, compared to 2020 when approximately 66% of production was comprised of refinance transactions. Residential mortgage loans originated for sale, generally consisting of longer-term fixed rate residential mortgage loans, totaled $644 million during 2021, or about 68% of the total residential mortgage loans originated, compared to approximately 78% in 2020. Residential mortgage loans originated not sold are generally comprised of adjustable rate residential mortgage loans. We remain pleased with the results of our strategic initiatives associated with the growth of our residential mortgage banking operation over the past few years, and remain optimistic that origination volumes will continue to be solid in future periods.

Other consumer-related loans declined $1.1 million during 2021, and at December 31, 2021 totaled $60.5 million, or 1.8% of total loans. As of December 31, 2020, the other consumer-related loan portfolio comprised 1.9% of total loans. We expect this loan portfolio segment to decline in dollar amount and as a percent of total loans in future periods as scheduled principal payments exceed origination volumes.

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The following table summarizes our loan portfolio:

(*) For December 31, 2021, and December 31, 2020, includes $40.1 million and $365 million in loans originated under the Paycheck Protection Program, respectively.

The following table presents total loans outstanding as of December 31, 2021, according to scheduled repayments of principal on fixed rate loans and repricing frequency on variable rate loans. Floating rate commercial loans that are currently at interest rate floors, representing approximately 50% of total commercial loans at year-end 2021, are treated as fixed rate loans and are reflected using maturity date and not repricing frequency.

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Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on the internal loan watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on impaired loans, as well as on foreclosed and repossessed assets, are reviewed periodically; however, we have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.

Nonperforming assets, comprised of nonaccrual loans, loans past due 90 days or more and accruing interest and foreclosed properties, totaled $2.5 million (0.1% of total assets) as of December 31, 2021, compared to $4.1 million (0.1% of total assets) as of December 31, 2020. The volume of nonperforming assets has remained under 0.3% of total assets since year-end 2015, and under 0.1% over the past three years. Given the low level of nonperforming loans and accruing loans 30 to 89 days delinquent, combined with a relatively steady level of watch list credits and what we believe are strong credit administration practices, we are pleased with the overall quality of the loan portfolio.

The following tables provide a breakdown of nonperforming assets by property type:

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The following tables provide a reconciliation of nonperforming assets:

Gross loan charge-offs totaled $1.0 million during 2021, while recoveries of prior period loan charge-offs totaled $2.7 million, providing for net loan recoveries of $1.7 million, or 0.05% of average total loans. We continue our collection efforts on charged-off loans, and expect to record recoveries in future periods; however, given the nature of these efforts, it is not practical to forecast the dollar amount and timing of the recoveries.

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The following table summarizes changes in the allowance for the past five years. For the years 2019, 2018, and 2017, presented loan and allowance data are reflective of only originated loans and the allowance for originated loans. We terminated the application of purchase accounting associated with our merger with Firstbank effective January 1, 2020.

(*) For the December 31, 2020 column, the balance of allowance for loans at beginning of year includes the December 31, 2019 balance of the allowance for acquired loans.

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The following table illustrates the breakdown of the allowance for loans balance by loan type (dollars in thousands) and of the total loan portfolio (in percentages). For the years 2019, 2018, and 2017, presented loan and allowance data are reflective of only originated loans and the allowance for originated loans. We terminated the application of purchase accounting associated with our merger with Firstbank effective January 1, 2020.

The following table depicts the ratio of our allowance to nonperforming loans:

The increasing trend of the ratio of our allowance to nonperforming loans over the past several years generally reflects the combined impact of an increased allowance balance and reduction in nonperforming loans.

In each accounting period, we adjust the allowance to the amount we believe is necessary to maintain the allowance at an adequate level. Through the loan review and credit departments, we establish specific portions of the allowance based on specifically identifiable problem loans. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Allowance Analysis, loan loss migration analysis, composition of the loan portfolio, third party analysis of the loan administration processes and portfolio, and general economic conditions.

Financial institutions were not required to comply with the CECL methodology requirements from the enactment date of the CARES Act until the earlier of the end of the President’s declaration of a National Emergency or December 31, 2020. The Consolidated Appropriations Act, 2021, that was enacted in December 2020, provided for a further extension of the required CECL adoption date to January 1, 2022. An economic forecast is a key component of the CECL methodology. As we continued to experience an unprecedented economic environment whereby a sizable portion of the economy had been significantly impacted by government-imposed activity limitations and similar reactions by businesses and individuals, substantial government stimulus was provided to businesses, individuals and state and local governments and financial institutions offered businesses and individuals payment relief options, economic forecasts were regularly revised with no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we elected to postpone the adoption of CECL until January 1, 2022, and continued to use our incurred loan loss reserve model as permitted through December 31, 2021.

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The Allowance Analysis applies reserve allocation factors to non-impaired outstanding loan balances, the result of which is combined with specific reserves to calculate an overall allowance amount. For non-impaired commercial loans, reserve allocation factors are based on the loan ratings as determined by our standardized grade paradigms and by loan purpose. Our commercial loan portfolio is segregated into five classes: 1) commercial and industrial loans; 2) vacant land, land development and residential construction loans; 3) owner occupied real estate loans; 4) non-owner occupied real estate loans; and 5) multi-family and residential rental property loans. The reserve allocation factors are primarily based on the historical trends of net loan charge-offs through a migration analysis whereby net loan losses are tracked via assigned grades over various time periods, with adjustments made for environmental factors reflecting the current status of, or recent changes in, items such as: lending policies and procedures; economic conditions; nature and volume of the loan portfolio; experience, ability and depth of management and lending staff; volume and severity of past due, nonaccrual and adversely classified loans; effectiveness of the loan review program; value of underlying collateral; lending concentrations; and other external factors, including competition and regulatory environment.

We established a Covid-19 reserve allocation factor to address the Coronavirus Pandemic and its potential impact on the collectability of the loan portfolio during the second quarter of 2020. The creation of this factor reflected our belief that the traditional nine environmental factors did not sufficiently capture and address the unique circumstances, challenges and uncertainties associated with the Coronavirus Pandemic, which included unprecedented federal government stimulus and interventions, statewide mandatory closures of nonessential businesses and periodic changes to such and our ability to provide payment deferral programs to commercial and retail borrowers without the interjection of troubled debt restructuring accounting rules. We review a myriad of items when assessing this new environmental factor, including virus infection rates, economic outlooks, employment data, business closures, foreclosures, payment deferments and government-sponsored stimulus programs. The Covid-19 reserve factor resulted in a $5.3 million increase to the allowance during 2020, which increased to $6.5 million as of December 31, 2021 given the significant core commercial loan and residential mortgage loan growth during the year.

We recorded a negative loan loss provision expense of $4.3 million during 2021, compared to a provision expense of $14.1 million during 2020. The negative provision expense recorded during 2021 primarily reflects reduced allowance allocations associated with the economic and business conditions environmental factor, depicting improvement in both current and forecasted economic conditions, and the recording of net loan recoveries, which combined more than offset required allowance allocations necessitated by the strong net core commercial loan growth. The economic and business conditions environmental factor was upgraded during both the second and fourth quarters of 2021, resulting in an aggregate allowance reduction of $7.3 million. The relatively large provision expense recorded during 2020 primarily reflected the onset of stressed conditions related to the Coronavirus Pandemic, including two separate downgrades of the economic and business conditions environmental factor, the introduction of the Covid-19 pandemic environmental factor to address the unique challenges and uncertainties associated with the Coronavirus Pandemic, and certain commercial loan downgrades.

Adjustments for specific lending relationships, particularly impaired loans, are made on a case-by-case basis. Non-impaired retail loan reserve allocations are determined in a similar fashion as those for non-impaired commercial loans, except that retail loans are segmented by type of credit and not a grading system. We regularly review the Allowance Analysis and make adjustments periodically based upon identifiable trends and experience.

A migration analysis is completed quarterly to assist us in determining appropriate reserve allocation factors for non-impaired loans. Our migration takes into account various time periods; however, at year-end 2021 we placed most weight on the period starting January 1, 2011 through December 31, 2021. We believe this period represents an appropriate range of economic conditions, and that it provides for an appropriate basis in determining reserve allocation factors given current economic conditions and the general market consensus of economic conditions in the near future. We continue to actively monitor our loan portfolio and assess reserve allocation factors in light of the Coronavirus Pandemic and its impact on the U.S. economic environment and our borrowers in particular.

Although the migration analysis provides an accurate historical accounting of our net loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data. Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and the relative aggressiveness in assigning and revising commercial loan risk ratings, with the most significant external environmental factor being the assessment of the current economic environment and the resulting implications on our loan portfolio.

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The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and the timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors’ rights in order to preserve our collateral position.

The allowance for loans equaled $35.4 million as of December 31, 2021, or 1.0% of total loans outstanding. The allowance for loans equaled 1.2% of total loans at year-end 2020. As of December 31, 2021, the allowance for loans was comprised of $34.9 million in general reserves relating to non-impaired loans and $0.5 million in specific allocations on other loans, primarily accruing loans designated as troubled debt restructurings.

Although we believe the allowance is adequate to absorb losses as they arise, there can be no assurance that we will not sustain losses in any given period that could be substantial in relation to, or greater than, the size of the allowance. Troubled debt restructurings totaled $17.5 million at December 31, 2021, consisting of $0.8 million that are on nonaccrual status and $16.7 million that are on accrual status. The latter, while considered and accounted for as impaired loans in accordance with accounting guidelines, is not included in our nonperforming loan totals. Impaired loans with an aggregate carrying value of $0.5 million as of December 31, 2021 had been subject to previous partial charge-offs aggregating $0.5 million over the past eleven years. As of December 31, 2021, there were no specific reserves allocated to impaired loans that had been subject to a previous partial charge-off.

The following table provides a breakdown of our loans categorized as troubled debt restructurings:

Securities available for sale increased $205 million during 2021, totaling $593 million as of December 31, 2021. The securities portfolio equaled 11.4% of average earning assets during 2021, compared to 8.9% during 2020. Purchases of U.S. Government agency bonds totaled $218 million during 2021, in part reflecting the reinvestment of proceeds from called U.S. Government agency bonds that totaled $61.9 million. Purchases of U.S. Government agency guaranteed mortgage-backed securities totaled $28.8 million during 2021, consisting of investments in Community Reinvestment Act-qualified securities, in part reflecting the reinvestment of $10.5 million from principal paydowns on U.S. Government agency guaranteed mortgage-backed securities. Purchases of municipal bonds totaled $51.8 million during 2021; proceeds from matured and called municipal bonds totaled $8.0 million. No bonds were sold during 2021. At December 31, 2021, the securities portfolio was comprised of U.S. Government agency bonds (66%), municipal bonds (27%) and U.S. Government agency guaranteed mortgage-backed securities (7%). All of our securities are currently designated as available for sale, and therefore are stated at fair value. The fair value of securities designated as available for sale at December 31, 2021 totaled $593 million, including a net unrealized loss of $4.7 million. We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function.

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The following table reflects the composition of the securities portfolio:

Federal Home Loan Bank of Indianapolis (“FHLBI”) stock totaled $18.0 million as of December 31, 2021, unchanged from the balance at December 31, 2020. Our investment in FHLBI stock is necessary to engage in their advance and other financing programs. We have regularly received quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods.

Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies and municipal bonds are determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. The market value of certain non-rated securities issued by relatively small municipalities generally located within our markets is estimated at carrying value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines. Reference is made to Note 17 of the Notes to Consolidated Financial Statements for additional information.

The following table shows by class of maturities as of December 31, 2021, the amounts and weighted average yields (on a fully taxable-equivalent basis) of investment securities:

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Interest-earning deposit balances, primarily consisting of funds deposited with the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. The average balance of these funds equaled $671 million, or 14.9% of average earning assets, during 2021, compared to $357 million, or 9.2% of average earning assets, during 2020, and a more typical $115 million, or 3.5% of average earning assets, during 2019. The elevated level during 2021 and 2020 primarily reflects increased local deposits stemming from federal government stimulus programs and reduced business and consumer investing and spending. Although we expect the level of interest-earning deposit balances to gradually decline during 2022, the level will likely remain elevated throughout the year and into 2023.

Non-Earning Assets

Cash and due from bank balances averaged 1.4% of total assets during 2021, similar to the average levels during 2020, and no significant changes are expected in future periods. Net premises and equipment declined $1.7 million during 2021, equaling $57.3 million as of December 31, 2021, or 1.1% of total assets. Increases were recorded during 2021 from remodeling and new lease activities, while declines of a similar total were recorded from the sales of a branch facility (along with the associated loans and deposits) and former branch offices, along with depreciation expense.

We had no foreclosed or repossessed assets at December 31, 2021, compared to $0.7 million at December 31, 2020. Although we expect periodic transfers from loans to foreclosed and repossessed assets in future periods reflecting our collection efforts on certain impaired lending relationships, we believe the strong quality of our loan portfolio will limit any overall increase in, and average balance of, this nonperforming asset category.

Source of Funds

Total deposits increased $672 million during 2021, totaling $4.08 billion as of December 31, 2021. Local deposits increased $695 million, while out-of-area deposits decreased $23.0 million. As a percent of total deposits, out-of-area deposits declined from 1.4% at December 31, 2020 to 0.6% as of year-end 2021. FHLBI advances decreased $20.0 million during 2021, totaling $374 million as of December 31, 2021.

Noninterest-bearing checking accounts and interest-bearing checking accounts increased $245 million and $65.8 million, respectively, during 2021, in large part reflecting federal government stimulus programs, especially the PPP, as well as lower business investing and spending. Money market deposit accounts grew $428 million during 2021, of which $314 million was during the last two quarters. A portion of the growth reflects federal government stimulus programs and lower business and consumer investing and spending; however, we believe a large portion of the growth during the third and fourth quarters, consisting of large additional deposits by several existing account holders, are temporary and will be withdrawn over the next three months to six months. Savings deposits increased $56.3 million, primarily reflecting the impact of federal government stimulus programs and lower consumer investing and spending. Local time deposits decreased $100 million during 2021, in large part reflecting the maturity and withdrawal of funds from certain municipal customers and time deposits that were opened as part of a special time deposit campaign we ran in early 2019. The $23.0 million reduction in out-of-area time deposits during 2021 reflects maturities that were not replaced as the funds were no longer needed.

Total local deposits have increased $1.50 billion since December 31, 2019. Noninterest-bearing checking accounts have grown $753 million during this time period, while interest-bearing checking accounts and money market deposit accounts are up $206 million and $531 million, respectively. The increases in these transactional deposit products largely reflect federal government stimulus programs, especially the PPP, as well as lower business investing and spending. Deposit growth associated with new commercial lending relationships has also been notable. Savings deposits are up $125 million over the past two years, primarily reflecting the impact of federal government stimulus programs and lower consumer investing and spending.

Sweep accounts increased $79.1 million during 2021, totaling $197 million as of December 31, 2021. The aggregate balance of this funding type can be subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances that many of the customers maintain. The average balance of sweep accounts equaled $159 million during 2021, with a high balance of $209 million and a low balance of $113 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts to overnight interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. All of our repurchase agreements are accounted for as secured borrowings.

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FHLBI advances declined $20.0 million during 2021, reflecting maturities that were not replaced as the funds were no longer needed. FHLBI advances aggregated $374 million as of December 31, 2021. FHLBI advances are primarily used to assist in funding loan demand, as well as playing an integral role in our interest rate risk management program. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on certain commercial real estate property loans, and substantially all other assets of our bank under a blanket lien arrangement. Our borrowing line of credit at year-end 2021 totaled $889 million, with remaining availability based on collateral of $509 million.

On December 15, 2021, we entered into Subordinated Note Purchase Agreements with certain institutional accredited investors pursuant to which we issued and sold $75.0 million in aggregate principal amount of its 3.25% fixed-to-floating rate subordinated notes (“Notes”). The Notes have a stated maturity of January 30, 2032, are redeemable by us at our option, in whole or in part, on or after January 30, 2027 on any interest payment date at a redemption price of 100% of the principal amount of the Notes being redeemed. The Notes are not subject to redemption at the option of the holder. The Notes will bear interest at a fixed rate of 3.25% per year until January 29, 2027. Commencing on January 30, 2027 and through the stated maturity date of January 30, 2032, the interest rate will reset quarterly at a variable rate equal to the then-current Three-Month Term SOFR plus 212 basis points. On December 15, 2021, we injected $70.0 million of the issuance proceeds to our bank as an increase to equity capital.

On January 14, 2022, we issued an additional $15.0 million of its Notes to certain institutional accredited investors, reflecting an expansion of the $75.0 million issuance completed on December 15, 2021. The additional $15.0 million issuance was completed on the same terms as the prior offering and under the existing indenture. On January 14, 2022, we injected $15.0 million of the issuance proceeds to our bank as an increase to equity capital.

Shareholders’ equity increased $15.0 million during 2021, totaling $457 million as of December 31, 2021. Positively impacting shareholders’ equity was net income of $59.0 million, while negatively affecting shareholders’ equity were cash dividends on our common stock totaling $18.5 million and share repurchases aggregating $21.4 million. Activity relating to the issuance and sale of common stock through various stock-based compensation programs and our dividend reinvestment plan positively impacted shareholders’ equity by a total of $5.1 million. Negatively impacting shareholders’ equity during 2021 was a $9.2 million after-tax decline in the market value of available for sale securities.

RESULTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2021 and 2020

Summary

We recorded net income of $59.0 million, or $3.69 per basic and diluted share, for 2021, compared to net income of $44.1 million, or $2.71 per basic and diluted share, for 2020. Costs and a charitable contribution related to the formation and initial funding of The Mercantile Bank Foundation decreased net income during 2021 by approximately $3.2 million, or $0.20 per diluted share. Excluding the impacts of these transactions, diluted earnings per share increased $1.18, or 43.5%, during 2021 compared to 2020.

The higher level of net income during 2021 compared to 2020 resulted from a lower provision for loan losses and increased noninterest income and net interest income, which more than offset higher noninterest expense. A negative loan loss provision expense was recorded during 2021, primarily reflecting reduced allocations associated with the economic and business conditions environmental factor and the recording of net loan recoveries during the year. Growth in noninterest income during 2021 mainly reflected an increased level of fee income generated from an interest rate swap program that was introduced during the fourth quarter of 2020. Increases in all other key fee income categories also contributed to the higher level of noninterest income. The increase in net interest income during 2021 resulted from the positive impact of earning asset growth, which more than offset the negative impact of a lower net interest margin. Noninterest expense increased in 2021 compared to 2020 primarily due to higher compensation costs and the previously mentioned formation expenses and initial funding contribution associated with The Mercantile Bank Foundation.

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The following table shows some of the key performance and equity ratios for the years ended December 31, 2021 and 2020:

Net Interest Income

Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $144 million and $19.4 million during 2021, respectively, providing for net interest income of $124 million. During 2020, interest income and interest expense equaled $149 million and $26.1 million, respectively, providing for net interest income of $122 million. In comparing 2021 with 2020, interest income decreased 3.2%, interest expense was down 25.5%, and net interest income increased 1.5%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types and levels of assets and liabilities, the interest rate environment, interest rate risk, asset quality, liquidity, and customer behavior also impact net interest income as well as the net interest margin.

The $1.8 million increase in net interest income in 2021 compared to 2020 resulted from a higher level of average earning assets, which more than offset a decreased net interest margin. During 2021, the net interest margin equaled 2.76%, down from 3.17% during 2020 due to a lower yield on average earning assets, which more than offset a reduction in the cost of funds. During 2021, earning assets averaged $4.51 billion, representing an increase of $643 million, or 16.6%, from the $3.87 billion average during 2020. Average interest-earning deposits increased $315 million, average securities were up $170 million, and average loans increased $158 million. The decreased yield on average earning assets mainly resulted from a change in earning asset mix, reflecting an increase in low-yielding interest-earning deposits. A significant volume of excess on-balance sheet liquidity, which initially surfaced in the second quarter of 2020 as a result of the Covid-19 environment and persisted during the remainder of 2020 and full year 2021, negatively impacted the yield on average earning assets by 46 basis points and 27 basis points during 2021 and 2020, respectively, and the net interest margin by 39 basis points and 22 basis points during the respective periods. The excess funds, consisting primarily of low-yielding deposits with the Federal Reserve Bank of Chicago, are mainly a product of continuing local deposit growth and PPP loan forgiveness activities. Lower yields on commercial loans and securities also contributed to the decreased yield on average earning assets. The reduced yield on commercial loans primarily resulted from lower interest rates on variable-rate commercial loans resulting from the FOMC significantly decreasing the targeted federal funds rate by 150 basis points in March of 2020, along with the origination of new loans and renewal of maturing loans in the lower interest rate environment. The decreased yield on securities mainly depicted a lower level of accelerated discount accretion on called U.S. Government agency bonds and reduced yields on newly purchased agency bonds, reflecting the declining interest rate environment. The cost of funds declined from 0.67% during 2020 to 0.43% during 2021, primarily due to a change in funding mix, consisting of an increase in lower-costing non-time deposits as a percentage of total funding sources, and decreased rates paid on local time deposits, reflecting the declining interest rate environment.

The following table depicts the average balance, interest earned and paid, and weighted average rate of our assets, liabilities and shareholders’ equity during 2021, 2020 and 2019. The subsequent table also depicts the dollar amount of change in interest income and interest expense of interest-earning assets and interest-bearing liabilities, respectively, segregated between change due to volume and change due to rate. Tax-exempt securities interest income and yield for 2021, 2020 and 2019 have been computed on a tax equivalent basis using a marginal tax rate of 21.0%. Securities interest income was increased by $0.2 million in 2021, 2020 and 2019 for this non-GAAP, but industry standard, adjustment. These adjustments equated to one basis point increases in our net interest margin during all three years.

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Interest income is primarily generated from the loan portfolio, and to a significantly lesser degree, from securities and other interest-earning assets. Interest income decreased $4.8 million during 2021 from that earned in 2020, totaling $144 million in 2021 compared to $149 million in the previous year. The decrease in interest income is attributable to a lower yield on average earning assets, which more than offset the positive impact of an increased level of average earning assets. The lower yield on average earning assets mainly resulted from a change in earning asset mix. During 2021 and 2020, earning assets had an average yield (tax equivalent-adjusted basis) of 3.19% and 3.84%, respectively. On average, lower-yielding interest-earning deposits represented 14.9% of earning assets during 2021, up from 9.2% during 2020, while higher-yielding loans represented 73.7% of earning assets during 2021, down from 81.9% during 2020. The significant increase in interest-earning deposits during 2021 primarily reflected ongoing local deposit growth stemming from federal government stimulus programs and lower business and consumer investing and spending and PPP loan forgiveness activities, which outpaced loan growth and an expanded securities portfolio. A decreased yield on commercial loans, primarily reflecting reduced interest rates on variable-rate loans stemming from FOMC rate cuts and the lower interest rate environment, and a decreased yield on securities, mainly reflecting a reduced level of accelerated discount accretion on called U.S. Government agency bonds and the lower interest rate environment, also contributed to the decreased yield on average earning assets. Accelerated discount accretion on called U.S. Government agency bonds totaling $3.0 million was recorded as interest income during 2020; accelerated discount accretion totaled less than $0.1 million during 2021. The accelerated discount accretion positively impacted the yield on average earning assets during 2020 by eight basis points.

Interest income generated from the loan portfolio decreased $2.4 million in 2021 compared to the level earned in 2020; a decrease in loan yield from 4.34% in 2020 to 4.06% in 2021 resulted in a $9.0 million decline in interest income, while growth in the loan portfolio during 2021 resulted in a $6.6 million increase in interest income. The lower yield on loans mainly resulted from a decreased yield on commercial loans, which equaled 4.09% during 2021, down from 4.35% during 2020 primarily due to the aforementioned FOMC rate cuts during March of 2020 and the lower interest rate environment.

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Interest income generated from the securities portfolio decreased $2.5 million in 2021 compared to the level earned in 2020; a decrease in the yield on securities from 3.00% during 2020 to 1.51% during 2021 resulted in a $6.3 million reduction in interest income, while growth in the average balance of the securities portfolio during 2021 resulted in an increase in interest income of $3.8 million. The decreased yield on securities mainly reflected a lower level of accelerated discount accretion on called U.S. Government agency bonds being recorded as interest income during 2021 and the decreased interest rate environment. Interest income on interest-earning deposits was up slightly in 2021 compared to the level earned in 2020 as an increase in interest income stemming from growth in these balances was substantially offset by a decrease in interest income resulting from a lower yield on these balances, reflecting the decreased interest rate environment. The increase in average interest-earning deposits during 2021 primarily resulted from continuing local deposit growth and PPP loan forgiveness activities.

Interest expense is generated from interest-bearing deposits and borrowed funds. Interest expense decreased $6.6 million during 2021 from that expensed in 2020, totaling $19.4 million in 2021 compared to $26.0 million in the previous year. The decrease in interest expense largely resulted from a lower cost of funds. During 2021 and 2020, interest-bearing liabilities had a weighted average rate of 0.72% and 1.09%, respectively; a decrease in interest expense of $5.9 million was recorded during 2021 due to the reduced cost of funds. The lower average cost of interest-bearing liabilities mainly resulted from decreased costs of local deposits and borrowings and a change in funding mix. The cost of time deposits declined from 1.96% during 2020 to 1.24% during 2021 primarily due to lower rates paid on local time deposits, depicting the decreased interest rate environment, and a change in composition, mainly reflecting a decline in higher-cost brokered funds. The cost of interest-bearing non-time deposit accounts decreased from 0.28% during 2020 to 0.20% during 2021, primarily reflecting lower interest rates paid on money market accounts; the reduced interest rates mainly reflected the decreased interest rate environment. The cost of borrowed funds decreased from 1.93% during 2020 to 1.71% during 2021, mainly reflecting lower costs of FHLBI advances and subordinated debentures, along with a change in borrowing mix. The cost of FHLBI advances was 2.08% during 2021, down from 2.22% during 2020, primarily reflecting the impact of a blend and extend transaction that was executed in June of 2020 and the declining interest rate environment. The blend and extend transaction with the FHLBI, which extended the duration of our FHLBI advance portfolio as part of our interest rate risk management program, consisted of us prepaying seven advances aggregating $70.0 million with maturities ranging from August 2020 through October 2021 and fixed interest rates from 1.36% to 2.84% and averaging 1.97%, using the proceeds from seven new advances aggregating $70.0 million with maturities ranging from June 2024 through June 2027 and fixed interest rates from 0.55% to 1.18% and averaging 0.84%.

The cost of subordinated debentures was 3.80% during 2021, down from 4.80% during 2020 due to decreases in the 90-Day Libor Rate. Average lower-cost sweep accounts represented 26.3% and 23.1% of average total borrowings during 2021 and 2020, respectively, while average higher-cost FHLBI advances represented 65.0% and 67.4% of average total borrowings during the respective periods. A change in funding mix, consisting of an increase in average lower-cost interest-bearing non-time deposits and a decrease in average higher-cost time deposits as a percentage of average total interest-bearing liabilities, also contributed to the lower weighted average cost of interest-bearing liabilities during 2021 compared to 2020.

A lower average rate paid on interest-bearing non-time deposits during 2021 resulted in a $1.2 million decrease in interest expense, while a $400 million increase in the average balance of these deposits equated to a $1.0 million increase in interest expense. A lower average rate paid on time deposits during 2021 resulted in a $3.7 million decrease in interest expense, while a $117 million decrease in the average balance of time deposits equated to a $2.0 million reduction in interest expense. Interest expense related to short-term borrowings, which are comprised entirely of sweep accounts, during 2021 remained virtually unchanged compared to the prior year as a lower level of expense resulting from a slight decrease in the average rate paid on these funds was substantially offset by a higher level of expense stemming from an increase in the average balance of these funds. A lower average rate paid on average FHLBI advances during 2021 resulted in a $0.5 million reduction in interest expense, while a $5.7 million increase in the average balance of advances resulted in a $0.1 million increase in interest expense. A decreased average rate paid on other borrowings during 2021 resulted in a $0.5 million decline in interest expense, while a $3.2 million increase in average other borrowings equated to a $0.1 million increase in interest expense.

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Provision for Loan Losses

A negative loan loss provision expense of $4.3 million was recorded in 2021, compared to a provision expense of $14.1 million recorded in 2020. The negative provision expense recorded during 2021 mainly reflected reduced allocations associated with the economic and business conditions environmental factor, depicting improvement in both current and forecasted economic conditions, and the recording of net loan recoveries during the year, which more than offset required reserve allocations necessitated by net growth in core commercial loans. Approximately 80% of the provision expense recorded during 2020 consisted of increased allocations associated with existing environmental factors, including economic and business conditions, loan review, and value of underlying collateral dependent commercial loans, and an allocation stemming from the creation of a Covid-19 pandemic environmental factor. The Covid-19 pandemic environmental factor, developed during the second quarter of 2020, is designed to address the unique challenges and economic uncertainty resulting from the pandemic and its potential impact on the collectability of the loan portfolio. The provision expense recorded during 2020 also reflected the downgrading of certain non-impaired commercial loan relationships, most of which occurred during the third quarter.

During 2021, loan charge-offs totaled $1.0 million, while recoveries of prior-period loan charge-offs equaled $2.7 million, providing for net loan recoveries of $1.7 million, or 0.05% of average total loans. During 2020, recoveries of prior-period loan charge-offs totaling $0.9 million slightly exceeded loan charge-offs, providing for a nominal level of net loan recoveries. The allowance for loans, as a percentage of total loans, was 1.0% as of December 31, 2021, and 1.2% as of December 31, 2020.

Noninterest Income

Noninterest income during 2021 was $56.2 million, compared to $45.2 million during 2020. Noninterest income during 2021 included a $1.1 million gain on the sale of a branch facility, a $0.6 million recovery of loan collection costs, and $0.5 million in gains on the sales of former branch facilities. Excluding the impacts of these transactions, noninterest income increased $8.9 million, or 19.8%, during 2021 compared to 2020. The higher level of noninterest income primarily resulted from increased fee income generated from an interest rate swap program that was implemented during the fourth quarter of 2020. The interest rate swap program provides certain commercial borrowers with a longer-term fixed-rate option and assists Mercantile in managing associated longer-term interest rate risk. Growth in credit and debit card income, mortgage banking income, service charges on accounts, and payroll processing fees also contributed to the increased level of noninterest income. Mortgage banking income remained robust in 2021 as ongoing strength in purchase mortgage originations and a higher gain on sale rate more than offset the negative impacts of a decline in refinance activity and a reduced mortgage loan sold percentage. Residential mortgage loan originations totaled $952 million during 2021, approximately 10% higher than originations during 2020. Purchase transactions totaled $494 million during 2021, compared to $297 million during 2020, representing an increase of $197 million, or approximately 66%. Refinance transactions totaled $458 million during 2021, compared to $567 million during 2020, representing a decrease of $109 million, or approximately 19%. Residential mortgage loans originated for sale, generally consisting of longer-term fixed rate residential mortgage loans, totaled $644 million, or approximately 68% of total mortgage loans originated, during 2021. During 2020, residential mortgage loans originated for sale totaled $672 million, or approximately 78% of total mortgage loans originated.

Noninterest Expense

Noninterest expense totaled $111 million during 2021, compared to $98.5 million during 2020. Overhead costs during 2021 included expenses and a charitable contribution associated with the formation and initial funding of The Mercantile Bank Foundation totaling $4.0 million and net losses on sales and write-downs of former branch facilities aggregating $0.6 million, while overhead costs during the prior year included write-downs of former branch facilities totaling $1.4 million. Excluding these transactions, noninterest expense increased $9.2 million, or 9.5%, during 2021 compared to 2020. The higher level of expense primarily resulted from increased compensation costs, mainly reflecting increased regular salary expense largely stemming from annual employee merit pay increases, higher stock-based compensation expense, an increased bonus accrual, larger signing bonus payments, and increased residential mortgage lender commissions and related incentives. FDIC deposit insurance premiums increased $0.7 million in 2021 compared to 2020, mainly reflecting an increased assessment base and rate. Health insurance costs were up $1.1 million in 2021 compared to 2020 mainly due to a higher level of claims, a large portion of which resulted from the treatment of Covid-19 related medical conditions. Data processing costs increased $0.7 million in 2021 compared to 2020, in large part reflecting higher credit and debit card and software maintenance expenses.

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Federal Income Tax Expense

During 2021, we recorded income before federal income tax of $73.7 million and a federal income tax expense of $14.7 million, compared to income before federal income tax of $54.8 million and a federal income tax expense of $10.7 million during 2020. The increase in federal income tax expense in 2021 compared to 2020 resulted from the higher level of income before federal income tax. Our effective tax rate was 19.9% during 2021, compared to 19.5% during 2020.

CAPITAL RESOURCES

Shareholders’ equity increased $15.0 million during 2021, totaling $457 million as of December 31, 2021. Positively impacting shareholders’ equity was net income of $59.0 million, while negatively affecting shareholders’ equity were cash dividends on our common stock totaling $18.5 million and share repurchases aggregating $21.4 million. Activity relating to the issuance and sale of common stock through various stock-based compensation programs and our dividend reinvestment plan positively impacted shareholders’ equity by a total of $5.1 million. Negatively impacting shareholders’ equity during 2021 was a $9.2 million after-tax decline in the market value of available for sale securities.

We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. As of December 31, 2021, our bank’s total risk-based capital ratio was 13.6%, compared to 13.5% at December 31, 2020. Our bank’s total regulatory capital increased $94.6 million during 2021, primarily reflecting the net impact of net income totaling $65.1 million, a $70.0 million equity capital injection from us in association with the $75.0 million issuance of subordinated notes and cash dividends paid to us aggregating $39.0 million. Our bank’s total risk-based capital ratio was also impacted by a $659 million increase in total risk-weighted assets, in large part reflecting growth in core commercial loans, residential mortgage loans and securities. As of December 31, 2021, our bank’s total regulatory capital equaled $552 million, or $147 million in excess of the amount necessary to attain the 10.0% minimum total risk-based capital ratio, which is among the requirements to be categorized as “well capitalized.”

We maintain a stock repurchase program, which is discussed in Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” in this Annual Report.

LIQUIDITY

Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-earning deposit balances. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.

To assist in providing needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, comprised of deposits from customers outside of our market areas and advances from the FHLBI, totaled $398 million, or 8.5% of combined deposits and borrowed funds as of December 31, 2021, compared to $441 million, or 11.2% of combined deposits and borrowed funds, as of December 31, 2020.

Sweep accounts increased $79.1 million during 2021, totaling $197 million as of December 31, 2021. The aggregate balance of this funding type can be subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances that many of the customers maintain. The average balance of sweep accounts equaled $159 million during 2021, with a high balance of $209 million and a low balance of $113 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts to overnight interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. All of our repurchase agreements are accounted for as secured borrowings.

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Information regarding our repurchase agreements as of December 31, 2021 and during 2021 is as follows:

FHLBI advances declined $20.0 million during 2021, reflecting maturities that were not replaced as the funds were no longer needed. FHLBI advances aggregated $374 million as of December 31, 2021. FHLBI advances are primarily used to assist in funding loan demand, as well as playing an integral role in our interest rate risk management program. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on certain commercial real estate property loans, and substantially all other assets of our bank under a blanket lien arrangement. Our borrowing line of credit at year-end 2021 totaled $889 million, with remaining availability based on collateral of $509 million.

We also have the ability to borrow up to $70.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. These lines of credit were not accessed during 2021. In contrast, our interest-earning deposit account at the Federal Reserve Bank of Chicago averaged $633 million during 2021. We have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Using certain municipal bonds as collateral, we could have borrowed up to $34.1 million at December 31, 2021. We did not utilize this line of credit in over ten years, and do not plan to access this line of credit in future periods.

The following table reflects, as of December 31, 2021, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:

In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. At December 31, 2021, we had a total of $1.53 billion in unfunded loan commitments and $33.1 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $1.32 billion were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $212 million were for loan commitments generally expected to close and become funded within the next 12 to 18 months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our liquidity management.

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The following table depicts our loan commitments at the end of the past three years:

We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, economic or market conditions, reductions in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting liquidity disruptions.

MARKET RISK ANALYSIS

Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on interest-earning assets over the interest paid on interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness.

Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality.

We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest-sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to the net interest margin during periods of changing market interest rates.

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The following table depicts our GAP position as of December 31, 2021:

The second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates.

Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors.

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We conducted multiple simulations as of December 31, 2021, in which it was assumed that changes in market interest rates occurred ranging from up 400 basis points to down 100 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested dollar and percentage changes in net interest income over the next twelve months in comparison to the $126 million in net interest income projected using our balance sheet amounts and anticipated replacement rates as of December 31, 2021. The resulting estimates are generally within our policy parameters established to manage and monitor interest rate risk.

The resulting estimates have been significantly impacted by the current interest rate and economic environments, as adjustments have been made to critical model inputs with regards to traditional interest rate relationships. This is especially important as it relates to floating rate commercial loans and nonmaturity deposits, which comprise a sizable portion of our balance sheet.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; level of nonperforming assets; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.

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