OP Bancorp (OPBK) FY 2023 MD&A

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our historical financial statements and the related notes thereto contained in this Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review the sections titled “Cautionary Note Regarding Forward-Looking Statements” and “Item 1A. Risk Factors” for a discussion of forward-looking statements and important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

OVERVIEW

We are a bank holding company headquartered in Los Angeles, California. Our commercial community banking activities are operated through Open Bank, our banking subsidiary. We offer commercial banking services to small and medium-sized businesses, their owners and retail customers primarily in the Korean-American community.

Our results of operations depend primarily on our net interest income. We drive our income from interest received on our loan portfolio and the fee income we receive in connection with our deposits, and the sale and service of SBA loans. Our major operating expenses are the interest we pay on deposits, the salaries and related benefits we pay our management and staff, and the rent we pay on our leased properties. We rely primarily on locally-generated deposits, mostly from the Korean-American market within California, to fund our loan activities. We currently operate eight branches in Los Angeles and Orange Counties in California, one branch in Santa Clara, California, one branch in Carrollton, Texas and one branch in Las Vegas, Nevada. We have four loan production offices in Pleasanton, California, Atlanta, Georgia, Aurora, Colorado, and Lynnwood, Washington.

We adopted Accounting Standards Update (“ASU”) 2016-13, which replaced the current incurred loss accounting model with the Current Expected Credit Losses approach. The adoption of this ASU increased the allowance for credit losses by $1.9 million and allowance for off-balance sheet commitments by $184 thousand and recorded a deferred tax assets of $624 thousand and a decrease to opening retained earnings of $1.5 million on January 1, 2023.

Banking Economy and Recent Developments

Beginning in late 2021, the Federal Reserve Board Open Markets Committee, which strives to manage benchmark interest rates in the United States, began a series of upward adjustments to the “discount rate” for short-term borrowings in response to perceived increases in inflationary pressures. Financial institutions and markets promptly followed these adjustments, significantly increasing interest rate pricing on loans and deposits. While such adjustments are commonplace and tend to affect the banking industry as a whole, the pace and degree of these adjustments were nearly unprecedented, resulting in banks, including the Bank, experiencing substantial pressure on multiple fronts. In particular, banks were forced to increase interest rates paid on deposits in order to meet competitive pressures from other financial institutions, as well as from treasury securities and other investment opportunities that offered greater earning capabilities for those

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customers. These increases correspondingly increased the Bank’s cost of funds and exerted downward pressure on our net interest margins.

The increases in market interest rates also were reflected in loan pricing, which had multiple effects, including a reduction in borrowing (and thus a reduction in interest paid to banks) by customers that had the ability to avoid or defer additional indebtedness, a decline in the origination of new loans, and an increase in credit risk as borrowers who faced rising interest rates found it more difficult to comply with their loan obligations. The combination of these factors has exerted downward pressure on our fee income, the volume of our interest-earning assets and our net interest income.

Lastly, as a result of the prolonged low-interest-rate environment that had prevailed for years prior to the more recent market rate increases, the Bank, like most other financial institutions, had invested in treasury securities and other relatively low-yielding but stable instruments as a means to preserve liquidity, accepting the lower returns as a trade-off for a perceived lower risk profile. However, the rapidity of the Federal Reserve’s rate increases resulted in a dramatic loss of value for bonds that were paying at lower interest rates as investors eschewed those investments for higher-yielding fixed- and adjustable-rate debt securities. These forces even resulted in the closure of three large U.S. banks, including two banks with extensive operations in our market area, when customers alarmed at the apparent instability in the banking sector quickly demanded a return of their deposits at a time when banks were confronting substantial challenges.

The following significant items are of note as of or for the periods presented:

As of December 31, 2023 compared to as of 2022

•Total assets were $2.15 billion, an increase of $53.2 million, or 2.5%, from $2.09 billion.

•Gross loans were $1.77 billion, an increase of $87.6 million, or 5.2%, from $1.68 billion.

•Total deposits were $1.81 billion, a decrease of $78.2 million, or 4.1%, from $1.89 billion.

•Shareholders’ equity was $192.6 million, an increase of $15.7 million, or 8.9%, from $176.9 million.

For the year ended December 31, 2023 compared to 2022

•Net interest income decreased to $68.7 million, a decrease of $8.2 million, or 10.7%, from $76.9 million.

•Net income was $23.9 million or $1.55 per diluted common share, a decrease of $9.4 million, or 28.2%, from $33.3 million or $2.14 per diluted common share.

For the year ended December 31, 2022 compared to 2021

•Net interest income increased to $76.9 million, an increase of $15.9 million, or 26.0%, from $61.0 million.

•Net income was $33.3 million or $2.14 per diluted common share, an increase of $4.5 million, or 15.5%, from $28.8 million or $1.88 per diluted common share.

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SELECTED FINANCIAL DATA

(1)    Represent noninterest expense divided by the sum of net interest income and noninterest income.

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Critical Accounting Policies and Estimates

Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statement. In particular, management has identified several accounting policies that, due to the estimates, assumptions and judgments inherent in those policies, are critical in understanding our financial statements.

The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in the “Notes to Consolidated Financial Statements, Note 1. Business and Summary of Significant Accounting Policies.”

New Accounting Pronouncements Adopted

Financial Accounting Standards Board ("FASB") Accounting Standards Update ("ASU") 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The Company adopted ASU 2016-13 using a modified retrospective approach on January 1, 2023. The Company replaced the current incurred loss accounting model with the Current Expected Credit Losses ("CECL") approach for financial instruments measured at amortized cost and other commitments to extend credit. CECL requires the immediate recognition of estimated credit losses expected to occur over the estimated remaining life of the asset. The forward-looking concept of CECL requires loss estimates to consider historical experience, current conditions and reasonable and supportable forecasts.

The adoption of this ASU increased the allowance for credit losses by $1.9 million and allowance for off-balance sheet commitments by $184 thousand. The Company also recorded a deferred tax assets of $624 thousand and a decrease to opening retained earnings of $1.5 million on January 1, 2023. The increase to allowance for credit losses was primarily due to longer duration of home mortgage loans, offset primarily by shorter duration of commercial and industrial ("C&I")

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loans. The Company did not record an allowance for credit losses on the Company’s available-for-sale debt securities as a result of this adoption. Disclosures for periods after January 1, 2023 are presented in accordance with ASC 326 while prior period amounts continue to be reported in accordance with previously applicable standards and the accounting policies.

Allowance for Credit Losses

The Company employs a modeled approach that takes into account current and future economic conditions to estimate lifetime expected losses on a collective basis. With the adoption of CECL, the Company elected not to consider accrued interest receivable in its estimated credit losses because the Company writes off uncollectible accrued interest receivable in a timely manner. The Company considers writing off accrued interest amounts once the amounts become 90 days past due to be considered within a timely manner. The Company has elected to write off accrued interest receivable by reversing interest income. The Company uses transition matrices to develop the Probability of Default ("PD") and Loss Given Default ("LGD") approach, incorporating quantitative factors and qualitative considerations in the calculation of the allowance for credit losses for collectively assessed loans. The model provides forecasts of PD and LGD based on national unemployment rates using regression analysis. The Company incorporates future economic conditions using a weighted multiple scenario approach: baseline and adverse. The Company applies a reasonable and supportable period of one year for the baseline scenario and two years for the adverse scenario, after which loss assumptions revert to historical loss information through a one-year reversion period for the baseline scenario and a two-year reversion period for the adverse scenario. We make critical accounting estimates, including the judgments made in the application of significant accounting policies, sensitivity to change, and the likelihood of materially different reported results if different assumptions were used.

In order to quantify the credit risk impact of other trends and changes within the loan portfolio, we utilize qualitative adjustments to the modeled estimated loss approaches. The parameters for making adjustments are established under a Credit Risk Matrix that provides different possible scenarios for each of the factors listed below. The Credit Risk Matrix and the possible scenarios enable the Bank to qualitatively adjust the loss rates. This matrix considers the following nine factors, which are patterned after the guidelines provided under the Federal Financial Institutions Examination Council Interagency Policy Statement on the Allowance for Credit Losses, updated to reflect the adoption of CECL:

•    Changes in lending policies and procedures, including changes in underwriting standards and practices for collection, charge-offs, and recoveries;

•    Actual and expected changes in national and local economic and business conditions and developments in which the institution operates that affect the collectivity of loans;

•    Changes in the nature and volume of the loan portfolio;

•    Changes in the experience, ability, and depth of lending management and staff;

•    Changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified loans;

•    Changes in the quality of the credit review function;

•    Changes in the value of the underlying collateral for loans that are not collateral-dependent;

•    The existence, growth, and effect of any concentrations of credit, and

•    The effect of other external factors, such as the regulatory, legal and technological environments; competition; and events such as natural disasters.

RESULTS OF OPERATIONS

Net Income

We reported net income for the year ended December 31, 2023 of $23.9 million, a decrease of $9.4 million, or 28.2%, compared to net income of $33.3 million for the same period of 2022. The decrease was primarily due to a $8.2 million decrease in net interest income, a $3.4 million decrease in noninterest income and a $2.9 million increase in noninterest expense, offset by a $3.8 million decrease income tax expense and a $1.3 million decrease in provision for credit losses.

We reported net income for the year ended December 31, 2022 of $33.3 million, and increase of $4.5 million, or 15.5%, compared to net income of $28.8 million for the same period of 2021. The increase was primarily due to a $15.9

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million increase in net interest income, partially offset by a $9.0 million increase in noninterest expense and a $2.5 million increase in provision for credit losses.

Net Interest Income

The management of interest income and expense is fundamental to our financial performance. Net interest income, the difference between interest income and interest expense, is the largest component of our total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). We seek to maximize net interest income without exposing us to an excessive level of interest rate risk through our asset and liability policies. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest-bearing assets and liabilities. Our net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

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The following table presents, for the periods indicated, information about: (i) weighted average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields, (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates, (iii) net interest income, (iv) the interest rate spread, and (v) the net interest margin.

(1)Includes income and average balances for Federal Home Loan Bank (“FHLB”) and Pacific Coast Bankers Bank stock, CRA qualified mutual fund, term federal funds, interest-earning time deposits and other miscellaneous interest-earning assets.

(2)Average loan balances include non-accrual loans and loans held for sale.

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(1)Includes income and average balances for Federal Home Loan Bank (“FHLB”) and Pacific Coast Bankers Bank stock, CRA qualified mutual fund, term federal funds, interest-earning time deposits and other miscellaneous interest-earning assets.

(2)Average loan balances include non-accrual loans and loans held for sale.

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Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest rates. The following tables set forth the effects of changing rates and volumes on our net interest income during the period shown. Information is provided with respect to (i) effects on interest income attributable to changes in volume (change in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Change applicable to both volume and rate have been allocated to volume and rate ratably.

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2023 Compared to 2022

Net interest income decreased $8.2 million, or 10.7%, to $68.7 million for the year ended December 31, 2023 from $76.9 million for the same period of 2022, primarily due to higher interest expense on deposits, partially offset by higher interest income on loans and investments.

Interest expense on deposits increased $38.2 million to $49.4 million for the year 2023, compared with $11.2 million for the same period of 2022. The increase was primarily due to a 32.1% increase in average balance of interest-bearing deposits and a 285 basis point increase in average cost of interest-bearing deposits driven by the Federal Reserve's rate increases.

Average balance of interest-bearing deposits increased $295 million or 32.1% compared with the same period of 2022 because a $167 million increase in average balance of loans and a $182 million decrease in noninterest-bearing deposits for the year 2023 were primarily funded through the increase in interest-bearing deposits. Average cost of interest-bearing deposits increased a 285 basis point to 4.1% for the year ended December 31, 2023, from 1.2% for the same period of 2022, primarily due to the Federal Reserve’s rate increases.

Interest income on total investments, including interest-bearing deposits in other banks and available-for-sale debt securities, increased $5.9 million primarily due to a 175 basis point increase in average yield on total investments to 3.79% for the year 2023 from 2.04% for the same period of 2022 driven by the Federal Reserve’s rate increases and higher yields on securities purchased in 2023.

Interest income on loans increased $27.6 million to $110.5 million for the year 2023 compared with $82.9 million for the year 2022, primarily due to a $167 million increase in average balance of loans and a 108 basis point increase in average yield on loans.

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Net interest margin was 3.37% for the year ended December 31, 2023, a 81 basis point decrease from 4.18% for the same period of 2022, primarily due to a 171 basis point decrease in net interest spread from the higher increase in average cost of interest-bearing deposits compared to the increase in average yield on loans and investments.

2022 Compared to 2021

Net interest income increased $15.9 million, or 26.0%, to $76.9 million for the year ended December 31, 2022 from $61.0 million for the same period of 2021, primarily due to higher interest income on loans. A $20.4 million increase in interest income on loans for the year ended December 31, 2022, compared with the same period of 2021, was primarily due to higher average loan balance from loan growth in home mortgage loans, commercial real estate loans, and C&I loans and rate increases in SBA loans, C&I loans and commercial real estate loans.

Average yield on interesting-bearing deposits in other banks was 1.76% for the year ended December 31, 2022, a 163 basis point increase from 0.13% for the same period of 2021, primarily due to the Federal Reserve’s rate increases. Average yield on available-for-sale debt securities was 1.97% for the year ended December 31, 2022, a 97 basis point increase from 1.00% for the same period of 2021, primarily due to purchases of securities that earn higher yields than existing investment portfolio.

Average loan yield was 5.25% for the year ended December 31, 2022, a 31 basis point increase from 4.94% for the same period of 2021. The increase was primarily due to higher average loan balance from loan growth of $212.5 million, $105.7 million and $28.0 million in home mortgage loans, commercial real estate loans, and C&I loans, respectively, and rate increases of 135 basis points in SBA loans, 117 basis points in C&I loans, and 31 basis points in commercial real estate loans.

Average cost of interest-bearing deposits was 1.22% for the year ended December 31, 2022, an 80 basis point increase from 0.42% for the same period of 2021, primarily due to the Federal Reserve’s rate increases. Average cost of deposits was 0.65% for the year ended December 31, 2022, a 43 basis point increase from 0.22% for the same period of 2021, primarily due to the Federal Reserve’s rate increases, partially offset by higher average balance of noninterest-bearing deposits.

Net interest margin was 4.18% for the year ended December 31, 2022, a 16 basis point increase from 4.02% for the same period of 2021, primarily due to a 56 basis point increase in average yield on interest-earning assets.

Provision for Credit Losses

Credit risk is inherent in the business of making loans. We establish an allowance for credit losses both on loans and off-balance sheet commitments through charges to earnings, which are shown in the statements of operations as the provision for credit losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for credit losses is determined by conducting a quarterly evaluation of the adequacy of our allowance for credit losses and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to earnings. The provision for credit losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in our market area.

2023 Compared to 2022

The provision for credit losses was $1.7 million for the year ended December 31, 2023, compared to $3.0 million for the same period of 2022. The $1.7 million in the provision for credit losses was mainly composed of a $735 thousand increase in qualitative reserves and a $754 thousand increase in net charge-offs for the year 2023. The qualitative reserves were primarily due to upward adjustments to qualitative factors based on deteriorating economic and business conditions in 2023 compared to 2022 and an increasing trend in nonperforming and classified loans in our loan portfolio. There was no change in quantitative reserves in 2023 as a $450 thousand increase in reserves from loan growth in 2023 was offset by an equivalent release of reserves from decreases in historical loss factors.

2022 Compared to 2021

The provision for loan losses was $3.0 million for the year ended December 31, 2022, compared to $522 thousand for the same period of 2021. The changes in quantitative reserves from loan growth in real estate and home mortgage loans

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accounted for an increase of $5.8 million in the provision for loan losses for the year ended December 31, 2022. The changes in quantitative reserves included a $205 thousand decrease in the provision for accrued interest receivables on deferred loans. The changes in qualitative factors, primarily due to improvements in economic conditions and commercial real estate concentration, accounted for a decrease of $2.8 million in the provision for loan losses for the year ended December 31, 2022.

Noninterest Income

While interest income remains the largest single component of total revenues, noninterest income is also an important component. A portion of our noninterest income is associated with SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Other sources of noninterest income include service charges on deposit.

2023 Compared to 2022

The following table sets forth the various components of our noninterest income for the years ended December 31, 2023 and 2022:

Noninterest income for the year ended December 31, 2023 was $14.2 million, a decrease of $3.4 million, or 19.5%, compared to $17.6 million for the same period of 2022, primarily due to a decrease in gain on sale of loans.

Gain on sale of loans was $7.8 million for the year ended December 31, 2023, compared to $12.3 million for the same period of 2022, a decrease of $4.4 million or 36.2%. The decrease was primarily due to a lower sold amount in SBA loans and a lower average sales premium. We sold $145.0 million of SBA loans with an average premium of 6.65% for the year ended December 31, 2023, compared to a sale of $181.9 million of SBA loans with an average premium of 7.45% in the same period of 2022.

Other income was $1.8 million for the year ended December 31, 2023, compared to $1.2 million, an increase of $523 thousand or 42.1%, primarily due to a $479 thousand increase in a holding gain on our equity in equity investments. Equity investments had an unrealized holding gain of $48 thousand as of December 31, 2023 compared to an unrealized holding loss of $431 thousand as of December 31, 2022.

Service charges on deposit was $2.1 million for the year ended December 31, 2023, compared to $1.7 million for the same period of 2022, an increase of $448 thousand or 26.7%, primarily due to an increase in deposit analysis fees from an increase in the number of analysis accounts.

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2022 Compared to 2021

The following table sets forth the various components of our noninterest income for the years ended December 31, 2022 and 2021:

Noninterest income for the year ended December 31, 2022 was $17.6 million, an increase of $1.6 million, or 10.0%, compared to $16.0 million for the same period of 2021.

Loan servicing fees, net of amortization, were $2.4 million, for the year ended December 31, 2022, compared to $2.0 million for the same period of 2021. The increase was primarily due to an increase in loan servicing portfolio and lower amortization of loan servicing fees as a result of lower SBA loan payoffs. Our total SBA loan servicing portfolio was $702.1 million as of December 31, 2022, compared to $667.0 as of the same period of 2021.

Gain on sale of loans was $12.3 million for the year ended December 31, 2022, compared to $11.3 million for the same period of 2021, an increase of $1.0 million or 8.6%. The increase was primarily due to higher sales volume partially offset by lower average premium on loan sales. We sold $181.9 million of SBA loans with an average premium of 7.45% for the year ended December 31, 2022, compared to a sale of $110.3 million of SBA loans with an average premium of 11.04% in the same period of 2021.

Noninterest Expense

2023 Compared 2022

The following table sets forth the major components of our noninterest expense for the years ended December 31, 2023 and 2022:

Noninterest expense for the year ended December 31, 2023 was $47.7 million, compared with $44.8 million for the same period of 2022, an increase of $2.9 million or 6.5%.

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Salaries and employee benefits for the year ended December 31, 2023 was $29.6 million, compared to $27.2 million for the same period of 2022, an increase of $2.4 million, or 8.8%. The increase was primarily due to a $1.0 million increase from a 17.2 increase in average number of full-time employees to 224.4 in 2023 from 207.2 in 2022, and a $850 thousand decrease in loan origination costs as a result of lower loan originations in 2023.

Occupancy and equipment for the year ended December 31, 2023 was $6.5 million, compared to $6.0 million for the same period of 2022, an increase of $526 thousand, or 8.8%. The increase was primarily due to the opening of Spring Mountain Office in Las Vegas, Nevada and two renewed leases for branches in California.

FDIC insurance and regulatory assessments for the year ended December 31, 2023 was $1.5 million, compared to $813 thousand, an increase of $644 thousand, or 79.2%. The increase was primarily due to our deposit growth from the same period of 2022 and an increase in FDIC assessment fees in 2023.

Foundation donations and other contributions for the year ended December 31, 2023 was $2.4 million, compared to $3.4 million, a decrease of $993 thousand, or 29.3%. The decrease was primarily due to lower donation accruals for Open Stewardship Foundation as a result of lower net income.

2022 Compared to 2021

The following table sets forth the major components of our noninterest expense for the years ended December 31, 2022 and 2021:

Noninterest expense for the year ended December 31, 2022 was $44.8 million, compared with $35.9 million for the same period of 2021, an increase of $9.0 million, or 25.0%.

Salaries and employee benefits expense for the year ended December 31, 2022 was $27.2 million, compared to $21.3 million for the same period of 2021, an increase of $5.9 million, or 27.9%. The increase was primarily due to increased salaries as a result of additional employees to support continued growth of the Company. The average number of full-time equivalent employees was 207.2 in 2022 compared to 181.5 in 2021.

Professional fees for the year ended December 31, 2022 was $1.6 million, compared to $1.2 million for the same period of 2021, an increase of $428 thousand, or 35.9%. The increase was primarily due to increases in accounting fees and other consulting fees.

Occupancy and equipment expense for the year ended December 31, 2022 was $6.0 million, compared to $5.2 million for the same period of 2021, an increase of $751 thousand, or 14.4%. The increase was primarily due to a new branch opened in the first quarter of 2022 and increased equipment expense to support our continued growth.

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Foundation donation and other contributions for the year ended December 31, 2022 were $3.4 million, compared to $2.9 million for the same period of 2021, an increase of $503 thousand, or 17.4%. The increase was primarily due to higher donation accruals for Open Stewardship Foundation as a result of higher net income.

Other expenses for the year ended December 31, 2022 were $2.5 million, compared to $1.5 million for the same period of 2021, an increase of $1.1 million, or 74.4%. The increase were primarily due to an increase in business development expense.

Income Tax Expense

Income tax expense was $9.6 million for the year ended December 31, 2023, compared to $13.4 million for the same period of 2022, primarily due to a $13.2 million or 28.3% decrease in income before income tax to $33.5 million in 2023 from $46.7 million for 2022. Effective tax rates were 28.6% and 28.7% for the years ended December 31, 2023 and 2022, respectively.

Income tax expense was $13.4 million for the year ended December 31, 2022, compared to $11.8 million for the same period of 2021. The increase was primarily due to higher tax provision as a result of higher net income. Effective tax rates were 28.7% and 29.1% for the years ended December 31, 2022 and 2021, respectively.

Some items of income and expense are recognized in different years for tax purposes than when applying GAAP, leading to timing differences between our actual tax liability and the amount accrued for liability based on book income. These temporary differences comprise the “deferred” portion of our tax expense or benefit, which accumulates on our books as a deferred tax asset or deferred tax liability, until such time as they reverse.

Realization of deferred tax assets is primarily dependent upon us generating sufficient future taxable income to obtain benefit from the reversal of net deductible temporary differences, along with the utilization of tax credit carry forwards and the net operating loss carry forwards for Federal and California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under GAAP a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax assets will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

We recognized net deferred tax assets of $13.3 million and $14.3 million as of December 31, 2023 and 2022, respectively. After consideration of the matters in the preceding paragraph, we have determined that it is more likely than not that net deferred tax assets as of December 31, 2023 will be fully realized in future years.

FINANCIAL CONDITION

Investment Portfolio

The securities portfolio is the second largest component of our interest earning assets, and the structure and composition of this portfolio is important to an analysis of our financial condition. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it provides liquidity to even out cash flows from the loan and deposit activities of customers; (iii) it can be used as an interest rate risk management tool, because it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and our other funding sources; and (iv) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.

We classify our securities as either available-for-sale or held-to-maturity at the time of purchase. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders’ equity. Monthly adjustments are made to reflect changes in the fair value of our available-for-sale securities.

All securities in our investment portfolio were classified as available-for-sale as of December 31, 2023. There were no held-to-maturity or trading securities in our investment portfolio as of December 31, 2023. All available-for-sale

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securities are carried at fair value and consist of U.S. government agencies or sponsored agency securities and tax-exempt municipal securities.

The following table summarizes the fair value of the available-for-sale securities portfolio as of the dates presented:

Available-for-sale debt securities decreased $15.6 million, or 7.4%, to $194.3 million as of December 31, 2023 from $209.8 million as of December 31, 2022, primarily due to 24.4 million in principal paydowns, partially offset by purchases of $5.6 million in tax exempt municipal securities for the year ended December 31, 2023. No issuer of the available-for-sale securities, other than U.S. Government and its agencies, comprised more than ten percent of our shareholders’ equity as of December 31, 2023 and 2022.

Certain securities have fair values less than amortized cost and, therefore, contain unrealized losses. The unrealized losses were primarily attributable to interest rate movement, not credit quality. These securities (Fannie Mae, Ginnie Mae, and Freddie Mac) are guaranteed or sponsored by agencies of the U.S. government, and the issuers of the securities are of high credit quality. We believe that the net unrealized losses presented in the previous tables are temporary and no credit losses are expected. As a result, we expects full collection of the carrying amount of these securities, does not intend to sell the securities in an unrealized loss position, and it was more-likely-than-not we will not have to sell these securities prior to recovery of amortized cost. Accordingly, for available-for-sale debt securities, we did not record an allowance for credit losses on January 1, 2023 and does not have allowance for credit losses as of December 31, 2023.

The following table sets forth certain information regarding contractual maturities and the weighted average yields of our investment securities as of the dates presented. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

We have not used interest rate swaps or other derivative instruments to hedge fixed rate loans or securities to otherwise mitigate interest rate risk.

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Loans

Our loans represent the largest portion of our earning assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing our financial condition.

The loan distribution table that follows sets forth our gross loans outstanding, and the percentage distribution in each category as of the dates indicated:

(1)     Includes net deferred loan costs and unamortized premiums of $140 thousand and $160 thousand as of December 31, 2023 and 2022, respectively.

Gross loans increased $87.6 million, or 5.2%, to $1.77 billion as of December 31, 2023, compared to $1.68 billion as of December 31, 2022. The increase was primarily attributable to new loan production of $374.5 million, partially offset by loan payoffs and paydowns of $213.8 million.

The following tables presents the contractual loan maturities by loan category and the contractual distribution of loans to changes in interest rates as of December 31, 2023 and 2022:

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Our loan portfolio is concentrated in commercial real estate, which includes unguaranteed balances in SBA loans, home mortgage and commercial (primarily manufacturing, wholesale, and services oriented entities). We do not have any material concentrations by industry or group of industries in the loan portfolio. However, 92.2% of our gross loans were secured by real property as of December 31, 2023, compared to 92.1% as of December 31, 2022.

Loans — Commercial Real Estate: We have established concentration limits in the loan portfolio for commercial real estate loans, commercial and industrial loans, and unsecured lending, among others. All loan types are within established limits. We use underwriting guidelines to assess the borrowers’ historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending agreements to allow us to react to a borrower’s deteriorating financial condition, should that occur.

Commercial real estate loans include owner-occupied and non-occupied commercial real estate. We originate both fixed and adjustable rate loans. Adjustable rate loans are based on the Wall Street Journal prime rate. Our commercial real estate loan portfolio totaled $885.6 million as of December 31, 2023 compared to $842.2 million as of December 31, 2022. During the year ended December 31, 2023, we originated $103.3 million of commercial real estate loans. As of December 31, 2023, approximately 76.1% of the commercial real estate portfolio consisted of fixed-rate loans. Our policy maximum loan-to-value, or LTV, is 70% for commercial real estate loans. As of December 31, 2023, our average loan to value for commercial real estate loans was 50.7%.

Loans — SBA: We are designated as an SBA Preferred Lender under the SBA Preferred Lender Program. We offer mostly SBA 7(a) variable-rate loans. We generally sell the 75% guaranteed portion of the SBA loans that we originate. Our SBA loans are typically made to small-sized manufacturing, wholesale, retail, hotel/motel and service businesses for working capital needs or business expansions. SBA loans have maturities up to 25 years. Typically, non-real estate secured loans mature in less than 10 years. Collateral may also include inventory, accounts receivable and equipment, and may include personal guarantees. Our unguaranteed SBA loans collateralized by real estate are monitored by collateral type and included in our commercial real estate Concentration Guidance.

As of December 31, 2023, our SBA portfolio totaled $239.7 million, compared to $234.7 million as of December 31, 2022. We originated $141.5 million for the year ended December 31, 2023. We sold SBA loans of $145.0 million with a 6.65% average premium during year ended December 31, 2023.

From our total SBA loan portfolio, $224.7 million is secured by real estate and $15.0 million is unsecured or secured by business assets as of December 31, 2023.

Loans — Commercial and Industrial: Commercial and industrial loans totaled $121.0 million as of December 31, 2023, compared to $117.0 million as of December 31, 2022. We originated $63.3 million for the year ended December 31, 2023.

Loans - Home Mortgage: We originate mainly non-qualified, alternative documentation single-family home mortgage loans (“home mortgage”) primarily through our retail branch network and our correspondent lender network. The primary loan product is a five-year or seven-year hybrid adjustable rate mortgage, which reprices after five years to a selected SOFR plus certain spreads. We also purchase residential mortgage loans from third party mortgage originators based on the review of their underwriting and file quality as opportunities arise.

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Home mortgage loans totaled $518.0 million as of December 31, 2023, compared to $482.9 million as of December 31, 2022. For the year ended December 31, 2023, we originated $65.0 million of home mortgage loans and purchased $11.2 million of home mortgage loans from third party mortgage originators.

Loan Servicing

As of December 31, 2023 and 2022, we serviced $707.4 and $702.1 million, respectively, of SBA loans for others. Activity for loan servicing rights was as follows:

Loan servicing rights are reported on our Consolidated Balance Sheets and reported net of amortization.

Allowance for Credit Losses

We adopted ASU 2016-13 using a modified retrospective approach on January 1, 2023 without electing the fair value option on eligible financial instruments under ASU 2019-05. We replaced the current incurred loss accounting model with the Current Expected Credit Losses ("CECL") approach for financial instruments measured at amortized cost and other commitments to extend credit. CECL requires the immediate recognition of estimated credit losses expected to occur over the estimated remaining life of the asset. The forward-looking concept of CECL requires loss estimates to consider historical experience, current conditions and reasonable and supportable forecasts.

The adoption of this ASU increased the allowance for credit losses by $1.9 million and allowance for off-balance sheet commitments by $184 thousand. We also recorded a deferred tax assets of $624 thousand and a decrease to opening retained earnings of $1.5 million on January 1, 2023. The increase to allowance for credit losses was primarily longer duration of home mortgage loans, offset primarily by shorter duration of commercial and industrial loans. We did not record an allowance for credit losses on our available-for-sale debt securities as a result of this adoption. Disclosures for periods after January 1, 2023 are presented in accordance with ASC 326 while prior period amounts continue to be reported in accordance with previously applicable standards and the accounting policies.

We employ a modeled approach that takes into account current and future economic conditions to estimate lifetime expected losses on a collective basis. With the adoption of CECL, we elected not to consider accrued interest receivable in its estimated credit losses because we write off uncollectible accrued interest receivable in a timely manner. We consider writing off accrued interest amounts once the amounts become 90 days past due to be considered within a timely manner. We have elected to write off accrued interest receivable by reversing interest income. We use transition matrices to develop the Probability of Default ("PD") and Loss Given Default ("LGD") approach, incorporating quantitative factors and qualitative considerations in the calculation of the allowance for credit losses for collectively assessed loans. The model provides forecasts of PD and LGD based on national unemployment rates using regression analysis. We incorporate future economic conditions using a weighted multiple scenario approach: baseline and adverse. We apply a reasonable and supportable period of one year for the baseline scenario and two years for the adverse scenario, after which loss assumptions revert to historical loss information through a one-year reversion period for the baseline scenario and a two-year reversion period for the adverse scenario. Additionally, we aggregated loan portfolio based on similar risk characteristic. We elected to use the Call Report codes and loan risk ratings for loan segmentation in allowance for credit losses.

The allowance for credit losses is sensitive to numerous factors, including unemployment rate forecasts, change in asset quality, prepayment rates, and real estate indices. Given the dynamic relationship between these factors within our model, it is difficult to estimate the impact of any one factor or input on the allowance for credit losses. Changes in the factors and inputs considered may not occur at the same rate and may not be consistent across all geographies or product types. Additionally, changes in factors and input may be discretionally inconsistent, such that improvement in one factor

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may offset deterioration in others. However, to provide additional context regarding the sensitivity of the allowance for credit losses to changes in key variable, we used the following assumptions in a sensitivity analysis of our allowance for credit losses: unemployment rate forecast based on supervisory severely adverse scenario, 0% prepayment rates, loan risk grade changes of commercial real estate and commercial and industrial loan portfolio in worst case scenario based on our history, and applying a 100% weighting to severely adverse scenario.

The analysis demonstrates the sensitivity to the allowance for credit losses to key quantitative assumptions and it is not intended to estimate changes in the overall allowance for credit losses and it does not capture all the potential unknown variables that could arise in the forecast period, but it provides an approximation of a possible outcome under hypothetical severe conditions.

In order to quantify the credit risk impact of other trends and changes within the loan portfolio, we utilize qualitative adjustments to the modeled estimated loss approaches. Included in the qualitative portion of our analysis of the allowance for credit losses are key inputs including GDP, unemployment rates, interest rates, asset quality ratios, loan portfolio concentration, California house price index and commercial real estate price index. The parameters for making adjustments are established under a Credit Risk Matrix that provides different possible scenarios for each of the factors listed below. The Credit Risk Matrix and the possible scenarios enable the Bank to qualitatively adjust the loss rates. This matrix considers the following nine factors, which are patterned after the guidelines provided under the Federal Financial Institutions Examination Council Interagency Policy Statement on the Allowance for Credit Losses, updated to reflect the adoption of CECL:

•    Changes in lending policies and procedures, including changes in underwriting standards and practices for collection, charge-offs, and recoveries;

•    Actual and expected changes in national and local economic and business conditions and developments in which the institution operates that affect the collectivity of loans;

•    Changes in the nature and volume of the loan portfolio;

•    Changes in the experience, ability, and depth of lending management and staff;

•    Changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified loans;

•    Changes in the quality of the credit review function;

•    Changes in the value of the underlying collateral for loans that are not collateral-dependent;

•    The existence, growth, and effect of any concentrations of credit, and

•    The effect of other external factors, such as the regulatory, legal and technological environments; competition; and events such as natural disasters.

We segment loans primarily by Call Report codes (collateral type) and loan risk ratings, considering that the same type of loans share considerable similar risk characteristics. For loans that do not share similar risk characteristics such as nonaccrual loans above $500 thousand, we evaluate these loans on an individual basis in accordance with ASC 326. Such nonaccrual loans are considered to have different risk profiles than performing loans and are therefore evaluated individually. We elected to collectively assess nonaccrual loans with balances below $500 thousand along with the performing and accrual loans, in order to reduce the operational burden of individually assessing small nonaccrual loans with immaterial balances. For individually assessed loans, the allowance for credit losses is measured using either 1) the present value of future cash flows discounted at the loan’s effective interest rate; or 2) the fair value of the collateral, if the loan is collateral-dependent. For the collateral-dependent loans, we obtain a new appraisal to determine the fair value of collateral. The appraisals are based on an “as-is” valuation. To ensure that appraised values remain current, we obtain updated appraisals every twelve months from a qualified independent appraiser. If the fair value of the collateral is less than the amortized balance of the loan, we recognize an allowance for credit losses with a corresponding charge to the provision for credit losses.

Collateral-dependent loans are loans where repayment is expected to be provided solely by the sale of the underlying collateral and there are no other available and reliable sources of repayment. The estimated credit losses for these loans are based on the collateral’s fair value less selling costs. In most cases, the Company records a partial charge-off to reduce the loan’s carrying value to the collateral’s fair value less selling costs at the time of foreclosure.

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As of December 31, 2023, there were $5.2 million of collateral-dependent loans which are primarily secured by residential and commercial real estate, as well as equipment. The allowance for credit losses allocated to these loans as of December 31, 2023 was $355 thousand.

The following table represents the amortized cost basis of collateral-dependent loans by class of loans as of December 31, 2023, for which repayment is expected to be obtained through the sale of the underlying collateral.

We maintain a separate allowance for credit losses for off-balance sheet commitments. We use an estimated funding rate to allocate an allowance to undrawn exposures. This funding rate is used as a credit conversion factor to capture how much undrawn lines of credit can potentially become drawn at any point. The funding rate is determined based on a look-back period of 8 quarters. Credit loss is not estimated for off-balance sheet commitments that are unconditionally cancellable by us.

The allowance for credit losses was $22.0 million as of December 31, 2023, compared to $19.2 million as of December 31, 2022. $1.7 million provision of credit losses was recorded for the year ended December 31, 2023, compared to provision for credit losses of $3.0 million for the same period in 2022.

Analysis of the Allowance for Credit Losses

The following table provides an analysis of the allowance for credit losses, provision for credit losses and net charge-offs, by category, for the year ended December 31, 2023, 2022 and 2021:

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(1)Excludes loans held for sale.

(2)Annualized.

The following table presents an allocation of the allowance for credit losses by portfolio as of December 31, 2023 and 2022:

Nonperforming Assets

Loans are considered delinquent when principal or interest payments are past due 30 days or more. Delinquent loans may remain on accrual status between 30 days and 90 days past due. Loans on which the accrual of interest has been discontinued are designated as non-accrual loans. Typically, the accrual of interest on loans is discontinued when principal or interest payments are 90 days past due or when, in the opinion of management, there is a reasonable doubt as to collectability in the normal course of business. When loans are placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current period interest income. Income on non-accrual loans is subsequently

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recognized only to the extent that cash is received, and the loan’s principal balance is deemed collectible. Loans are restored to accrual status when loans become well-secured and management believes full collectability of principal and interest is probable.

Nonperforming loans include loans that are 90 days past due and still accruing, loans accounted for on a non-accrual basis and accruing restructured loans. Nonperforming assets consist of nonperforming loans plus other real estate owned ("OREO").

Nonperforming loans were $6.1 million as of December 31, 2023, compared to $2.0 million as of December 31, 2022. Nonperforming loans excluded the guaranteed portion of SBA loans of $2.0 million and $1.0 million as of December 31, 2023 and 2022, respectively.

Real estate we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as OREO until sold, and is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. We had no OREO as of December 31, 2023 and 2022.

The following table sets forth the allocation of our nonperforming assets among our different asset categories as of the dates indicated. Nonperforming loans include non-accrual loans, loans past due 90 days or more and still accruing interest, and loans modified under troubled debt restructurings.

(1)Excludes guaranteed portion of SBA loans of $2.0 million and $1.0 million as of December 31, 2023 and 2022, respectively.

Deposits and Other Sources of Funds

We gather deposits primarily through our branch locations. We offer a variety of deposit products including demand deposits accounts, interest-bearing products, savings accounts and certificate of deposits. We dedicate continuing effort into gathering noninterest demand deposits accounts through marketing to our existing and new loan customers, customer referrals, our marketing staff and various involvement with community networks.

The following table show the composition of deposits by type as of the dates presented:

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The following tables set forth the maturity of time deposits as of December 31, 2023:

Other than deposits, we also utilized FHLB advances as a supplementary funding source to finance our operations. The advances from the FHLB are collateralized by residential and commercial real estate loans. As of December 31, 2023 and 2022, we had maximum borrowing capacity from the FHLB of $655.9 million and $582.8 million, respectively. We had $105.0 million borrowings from FHLB as of December 31, 2023 and no borrowing from FHLB as of December 31, 2022. The Company had estimated uninsured deposits of $1.14 billion, or 63.3% of total deposits, and $1.14 billion, or 60.3% of total deposits, as of December 31, 2023 and 2022, respectively.

Liquidity and Capital Resources

Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders. Our short-term and long-term liquidity requirements are primarily met through cash flow from operations, redeployment of prepaying and maturing balances in our loan and investment portfolios, and increases in customer deposits. Other alternative sources of funds will supplement these primary sources to the extent necessary to meet additional liquidity requirements on either a short-term or long-term basis.

Deposits are the primary funding source for the Bank. Deposits provide a stable source of funding and reduce our reliance on the wholesale funding markets. The following table presents the loan and deposit balances, the loans-to-deposit ratios, and deposits as a percentage of total liabilities as of December 31, 2023 and 2022:

In addition to deposits, we have access to various sources of wholesale funding, as well as borrowing capacity at the FHLB, Federal Reserve, and correspondent banks to sustain an adequate liquid asset portfolio, meet daily cash demands and allow management flexibility to execute the business strategy. Economic conditions and the stability of capital markets impact the access to and the cost of wholesale funding. The access to capital markets is also affected by the ratings received from various credit rating agencies.

We had $100.0 million of unsecured federal funds lines with no amounts advanced as of December 31, 2023 and 2022. In addition, on such dates we had lines of credit from the Federal Reserve discount window of $183.0 million and $175.6 million, respectively. The Federal Reserve discount window lines were collateralized by a pool of commercial real estate loans and commercial and industrial loans totaling $251.0 million and $254.7 million as of December 31, 2023 and 2022, respectively. We did not have any borrowings outstanding with the Federal Reserve as of December 31, 2023 or December 31, 2022, and our borrowing capacity is limited only by eligible collateral.

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Based on the values of loans pledged as collateral, we had $363.6 million of additional borrowing availability with the FHLB as of December 31, 2023. We also maintain relationships in the capital markets with brokers to issue certificates of deposit and money market accounts.

We maintain ample access to liquidity, including highly liquid assets on our balance sheet and available unused borrowings from other financial institutions. The following table presents our liquid assets and available borrowings as of December 31, 2023 and 2022:

The following tables summarizes short- and long-term material cash requirements as of December 31, 2023, which we believe that we will be able to fund these obligations through cash generated from our operations and available alternative sources of funds:

(1)Includes deposits with no defined maturity, such as noninterest-bearing demand, savings and money market.

(2)Excludes accrued interest.

In addition to contractual obligations, other commitments of us impact liquidity. These include unused commitments to extend credit, standby letters of credit and commercial letters of credit. Since many of these commitments expire without being drawn upon, and each customer must continue to meet the conditions established in the contract, the total amount of these commercial commitments does not necessarily represent the future cash requirements of us. Our liquidity sources have been, and are expected to be, sufficient to meet the cash requirements of its lending activities, Information about our loan commitments, standby letters of credit and commercial letters of credit is provided in Note 10. Commitments and Contingencies to the Consolidated Financial Statements in this Form 10-K.

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Capital Requirements

We are subject to various regulatory capital requirements administered by the federal and state banking regulators. Failure to meet regulatory capital requirements may result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for “prompt corrective action”, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting policies. The capital amounts and classifications are subject to qualitative judgments by the federal banking regulators regarding components, risk weightings and other factors. Qualitative measures established by regulation to ensure capital adequacy required us to maintain minimum amounts and various ratios of CET1 capital, Tier 1 capital and total capital to risk-weighted assets and of Tier 1 capital to average consolidated assets, referred to as the “leverage ratio.”

The table below also summarizes the capital requirements applicable to us and the Bank in order to be considered “well-capitalized” from a regulatory perspective, as well as our and the Bank’s capital ratios as of December 31, 2023 and 2022. The Bank exceeded all regulatory capital requirements under the Basel III Capital Rules and were considered to be “well-capitalized” as of the dates reflected in the table below. As of December 31, 2023, the FDIC categorized us as well-capitalized under the prompt corrective action framework. There have been no conditions or events since December 31, 2023 that management believes would change this classification.

(1)    The capital requirements are only applicable to the Bank, and our ratios are included for comparison purpose.

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(1)    The capital requirements are only applicable to the Bank, and our ratios are included for comparison purpose.