Oak Valley Bancorp (OVLY) FY 2021 MD&A

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

The following discussion of financial condition as of December 31, 2021 and 2020 and results of operations for each of the years in the two-year period ended December 31, 2021 should be read in conjunction with our consolidated financial statements and related notes thereto, included in this report. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs and involve numerous risks and uncertainties. Actual results may differ materially from those contained in any forward-looking statements. You should carefully read “Special Note Regarding Forward-Looking Statements” included in this report.

Introduction

Our continued focus on responsible community banking fundamentals and our strong customer relationships have enabled us to increase our market presence through growth in our loan portfolio, which is primarily funded by steady core deposit growth.

As of December 31, 2021, we had approximately $1.96 billion in total assets, $0.86 billion in total gross loans, and $1.81 billion in total deposits.

We believe the following were key indicators of our performance during 2021:

These items, as well as other factors, contributed to the increase in net income for 2021 to $16.3 million from $13.7 million in 2020, which translates into $2.00 per diluted share in 2021 as compared to $1.68 per diluted share in 2020.

Over the past several years, our network of branches and loan production offices have expanded geographically. We currently maintain seventeen full-service offices. We intend to continue our growth strategy in future years through the opening of additional branches and loan production offices as our needs and resources permit.

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COVID-19 Impact

The coronavirus (“COVID-19”) pandemic and the Federal Reserve's response to the economic challenges has resulted in an uncertain and rapidly evolving economy. In the early stages of the pandemic, a significant portion of staff worked remotely, but essentially all staff have returned to the office as of December 31, 2021. The remote work arrangements did not adversely impact the ability to serve clients and did not have an impact on the Company’s financial reporting systems or the internal controls over financial reporting, disclosures and related procedures.

The most significant impact of COVID-19 on the Company’s business has been to the quality of the loan portfolio and to net interest income as short-term interest rates have sharply declined. In 2020, the Company increased the qualitative factors used in the determination of the adequacy of the allowance for loan and lease loss in anticipation of the impact that COVID-19 will have on clients and their ability to fulfill their obligations. In 2021, the financial stress subsided to some degree and credit quality improved allowing the Company to reverse $635,000 in loan loss provisions. The allowance for loan losses decreased to $10,738,000 as of December 31, 2021, as compared with $11,297,000 as of December 31, 2020. The allowance for loan losses as a percentage of total loans increased from 1.12% as of December 31, 2020 to 1.25%, as loan loss reserves relative to gross loans remain at acceptable levels and credit quality remains stable. The increase compared to 1.12% as of December 31, 2020 was due to the decrease in outstanding PPP loans that do not require a loan loss reserve as they are guaranteed by the federal government through the SBA program.

There is no certainty that the allowance for loan losses as of December 31, 2021 will be sufficient to absorb the losses that stem from the impact of COVID-19 on the Company’s clients. As the longer-term effects on clients from the COVID-19 pandemic become more apparent, it may be necessary to charge-off some or all of the balance on certain loans and make further provisions to increase the allowance for loan and lease losses. These potential additional provisions for loan and lease losses will have a direct impact upon capital, including the potential need to reevaluate a valuation allowance on our deferred tax asset. At this time, the Company does not expect that there would be any material impairment to the valuation of other long-lived assets, right of use assets, or our investment securities.

Increased demand for liquidity by clients is another impact that could occur should the COVID-19 effects be prolonged. As of December 31, 2021, the Company and the Bank's on-balance sheet liquidity was very strong and combined with contingent liquidity resources, management believes that the Bank has sufficient resources to meet the liquidity needs of its clients. In response to COVID-19, the Federal Reserve has made other provisions that could assist the Bank in satisfying its liquidity needs, such as reducing the reserve requirement to zero, expanding access to the discount window through collateral pledging and extension of term borrowings.

The extent to which the COVID-19 pandemic affects the Company’s future financial results and operations will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the duration and broad impacts of the pandemic, and current or future actions in response thereto. See “Management’s Discussion and Analysis of Financial Position and Results of Operations” and Part II, Item 1A, Risk Factors, for an additional discussion of risk related to COVID-19.

2022 Outlook

As we begin our strategic business plan for 2022, we remained focused on relationship-based expansion throughout our market area. We plan to continue to focus on increasing our loan-to-deposit ratio to expand our net interest margin, while attempting to control expenses and credit losses.

Favorable trends in our economy prompted the Federal Reserve Open Market Committee, or FOMC, to increase the target federal funds by 0.25% in 2016, 0.75% in 2017 and 1.00% in 2018, which was followed by decreases of 0.75% and 1.50% in 2019 and 2020, respectively. The increased market interest rates from 2016 through 2018 had a positive impact on net interest income mainly due to growth of earning assets and the fact that our balance sheet is slightly asset sensitive. In 2019 through 2021, that trend reversed and we recognized yield compression on our earning assets due to the FOMC rate cuts. Even though further FOMC rate cuts are not forecasted for 2022, we expect this negative impact will continue to some degree due to continued repricing of existing loans and investment securities, until FOMC decides to raise rates. Although, rate increases are expected in 2022, the potential compression of net interest income and net interest margin could occur if interest rates remain static or decline, given that our balance sheet is asset sensitive to interest rate changes primarily due to the number of variable rate loans and a high level of interest-earning cash balances. This could in turn result in further decrease on the yield of earning assets compared to the cost of deposits and other funds, which remain at historic lows and cannot reasonably be further reduced.

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Given our asset sensitive balance sheet, we expect our net interest income to benefit from interest rate increases, but we expect any such benefit to be proportional to the increase in rates. If we experience an increase in our yield on earnings assets, we could then determine to increase the interest rates we pay on our deposit accounts or change our promotional or other interest rates on new deposits in marketing activation programs to attempt to achieve a certain net interest margin. That said, in light of the current economic environment, if the rates increase is modest, it may not be possible to manage the interest margin in this manner, as competitive pressures may dictate that we increase deposit rates at a faster rate than the earning assets increase, thereby offsetting any gains to the net interest margin. The economies and real estate markets in our primary market areas are expected to continue to be significant determinants of the quality of our assets in future periods and, thus, our results of operations, liquidity and financial condition.

For 2022, management remains focused on the above challenges and opportunities and other factors affecting the business similar to the factors driving the 2021 results as discussed in this section.

Critical Accounting Estimates

Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation and uncertainty and have had or are reasonably likely to have a material impact on our financial condition and results of operations. We consider accounting estimates to be critical to our financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, (ii) management could have applied different assumptions during the reported period, and (iii) changes in the accounting estimate are reasonably likely to occur in the future and could have a material impact on our financial statements. Management has determined the following accounting estimates and related policies to be critical:

Goodwill Impairment

The Company applies a qualitative analysis of conditions in order to determine if it is more likely than not that the carrying value is impaired. In the event that the qualitative analysis suggests that the carrying value of goodwill may be impaired, the Company uses several quantitative valuation methodologies in evaluating goodwill for impairment that includes assumptions and estimates made concerning the future earnings potential of the organization, and a market-based approach that looks at values for organizations of comparable size, structure and business model.

Estimates of fair value are based on a complex model using, among other things, estimated cash flows and industry pricing multiples. The Company tests its goodwill for impairment annually as of December 31 (the Measurement Date), and quarterly if a triggering event causes concern of a possible goodwill impairment charge. At each Measurement Date, the Company, in accordance with ASC 350-20-35-3, evaluates, based on the weight of evidence, the significance of all qualitative factors to determine whether it is more likely than not that the fair value of each of the reporting units is less than its carrying amount.

The assessment of qualitative factors at the most recent Measurement Date (December 31, 2021), indicated that it was not more likely than not that impairment existed; as a result, no further testing was performed.

Allowance for Loan Losses

Credit risk is inherent in the business of lending and making commercial loans. Accounting for our allowance for loan losses involves significant judgment and assumptions by management and is based on historical data and management’s view of the current economic environment. At least on a quarterly basis, our management reviews the methodology and adequacy of allowance for loan losses and reports its assessment to the Board of Directors for its review and approval.

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The allowance for loan losses is an estimate of probable incurred losses with regard to our loans. Our loan loss provision for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loans, delinquencies, management's assessment of the quality of the loans, the valuation of problem loans and the general economic conditions in our market area. We base our allowance for loan losses on an estimation of probable losses inherent in our loan portfolio.

Our methodology for assessing loan loss allowances are intended to reduce the differences between estimated and actual losses and involves a detailed analysis of our loan portfolio, in three phases:

● the specific review of individual loans,

● the segmenting and review of loan pools with similar characteristics, and

● our judgmental estimate based on various subjective factors:

The first phase of our methodology involves the specific review of individual loans to identify and measure impairment. We evaluate each loan by use of a risk rating system, except for homogeneous loans, such as automobile loans and home mortgages. Specific risk rated loans are deemed impaired if all amounts, including principal and interest, will likely not be collected in accordance with the contractual terms of the related loan agreement. Impairment for commercial and real estate loans is measured either based on the present value of the loan’s expected future cash flows or, if collection on the loan is collateral dependent, the estimated fair value of the collateral, less selling and holding costs.

The second phase involves the segmenting of the remainder of the risk rated loan portfolio into groups or pools of loans, together with loans with similar characteristics, for evaluation. We determine the calculated loss ratio to each loan pool based on its historical net losses and benchmark it against the levels of other peer banks.

In the third phase, we consider relevant internal and external factors that may affect the collectability of loan portfolio and each group of loan pool. The factors considered are, but are not limited to:

● concentration of credits,

● nature and volume of the loan portfolio,

● delinquency trends,

● non-accrual loan trends,

● problem loan trends,

● loss and recovery trends,

● quality of loan review,

● lending and management staff,

● lending policies and procedures,

● economic and business conditions, and

● other external factors.

Management estimates the probable effect of such conditions based on our judgment, experience and known or anticipated trends. Such estimation may be reflected as an additional allowance to each group of loans, if necessary. Management reviews these conditions with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the month-end evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment.

Central to our credit risk management and our assessment of appropriate loss allowance is our loan risk rating system. Under this system, the originating credit officer assigns borrowers an initial risk rating based on a thorough analysis of each borrower’s financial capacity in conjunction with industry and economic trends. Approvals are made based upon the amount of inherent credit risk specific to the transaction and are reviewed for appropriateness by senior line and credit administration personnel. Credits are monitored by line and credit administration personnel for deterioration in a borrower’s financial condition which may impact the ability of the borrower to perform under the contract. Although management has allocated a portion of the allowance to specific loans, specific loan pools, and off-balance sheet credit exposures (which are reported separately as part of other liabilities), the adequacy of the allowance is considered in its entirety.

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It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the overall loan portfolio, however, the loan portfolio can be adversely affected if the state of California’s economic conditions and its real estate market in our general market area were to further deteriorate or weaken. Additionally, further weakness of a prolonged nature in the agricultural and general economy would have a negative impact on the local market. The effect of such economic events, although uncertain and unpredictable at this time, could result in an increase in the levels of nonperforming loans and additional loan losses, which could adversely affect our future growth and profitability. No assurance of the level of predicted credit losses can be given with any certainty.

Income Taxes

Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of our assets and liabilities. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled using the liability method. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

We file income tax returns in the U.S. federal jurisdiction, and the state of California. With few exceptions, we are no longer subject to U.S. federal or state/local income tax examinations by tax authorities for years before 2017.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities available for sale, derivatives, and loans held for sale, if any, are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record certain assets at fair value on a non-recurring basis, such as certain impaired loans held for investment and securities held to maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.

We have established and documented a process for determining fair value. We maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Whenever there is no readily available market data, management uses its best estimate and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of management's judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial statements. For detailed information on our use of fair value measurements and our related valuation methodologies, see Note 14 to the Consolidated Financial Statements in Item 8 of this report.

Recently Issued Accounting Standards

See Note 1 to the Consolidated Financial Statements in Item 8 of this report.

Results of Operations

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of deposit service charges and fees, the increase in cash surrender value of life insurance, investment advisory service fee income and mortgage commissions. The majority of the Company's noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

Overview

We recorded net income for the year ended December 31, 2021 of $16,337,000 or $2.00 per diluted share compared to $13,687,000 or $1.68 per diluted share for the year ended December 31, 2020. The increase in net income for the year ended December 31, 2021 was primarily due to an increase of $4,697,000 in net interest income, mainly from PPP loan fees and interest income and the growth of our loan and investment portfolios. Non-interest income increased by $348,000 in 2021, mainly as a result of increased debit card transaction fee income. The provision for loan losses decreased compared to last year, mainly due to $1,620,000 in qualitative adjustments in the loan loss reserve during 2020, corresponding to COVID-19 pandemic. Non-interest expense increased by $2,518,000 associated with staffing and general operating overhead increases to support the growth of our loan and deposit portfolios.

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

Net Interest Income and Net Interest Margin

Our primary source of revenue is net interest income, which is the difference between interest and fees derived from earning assets and interest paid on liabilities obtained to fund those assets. Our net interest income is affected by changes in the level and mix of interest-earning assets and interest- bearing liabilities, referred to as volume changes. Our net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on our loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond our control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters, and the actions of the Federal Reserve Board.

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For a detailed analysis of interest income and interest expense, see the “Average Balance Sheets” and the “Rate/Volume Analysis” below.

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Net interest income, on a fully tax equivalent basis (“FTE”), increased $3,989,000 or 8.7% to $49,873,000 for the year ended December 31, 2021, compared to $45,884,000 in 2020. Net interest spread and net interest margin were 2.99% and 3.04%, respectively, for the year ended December 31, 2021, compared to 3.52% and 3.59%, respectively, for the year ended December 31, 2020. This downward trend is mainly due to the FOMC rate cuts in March 2020 of 1.50% resulting in a decrease in earning asset yields, as described below.

Our earning asset yield decreased 58 basis points in 2021 compared to 2020, due mainly to an increase of $344,027,000 in the average balance of interest-bearing cash accounts, which yield approximately 0.15% as of December 31, 2021. The yield on loans recognized an increase of 34 basis points for 2021 compared to 2020, primarily due to fee income on PPP loans as described below, but was partially offset by the downward repricing of variable rate loans and lower rate indexes on new loans, resulting from the FOMC rate cuts in March 2020. The FOMC cut rates by 0.25% three times in 2019 and again by 1.50% in March 2020, so rates on average were lower in 2021, as compared to 2020. Further compressing loan yield was the funding of the PPP loans, which only earned a contractual interest rate of 1.00%. These negative factors to loan yield were offset by PPP loan fees, net of costs, totaling $7,264,000 that were recognized during 2021, as compared to $3,091,000 in 2020. These loan fees were paid by the SBA at the time the loans were funded and were scheduled to be deferred over the life of the PPP loans, and thus unamortized amounts were fully recognized upon receipt of the forgiveness payments. Also offsetting the earning asset yield compression was growth in the core loan, which excludes PPP loans, and investment portfolio average balances of $25,028,000 and $6,821,000, respectively, in 2021 as compared to 2020.

The cost of funds on interest-bearing liabilities decreased to 0.11% in 2021 compared to 0.16% in 2020 as our excess liquidity has allowed us to keep deposit rates at historic lows and even make some downward adjustments on certain accounts. Average non-interest-bearing demand deposit balances increased by $167,709,000 in 2021 compared to 2020, which contributed in lowering our cost of funds on total deposits.

The net interest margin compression the Company recognized in 2021, is due to the factors discussed above which could possibly result in further compression if rate indexes on assets were to fall, and/or: 1) deposit interest rates remain at historic lows from which they cannot reasonably be further reduced, 2) competition in the lending market restrict significant increases in new loan rates, and 3) deposit growth out-paces loan growth as recognized in recent years, resulting in higher interest-bearing cash balances, which yield approximately 0.15% as of December 31, 2021.

Changes in volume resulted in an increase in net interest income (on a FTE basis) of $2,194,000 for the year of 2021 compared to the year 2020, and changes in interest rates and the mix resulted in an increase in net interest income (on a FTE basis) of $1,795,000 for the year 2021 versus the year 2020. Management closely monitors both total net interest income and the net interest margin.

Market rates are in part based on the FOMC target Federal funds interest rate (the interest rate banks charge each other for short-term borrowings).  The change in the Federal funds sold rates is the result of target rate changes implemented by the FOMC.   In 2020, the FOMC decreased the Federal funds rate by 0.50% and 1.00% on two occasions in March resulting in a range of 0.00% to 0.25% as of December 31, 2020 and 2021. Even though further FOMC rate cuts are not forecasted for 2022, we expect this negative impact will continue to some degree due to continued repricing of existing loans and investment securities, until FOMC decides to raise rates.

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Rate/Volume Analysis

The following table below sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in average volume multiplied by old rate); and (ii) changes in rates (change in rate multiplied by old average volume). Changes in rate/volume (change in rate multiplied by the change in volume) have been allocated to the changes due to volume and rate in proportion to the absolute value of the changes due to volume and rate prior to the allocation.

Provision for Loan Losses

Credit risk is inherent in the business of making loans. The Company establishes an allowance for loan losses through charges to earnings, which are shown in the consolidated statements of income as the provision for loan losses. Specifically identifiable and quantifiable losses are promptly charged off against the allowance. The Company maintains the allowance for loan losses at a level that it considers to be adequate to provide for credit losses inherent in its loan portfolio. Management determines the level of the allowance by performing a quarterly analysis that considers concentrations of credit, past loss experience, current economic conditions, the amount and composition of the loan portfolio (including nonperforming and potential problem loans), estimated fair value of underlying collateral, and other information relevant to assessing the risk of loss inherent in the loan portfolio such as loan growth, net charge-offs, changes in the composition of the loan portfolio, and delinquencies. As a result of management’s analysis, a range of the potential amount of the allowance for loan losses is determined.

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The Company recorded provision for loan loss reversals totaling $635,000 during the year ended December 31, 2021, as compared to provisions of $2,165,000 during the year ended December 31, 2020. Both of these year end periods include a qualitative adjustment corresponding to the COVID-19 pandemic, which was initially recorded during the second quarter of 2020 and totaled $1,620,000 at that time. The Company did not have any nonperforming loans as of December 31, 2021 and 2020. The allowance for loan losses was $10,738,000 and $11,297,000 as of December 31, 2021 and 2020, or 1.25% and 1.12%, respectively, of total loans. The increase as a percentage of total loans is due to the $31 million and $211 million in PPP loans outstanding as of December 31, 2021 and 2020, respectively, that do not require a reserve as they are fully guaranteed by the U.S. government through the SBA program. The strong credit quality has resulted in net loan recoveries of $76,000 in 2021 and net loan charge-offs of $14,000 in 2020.

The Company will continue to monitor the adequacy of the allowance for loan losses and make additions to the allowance in accordance with the analysis referred to above. Because of uncertainties inherent in estimating the appropriate level of the allowance for loan losses, actual results may differ from management’s estimate of credit losses and the related allowance.

Noninterest Income

The following table sets forth a summary of noninterest income for the periods indicated:

Noninterest income was $5,426,000 for the year ended December 31, 2021, compared to $4,815,000 for the year 2020. Service charge income increased to $1,287,000 in 2021 compared to $1,272,000 for 2020, due to a higher number of checking accounts. Debit card transaction fee income increased to $1,693,000 in 2021 as compared to $1,355,000 in 2020, as a result of the increase in the aggregate number of transaction deposit accounts and corresponding service fee income, and a spending pattern trend shifting to debit cards payments in recent years. Earnings on the cash surrender value of life insurance recognized an increase of $25,000 in 2021 compared to 2020, due partially to higher yields earned on certain life insurance policies. Mortgage commissions have increased by $22,000 for the year 2021, as compared to 2020, as a result of the increased demand for home purchases and refinancing. Gains on called and sold securities increased by $152,000 in 2021 compared to 2020, mainly due to calls but also includes one sale in 2021 resulting in a gain of $60,000. There was one sale of an OREO property in 2020, which resulted in a gain of $34,000 as compared to no sales or corresponding gains in 2021. In 2021, other income increased by $93,000, which was attributable to investment advisory fee income increases. The Company continues to evaluate its deposit product offerings with the intention of continuing to expand its offerings to the consumer and business depositors.

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Noninterest Expense

The following table sets forth a summary of noninterest expenses for the periods indicated:

Noninterest expense was $33,219,000 for the year ended December 31, 2021, an increase of $3,355,000 or 11.2% compared to $29,864,000 for the year ended 2020. Salaries and employee benefits increased by $2,238,000 in 2021 to $20,210,000 compared to the prior year, due to expanding our staff to support loan and deposit growth. Included in the salary and benefit expense total is deferred loan cost accounting adjustments of $694,000 and $1,253,000 against salary expense in 2021 and 2020, respectively, corresponding to PPP loans funded, which further contributed to the increase in salary and benefit expense in 2021.

Occupancy expense realized an increase of $330,000 in 2021 compared to the prior year, primarily from fixed asset depreciation expense, rent and facility maintenance increases on certain branch locations.

Data processing costs increased in 2021 over 2020 by $55,000, primarily due to servicing costs on the growing number of loan and deposit accounts.

FDIC and DFPI regulatory assessments increased by $325,000 in 2021 compared to 2020, mainly due substantial increases in our deposit balances. In January 2019, the FDIC sent notification that small banks less than $10 billion would receive assessment credits for the portion of their assessments that contributed to the growth in the Deposit Insurance Fund Reserve Ratio from 1.15% to 1.35%, to be applied when the reserve ratio reached 1.38%. That threshold was met in the early part of 2019 and therefore the Company did not recognize any expense for FDIC assessments during the last six months of 2019 and the first quarter of 2020. The Company resumed its expense accrual during the second quarter of 2020, when the credit was fully utilized. Additionally, the initial base assessment rate for financial institutions varies based on the overall risk profile of the institution as defined by the FDIC and the Company’s risk profile has remained at stable levels in 2020, with modest increases in the assessment rate during 2021 related to normal business cycles but still remains relatively low. Management recognizes that assessments could increase further depending on deposit growth throughout the remainder of 2022, as the FDIC assessment rates are applied to average quarterly total liabilities as the primary basis.

Other operating expenses increased by $407,000 or 6.9% to $6,271,000 in 2021, primarily as a result of various general operating expense increases required to support our growing business portfolios and compliance mandates, some of which included charitable contributions, software license fees and provisions for losses on undisbursed loan commitments.

Management anticipates that noninterest expense should continue to increase as we continue to grow, and management believes the Company’s administration as currently set up is scalable to handle future deposit growth.  However, management remains committed to cost-control and efficiency, and we expect to keep these increases to a minimum relative to growth.

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Provision for Income Taxes

We reported a provision for income taxes of $5,340,000 and $4,056,000 for the years 2021 and 2020, respectively. The effective income tax rate on income from continuing operations was 24.6% for the year ended December 31, 2021, compared to 22.9% for the year 2020. These provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities, BOLI and certain tax-exempt loans). The disparity between the effective tax rates for 2021 as compared to 2020 is primarily due to tax credits from low-income housing projects as well as tax-free income on municipal securities and loans that comprised a larger proportion of pre-tax income in 2020 as compared to 2021.

Financial Condition

The Company’s total assets were $1,964,478,000 at December 31, 2021 compared to $1,511,478,000 at December 31, 2020, an increase of $453,000,000 or 30.0%. Net loans decreased by $149,399,000, investments increased $45,691,000, bank premises and equipment decreased $348,000, interest receivable and other assets increased $1,394,000, while cash and cash equivalents increased $551,611,000 for the year ended December 31, 2021 as compared to December 31, 2020.

Loans gross of the allowance for loan losses and deferred fees were $860,037,000 as of December 31, 2021, compared to $1,013,115,000 as of December 31, 2020, a decrease of $153,078,000 or 15.1%. The decrease was due to a decrease of $182,452,000 or 62.5% in commercial and industrial loans which included a decrease of $180,319,000 in PPP loans, an increase of $27,797,000 or 4.2% in commercial real estate loans, a decrease of $2,668,000 or 8.5% in consumer loans and consumer residential loans and an increase of $4,245,000 or 15.0% in agriculture loans. The PPP loans changed the composition of the loan portfolio categories, but excluding those loans, the composition remained relatively unchanged as a percentage of total loans, with commercial real estate comprising 80% and 65% of the loan portfolio at December 31, 2021 and 2020, respectively.

Deposits increased $439,157,000 or 32.1% to $1,806,966,000 as of December 31, 2021 compared to $1,367,809,000 at December 31, 2020. Demand, Money Market and Savings increased by $302,240,000, $99,566,000 and $34,679,000, respectively, while Time Deposits increased by $2,672,000 as of December 31, 2021 as compared to December 31, 2020.

There were no short-term borrowing or long-term debt outstanding balances at December 31, 2021 and 2020. The Company uses short-term borrowings, primarily short-term FHLB advances, to fund short-term liquidity needs and manage net interest margin.

Equity increased $12,918,000 or 10.0% to $142,612,000 as of December 31, 2021, compared to $129,694,000 at December 31, 2020.

Investment Activities

Investments are a key source of interest income. Management of our investment portfolio is set in accordance with strategies developed and overseen by our Investment Committee. Investment balances, including cash equivalents and interest-bearing deposits in other financial institutions, are subject to change over time based on our asset/liability funding needs and interest rate risk management objectives. Our liquidity levels take into consideration anticipated future cash flows and all available sources of credits and are maintained at levels management believes are appropriate to assure future flexibility in meeting anticipated funding needs.

Cash Equivalents and Interest-bearing Deposits in other Financial Institutions

The Company holds federal funds sold, unpledged available-for-sale securities and salable government guaranteed loans to help meet liquidity requirements and provide temporary holdings until the funds can be otherwise deployed or invested. As of December 31, 2021, and 2020, we had $42,935,000 and $33,085,000, respectively, in federal funds sold.

Investment Securities

Management of our investment securities portfolio focuses on providing an adequate level of liquidity and establishing an interest rate-sensitive position, while earning an adequate level of investment income without taking undue risk. Investment securities that we intend to hold until maturity are classified as held-to-maturity securities, and all other investment securities are classified as either available-for-sale or equity securities. Currently, all of our investment securities are classified as available-for-sale, except for one mutual fund classified as an equity security.

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The fair value of the equity security was $3,391,000 and $3,425,000 at December 31, 2021 and December 31, 2020, respectively. Consistent with ASU 2016-01, equity securities are carried at fair value with the changes in fair value recognized in the consolidated statement of income. Accordingly, the Company recognized an unrealized loss of $99,000 during the year ended December 31, 2021, as compared to an unrealized gain of $48,000 during the year ended December 31, 2020.

Our available for sale investment securities holdings increased by $45,725,000 or 21.1% to $262,889,000 at December 31, 2021, compared to holdings of $217,164,000 at December 31, 2020. The carrying values of available-for-sale investment securities are adjusted for unrealized gains or losses as a valuation allowance and any gain or loss is reported on an after-tax basis as a component of other comprehensive income.

Total investment securities as a percentage of total assets decreased to 13.6% as of December 31, 2021 compared to 14.6% at December 31, 2020. As of December 31, 2021, $202,610,000 of the investment securities were pledged to secure public deposits.

As of December 31, 2021, the total unrealized loss on debt securities that were in a loss position for less than 12 continuous months was $317,000 with an aggregate fair value of $37,039,000. The total unrealized loss on debt securities that were in a loss position for greater than 12 continuous months was $81,000 with an aggregate fair value of $9,321,000.

The following table summarizes the maturity and repricing schedule of our debt investment securities, which does not include equity securities, at their amortized cost and their weighted average yields at December 31, 2021:

Debt Investment Maturities and Repricing Schedule

Yields in the above table have been adjusted to a fully tax equivalent basis. The yields are calculated using a weighted average method based on the investment security balances as of December 31, 2021. Securities are reported at the earliest possible call, repricing or maturity date.

Loans

Our residential loan portfolio includes no sub-prime loans, nor is it our normal practice to underwrite loans commonly referred to as "Alt-A mortgages", the characteristics of which are loans lacking full documentation, borrowers having low FICO scores or collateral compositions reflecting high loan-to-value ratios. Substantially all of our residential loans are indexed to U.S. Treasury Constant Maturity Rates and have provisions to reset five years after their origination dates.

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The following table summarizes our commercial real estate loan portfolio by the geographic location in which the property is located as of December 31, 2021 and 2020:

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Construction and land loans are classified as commercial real estate loans and decreased $8.9 million in 2021 as compared to 2020.  The table below shows an analysis of construction and land loans by type and location. Non-owner-occupied land loans of $3.1 million as of December 31, 2021 included loans for lands specified for commercial development of $1.2 million and for residential development of $1.9 million, the majority of which are located in Stanislaus County.

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Loan Maturities

The following table shows the contractual maturity distribution and repricing intervals of the outstanding loans in our portfolio, as of December 31, 2021. In addition, the table shows the distribution of such loans between those with variable or floating interest rates and those with fixed or predetermined interest rates. The large majority of the variable rate loans are tied to independent indices (such as the Wall Street Journal prime rate or a Treasury Constant Maturity Rate). Substantially all loans with an original term of more than five years have provisions for the fixed rates to reset, or convert to a variable rate, after one, three or five years and are therefore classified as a variable rate loan in the table below.

The majority of the properties taken as collateral are located in Northern California. We employ strict guidelines regarding the use of collateral located in less familiar market areas. Positive trends in Northern California real estate values, the low loan-to-value ratios in our commercial real estate portfolio, and the high percentage of owner-occupied properties further solidify our credit quality position.

Nonperforming Assets

Financial institutions generally have a certain level of exposure to credit quality risk and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company's management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines due to customers' inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies which have brought about declines in overall property values. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor's financial capacity to repay deteriorates.

Nonperforming assets consist of loans on non-accrual status, loans 90 days or more past due and still accruing interest, loans restructured, where the terms of repayment have been renegotiated resulting in a reduction or deferral of interest or principal and OREO.

Loans are generally placed on non-accrual status when they become 90 days past due, unless management believes the loan is adequately collateralized and in the process of collection. The past due loans may or may not be adequately collateralized, but collection efforts are continuously pursued. Loans may be restructured by management when a borrower has experienced some changes in financial status, causing an inability to meet the original repayment terms, and where we believe the borrower will eventually overcome those circumstances and repay the loan in full. OREO consists of properties acquired by foreclosure or similar means and which management intends to offer for sale. The Company did not have any nonperforming loans as of December 31, 2021 and 2020.

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The Company held one OREO property as of December 31, 2021 and 2020, a residential land property that was acquired through foreclosure that was written down to a zero balance because the public utilities have not been obtainable, thereby rendering these land lots unmarketable at this time. Accordingly, the Company had zero non-performing assets recorded on the balance sheet as of at December 31, 2021 and 2020.

Allowance for Loan Losses

In anticipation of credit risk inherent in our lending business, we set aside allowances through charges to earnings. Such charges are not only made for the outstanding loan portfolio, but also for off-balance sheet items, such as commitments to extend credits or letters of credit. The charges made for the outstanding loan portfolio are credited to the allowance for loan losses, whereas charges for off-balance sheet items are credited to the reserve for off-balance sheet items, which is presented as a component of other liabilities. The provision for loan losses is discussed in the section entitled “Provision for Loan Losses” above.

The balance of our allowance for loan losses is management's best estimate of the probable losses inherent in the portfolio. The ultimate adequacy of the allowance is dependent upon a variety of factors beyond our control, including the real estate market, changes in interest rate and economic and political environments.

In the years leading up to the pandemic, the economic recovery had a positive impact on the financial stability of our borrowers resulting in improvements in credit quality of our loan portfolio which has allowed us to reduce the reserve for loan losses as a percentage of gross loans. In 2020, the economy briefly slipped into a recession following the COVID-19 pandemic which inevitability impacted the financial condition of certain borrowers. We responded by making qualitative risk-based discretionary adjustments in connection with the COVID-19 pandemic and corresponding economic stress. In 2021, the financial stress subsided to some degree and credit quality improved allowing the Company to reverse $635,000 in loan loss provisions. The allowance for loan losses decreased to $10,738,000 as of December 31, 2021, as compared with $11,297,000 at December 31, 2020. The allowance for loan losses as a percentage of total loans increased to 1.25% as of December 31, 2021, as compared to 1.12% as of December 31, 2020, mainly due to the higher balance in outstanding PPP loans in the prior year, that do not require a loan loss reserve as they are guaranteed by the federal government through the SBA program. Based on the current conditions of the loan portfolio, management believes that the $10,738,000 allowance for loan losses at December 31, 2021 is adequate to absorb losses inherent in our loan portfolio. No assurance can be given, however, that adverse economic conditions or other circumstances will not result in increased losses in the portfolio.

Diversification, low loan-to-values, strong credit quality and enhanced credit monitoring contribute to a reduction in the portfolio’s overall risk in recent years and help to offset the economic risk corresponding to the current COVID-19 pandemic. We continue to monitor the impact of the economic environment, and adjustments to the provision for loan loss will be made accordingly. During 2021, the Company recognized net loan recoveries of $76,000 as compared to net loan charge-offs of $14,000 in 2020.

Management reviews these conditions with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Although management has allocated a portion of the allowance to specific loan categories, the adequacy of the allowance is considered in its entirety.

Our allowance for loan losses consisted of amounts allocated to three phases of our methodology for assessing loan loss allowances, as follows (see details of methodology for assessing allowance for loan losses in the section entitled “Critical Accounting Estimates”):

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The Components of the Allowance for Loan Losses

As stated previously in "Critical Accounting Estimates," the overall allowance consists of a specific allowance for individually identified impaired loans, an allowance factor for categories of credits with similar characteristics and trends, and an allowance for changing environmental factors.

The first component, the specific allowance, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable. Through management's ongoing loan grading process, individual loans are identified that have conditions that indicate the borrower may be unable to pay all amounts due under the contractual terms. These loans are evaluated individually by management and specified allowances for loan losses are established when the discounted cash flows of future payments or collateral value of collateral-dependent loans are lower than the recorded investment in the loan. Generally, with problem credits that are collateral-dependent, we obtain appraisals of the collateral at least annually. We may obtain appraisals more frequently if we believe the collateral value is subject to market volatility, if a specific event has occurred to the collateral (e.g. tentative map has been filed), or if we believe foreclosure is imminent.  Impaired loan balances remained at zero at December 31, 2021 and 2020, and therefore there was no specific allowances for impaired loans, as we charge off substantially all of our estimated losses related to specifically identified impaired loans as the losses are identified.

The second component, the allowance factor, is an estimate of the probable inherent losses in each loan pool stratified by major categories or loans with similar characteristics in our loan portfolio. This analysis encompasses segmenting and reviewing historical losses, loan grades by pool and current general economic and business conditions. Confirmation of the quality of our grading process is obtained by independent reviews conducted by consultants specifically hired for this purpose and by various bank regulatory agencies. This analysis covers our entire loan portfolio but excludes any loans that were analyzed individually for specific allowances as discussed above. There are limitations to any credit risk grading process. The number of loans makes it impractical to review every loan every quarter. Therefore, it is possible that in the future, some currently performing loans not recently graded will not be as strong as their last grading and an insufficient portion of the allowance will have been allocated to them. Grading and loan review often must be done without knowing whether all relevant facts are at hand. Troubled borrowers may deliberately or inadvertently omit important information from reports or conversations with lending officers regarding their financial condition and the diminished strength of repayment sources.

The total amount allocated for the second component is determined by applying loss estimation factors based on loss history to outstanding loans. As of December 31, 2021 and 2020, the allowance allocated by categories of credits totaled $4.9 million and $4.5 million, respectively.

The third component of the allowance for loan losses is an economic and qualitative component that is intended to absorb losses caused by portfolio trends, concentration of credit, growth, and economic trends, as stated previously in "Critical Accounting Estimates". At December 31, 2021 and 2020, the general valuation allowance, including the economic component, totaled $5.8 million and $6.8 million, respectively, which includes the qualitative risk-based adjustments pertaining to inherent risk associated with the economic impact of the COVID-19 pandemic. The decrease compared to prior year relates to improved financial condition of various borrowers that were negatively impacted by the recession in early 2020. While published economic data indicates that the economy is recovering from a recession cycle prompted by the COVID-19 pandemic, it is uncertain that the recovery cycle will continue for any definite period of time. In response to this, we have been proactive in evaluating reserve percentages for economic and other qualitative loss factors used to determine the adequacy of the allowance for loan losses. The increase to the third component of the allowance for loan losses reflected such evaluation.

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The table below summarizes, for the periods indicated, loan balances at the end of each period, the daily averages during the period, changes in the allowance for loan losses arising from loans charged off, recoveries on loans previously charged off, additions to the allowance and certain ratios related to the allowance for loan losses:

Allowance for Loan Losses

The table below summarizes the allowance for loan loss balance by type of loan balance at the end of each period (See “Loan Portfolio” above for a description of each type of loan balance):

Allocation of the Allowance for Loan Losses

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Other Earning Assets

For various business purposes, we make investments in earning assets other than the interest-earning securities and loans discussed above. The primary other earning assets held by the Company as of December 31, 2021 and 2020, includes the cash surrender value of the BOLI policies, Federal Home Loan Bank stock and Federal Reserve Bank stock. During 2021, we purchased 17 new life insurance policies on certain employees for a total investment of $3.4 million. During 2018, we committed to invest $5 million in a low-income housing tax credit fund (“LIHTC”) to promote our participation in CRA activities, which had an unfunded commitment of $895,000 and $1,425,000 as of December 31, 2021 and 2020, respectively. As of December 31, 2021 and 2020, we held another LIHTC investment that we’ve participated in since 2006, for which the original investment was $1 million, and there were no unfunded commitments as of December 31, 2021 and 2020. For both LIHTC investments, we receive the return in the form of tax credits and tax deductions over a period of approximately 15 years. In 2017, we made a $1 million commitment as a limited partner, to a small business private equity partnership to promote our participation in CRA activities. Returns will be received in the form of dividends from the general partner. As of December 31, 2021, we have remaining commitments to fund an additional $380,000 on this investment.

The balances of other earning assets as of December 31, 2021 and December 31, 2020 were as follows:

Deposits and Other Sources of Funds

Deposits

Total deposits at December 31, 2021 and 2020 were $1,806,966,000 and $1,367,809,000, respectively, representing an increase of $439,157,000 or 32.1% in 2021. The average deposits for the year ended December 31, 2021 increased $382,411,000 or 31.4% to $1,600,977,000 compared to $1,218,566,000 at December 31, 2020.

Deposits are the Company’s primary source of funds. Due to strategic emphasis by management, core deposits (based on a definition provided by FDIC’s Uniform Bank Performance Report) increased by $436,729,000 or 32.3% in 2021 to $1,788,405,000 at December 31, 2021. The percentage of core deposits to total deposits increased slightly to 99.0% at December 31, 2021 as compared to 98.8% at December 31, 2020. The average rate paid on time deposits in denominations of over $250,000 was 0.28% for the years ended December 31, 2021 and 2020. The composition and cost of the Company's deposit base are important components in analyzing the Company's net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. See “Net Interest Income and Net Interest Margin” for further discussion.

The Company's liquidity is impacted by the volatility of deposits or other funding instruments or, in other words, by the propensity of that money to leave the institution for rate-related or other reasons. Deposits can be adversely affected if economic conditions in California and the Company's market area in particular, continue to weaken. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $250,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

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The following tables summarize the distribution of average daily deposits and the average daily rates paid for the periods indicated:

Distribution of Average Daily Deposits

The scheduled maturities of our time deposits in denominations of more than $250,000 at December 31, 2021 are as follows:

Maturities of Time Deposits over $250,000

(Dollars in Thousands)

Because our client base is comprised primarily of commercial and industrial accounts, individual account balances are generally higher than those of consumer-oriented banks. Four of our clients carry deposit balances of more than 1% of our total deposits, none of which had a deposit balance of more than 3% of total deposits at December 31, 2021. The Company had no brokered deposits as of December 31, 2021 and 2020.

FHLB Borrowings

Although deposits are the primary source of funds for our lending and investment activities and for general business purposes, we may obtain advances from the FHLB as an alternative to retail deposit funds. We had no outstanding balances as of December 31, 2021 and 2020, but did advance $50 million during the second quarter of 2020 in anticipation of PPP loan fundings, which was fully paid off by July 2020. The average balance of FHLB advances outstanding in 2021 and 2020 was $0 and $10.8 million, respectively, for which we paid an average interest rate of 0.32% in 2020. See “Liquidity Management” below for the details on the FHLB borrowings program.

Deferred Compensation Obligations

We maintain a nonqualified, unfunded deferred compensation plan for certain key management personnel.  Under this plan, participating employees may defer compensation, which will entitle them to receive certain payments upon retirement, death, or disability.  The plan provides for payments commencing upon retirement and reduced benefits upon early retirement, disability, or termination of employment. As of December 31, 2021 and 2020, our aggregate payment obligations under this plan totaled $11.4 million and $10.6 million, respectively.

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Liquidity and Asset/Liability Management

Management seeks to ascertain optimum and stable utilization of available assets and liabilities as a vehicle to attain our overall business plans and objectives. In this regard, management focuses on measurement and control of liquidity risk, interest rate risk and market risk, capital adequacy, operation risk and credit risk.

Liquidity

Liquidity to meet borrowers’ credit and depositors’ withdrawal demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from depositors. Additional sources of liquidity may include institutional deposits, advances from the FHLB and other short-term borrowings, such as federal funds purchased.

Since our deposit growth strategy emphasizes core deposit growth, we have avoided relying on brokered deposits as a consistent source of funds. The Company had no brokered deposits as of December 31, 2021 and 2020.

As a secondary source of liquidity, we rely on advances from the FHLB to supplement our supply of lendable funds and to meet deposit withdrawal requirements. Advances from the FHLB are typically secured by a portion of our loan portfolio and stock issued by the FHLB. The FHLB determines limitations on the amounts of advances by assigning a percentage to each eligible loan category that will count towards the borrowing capacity. As of December 31, 2021 and 2020, the Company had no FHLB advances outstanding and had sufficient collateral to borrow an additional $368.5 million and $317.6 million, respectively. In addition, the Company had lines of credit with its correspondent banks to purchase overnight federal funds totaling $70 million at December 31, 2021 and 2020. No advances were made on these lines of credit as of December 31, 2021 and 2020.

The Company’s liquidity depends primarily on dividends paid to it as the sole shareholder of the Bank. The Bank’s ability to pay dividends to the Company may depend on whether the Bank will be in a position to pay dividends based on regulatory requirements and the performance of the Bank.

Maintenance of adequate liquidity requires that sufficient resources be available at all time to meet our cash flow requirements. Liquidity in a banking institution is required primarily to provide for deposit withdrawals and the credit needs of its customers and to take advantage of investment opportunities as they arise. Liquidity management involves our ability to convert assets into cash or cash equivalents without incurring significant loss, and to raise cash or maintain funds without incurring excessive additional cost. For this purpose, we maintain a portion of our funds in cash and cash equivalents, loans and securities available for sale. Our liquid assets at December 31, 2021 and 2020 totaled approximately $858.2 million and $336.6 million, respectively. Our liquidity level measured as the percentage of liquid assets to total assets was 43.7% and 22.3% as of December 31, 2021, and 2020, respectively.

We believe that our current unrestricted cash and cash equivalents, cash flows from operations and borrowing capacity under our credit facility will be sufficient to meet our working capital, capital expenditures, and any other capital needs for at least the next 12 months. We are currently not aware of any trends or demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in our liquidity increasing or decreasing in any material way that will impact our capital needs during or beyond the next 12 months. We continue to monitor the impact of COVID-19 on our business to ensure our liquidity and capital resources remain appropriate throughout this period of uncertainty.

Capital Resources and Capital Adequacy Requirements

In the past two years, our primary source of capital has been internally generated operating income through retained earnings. At December 31, 2021, total shareholders’ equity increased to $142.6 million, representing an increase of $12.9 million from December 31, 2020. The increase was due to net income of $16.3 million recorded to retained earnings, offset by other comprehensive loss of $1.5 million, net of income taxes, due to the negative effect that rising treasury yields had on the unrealized market value adjustment of our available for sale investment portfolio during 2021. Also, retained earnings was reduced by the common stock dividend payments totaling $2.4 million during 2021. As of December 31, 2021, we had no material commitments for capital expenditures.

We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger regulatory actions that could have a material adverse effect on our financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that rely on the quantitative measures of our assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. (See “Description of Business-Regulation and Supervision-Capital Adequacy Requirements” in this report for exact definitions and regulatory capital requirements.)

As of December 31, 2021, we were qualified as a “well capitalized institution” under the regulatory framework for prompt corrective action. For more information on our capital resources and capital adequacy requirements, see Note 19 to the Consolidated Financial Statements in Item 8 of this report.

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