National Bank Holdings Corp (NBHC) FY 2021 MD&A

Item 7.       MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

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The following management's discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes as of and for the years ended December 31, 2021, 2020, and 2019, and with the other financial and statistical data presented in this annual report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions that may cause actual results to differ materially from management's expectations. Factors that could cause such differences are discussed in the section entitled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors” and should be read herewith.

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Management’s discussion focuses on 2021 results compared to 2020. For a discussion of 2020 results compared to 2019, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.

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All amounts are in thousands, except share and per share data, or as otherwise noted.

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Overview

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Our focus is on building relationships by creating a win-win scenario for our clients and our Company. We believe in providing solutions and services to our clients that are based on fairness and simplicity. We have established a solid financial services franchise with a sizable presence for deposit gathering and building client relationships necessary for growth. Additionally, we are innovating and building strategic partnerships with the goal of delivering a comprehensive digital financial ecosystem for our clients. We are focused on providing small and medium-sized businesses with alternative digital access to address borrowing, depository and cash management needs, while also providing information management and access to blockchain payment tools, under the safety of a regulated bank. We believe that our established presence in our core markets of Colorado, the greater Kansas City region, Texas, Utah and New Mexico, as well as our ongoing investment in digital and blockchain solutions position us well for growth opportunities. As of December 31, 2021, we had $7.2 billion in assets, $4.5 billion in loans, $6.2 billion in deposits and $0.8 billion in equity.

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Operating Highlights and Key Challenges

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Profitability and returns

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Strategic execution

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Loan portfolio

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Credit quality

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Client deposit funded balance sheet

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Revenues

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Expenses

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Strong capital position

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Key Challenges

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There are a number of significant challenges confronting us and our industry. We face continual challenges implementing our business strategy. These include growing our assets, particularly loans, and deposits amidst intense competition, changing interest rates, adhering to changes in the regulatory environment and identifying and consummating disciplined acquisition and other expansionary opportunities in a very competitive environment.

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The COVID-19 pandemic has caused disruption and is likely to continue to present challenges to our business. We continue to remain committed to ensuring our associates, clients and communities are receiving the support they need through our banking centers and our digital banking platform. Our teams have been working diligently to support our clients who are experiencing financial hardship due to COVID-19 through participation in the SBA’s Paycheck Protection Program, including assistance with PPP loan forgiveness applications, and loan modifications, as needed. While access to vaccines in the United States has increased, the efficacy of those vaccines, the impact of emerging targeted vaccine mandates and new

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variants of the virus, and the length of time that the government-mandated measures must remain in place or potentially be reinstituted to address COVID-19 are unknown. The pandemic has had a negative impact to the U.S. labor market, consumer spending and business operations, and it is not clear how long new outbreaks of COVID-19 cases will have a continued impact.

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Our markets have historically outperformed the national averages on many key indicators; however, the economic impact from the COVID-19 pandemic has caused economic strain nationally and across all of our markets. We are encouraged by the positive signs of economic recovery we are seeing throughout our markets. We are focused on growing our loan portfolio while taking a careful approach to extending new credit and adhering to our established underwriting standards and self-imposed concentration limits. A significant portion of our loan portfolio is secured by real estate and any deterioration in real estate values or credit quality or elevated levels of non-performing assets would ultimately have a negative impact on the quality of our loan portfolio.

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As of December 31, 2021, the Company had low exposure to industries highly impacted by the COVID-19 pandemic. Within the commercial loan segment, restaurants were 5.7%, retailers 2.7%, hospital/medical 6.8% and oil and gas 0.7% of total loans. Within the commercial real estate non-owner occupied loan segment, hotel and lodging was 4.1%, multifamily 2.1% and retail 1.5% of total loans. The Company had no direct exposure to other industries and loan types more highly impacted by the pandemic including aviation, cruise lines, energy services, auto manufacturing/dealer floor plans, hedge funds, convention centers, credit cards, malls and taxi/ride share businesses. Furthermore, the Company had no consumer credit card, indirect auto or car leasing exposure.

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The agriculture industry continues to be impacted by volatility in commodity prices as well as supply chain issues driven by the COVID-19 pandemic. Our food and agribusiness portfolio is only 4.5% of total loans and is well-diversified across food production, crop and livestock types. Crop and livestock loans represent 1.0% of total loans. We have maintained relationships with food and agribusiness clients that generally possess low leverage and, correspondingly, low bank debt to assets, minimizing any potential credit losses in the future.

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The extraordinary government measures enacted during the COVID-19 pandemic have generated unprecedented levels of economic stimulus funding and have produced high levels of cash liquidity within the banking industry. Our cash balances total $845.7 million at December 31, 2021 and have increased $240.1 million from December 31, 2020. Future growth in our interest income will ultimately be dependent on our ability to deploy the excess cash liquidity into high-quality originated loans and other high-quality earning assets such as investment securities. Investment securities totaled $1.3 billion at December 31, 2021 and increased $262.3 million, or 25.3%, compared to December 31, 2020. At December 31, 2021, our loans outstanding totaled $4.5 billion, increasing $159.7 million, or 3.7%, compared to December 31, 2020. During the year ended December 31, 2021, our weighted average rate on new loans funded at the time of origination was 3.51%, compared to the weighted average yield of our originated loan portfolio of 3.98% (FTE). Our net interest income has been impacted by lower average loan balances and interest rate actions taken by the Federal Reserve in response to the COVID-19 pandemic, and our future earnings will be impacted by the Federal Reserve’s future interest rate policy decisions.

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Continued regulation, impending new liquidity and capital constraints, and a continual need to bolster cybersecurity are adding costs and uncertainty to all U.S. banks and could affect profitability. Also, nontraditional participants in the market may offer increased competition as non-bank payment businesses, including fintechs, are expanding into traditional banking products. While certain external factors are out of our control and may provide obstacles to our business strategy, we are prepared to deal with these challenges and expand our offerings in digital technology, including by partnering with and investing in fintechs where appropriate. We seek to remain flexible, yet methodical and proactive, in our strategic decision making so that we can quickly respond to market changes and the inherent challenges and opportunities that accompany such changes.

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Application of Critical Accounting Policies and Significant Estimates

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We use accounting principles and methods that conform to GAAP and general banking practices. We are required to apply significant judgment and make material estimates in the preparation of our financial statements and with regard to various accounting, reporting and disclosure matters. Assumptions and estimates are required to apply these principles where actual measurement is not possible or practical. The most significant of these estimates relate to the determination of the allowance

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for credit losses. See additional discussion of our ACL policy in note 2 – Summary of Significant Accounting Policies in the notes to our consolidated financial statements for the year ended December 31, 2021.

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The determination of the ACL, which represents management’s estimate of lifetime credit losses inherent in our loan portfolio at the balance sheet date, involves a high degree of judgment and complexity. The Company estimates the collective ACL by first disaggregating the loan portfolio into segments based upon broad characteristics such as primary use and underlying collateral. Within these segments, the portfolio is further disaggregated into classes of loans with similar attributes and risk characteristics. The collective ACL is determined at the class level, analyzing loss history based upon specific loss drivers and risk factors affecting each loan class. The Company utilizes a discounted cash flow (“DCF”) model that incorporates forecasts of certain national macroeconomic factors (reasonable and supportable forecasts) which drive the losses predicted in establishing the Company’s collective ACL. Management accounts for the inherent uncertainty of the underlying economic forecast by reviewing and weighting alternate forecast scenarios. For periods beyond the reasonable and supportable forecast period, the Company reverts to historical long-term average loss rates on a straight-line basis. Additionally, the collective ACL calculation includes subjective adjustments for qualitative risk factors that are likely to cause estimated credit losses to differ from historical experience. Changes in these assumptions, estimates or the conditions surrounding them may have a material impact on our financial condition. For further discussion of the ACL, see notes 2 and 7 to our consolidated financial statements.

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Future Accounting Pronouncements

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In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. ASU 2020-04 was effective upon issuance and can be adopted during any interim period through December 31, 2022. It provides optional expedients and guidance for applying generally accepted accounting principles to contract modifications and hedging relationships, if certain criteria are met, that reference LIBOR or any other reference rate that is expected to be discontinued. To address reference rate reform, the Company established a LIBOR transition subcommittee in January of 2020 to identify exposure to reference rates within loan and derivative contracts. The Company had no exposure to LIBOR tenors that were discontinued as of January 1, 2022. For tenors expiring on future dates the Company is working to ensure all documentation includes contingency terms, if necessary, that may be utilized at such time when the LIBOR is discontinued. Beginning January 1, 2022, the Company no longer originates loans using LIBOR as a reference rate. The Company has assessed, and will continue to evaluate, the impact from ASU 2020-04 and does not expect the adoption of ASU 2020-04, or any updates issued to date, to have a material impact on its financial statements.

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Financial Condition

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Total assets were $7.2 billion at December 31, 2021, compared to $6.7 billion at December 31, 2020, an increase of $554.1 million, or 8.3%. Cash and cash equivalents increased $240.1 million, and total loans increased $159.7 million, or 3.7%.

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During 2021, lower cost demand, savings and money market deposits (“transaction deposits”) increased $0.7 billion, or 15.0%, compared to the prior year, as we continued developing full banking relationships with our clients. Our clients used their core operating accounts for PPP funds and economic stimulus checks, which aided the strong deposit growth. In addition to providing excess cash liquidity, the increase in transaction deposits provided low-cost funding utilized to fund loan growth.

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Investment securities

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Available-for-sale

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Total investment securities available-for-sale were $691.8 million at December 31, 2021, compared to $662.0 million at December 31, 2020, an increase of $29.9 million, or 4.52%. During 2021 and 2020, purchases of available-for-sale securities totaled $288.6 million and $286.1 million, respectively. Maturities and paydowns of available-for-sale securities during 2021 and 2020 totaled $235.9 million and $271.5 million, respectively. There were no sales of available-for-sale securities during 2021 or 2020.

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Available-for-sale investment securities are summarized as follows as of the dates indicated:

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As of December 31, 2021 and 2020, nearly all the available-for-sale investment portfolio was backed by mortgages. The residential mortgage pass-through securities portfolio is comprised of both fixed rate and adjustable rate Federal Home Loan Mortgage Corporation (“FHLMC”), Federal National Mortgage Association (“FNMA”) and Government National Mortgage Association (“GNMA”) securities. The other mortgage-backed securities (“MBS”) are comprised of securities backed by FHLMC, FNMA and GNMA securities.

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Mortgage-backed securities may have actual maturities that differ from contractual maturities depending on the repayment characteristics and experience of the underlying financial instruments. The estimated weighted average life of the available-for-sale mortgage-backed securities portfolio was 4.2 years and 2.7 years at December 31, 2021 and December 31, 2020, respectively. This estimate is based on assumptions and actual results may differ. At December 31, 2021 and December 31, 2020, the duration of the total available-for-sale investment portfolio was 3.8 years and 2.6 years, respectively.

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At December 31, 2021 and 2020, adjustable rate securities comprised 1.7% and 2.3%, respectively, of the available-for-sale mortgage-backed security portfolio. The remainder of the portfolio was comprised of fixed rate amortizing securities with 10 to 30 year contractual maturities, with a weighted average coupon of 1.70% per annum and 2.00% per annum at December 31, 2021 and 2020, respectively.

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The available-for-sale investment portfolio included $3.4 million of unrealized gains and $13.3 million of unrealized losses at December 31, 2021. At December 31, 2020, the available-for-sale investment portfolio included $11.7 million of unrealized gains and $0.4 million of unrealized losses. We believe any unrealized losses are a result of prevailing interest rates, and as such, we do not believe that any of the securities with unrealized losses were impaired. Management believes that default of the available-for-sale securities is highly unlikely. FHLMC, FNMA and GNMA guaranteed mortgage-backed securities have a long history of zero credit losses, an explicit guarantee by the U.S. government (although limited for FNMA and FHLMC securities) and yields that generally trade based on market views of prepayment and liquidity risk rather than credit risk.

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Held-to-maturity

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At December 31, 2021, we held $609.0 million of held-to-maturity investment securities, compared to $376.6 million at December 31, 2020, an increase of $232.4 million, or 61.7%. Purchases of held-to-maturity securities totaled $397.8 million and $284.2 million during 2021 and 2020, respectively. Maturities and paydowns of held-to-maturity securities totaled $161.9 million and $88.1 million during 2021 and 2020, respectively.

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Held-to-maturity investment securities are summarized as follows as of the dates indicated:

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The residential mortgage pass-through and other residential MBS held-to-maturity investment portfolios are comprised of fixed rate FHLMC, FNMA and GNMA securities.

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The fair value of the held-to-maturity investment portfolio included $2.2 million and $5.3 million of unrealized gains and $11.9 million and $0.3 million of unrealized losses at December 31, 2021 and December 31, 2020, respectively.

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The Company does not measure expected credit losses on a financial asset, or group of financial assets, in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero. Management evaluated held-to-maturity securities noting they are backed by loans guaranteed by either U.S. government agencies or U.S. government sponsored entities, and management believes that default is highly unlikely given this governmental backing and long history without credit losses. Additionally, management notes that yields on which the portfolio generally trades are based upon market views of prepayment and liquidity risk and not credit risk. The Company has no intention to sell the securities and believes it will not be required to sell the securities before the recovery of their amortized cost.

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Mortgage-backed securities may have actual maturities that differ from contractual maturities depending on the repayment characteristics and experience of the underlying financial instruments. The estimated weighted average expected life of the held-to-maturity mortgage-backed securities portfolio as of December 31, 2021 and December 31, 2020 was 4.1 years and 2.4 years, respectively. This estimate is based on assumptions and actual results may differ. The duration of the total held-to-maturity portfolio was 3.8 years and 2.4 years as of December 30, 2021 and December 31, 2020, respectively.

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Residential mortgage pass-through investments due after one year but within five years had a weighted average yield of 3.35% at December 31, 2021. Those due after five years but within 10 years had a weighted average yield of 1.91%, and those due after 10 years had a weighted average yield of 1.26% at December 31, 2021. Other residential MBS held-to-maturity investments due after five years but within 10 years had a weighted average yield of 1.64%, and those due after 10 years had a weighted average yield of 1.23%.

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Non-marketable securities

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During 2021, the Company updated its asset classifications to include certain financial instruments previously included in other assets within non-marketable securities in the statements of financial condition.

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Non-marketable securities totaled $50.7 million and $22.1 million at December 31, 2021 and 2020, respectively, and included FRB stock, FHLB stock and other non-marketable securities. At December 31, 2021, other non-marketable securities totaled $36.2 million and consisted of equity method investments and convertible preferred stock without readily determinable fair values. During the years ended December 31, 2021 and 2020, purchases of non-marketable securities totaled $27.7 million and $4.1 million, respectively. Included in the purchases during 2021 were investments in two fintech firms, Finstro Global Holdings, Inc. of $20.0 million and Figure Technologies of $2.0 million. The Company will continue to invest with fintech solution providers to support our ecosystem buildout, support our core bank products and offerings, and to leverage efficiencies and technological solutions in our shared services areas. At December 31, 2020, the Company held $5.6 million of equity method investments.

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At December 31, 2021, the Company held $13.9 million of FRB stock and $0.7 million of FHLB stock for regulatory or debt facility purposes. At December 31, 2020, the Company held $13.9 million of FRB stock and $2.6 million of FHLB stock. These are restricted securities which, lacking a market, are carried at cost. The Company is not aware of any events or changes in circumstances that may have an adverse effect on the investments carried at cost.

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Loans overview

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At December 31, 2021, our loan portfolio was comprised of new loans that we have originated and loans that were acquired in connection with our six acquisitions to date.

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The table below shows the loan portfolio composition at the respective dates:

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The Company maintains a granular and well-diversified loan portfolio with self-imposed concentration limits. Our loan portfolio increased $159.7 million, or 3.7%, from December 31, 2020. Excluding PPP loans, total loans increased $314.1 million or 7.5%, led by commercial loan growth of $272.8 million, or 9.5%. New loan originations during the year ended December 31, 2021 totaled a record $1.5 billion, led by commercial loan originations of $1.1 billion including PPP loan originations of $121.1 million.

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Our commercial and industrial loan portfolio is comprised of diverse industry segments. At December 31, 2021, these segments included finance and financial services, primarily lender finance loans of $183.7 million, hospital/medical loans of $307.1 million, manufacturing-related loans of $117.0 million, and a variety of smaller subcategories of commercial and industrial loans. Food and agribusiness loans, which are well-diversified across food production, crop and livestock types, totaled $203.6 million and were 24.9% of the Company’s risk based capital. Crop and livestock loans represent 1.0% of total loans.

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Non-owner occupied CRE loans were 81.5% of the Company’s risk based capital, or 14.7% of total loans, and no specific property type comprised more than 5.0% of total loans. The Company maintains very little exposure to non-owner occupied CRE retail properties, comprising 1.5% of total loans. Multi-family loans totaled $93.2 million, or 2.1% of total loans as of December 31, 2021.

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When considering the loan portfolio in its entirety, 75.1% of loans were located within our footprint of Colorado, the greater Kansas City region, Texas, Utah and New Mexico as of December 31, 2021, based on the domicile of the borrower or, in the case of collateral-dependent loans, the geographical location of the collateral.

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New loan origination is a direct result of our ability to recruit and retain top banking talent, connect with clients in our markets and provide needed services at competitive rates. Loan originations totaled a record $1.5 billion over the past 12 months, led by commercial loan originations of $1.1 billion, which included PPP loan originations of $121.1 million. Originations are defined as closed end funded loans and revolving lines of credit advances net of any current period paydowns. Management utilizes this more conservative definition of originations to better approximate the impact of originations on loans outstanding and ultimately net interest income.

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The following tables represent new loan originations during 2021 and 2020:

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Included in originations are net fundings (paydowns) under revolving lines of credit of $138,777, $29,154, $59,520 and ($26,395) as of the fourth, third, second and first quarter of 2021, respectively.

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Included in originations are net fundings (paydowns) under revolving lines of credit of $50,982, ($27,899), ($55,826) and $48,789 as of the fourth, third, second and first quarter of 2020, respectively.

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The tables below show the contractual maturities of our loans for the dates indicated:

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The stated interest rate (which excludes the effects of non-refundable loan origination and commitment fees, net of costs and the accretion of fair value marks) of total loans with maturities over one year is as follows at the dates indicated:

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Asset quality

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Asset quality is fundamental to our success and remains a strong point, driven by our disciplined adherence to our self-imposed concentration limits across industry sector and real estate property type. Accordingly, for the origination of loans, we have established a credit policy that allows for responsive, yet controlled lending with credit approval requirements that are scaled to loan size. Within the scope of the credit policy, each prospective loan is reviewed in order to determine the appropriateness and the adequacy of the loan characteristics and the security or collateral prior to making a loan. We have established underwriting standards and loan origination procedures that require appropriate documentation, including financial data and credit reports. For loans secured by real property, we require property appraisals, title insurance or a title opinion, hazard insurance and flood insurance, in each case where appropriate.

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Additionally, we have implemented procedures to timely identify loans that may become problematic in order to ensure the most beneficial resolution for the Company. Asset quality is monitored by our credit risk management department and evaluated based on quantitative and subjective factors such as the timeliness of contractual payments received. Additional factors that are considered, particularly with commercial loans over $500,000, include the financial condition and liquidity of individual borrowers and guarantors, if any, and the value of our collateral. To facilitate the oversight of asset quality, loans are categorized based on the number of days past due and on an internal risk rating system, and both are discussed in more detail below.

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Our internal risk rating system uses a series of grades which reflect our assessment of the credit quality of loans based on an analysis of the borrower's financial condition, liquidity and ability to meet contractual debt service requirements. Loans that are perceived to have acceptable risk are categorized as “Pass” loans. “Special mention” loans represent loans that have potential credit weaknesses that deserve close attention. Special mention loans include borrowers that have potential weaknesses or unwarranted risks that, unless corrected, may threaten the borrower's ability to meet debt service requirements. However, these borrowers are still believed to have the ability to respond to and resolve the financial issues that threaten their financial situation. Loans classified as “Substandard” have a well-defined credit weakness and are inadequately protected by the current paying capacity of the obligor or of the collateral pledged, if any. Although these loans are identified as potential problem loans, they may never become non-performing. Substandard loans have a distinct possibility of loss if the deficiencies are not corrected. “Doubtful” loans are loans that management believes that collection of payments in accordance with the terms of the loan agreement are highly questionable and improbable. Doubtful loans are deemed impaired and put on non-accrual status.

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In the event of borrower default, we may seek recovery in compliance with state lending laws, the respective loan agreements, and credit monitoring and remediation procedures that may include modifying or restructuring a loan from its original terms, for economic or legal reasons, to provide a concession to the borrower from their original terms due to borrower financial difficulties in order to facilitate repayment. Such restructured loans are considered TDRs in accordance with ASC 310-40. Assets that have been foreclosed on or acquired through deed-in-lieu of foreclosure are classified as OREO until sold, and are carried at the fair value of the collateral less estimated costs to sell, with any initial valuation adjustments charged to the ACL and any subsequent declines in carrying value charged to impairments on OREO.

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Non-performing assets and past due loans

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Non-performing assets consist of non-accrual loans and OREO. Interest income that would have been recorded had non-accrual loans performed in accordance with their original contract terms during 2021 and 2020 was $0.8 million and $1.2 million, respectively.

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Past due status is monitored as an indicator of credit deterioration. Loans are considered past due or delinquent when the contractual principal or interest due in accordance with the terms of the loan agreement remains unpaid after the due date of the scheduled payment. Loans that are 90 days or more past due are put on non-accrual status unless the loan is well secured and in the process of collection.

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The following table sets forth the non-performing assets and past due loans as of the dates presented:

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During 2021, total non-performing loans decreased $9.6 million, or 46.9%, from December 31, 2020. During 2021, accruing TDRs decreased $6.8 million, or 48.5%. OREO increased $2.3 million, or 48.1%, to $7.0 million at December 31, 2021, compared to December 31, 2020 primarily related to one previously acquired loan.

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Loans 30-89 days past due and still accruing interest increased $0.7 million from December 31, 2020 to December 31, 2021, and loans 90 days or more past due and still accruing interest increased $0.3 million from December 31, 2020 to December 31, 2021.

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The Company continues to monitor the operating status and trends of our clients to enable us to quickly detect credit deterioration and take action where needed. The CARES Act afforded financial institutions the option to modify loans within certain parameters in response to the COVID-19 pandemic without requiring the modifications to be classified as TDRs under ASC Topic 310 if the borrower has been adversely impacted by COVID-19 and was current on their loan payments. The Company modified 19 loans totaling $9.9 million during the year ended December 31, 2021 and 510 loans totaling $519.0 million during the year ended December 31, 2020, due to the effects of the COVID-19 pandemic, that were not classified as TDRs. Modified loans that remained on a payment deferral plan, paying interest only, at December 31, 2021 totaled $5.3 million. At December 31, 2021, $206 thousand of loan modifications related to COVID-19 were a subsequent modification, and one loan totaling $206 thousand was classified as non-accrual. At December 31, 2020, modified loans that remained on a payment deferral plan totaled $173.6 million, or 4.0% of the total loan portfolio, of which $45.4 million, or 26.2%, were a subsequent modification.

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Allowance for credit losses

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The ACL represents the amount that we believe is necessary to absorb estimated lifetime credit losses inherent in the loan portfolio at the balance sheet date and involves a high degree of judgment and complexity. On January 1, 2020, the Company adopted ASU 2016-13, Measurement of Credit Losses on Financial Instruments which replaced the incurred loss methodology for recognizing credit losses with a CECL model. The Company utilizes a DCF model developed within a third-party software tool to establish expected lifetime credit losses for the loan portfolio. The ACL is calculated as the difference between the amortized cost basis and the projections from the DCF analysis. The DCF model allows for individual life of loan cash flow modeling, excluding extensions and renewals, using loan-specific interest rates and repayment schedules including estimated prepayment rates and loss recovery timing delays. The model incorporates forecasts of certain national macro-economic factors, including unemployment rates, home price index (“HPI”), retail sales and gross domestic product (“GDP”), which drive correlated loss rates. The determination and application of the ACL accounting policy involves judgments, estimates and uncertainties that are subject to change. For periods beyond the reasonable and supportable forecast period, we revert to historical long-term average loss rates on a straight-line basis.

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We measure expected credit losses for loans on a pooled basis when similar risk characteristics exist. We have identified four primary loan segments within the ACL model that are further stratified into 11 loan classes to provide more granularity in analyzing loss history and to allow for more definitive qualitative adjustments based upon specific risk factors affecting each loan class. Generally, the underlying risk of loss for each of these loan segments will follow certain norms/trends in various economic environments. Loans that do not share risk characteristics are evaluated on an individual basis and are not included in the collective evaluation. Following are the loan classes within each of the four primary loan segments:

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Loans on non-accrual, in bankruptcy and TDRs with a balance greater than $250,000 are excluded from the pooled analysis and are evaluated individually. If management determines that foreclosure is probable, expected credit losses are evaluated based on the criteria listed below, adjusted for selling costs as appropriate. Typically, these loans consist of commercial, commercial real estate and agriculture loans and exclude homogeneous loans such as residential real estate and consumer loans. Specific allowances are determined by collectively analyzing:

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The collective resulting ACL for loans is calculated as the sum of the general reserves, specific reserves on individually evaluated loans, and qualitative factor adjustments. While these amounts are calculated by individual loan or on a pool basis by segment and class, the entire ACL is available for any loan that, in our judgment, should be charged-off. The determination and application of the ACL accounting policy involves judgments, estimates, and uncertainties that are subject to change. Changes in these assumptions, estimates or the conditions surrounding them may have a material impact on our financial condition, liquidity or results of operations.

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Net charge-offs on loans during the year ended December 31, 2021 totaled $1.3 million, or 0.03% of total loans. During the year ended December 31, 2021, the Company recorded a provision release of $9.3 million, which included a provision release of $8.8 million for funded loans and a provision release of $0.5 million for unfunded loan commitments. Provision release was driven by strong asset quality and an improved outlook in the CECL model’s underlying economic forecast. Specific reserves on loans totaled $1.6 million at December 31, 2021.

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Net charge-offs on loans during the year ended December 31, 2020 totaled $2.7 million, or 0.06% of total loans. During the year ended December 31, 2020, the Company recorded total provision expense of $17.6 million, which included a provision expense of $17.5 million for funded loans and a provision expense of $0.1 million for unfunded loan commitments. Provision expense was recorded to provide coverage for the impact of deteriorating economic conditions as a result of COVID-19 and to support non-PPP originated loan growth. Specific reserves on loans totaled $1.9 million at December 31, 2020.

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The Company has elected to exclude accrued interest receivable (“AIR”) from the ACL calculation. When a loan is placed on non-accrual, any recorded AIR is reversed against interest income. As of December 31, 2021 and December 31, 2020, AIR from loans totaled $15.7 million and $16.7 million, respectively.

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Total ACL

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After considering the above mentioned factors, we believe that the ACL of $49.7 million is adequate to cover estimated lifetime losses inherent in the loan portfolio at December 31, 2021. However, it is likely that future adjustments to the ACL will be necessary. Any changes to the underlying assumptions, circumstances or estimates, including but not limited to changes in the underlying macro-economic forecast, used in determining the ACL, could negatively or positively affect the Company's results of operations, liquidity or financial condition.

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The following schedule presents, by class stratification, the changes in the ACL during the years listed:

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The following tables present the allocation of the ACL and the percentage of the total amount of loans in each loan category listed as of the dates presented:

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Deposits

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Deposits from banking clients serve as a primary funding source for our banking operations and our ability to gather and manage deposit levels is critical to our success. Deposits not only provide a low-cost funding source for our loans, but also provide a foundation for the client relationships that are critical to future loan growth. The following table presents information regarding our deposit composition at December 31, 2021 and 2020:

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The following table shows uninsured time deposits by scheduled maturity as of December 31, 2021:

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At December 31, 2021 and 2020, time deposits that were scheduled to mature within 12 months totaled $555.4 million and $659.5 million, respectively. Of the time deposits scheduled to mature within 12 months at December 31, 2021, $81.4 million were in denominations of $250,000 or more, and $474.0 million were in denominations less than $250,000. The aggregate amount of time deposits that exceeded the FDIC insurance limit was $57.4 million at December 31, 2021. Note 12 to the consolidated financial statements provides a maturity schedule of time deposits outstanding at December 31, 2021.

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Long-term debt

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During the fourth quarter of 2021, the Company entered into a subordinated note purchase agreement to issue and sell a fixed-to-floating rate note totaling $40.0 million. The balance on the note at December 31, 2021, net of long-term debt issuance costs totaling $0.5 million, totaled $39.5 million. Interest expense totaling $183.3 thousand was recorded within other liabilities in the consolidated statements of financial condition during the year ended December 31, 2021.

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The note is subordinated, unsecured and matures on November 15, 2031. Payments consist of interest only. Beginning November 15, 2021, the note will initially be payable semi-annually in arrears and will bear interest at 3.00% per annum until November 15, 2026 (or any earlier redemption date). From November 15, 2026 until November 15, 2031 (or any earlier redemption date) payments will be made quarterly in arrears, and the interest rate shall reset quarterly to an interest rate per annum equal to the then current three-month term SOFR plus 203 basis points. The Company intends to use the net proceeds from the sale of the note for general corporate purposes. Prior to November 5, 2026, the Company may redeem the note only under certain limited circumstances. Beginning on November 5, 2026 through maturity, the note may be redeemed, at the Company’s option, on any scheduled interest payment date. Any redemption by the Company would be at a redemption price equal to 100% of the principal amount of the note being redeemed, together with any accrued and unpaid interest on the note being redeemed up to but excluding the date of redemption. The note is not subject to redemption at the option of the holder.

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Other borrowings

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As of December 31, 2021 and 2020, the Bank sold securities under agreements to repurchase totaling $22.8 million and $22.9 million, respectively. In addition, as a member of the FHLB, the Bank has access to a line of credit and term financing from the FHLB with total available credit of $0.9 billion at December 31, 2021. The Bank utilizes its FHLB line of credit as a funding mechanism for originated loans and loans held for sale. At December 31, 2021 and 2020, the Bank had no outstanding borrowings with the FHLB. The Bank may pledge investment securities and loans as collateral for FHLB advances. There were no investment securities pledged at December 31, 2021 or 2020. Loans pledged were $1.3 billion at December 31, 2021 and $1.2 billion at December 31, 2020. The Company incurred no interest expense related to FHLB advances or other short-term borrowings for the year ended December 31, 2021, compared to $1.3 million for the year ended December 31, 2020.

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Regulatory Capital

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Our subsidiary bank and the holding company are subject to the regulatory capital adequacy requirements of the Federal Reserve Board and the FDIC, as applicable. Failure to meet the minimum capital requirements can initiate certain mandatory and possibly further discretionary actions by regulators that could have a material adverse effect on us. At December 31, 2021 and 2020, our subsidiary bank and the consolidated holding company exceeded all capital ratio requirements under prompt corrective action and other regulatory requirements, as further detailed in note 14 of our consolidated financial statements.

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Results of Operations

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Our net income depends largely on net interest income, which is the difference between interest income from interest earning assets and interest expense on interest bearing liabilities. Our results of operations are also affected by provisions for loan losses and non-interest income, such as service charges, bank card income, swap fee income, and gain on sale of mortgages. Our primary operating expenses, aside from interest expense, consist of salaries and benefits, occupancy costs, telecommunications data processing expense, and intangible asset amortization. Any expenses related to the resolution of problem assets are also included in non-interest expense.

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Overview of results of operations

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Net income totaled a record $93.6 million, or $3.01 per diluted share, during 2021, compared to net income of $88.6 million, or $2.85 per diluted share, during 2020. The return on average tangible assets was 1.37% and 1.44% during the years ended December 31, 2021 and 2020, respectively, and the return on average tangible common equity was 12.87% and 13.27%, respectively.

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Net interest income

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We regularly review net interest income metrics to provide us with indicators of how the various components of net interest income are performing. We regularly review: (i) our loan mix and the yield on loans; (ii) the investment portfolio and the related yields; (iii) our deposit mix and the cost of deposits; and (iv) net interest income simulations for various forecast periods.

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The table below presents the components of net interest income on a FTE basis for the years ended December 31, 2021, 2020 and 2019. The effects of trade-date accounting of investment securities for which the cash had not settled are not considered interest earning assets and are excluded from this presentation for time frames prior to their cash settlement, as are the market value adjustments on the investment securities available-for-sale and loans.

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Net interest income totaled $187.1 million, $192.9 million and $205.8 million during the years ended 2021, 2020 and 2019, respectively. Net interest income on an FTE basis totaled $192.3 million, $198.0 million and $210.9 million during the years ended 2021, 2020 and 2019, respectively. The yield on earning assets decreased 69 basis points, led by a decrease in the originated portfolio yields due to a remix of assets into lower-yielding cash balances and interest rate actions taken by the Federal Reserve during 2020. During 2021, the cost of funds decreased 22 basis points, compared to the prior year.

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Average loans comprised $4.3 billion, or 66.4%, of total average interest earning assets during 2021, compared to $4.5 billion, or 78.3%, during 2020. The decrease in average loan balances was primarily driven by our careful approach to extending new credit, a focus on managing credit risk and yield and a decrease in PPP loan balances. During 2021, loan originations totaled $1.5 billion.

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Average investment securities comprised 19.1% and 14.5% of total interest earning assets during 2021 and 2020, respectively. The increase in the investment portfolio was driven by strategic decisions to deploy a portion of excess liquidity into investment securities. Average interest bearing cash balances totaled $751.8 million during 2021, compared to $206.9 million during 2020.

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Average balances of interest bearing liabilities decreased $179.5 million during 2021, compared to 2020. The decrease was driven by time deposits totaling $123.3 million, FHLB advances totaling $95.4 million and securities sold under agreements to repurchase totaling $8.2 million. The decrease was partially offset by increases in interest bearing demand, savings and money market deposits totaling $41.2 million and long-term debt totaling $6.2 million.

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Total interest expense related to interest bearing liabilities was $13.8 million and $25.1 million during 2021 and 2020, respectively, at an average cost of 0.37% and 0.64% during 2021 and 2020, respectively. Additionally, the cost of deposits decreased 22 basis points to 0.23% during 2021, compared to 0.45% during 2020, due to the decline in short-term interest rates as a result of interest rate actions taken by the Federal Reserve.

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The following table summarizes the changes in net interest income on an FTE basis by major category of interest earning assets and interest bearing liabilities, identifying changes related to volume and changes related to rates for 2021, 2020 and 2019:

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Below is a breakdown of average deposits and the average rates paid during the periods indicated:

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Provision for loan losses

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The provision for loan losses represents the amount of expense that is necessary to bring the ACL to a level that we deem appropriate to absorb estimated lifetime losses inherent in the loan portfolio as of the balance sheet date. The determination of the ACL, and the resultant provision for loan losses, is subjective and involves significant estimates and assumptions.

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The Company recorded a provision release of $9.3 million for the year ended December 31, 2021, which included a provision release of $8.8 million for funded loans and a provision release of $0.5 million for unfunded loan commitments, driven by strong asset quality and an improved outlook in the CECL model’s underlying economic forecast. During the year ended December 31, 2020, the Company recorded total provision expense of $17.6 million, which included a provision expense of $17.5 million for funded loans and a provision expense of $0.1 million for unfunded loan commitments, to provide coverage for the impact of deteriorating economic conditions as a result of COVID-19 and to support non-PPP originated loan growth.

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The allowance for credit losses totaled 1.10% of total loans at December 31, 2021, compared to 1.37% at December 31, 2020. Excluding PPP loans, the allowance for credit losses totaled 1.11% of loans at December 31, 2021, compared to 1.43% at December 31, 2020.

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Non-interest income

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The table below details the components of non-interest income for the years presented:

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Non-interest income totaled $110.4 million for the year ended December 31, 2021, compared to $140.3 million for the year ended December 31, 2020. The decrease was driven by $39.0 million lower mortgage banking income due to slower refinance activity in 2021 and competition driving tighter gain on sale margins. Included in mortgage banking income was a $1.3 million gain from the sale of mortgage servicing rights during 2021. Other non-interest income increased $7.5 million during 2021 due to $4.6 million of banking center consolidation-related income and $3.0 million of unrealized gains from equity method investments. Bank card fees increased $2.2 million due to changes in consumer behavior.

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Non-interest expense

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The table below details the components of non-interest expense for the years presented:

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During the year ended December 31, 2021, non-interest expense decreased $14.3 million, or 7.0%, compared to the year ended December 31, 2020, primarily due to lower mortgage-related compensation as well as the Company’s strategic efforts to improve operating efficiency. Salaries and benefits decreased $13.7 million primarily due to lower mortgage banking related compensation. Included in 2021 were $2.5 million of transaction-related professional fees for the investments in Finstro Global Holdings, Inc. and Figure Technologies. Occupancy and equipment decreased $2.2 million largely due to efficiencies gained from banking center consolidations. Problem asset workout expense decreased $1.1 million, and gain on sale of OREO increased $0.4 million.

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Income taxes

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Income taxes are accounted for in accordance with ASC Topic 740. Under this guidance, deferred income taxes are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of enacted tax laws. ASC Topic 740 requires the establishment of a valuation allowance against the net deferred tax asset unless it is more-likely-than-not that the tax benefit of the deferred tax asset will be realized. For purposes of projecting whether the deferred tax asset will be realized, we consider tax regulations of the jurisdictions in which we operate, estimates of future taxable income, and available tax planning strategies. If tax regulations, operating results, or the ability to implement tax planning strategies varies, adjustments to the carrying value of the deferred tax assets may be required. We believe that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

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Income tax expense totaled $21.4 million during 2021, compared to $20.8 million during 2020. Included in income tax expense was $0.6 million of tax benefit and $0.1 million of tax expense from stock compensation activity during 2021 and 2020, respectively. Adjusting for the stock compensation activity, the effective tax rate for 2021 was 19.1% compared to an adjusted rate of 19.0% for 2020. As of December 31, 2021, our marginal tax rate (the rate we pay on each incremental dollar of earnings) was approximately 23%. However, our effective tax rate (income tax expense divided by income before income taxes) for a given period differs from our marginal rate largely due to income and expense items that are non-taxable or non-deductible in the calculation of income tax expense. The lower effective tax rate compared to the federal statutory tax rate was primarily due to interest income from tax-exempt lending, bank-owned life insurance income, and the relationship of these items to pre-tax income.

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Liquidity and Capital Resources

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Liquidity

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Liquidity is monitored and managed to ensure that sufficient funds are available to operate our business and pay our obligations to depositors and other creditors, while providing ample available funds for opportunistic and strategic investments. Management believes that the Company's excess cash, borrowing capacity and access to sufficient sources of capital are adequate to meet its short-term and long-term liquidity needs in the foreseeable future. Our primary sources of funds are deposits, securities sold under agreements to repurchase, prepayments and maturities of loans and investment securities, the sale of investment securities, and funds provided from operations. We anticipate having access to other third party funding sources, including the ability to raise funds through the issuance of shares of our common stock or other equity or equity-related securities, incurrence of debt, and federal funds purchased, that may also be a source of liquidity. We anticipate that these sources of liquidity will provide adequate funding and liquidity for at least a 12-month period, and we may utilize any combination of these funding sources for long-term liquidity needs if deemed prudent.

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On-balance sheet liquidity is represented by our cash and cash equivalents and unencumbered investment securities, and is detailed in the table below as of December 31, 2021 and 2020:

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Total on-balance sheet liquidity increased $507.4 million from December 31, 2020 to December 31, 2021, primarily driven by strong deposit growth.

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Through our relationship with the FHLB, the Bank may pledge qualifying loans and investment securities allowing us to obtain additional liquidity through FHLB advances and lines of credit. There were no investment securities pledged at December 31, 2021 or 2020. The Bank had loans pledged as collateral for FHLB advances of $1.3 billion at December 31, 2021 and $1.2 billion at December 31, 2020. FHLB advances, lines of credit and other short-term borrowing availability totaled $0.9 billion at December 31, 2021. The Bank can obtain additional liquidity through the FHLB facility, if required, and also has access to federal funds lines of credit with correspondent banks.

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During 2021, the Company entered into a subordinated note purchase agreement to issue and sell a fixed-to-floating note. The Company intends to use the net proceeds from the sale of the note for general corporate purposes. The note is not subject to redemption at the option of the holder.

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Our primary uses of funds are loan originations, investment security purchases, withdrawals of deposits, settlement of repurchase agreements, capital expenditures, operating expenses, and share repurchases. For additional information regarding our operating, investing and financing cash flows, see our consolidated statements of cash flows in the accompanying consolidated financial statements.

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Exclusive from the investing activities related to acquisitions, our primary investing activities are originations and pay-offs and paydowns of loans and purchases and sales of investment securities. At December 31, 2021, pledgeable investment securities represented a significant source of liquidity. Our available-for-sale investment securities are carried at fair value and our held-to-maturity securities are carried at amortized cost. Our collective investment securities portfolio totaled $1.3 billion at December 31, 2021, inclusive of pre-tax net unrealized gains of $3.4 million on the available-for-sale securities portfolio. Additionally, our held-to-maturity securities portfolio had $2.2 million of pre-tax net unrealized gains at December 31, 2021. The gross unrealized gains and losses are detailed in note 4 of our consolidated financial statements. As of December 31, 2021, our investment securities portfolio consisted primarily of MBS, all of which were issued or guaranteed by U.S. Government agencies or sponsored enterprises. The anticipated repayments and marketability of these securities offer substantial resources and flexibility to meet new loan demand, reinvest in the investment securities portfolio, or provide optionality for reductions in our deposit funding base.

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At present, financing activities primarily consist of changes in deposits and repurchase agreements, and advances from the FHLB, in addition to the payment of dividends and the repurchase of our common stock. Maturing time deposits represent a potential use of funds. As of December 31, 2021, $555.4 million of time deposits were scheduled to mature within 12 months. Based on the current interest rate environment, market conditions, and our consumer banking strategy focusing on both lower cost transaction accounts and term deposits, our strategy is to replace a portion of those maturing time deposits with transaction deposits and market-rate time deposits.

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We enter into contractual obligations that require a future cash settlement. These may include operating lease obligations, purchase obligations, time deposits and issuance of long-term debt. For the year ended December 31, 2021, contractual obligations totaled $924.6 million with $576.1 million estimated to be paid within one year. Included within those contractual obligations were time deposits totaling $833.9 million, with $555.4 million of that estimated to be paid within one year.

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Capital

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Under the Basel III requirements, at December 31, 2021, the Company and the Bank met all capital adequacy requirements, and the Bank had regulatory capital ratios in excess of the levels established for well-capitalized institutions. For more information on regulatory capital, see note 14 in our consolidated financial statements.

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Our shareholders' equity is impacted by earnings, changes in unrealized gains and losses on securities, net of tax, stock-based compensation activity, share repurchases and the payment of dividends.

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The Board of Directors has from time to time authorized multiple programs to repurchase shares of the Company’s common stock either in open market or in privately negotiated transactions in accordance with applicable regulations of the SEC. On February 24, 2021, the Company’s Board of Directors authorized a new program to repurchase up to $75.0 million of the Company’s stock which replaces the previously authorized $50.0 million stock repurchase program announced in February 2020 in its entirety. During 2021, the Company repurchased 912,213 shares for $36.4 million at a weighted average price per share of $39.88. The remaining authorization under the new program as of December 31, 2021 was $38.6 million.

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On January 20, 2022, our Board of Directors declared a quarterly dividend of $0.23 per common share, payable on March 15, 2022 to shareholders of record at the close of business on February 25, 2022.

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Asset/Liability Management and Interest Rate Risk

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Management and the Board of Directors are responsible for managing interest rate risk and employing risk management policies that monitor and limit this exposure. Interest rate risk is measured using net interest income simulations and market value of portfolio equity analyses. These analyses use various assumptions, including the nature and timing of interest rate changes, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/replacement of asset and liability cash flows.

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The principal objective of the Company's asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing earnings and preserving adequate levels of liquidity and capital. The asset and liability management function is under the guidance of the Asset Liability Committee with direction from the Board of Directors. The Asset Liability Committee meets monthly to review, among other things, the sensitivity of the Company's assets and liabilities to interest rate changes, local and national market conditions and rates. The Asset Liability Committee also reviews the liquidity, capital, deposit mix, loan mix and investment positions of the Company.

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Instantaneous parallel rate shift scenarios are modeled and utilized to evaluate risk and establish exposure limits for acceptable changes in net interest margin. These scenarios, known as rate shocks, simulate an instantaneous change in interest rates and utilize various assumptions, including, but not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows.

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We also analyze the economic value of equity as a secondary measure of interest rate risk. This is a complementary measure to net interest income where the calculated value is the result of the market value of assets less the market value of liabilities. The economic value of equity is a longer term view of interest rate risk because it measures the present value of the future cash flows. The impact of changes in interest rates on this calculation is analyzed for the risk to our future earnings and is used in conjunction with the analyses on net interest income.

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Our interest rate risk model indicated that the Company was asset sensitive in terms of interest rate sensitivity at December 31, 2021 and 2020. During the year ended December 31, 2021, our asset sensitivity decreased slightly for a rising rate environment as a result of the balance sheet mix. The table below illustrates the impact of an immediate and sustained 200 and 100 basis point increase and a 25 basis point decrease in interest rates on net interest income based on the interest rate risk model at December 31, 2021 and 2020:

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Many assumptions are used to calculate the impact of interest rate fluctuations. Actual results may be significantly different than our projections due to several factors, including the timing and frequency of rate changes, market conditions and the shape of the yield curve. The computations of interest rate risk shown above do not include actions that management may undertake to manage the risks in response to anticipated changes in interest rates and actual results may also differ due to any actions taken in response to the changing rates.

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As part of the asset/liability management strategy to manage primary market risk exposures expected to be in effect in future reporting periods, management has emphasized the origination of longer duration loans. The strategy with respect to liabilities has been to continue to emphasize transaction account growth, particularly non-interest or low interest bearing non-maturing deposit accounts while building long-term client relationships. Non-maturing deposit accounts totaled 86.5% of total deposits at December 31, 2021, compared to 82.6% at December 31, 2020. We currently have no brokered time deposits.

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Impact of Inflation and Changing Prices

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The primary impact of inflation on our operations is reflected in increasing operating costs and non-interest expense. Unlike most industrial companies, virtually all of our assets and liabilities are monetary in nature. As a result, changes in interest rates have a more significant impact on our performance than do changes in the general rate of inflation and changes in prices. Interest rate changes do not necessarily move in the same direction, nor have the same magnitude, as changes in the prices of goods and services. Although not as critical to the banking industry as many other industries, inflationary factors may have some impact on our ability to grow, total assets, earnings and capital levels. We do not expect inflation to be a significant factor in our financial results in the near future. To help curb inflation, the Federal Reserve has indicated that they will more than likely increase interest rates during the first quarter of 2022.

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Off-Balance Sheet Activities

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In the normal course of business, we are a party to various contractual obligations, commitments and other off-balance sheet activities that contain credit, market, and operational risk that are not required to be reflected in our consolidated financial statements. The most significant of these are the loan commitments that we enter into to meet the financing needs of clients, including commitments to extend credit, commercial and consumer lines of credit and standby letters of credit. As of December 31, 2021 and 2020, we had loan commitments totaling $992.5 million and $848.6 million, respectively, and standby letters of credit that totaled $7.3 million for both 2021 and 2020. Unused commitments do not necessarily represent future credit exposure or cash requirements, as commitments often expire without being drawn upon. We do not anticipate any material losses arising from commitments or contingent liabilities, and we do not believe that there are any material commitments to extend credit that represent risks of an unusual nature.

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