SOUTHSIDE BANCSHARES INC (SBSI) FY 2021 MD&A

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

OF OPERATIONS

The following discussion and analysis provides a comparison of our results of operations for the years ended December 31, 2021, 2020 and 2019 and financial condition as of December 31, 2021 and 2020.  This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this report.

CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements of other than historical fact that are contained in this report may be considered to be “forward-looking statements” within the meaning of and subject to the safe harbor protections of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date.  These statements may include words such as “expect,” “estimate,” “project,” “anticipate,” “appear,” “believe,” “could,” “should,” “may,” “might,” “will,” “would,” “seek,” “intend,” “probability,” “risk,” “goal,” “target,” “objective,” “plans,” “potential,” and similar expressions. Forward-looking statements are statements with respect to our beliefs, plans, expectations, objectives, goals, anticipations, assumptions, estimates, intentions and future performance and are subject to significant known and unknown risks and uncertainties, which could cause our actual results to differ materially from the results discussed in the forward-looking statements.  For example, discussions of the effect of our expansion, benefits of the Share Repurchase Plan, trends in asset quality, capital, liquidity, our ability to sell nonperforming assets, expense reductions, planned operational efficiencies and earnings from growth and certain market risk disclosures, including the impact of interest rates, tax reform, inflation and other economic factors are based upon information presently available to management and are dependent on choices about key model characteristics and assumptions and are subject to various limitations.  By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future.  Accordingly, our results could materially differ from those that have been estimated.  The most recent factor that could cause future results to differ materially from those anticipated by our forward-looking statements include the negative impact of the COVID-19 pandemic and related variants on our business, financial position, operations and prospects, including our ability to continue our business activities in certain communities we serve, the duration of the pandemic and its continued effects on financial markets, a reduction in financial transactions and business activities resulting in decreased deposits and reduced loan originations, increases in unemployment rates impacting our borrowers’ ability to repay their loans, our ability to manage liquidity in a rapidly changing and unpredictable market, additional interest rate changes by the Federal Reserve and other government actions in response to the pandemic including regulations or laws enacted to counter the effects of the COVID-19 pandemic on the economy. Other factors that could cause actual results to differ materially from those indicated by forward-looking statements include, but are not limited to, the following:

•the impact of the COVID-19 pandemic and related variants on our future consolidated financial condition and results of operations;

•general (i) political conditions, including, without limitation, governmental action and uncertainty resulting from U.S. and global political trends and (ii) economic conditions, either globally, nationally, in the State of Texas, or in the specific markets in which we operate, including, without limitation, the deterioration of the commercial real estate, residential real estate, construction and development, energy, oil and gas, credit or liquidity markets, which could cause an adverse change in our net interest margin, or a decline in the value of our assets, which could result in realized losses;

•current or future legislation, regulatory changes or changes in monetary or fiscal policy that adversely affect the businesses in which we or our customers or our borrowers are engaged, including the impact of the Dodd-Frank Act, the Federal Reserve’s actions with respect to interest rates, the capital requirements promulgated by the Basel Committee, the CARES Act, the Economic Aid Act, uncertainty relating to calculation of LIBOR and other regulatory responses to economic conditions;

•adverse changes in the status or financial condition of the GSEs which impact the GSEs’ guarantees or ability to pay or issue debt;

•adverse changes in the credit portfolios of other U.S. financial institutions relative to the performance of certain of our investment securities;

•economic or other disruptions caused by acts of terrorism, war or other conflicts, natural disasters, such as hurricanes, freezes, flooding and other man-made disasters, such as oil spills or power outages, health emergencies, epidemics or pandemics or other catastrophic events;

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•technological changes, including potential cyber-security incidents and other disruptions, or innovations to the financial services industry, including as a result of the increased telework environment;

•our ability to identify and address cyber-security risks such as data security breaches, malware, “denial of service” attacks, “hacking” and identity theft, which could disrupt our business and result in the disclosure of and/or misuse or misappropriation of confidential or proprietary information, disruption or damage of our systems, increased costs, significant losses, or adverse effects to our reputation;

•the risk that our enterprise risk management framework, compliance program or our corporate governance and supervisory oversight functions may not identify or address risks adequately, which may result in unexpected losses;

•changes in the interest rate yield curve such as flat, inverted or steep yield curves, or changes in the interest rate environment that impact net interest margins and may impact prepayments on our MBS portfolio;

•increases in our nonperforming assets;

•our ability to maintain adequate liquidity to fund operations and growth;

•any applicable regulatory limits or other restrictions on the Bank and its ability to pay dividends to us;

•the failure of our assumptions underlying our allowance for credit losses and other estimates;

•the failure to maintain an effective system of controls and procedures, including internal control over financial reporting;

•the effectiveness of our derivative financial instruments and hedging activities to manage risk;

•unexpected outcomes of, and the costs associated with, existing or new litigation involving us, including the costs and effects of litigation related to our participation in government stimulus programs associated with the COVID-19 pandemic;

•changes impacting our balance sheet and leverage strategy;

•risks related to actual mortgage prepayments diverging from projections;

•risks related to actual U.S. agency MBS prepayments exceeding projected prepayment levels;

•risks related to U.S. agency MBS prepayments increasing due to U.S. government programs designed to assist homeowners to refinance their mortgage that might not otherwise have qualified;

•our ability to monitor interest rate risk;

•risks related to fluctuations in the price per barrel of crude oil;

•significant increases in competition in the banking and financial services industry;

•changes in consumer spending, borrowing and saving habits, including as a result of rising inflation and the economic impact of COVID-19;

•execution of future acquisitions, reorganization or disposition transactions, including the risk that the anticipated benefits of such transactions are not realized;

•our ability to increase market share and control expenses;

•our ability to develop competitive new products and services in a timely manner and the acceptance of such products and services by our customers;

•the effect of changes in federal or state tax laws;

•the effect of compliance with legislation or regulatory changes;

•the effect of changes in accounting policies and practices, including the CECL model;

•credit risks of borrowers, including any increase in those risks due to changing economic conditions;

•risks related to loans secured by real estate, including the risk that the value and marketability of collateral could decline;

•risks related to environmental liability as a result of certain lending activity;

•risks associated with our common stock and our other securities, including fluctuations in our stock price and general volatility in the stock market; and

•the risks identified in “Part I - Item 1A.  Risk Factors – Risks Related to Our Business” in this report.

All written or oral forward-looking statements made by us or attributable to us are expressly qualified by this cautionary notice.  We disclaim any obligation to update any factors or to announce publicly the result of revisions to any of the forward-looking statements included herein to reflect future events or developments, unless otherwise required by law.

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CRITICAL ACCOUNTING ESTIMATES

Our accounting and reporting estimates conform with U.S. GAAP and general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could differ from those estimates.  We consider our critical accounting policies to include the following:

Allowance for Credit Losses.  With the adoption of ASU 2016-13 on January 1, 2020, the allowance for credit losses includes credit losses on loans as well as the off-balance-sheet credit exposure, which is reported as a component of other liabilities on our consolidated balance sheets. The allowance for credit losses on loans is estimated and recognized upon origination of the loan based on expected credit losses. The off-balance-sheet credit exposure is evaluated using the expected credit losses using usage given defaults and credit conversion factors depending on the type of commitment and based upon historical usage rates. ASU 2016-13 replaced the previous incurred loss model which incorporated only known information as of the balance sheet date. The CECL model uses historical experience and current conditions for homogeneous pools of loans, and reasonable and supportable forecasts about future events. Management selects models through which historical reserve factor estimates are calibrated to economic forecasts over the reasonable and supportable forecast period based on the projected performance of specific economic variables that statistically correlate with the probability of default and loss given default pools. Loss estimates revert to the long-term trend of each economic variable beyond the forecast period. Management selects economic variables it believes to be most relevant based on the composition of the loan portfolio and customer base, including forecasted levels of employment, gross domestic product, corporate bond and treasury spreads, industrial production levels, consumer and commercial real estate price indices as well as housing statistics. The allowance for credit losses is highly sensitive to the economic forecasts used to develop the estimate. Due to the high level of uncertainty regarding significant assumptions, we evaluate a range of economic scenarios, including a more severe economic forecast scenario, with varying speeds of recovery. Selecting a different forecast could result in a significantly different estimated allowance for credit losses. To the extent actual outcomes differ from management estimates, additional provision for credit losses may be required that would adversely impact earnings in future periods.

Refer to “Part II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Allowance for Credit Losses - Loans and Allowance for Credit Losses - Off-Balance-Sheet Credit Exposures,” “Note 1 – Summary of Significant Accounting and Reporting Policies,” “Note 5 – Loans and Allowance for Loan Losses” and “Note 17 - Off-Balance-Sheet Arrangements, Commitments and Contingencies” to our consolidated financial statements included in this report for a detailed description of our estimation process and methodology related to the allowance for loan losses.

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NON-GAAP FINANCIAL MEASURES

Certain non-GAAP measures are used by management to supplement the evaluation of our performance. These include the following fully taxable-equivalent measures: Net interest income (FTE), net interest margin (FTE) and net interest spread (FTE), which include the effects of taxable-equivalent adjustments using a federal income tax rate of 21% to increase tax-exempt interest income to a tax-equivalent basis.  Interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than taxable investments.

Net interest income (FTE), net interest margin (FTE) and net interest spread (FTE). Net interest income (FTE) is a non-GAAP measure that adjusts for the tax-favored status of net interest income from certain loans and investments and is not permitted under GAAP in the consolidated statements of income. We believe this measure to be the preferred industry measurement of net interest income, and that it enhances comparability of net interest income arising from taxable and tax-exempt sources. The most directly comparable financial measure calculated in accordance with GAAP is our net interest income. Net interest margin (FTE) is the ratio of net interest income (FTE) to average earning assets.  The most directly comparable financial measure calculated in accordance with GAAP is our net interest margin. Net interest spread (FTE) is the difference in the average yield on average earning assets on a tax-equivalent basis and the average rate paid on average interest bearing liabilities.  The most directly comparable financial measure calculated in accordance with GAAP is our net interest spread.

These non-GAAP financial measures should not be considered alternatives to GAAP-basis financial statements and other bank holding companies may define or calculate these non-GAAP measures or similar measures differently. Whenever we present a non-GAAP financial measure in an SEC filing, we are also required to present the most directly comparable financial measure calculated and presented in accordance with GAAP and reconcile the differences between the non-GAAP financial measure and such comparable GAAP measure.

In the following table we present the reconciliation of net interest income to net interest income adjusted to a fully taxable-equivalent basis assuming a 21% marginal tax rate for interest earned on tax-exempt assets such as municipal loans and investment securities (dollars in thousands), along with the calculation of net interest margin (FTE) and net interest spread (FTE).

(1)    These amounts are presented on a fully taxable-equivalent basis and are non-GAAP measures.

Management believes adjusting net interest income, net interest margin and net interest spread to a fully taxable-equivalent basis is a standard practice in the banking industry as these measures provide useful information to make peer comparisons. Tax-equivalent adjustments are reported in the respective earning asset categories as listed in the “Average Balances with Average Yields and Rates” tables under Results of Operations.

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OVERVIEW

COVID-19

During March 2020, the World Health Organization declared COVID-19 a global pandemic in response to the rapidly growing outbreak of the virus. COVID-19 significantly impacted local, national and global economies due to stay-at-home orders and social distancing guidelines. In compliance with social distancing guidelines issued by federal, state and local governments, we initially closed all of our grocery store branches. As stay-at-home orders were issued by local governments in our market areas to combat the spread of the virus, we closed all traditional lobbies and wealth management and trust offices to walk-in customers, however, most of these traditional locations were offering certain services by appointment only. All other banking services were available to customers through our drive-thrus, ATMs/ITMs and automated telephone, internet and mobile banking products. After careful consideration and implementation of additional safety precautions, all locations were reopened on June 1, 2020. We have since made adjustments to select branch hours and openings, and we continue to closely monitor the COVID-19 situation. Approximately 45% of our workforce has remote working capabilities, however most of our workforce have returned to our office and branch locations.

COVID-19 significantly disrupted supply chains, business activity and the overall economic and financial markets globally and in our footprint.  As of December 31, 2021, economic conditions in Texas have returned close to pre-pandemic levels. Commercial activity has resumed to levels close to those existing prior to the outbreak of the pandemic. While the overall outlook has improved based on the availability of the vaccine, the risk of further resurgence and possible reimplementation of restrictions remains. Until the pandemic fully subsides, the potential for adverse impact on the markets in which we operate and on our business, operations and financial condition is expected to remain elevated.

In response to the COVID-19 pandemic, the CARES Act was signed into law on March 27, 2020. The CARES Act provided an estimated $2.2 trillion to address the economic impact of the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of financial relief. The CARES Act also included provisions to encourage financial institutions to work prudently with borrowers. As an SBA lender, we were well positioned to assist business customers in accessing funds available through the PPP implemented in April of 2020. On December 27, 2020, the Economic Aid Act was signed into law. This second coronavirus relief package granted additional funds for a new round of PPP loans. Additionally, it expanded the eligibility for loans and allowed certain businesses to request a second loan. The SBA began accepting applications for the second round of PPP loans on January 13, 2021, and we accepted new applications through April 6, 2021. During the first half 2021, we originated $112.3 million of additional PPP loans under this second round of PPP loans. At December 31, 2021, we had $31.0 million of approved PPP loans outstanding. On March 11, 2021, the American Rescue Plan was signed into law granting additional funds for unemployment benefits, individuals and other types of financial relief.

Additionally, we assisted both our consumer and commercial borrowers that experienced financial hardship due to COVID-19-related challenges. As of December 31, 2021, there were no remaining loans with payment deferrals. The decrease in the COVID-19 modified loans are the result of the loans coming out of the deferral periods and resuming performance.

OPERATING RESULTS

During the year ended December 31, 2021, our net income increased $31.2 million, or 38.0%, to $113.4 million from $82.2 million for the same period in 2020. The increase in net income was a direct result of a reversal of provision for credit losses of $17.0 million compared to a large increase in the allowance for credit losses of $20.2 million in the same period in 2020. The decrease in the provision was primarily due to an improved economic forecast and improved asset quality. The increase in net income was also due to the $18.1 million decrease in interest expense, partially offset by the $15.8 million decrease in interest income, the $6.1 million increase in income tax expense and the $1.7 million increase in noninterest expense. Earnings per diluted common share increased $1.00, or 40.5%, to $3.47 for the year ended December 31, 2021, from $2.47 for the same period in 2020.

During the year ended December 31, 2020, our net income increased $7.6 million, or 10.2%, to $82.2 million, from $74.6 million for the same period in 2019. The increase was primarily driven by the $17.5 million increase in net interest income, the $7.4 million increase in noninterest income, partially offset by the $15.1 million increase in the provision for credit losses after adopting CECL and the $4.0 million increase in noninterest expense. Earnings per diluted common share increased $0.27, or 12.3%, to $2.47 for the year ended December 31, 2020, from $2.20 for the same period in 2019. The increase in the provision for credit losses for the year ended December 31, 2020 was primarily due to the economic environment related to COVID-19 and the resulting impact on the economic assumptions used in the CECL model.

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The following table sets forth selected financial data regarding our results of operations and financial position for, and as of the end of, each of the fiscal years in the three-year period ended December 31, 2021.  This information should be read in conjunction with “Item 8.  Financial Statements and Supplementary Data,” as set forth in this report (in thousands, except per share data):

(1)Upon adoption of CECL on January 1, 2020, the provision for credit losses is the sum of the provision for loan losses and the provision for off-balance-sheet credit exposures. Prior to the adoption of CECL, the provision for off-balance-sheet credit exposures was included in other noninterest expense.

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FINANCIAL CONDITION

Our total assets increased $251.4 million, or 3.6%, to $7.26 billion at December 31, 2021 from $7.01 billion at December 31, 2020. Our securities portfolio increased by $158.8 million, or 5.9%, to $2.86 billion, compared to $2.70 billion at December 31, 2020. The increase in our securities portfolio was comprised of an increase of $587.4 million in investment securities, partially offset by a decrease of $428.6 million in MBS as the composition of the securities portfolio continued to change as municipal bonds and, to a lesser extent, corporate bonds and U.S. Treasury Notes increased while MBS decreased. Our FHLB stock decreased $10.9 million, or 43.1%, to $14.4 million from $25.3 million at December 31, 2020, due to the decline in our FHLB borrowings during 2021, reducing the amount of FHLB stock we are required to hold.

Loans at December 31, 2021 were $3.65 billion, a decrease of $12.6 million, or 0.3%, compared to $3.66 billion at December 31, 2020. Our PPP loans, a component of the commercial loan category, decreased $183.8 million during the year due to forgiveness payments received for loans funded under the CARES Act. Excluding PPP loans, total loans increased $171.2 million, or 5.0%, due to increases of $302.4 million in commercial real estate loans, $45.7 million in commercial loans (excluding PPP loans) and $34.1 million in municipal loans. The increases were partially offset by decreases of $134.1 million in construction loans, $68.8 million in 1-4 family residential loans and $8.1 million in loans to individuals. Loans held for sale decreased $2.0 million, or 54.4%, to $1.7 million at December 31, 2021 from $3.7 million at December 31, 2020.

Our nonperforming assets at December 31, 2021 decreased $5.9 million, or 33.6%, to $11.6 million and represented 0.16% of total assets, compared to $17.5 million, or 0.25% of total assets, at December 31, 2020.  Nonaccruing loans decreased $5.2 million, or 67.1%, to $2.5 million, and the ratio of nonaccruing loans to total loans decreased to 0.07% at December 31, 2021, compared to 0.21% at December 31, 2020.  Restructured loans were $9.1 million at December 31, 2021, a decrease of 5.9%, from $9.6 million at December 31, 2020. There were no OREO properties as of December 31, 2021, compared to $106,000 at December 31, 2020.

Our deposits increased $790.0 million, or 16.0%, to $5.72 billion at December 31, 2021 from $4.93 billion at December 31, 2020. The increase was primarily driven by PPP loan disbursements and stimulus checks deposited during the first half of 2021, an increase in brokered deposits, and to a lesser extent, an increase in public fund deposits. During the year ended December 31, 2021, brokered deposits increased $156.9 million, or 113.7%, associated with funding our cash flow hedge swaps in place of the FHLB advances to obtain lower cost funding.

Total FHLB borrowings decreased $488.5 million, or 58.7%, to $344.0 million at December 31, 2021, from $832.5 million at December 31, 2020.

Our subordinated notes, net of unamortized debt issuance costs, decreased $98.7 million, or 50.0%, to $98.5 million at December 31, 2021 from $197.3 million at December 31, 2020. On November 6, 2020, we issued 3.875% coupon $100.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes due on November 15, 2030. On September 30, 2021, we redeemed our 5.50% coupon $100.0 million subordinated notes due September 30, 2026. Refer to “Note 9 - Long-term Debt” in our consolidated financial statements included in this report for a detailed description of the terms of the redemption of the subordinated notes.

Our total shareholders’ equity at December 31, 2021 increased 4.2%, or $36.9 million, to $912.2 million, or 12.6% of total assets, compared to $875.3 million, or 12.5% of total assets, at December 31, 2020. The increase in shareholders’ equity was the result of net income of $113.4 million, net issuance of common stock under employee stock plans of $7.2 million, stock compensation expense of $3.0 million and common stock issued under our dividend reinvestment plan of $1.4 million. These increases were partially offset by cash dividends paid of $44.6 million, the repurchase of $34.1 million of our common stock and other comprehensive loss of $9.4 million.

Economic conditions in our market areas are relatively strong with economic activity having quickly returned close to pre-pandemic levels. Worker shortages especially in the restaurant, hospitality and retail industries combined with supply chain disruptions impacting numerous industries has had some impact on the level of economic growth. Overall, Texas continues to experience economic growth due to company relocations and expansions combined with overall population growth.

Key financial indicators management follows include, but are not limited to, numerous interest rate sensitivity and interest rate risk indicators, credit risk, operations risk, liquidity risk, capital risk, regulatory risk, inflation risk, competition risk, yield curve risk, U.S. agency MBS prepayment risk and economic risk indicators.

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BALANCE SHEET STRATEGY

Determining the appropriate size of the balance sheet is one of the critical decisions any bank makes. Our balance sheet is not merely the result of a series of micro-decisions, but rather the size is controlled based on the economics of assets compared to the economics of funding and funding sources. Changing interest rate environments and economic conditions require that we monitor the interest rate sensitivity of the assets, the funding driving our growth and closely align ALCO objectives accordingly.

During 2021 and 2020, the composition of our funding changed as we replaced approximately $700 million of our more interest rate sensitive funding sources, FHLB advances and brokered deposits, with lower cost non-maturity deposits, which increased $1.7 billion, or 51% during this period. At December 31, 2021, 95% of our remaining FHLB advances and brokered deposits were swapped at a fixed rate.

We utilize wholesale funding and securities to enhance overall profitability by maximizing the use of our capital, determining acceptable levels of credit, interest rate and liquidity risk consistent with prudent capital management.  This balance sheet strategy currently consists of borrowing funds from the FHLB and the brokered funds market.  These funds are invested primarily in U.S. agency MBS and long-term municipal securities.  Although U.S. agency MBS often carry lower yields than loans we make, these securities generally (i) increase the overall quality of our assets because of either the implicit or explicit guarantees of the U.S. Government, (ii) are more liquid than individual loans and (iii) may be used to collateralize our borrowings or other obligations.

Risks associated with this asset structure include a potentially lower net interest rate spread and margin when compared to our peers, changes in the slope of the yield curve, increased interest rate risk, the length of interest rate cycles, changes in volatility or spreads associated with the MBS and municipal securities, the unpredictable nature of MBS prepayments and credit risks associated with the municipal securities.  See “Part I - Item 1A.  Risk Factors – Risks Related to Our Business” in this report for a discussion of risks related to interest rates.  An additional risk is significant increases in interest rates, especially long-term interest rates, which could adversely impact the fair value of the AFS securities portfolio and could also impact our equity capital.  Due to the unpredictable nature of MBS prepayments, the length of interest rate cycles and the slope of the interest rate yield curve, net interest income could fluctuate more than simulated under the scenarios modeled by our ALCO and described under “Item 7A.  Quantitative and Qualitative Disclosures about Market Risk” in this report.

Our securities portfolio increased from $2.70 billion at December 31, 2020 to $2.86 billion at December 31, 2021. The increase in the securities portfolio was in conjunction with our balance sheet strategy and ALCO objectives.

During 2021, the composition of the securities portfolio continued to change as municipal and corporate bonds increased while MBS decreased. The decrease in MBS was attributable to fewer MBS purchases and higher MBS prepayment speeds due to the significantly low interest rate environment. During the year ended December 31, 2021, we purchased $540.5 million in highly rated primarily Texas municipal securities, $262.4 million of which were taxable, $96.7 million in U.S. Treasury Notes, $61.3 million in investment grade subordinated debt and $13.1 million in U.S. Agency MBS. We sold approximately $35.1 million AFS electric utility revenue municipals due to electric utility company uncertainties caused by the severe winter storm in Texas during February. We also sold $82.8 million in U.S Agency MBS and $38.8 million in U.S. Treasury Notes. Sales of AFS securities for the year ended December 31, 2021, resulted in a net realized gain of $3.9 million.

At December 31, 2021, securities as a percentage of assets totaled 39.3%, compared to 38.5% at December 31, 2020, due to the $158.8 million, or 5.9%, increase in the securities portfolio. Our balance sheet management strategy is dynamic and is continually evaluated as market conditions warrant.

With respect to funding sources, we primarily utilize deposits and to a lesser extent wholesale funding to achieve our strategy of minimizing cost while achieving overall interest rate risk objectives as well as the liability management objectives of the ALCO.  Our primary wholesale funding sources are FHLB borrowings and brokered deposits. Our FHLB borrowings decreased 58.7%, or $488.5 million, to $344.0 million at December 31, 2021 from $832.5 million at December 31, 2020.

For the year ended December 31, 2021, our total wholesale funding as a percentage of deposits, not including brokered deposits, decreased to 11.8% from 20.2% at December 31, 2020. The decrease was due to the increase in our non-maturity deposits which were used to decrease FHLB borrowings.

Our brokered deposits consist of CDs and non-maturity deposits. Our brokered CDs decreased $78.1 million, or 76.0%, from $102.8 million at December 31, 2020 to $24.7 million at December 31, 2021. At December 31, 2021, our brokered CDs had a weighted average cost of 25 basis points and remaining maturities of less than seven months. Our brokered non-maturity deposits increased to $270.1 million at December 31, 2021 from $35.1 million at December 31, 2020, with a weighted average cost of three basis points and 17 basis points, respectively. Our wholesale funding policy currently allows for maximum brokered deposits of $850 million, with an additional $50 million of flexibility for deposits maturing within 30 days. Potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered deposits.

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In connection with some of our wholesale funds, the Bank has entered into various variable rate agreements and fixed rate short-term pay agreements with an interest rate tied to three-month LIBOR or to one-month LIBOR. In connection with $605.0 million and $670.0 million of the agreements outstanding at December 31, 2021 and 2020, respectively, the Bank also entered into various interest rate swap contracts that are treated as cash flow hedges under ASC Topic 815, “Derivatives and Hedging” that are expected to be effective in hedging the variability in future cash flows attributable to fluctuations in the underlying LIBOR interest rate. The interest rate swap contracts had an average interest rate of 1.10% with a remaining average weighted maturity of 3.2 years at December 31, 2021. Refer to “Note 11 – Derivative Financial Instruments and Hedging Activities” in our consolidated financial statements included in this report for a detailed description of our hedging policy and methodology related to derivative instruments.

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RESULTS OF OPERATIONS

Our results of operations are dependent primarily on net interest income, which is the difference between the interest income earned on assets (loans and investments) and interest expense due on our funding sources (deposits and borrowings) during a particular period.  Results of operations are also affected by our noninterest income, provision for credit losses, noninterest expenses and income tax expense.  General economic and competitive conditions, particularly changes in interest rates, changes in interest rate yield curves, prepayment rates of MBS and loans, repricing of loan relationships, government policies and actions of regulatory authorities also significantly affect our results of operations.  Future changes in applicable law, regulations or government policies may also have a material impact on us. The adoption of CECL and the COVID-19 pandemic significantly impacted our results of operations in 2020 and 2021 and may continue to impact our results of operations into 2022.

The following table presents net interest income for the periods presented (in thousands):

NET INTEREST INCOME

Net interest income is one of the principal sources of a financial institution’s earnings stream and represents the difference or spread between interest and fee income generated from interest earning assets and the interest expense paid on interest bearing liabilities. Fluctuations in interest rates or interest rate yield curves, as well as repricing characteristics and volume and changes in the mix of interest earning assets and interest bearing liabilities, materially impact net interest income. During the first quarter of 2020, the Federal Reserve reduced target federal funds rate by 150 basis points to 25 basis points. During the second half of 2019, the Federal Reserve decreased the federal funds rate by 75 basis points. There were no changes to the federal funds rate during 2021, however, the Federal Reserve has indicated its intention to raise rates in March of 2022.

Net interest income was $189.6 million for the year ended December 31, 2021 compared to $187.3 million, an increase of $2.3 million, or 1.2%, compared to the same period in 2020. The increase in net interest income for the year ended December 31, 2021 was due to the decrease in interest expense on our interest bearing liabilities, partially offset by the decrease in interest income, both primarily a result of an overall decline in interest rates. Total interest expense decreased $18.1 million, or 40.7%, to $26.4 million for the year ended December 31, 2021, compared to $44.6 million for the same period in 2020. Total interest income decreased $15.8 million, or 6.8%, to $216.0 million for the year ended December 31, 2021, compared to $231.8 million for the same period in 2020. Our net interest margin (FTE), a non-GAAP measure, increased to 3.16% for the year ended December 31, 2021, compared to 3.07% for the same period in 2020, and our net interest spread (FTE), also a non-GAAP measure, increased to 3.01%, compared to 2.86% for the same period in 2020. See “Non-GAAP Financial Measures” for more information and for a reconciliation to GAAP.

Net interest income for the year ended December 31, 2020 increased $17.5 million, or 10.3%, to $187.3 million, compared to $169.8 million for the same period in 2019. The increase in net interest income for the year ended December 31, 2020 was due to the decrease in interest expense on our interest bearing liabilities, a result of lower funding costs on our interest

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bearing liabilities that more than offset the decrease in interest income due to a lower yield on our interest earning assets. Total interest income decreased $9.0 million, or 3.7%, to $231.8 million for the year ended December 31, 2020, compared to $240.8 million for the same period in 2019. Total interest expense decreased $26.4 million, or 37.2%, to $44.6 million for the year ended December 31, 2020, compared to $71.0 million for the same period in 2019. Our net interest margin (FTE), a non-GAAP measure, increased to 3.07% for the year ended December 31, 2020, compared to 3.06% for the same period in 2019, and our net interest spread (FTE), also a non-GAAP measure, increased to 2.86%, compared to 2.71% for the same period in 2019. See “Non-GAAP Financial Measures” for more information and for a reconciliation to GAAP.

ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE

The following table presents on a fully taxable-equivalent basis, a non-GAAP measure, the net change in net interest income and sets forth the dollar amount of increase (decrease) in the average volume of interest earning assets and interest bearing liabilities and from changes in yields/rates. Volume/Yield/Rate variances (change in volume times change in yield/rate) have been allocated to amounts attributable to changes in volumes and to changes in yields/rates in proportion to the amounts directly attributable to those changes (in thousands):

(1)Interest yields on loans and securities that are nontaxable for federal income tax purposes are presented on a fully taxable-equivalent basis assuming a marginal tax rate of 21%. See “Non-GAAP Financial Measures.”

The decrease in total interest income was primarily attributable to the decrease in the average yield on earning assets to 3.58% for the year ended December 31, 2021 from 3.75% for the year ended December 31, 2020, and to a lesser extent, the decrease in average earning assets of $83.9 million, or 1.3%. The decrease in the average yield on total earning assets during the year ended December 31, 2021 was a result of decreases in the short-term interest rate yield curve during the first half of 2021 and the tightening credit spreads that occurred primarily during the last half of 2020 and the first half of 2021. The decrease in average earning assets was primarily the result of the decrease in MBS and loans, partially offset by an increase in the investment securities.

The decrease in total interest income was attributable to the decrease in the average yield on earning assets to 3.75% for the year ended December 31, 2020 from 4.28% for the year ended December 31, 2019, partially offset by the increase in average earning assets of $685.8 million, or 11.8%. The decrease in the average yield on total earning assets during the year ended December 31, 2020 was a result of decreases across the entire interest rate yield curve during the first quarter of 2020 and the tightening credit spreads that occurred primarily during the last half of the year. The increase in average earning assets

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was primarily the result of the increases in the investment securities and the PPP loan portfolio, partially offset by a decrease in MBS.

The decrease in total interest expense for the year ended December 31, 2021 was attributable to an overall decline in interest rates paid on total interest bearing liabilities to 0.57% for the year ended December 31, 2021 from 0.89% for the year ended December 31, 2020, and the decrease in average interest bearing liabilities.

The decrease in total interest expense for the year ended December 31, 2020 was attributable to an overall decline in interest rates during the first quarter and the resulting decrease in the average rates paid on total interest bearing liabilities to 0.89% for the year ended December 31, 2020 from 1.57% for the year ended December 31, 2019. This was partially offset by the increase in average interest bearing liabilities.

Interest bearing demand, savings and noninterest bearing demand deposits are considered the lowest cost deposits and increased to 87.3% of total average deposits for the year ended December 31, 2021 from 76.2% for the year ended December 31, 2020 and 74.4% for the year ended December 31, 2019.

At December 31, 2021, our brokered CDs had remaining maturities of less than seven months.  At December 31, 2021, brokered CDs decreased to 0.4% of deposits compared to 2.1% of deposits at December 31, 2020, and 7.8% at December 31, 2019.  Our brokered non-maturity deposits increased to 4.7% of deposits at December 31, 2021 compared to 0.7% of deposits at December 31, 2020 and 0.1% at December 31, 2019. Our wholesale funding policy allows for maximum brokered deposits of $850 million. This brokered deposit maximum limit could increase or decrease depending on changes in ALCO objectives.  Potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered deposits.

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AVERAGE BALANCES WITH AVERAGE YIELDS AND RATES

The following table presents average earning assets and interest bearing liabilities together with the average yield on the earning assets and the average rate of the interest bearing liabilities for the years ended December 31, 2021, 2020 and 2019.  The interest and related yields presented are on a fully taxable-equivalent basis and are therefore, non-GAAP measures. See “Non-GAAP Financial Measures” for more information, and for a reconciliation to GAAP. The information should be reviewed in conjunction with the consolidated financial statements for the same years then ended (dollars in thousands):

(1)Interest on loans includes net fees on loans that are not material in amount.

(2)For the purpose of calculating the average yield, the average balance of securities is presented at historical cost.

Note: As of December 31, 2021, 2020 and 2019, loans totaling $2.5 million, $7.7 million and $5.0 million, respectively, were on nonaccrual status. Our policy is to reverse previously accrued but unpaid interest on nonaccrual loans; thereafter, interest income is recorded to the extent received when appropriate.

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PROVISION FOR CREDIT LOSSES

For the year ended December 31, 2021, there was a reversal of provision for credit losses of $17.0 million, compared to a provision for credit losses of $20.2 million and $5.1 million for the years ended December 31, 2020 and 2019, respectively. The decrease in provision expense for the year ended December 31, 2021, compared to 2020, was primarily reflective of an improved economic forecast and improved asset quality based on known and knowable information as of December 31, 2021. The increase in provision expense for the year ended December 31, 2020, compared to 2019, was primarily due to the economic impact of COVID-19 on macroeconomic factors used in the CECL methodology, including the potential for credit deterioration.

As of December 31, 2021, and 2020, our reviews of the loan portfolio indicated that loan loss allowances of $35.3 million and $49.0 million, respectively, were appropriate to cover expected credit losses in the portfolio. See the section captioned “Allowance for Credit Losses - Loans” elsewhere in this discussion for further analysis of the provision for credit losses for loans.

The balance of the allowance for off-balance-sheet credit exposures at December 31, 2021 and 2020, was $2.4 million and $6.4 million, respectively, and is included in other liabilities. See the section captioned “Allowance for Credit Losses - Off-Balance-Sheet Credit Exposures” elsewhere in this discussion for further analysis of the provision for credit losses for off-balance-sheet credit exposures.

The following table details the provision for (reversal of) loan losses and provision for (reversal of) off-balance-sheet credit exposures for the years ended December 31, 2021, 2020 and 2019 (dollars in thousands):

(1)We adopted ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” on January 1, 2020. Prior to 2020, provisions for (reversals of) off-balance-sheet credit exposures where included in other noninterest expense. For the year ended December 31, 2019, the reversal of provision for off-balance-sheet credit exposures, included in other noninterest expense, was $435,000.

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NONINTEREST INCOME

Noninterest income consists of revenue generated from a broad range of financial services and activities and other fee generating services that we either provide or in which we participate.

The following table details the categories included in noninterest income for the years ended December 31, 2021, 2020 and 2019 (dollars in thousands):

The 0.8% decrease in noninterest income for the year ended December 31, 2021, when compared to the same period in 2020, was due to decreases in net gain on sale of securities AFS and gain on sale of loans, partially offset by increases in deposit services income, other noninterest income, brokerage services income and trust fees. The 17.4% increase in noninterest income for the year ended December 31, 2020, when compared to the same period in 2019, was primarily due to the increases in net gain on sale of securities AFS and gain on sale of loans, partially offset by decreases in deposit services income and trust fees.

The increase in deposit services income for the year ended December 31, 2021, when compared to the same period in 2020, was primarily the result of increases in debit card income and service charges on commercial deposit accounts, partially offset by a decrease in overdraft income due to an increase in funds available to customers through government issued stimulus checks and PPP loans. The increase in debit card income was the result of an increase in debit card transactions for the year ended December 31, 2021. The decrease in deposit services income for the year ended December 31, 2020, when compared to the same period in 2019, was primarily the result of a decrease in overdraft income due to a general decline in customer spending activity driven by the economic impact of COVID-19, as well as an increase in funds available to customers through government issued stimulus checks and additional unemployment benefits.

During the year ended December 31, 2021, we sold MBS, municipal securities and U.S. Treasury securities that resulted in a net gain on sale of AFS securities of $3.9 million. During the year ended December 31, 2020, we sold primarily MBS, municipal securities and corporate bonds that resulted in a net gain on sale of AFS securities of $8.3 million. During the year ended December 31, 2019, we sold Texas municipal securities and MBS that resulted in a net gain on sale of AFS securities of $756,000.

Gain on sale of loans decreased for the year ended December 31, 2021, when compared to the same period in 2020, and increased for the year ended December 31, 2020, when compared to the same period in 2019. Overall mortgage loan production increased during 2020 and into 2021 as a result of lower interest rates, however, the volume of loans we decided to sell decreased for the year ended December 31, 2021, when compared to the same period in 2020.

The increase in trust fees for the year ended December 31, 2021, when compared to the same period in 2020, was primarily due to an increase in assets under management. The market value of our wealth management and trust assets under management, which are not reflected in our consolidated balance sheets, increased 4.4% during 2021 and were approximately $1.65 billion at December 31, 2021, compared to $1.58 billion at December 31, 2020. The decrease in trust fees for the year ended December 31, 2020, when compared to the same period in 2019, was primarily due to a decrease in assets under management to approximately $1.58 billion at December 31, 2020, compared to $1.72 billion at December 31, 2019.

The increase in BOLI income during the year ended December 31, 2020, when compared to the same period in 2019, was due to $12.5 million in additional BOLI purchased during the second quarter of 2020.

Brokerage services income increased for the year ended December 31, 2021, when compared to the same period in 2020, due to growth in our client base and recurring revenue.

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Other noninterest income increased for the year ended December 31, 2021, when compared to the same period in 2020, primarily due to increases in mortgage servicing fee income and swap fee income, partially offset by decreases in mortgage derivative income.

NONINTEREST EXPENSE

We incur certain types of noninterest expenses associated with the operation of our various business activities. The following table details the categories included in noninterest expense for the years ended December 31, 2021, 2020 and 2019 (dollars in thousands):

The increase in noninterest expense for the year ended December 31, 2021, compared to the same period in 2020, was the result of increases in salaries and employee benefits, a loss on the redemption of subordinated notes, increases in software and data processing expense and FDIC insurance, partially offset by decreases in other noninterest expense and amortization of intangibles. The increase in noninterest expense for the year ended December 31, 2020, compared to the same period in 2019, was the result of increases in salaries and employee benefits, net occupancy expense, other noninterest expense, software and data processing expense and FDIC insurance, partially offset by decreases in advertising, travel and entertainment expense, amortization of intangibles and professional fees.

Salaries and employee benefits expense increased during the year ended December 31, 2021, compared to the same period in 2020, due to increases in direct salary expense and health insurance expense, partially offset by a decrease in retirement expense. Salaries and employee benefits expense increased during the year ended December 31, 2020, compared to the same period in 2019, due to increases in direct salary expense and retirement expense, partially offset by a decline in health insurance expense.

Direct salary expense increased $2.9 million, or 4.4%, for the year ended December 31, 2021, compared to the same period in 2020, primarily due to normal salary increases effective in the first quarter of 2021. Direct salary expense increased $2.5 million, or 4.0%, for the year ended December 31, 2020, compared to the same period in 2019, due to normal salary increases effective in the first quarter of 2020, and to a lesser extent, the addition of several new commercial lenders.

Health and life insurance expense, included in salaries and employee benefits, increased $1.7 million, or 23.3%, for the year ended December 31, 2021 compared to the same period in 2020 due to an increase in health claims expense. For the year ended December 31, 2020, health and life insurance expense decreased $833,000, or 10.4%, compared to the same period in 2019, due to decreases in both health claims expense and health plan administrative costs. We have a self-insured health plan which is supplemented with a stop loss insurance policy. Health insurance costs are rising nationwide and these costs may continue to increase during 2022.

Retirement expense, included in salaries and employee benefits, decreased $1.9 million, or 31.5%, for the year ended December 31, 2021, compared to the same period in 2020. The decrease was due to the freeze of the Retirement Plan and Restoration Plan to further benefit accruals as of December 31, 2020, which resulted in no defined benefit plan service cost expense in 2021. Deferred compensation plan expense also decreased for the year ended December 31, 2021. These decreases were partially offset by increases in our 401(k) Plan matching expense and split dollar agreement expense. For the year ended December 31, 2020, retirement expense increased $1.9 million, or 46.4%, compared to the same period in 2019. The increase was due to increases in our deferred compensation plan expense, defined benefit expense, 401(k) Plan matching expense, ESOP

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expense and split dollar agreement expense. The increase in deferred compensation expense was due to entry into additional deferred compensation agreements. The increase in the defined benefit expense was due primarily to the decrease in the discount rate associated with the re-measurement of the defined benefit plan at June 30, 2020 in connection with freezing the defined benefit plan to further benefit accruals as of December 31, 2020. The increase in 401(k) Plan matching expense was related to an increase in eligible matching participants during the second quarter of 2020.

Net occupancy expense increased during the year ended December 31, 2020, compared to the same period in 2019, due to increased depreciation, rent expense and other occupancy related expense primarily associated with relocating a branch location and the early termination of three branch leases.

Advertising, travel and entertainment expense increased during the year ended December 31, 2021, compared to the same period in 2020, primarily due to increased activity as travel restrictions eased during 2021 and increased media advertising. Advertising, travel and entertainment expense decreased during the year ended December 31, 2020, compared to the same period in 2019, primarily due to decreases in travel, meals and entertainment and media advertising as a result of COVID-19.

ATM expense increased for the year ended December 31, 2021, compared to the same period in 2020, and increased for the year ended December 31, 2020, compared to the same period in 2019, due to higher ATM maintenance expense as new ATMs and ITMs were put into service and hardware upgrades were completed.

For the year ended December 31, 2020, professional fees decreased compared to the same period in 2019, due to lower legal expense and other professional fees.

Software and data processing expense increased for the year ended December 31, 2021, compared to the same period in 2020, and increased for the year ended December 31, 2020, compared to the same period in 2019, due to entry into several new software contracts and increases in contract renewal costs.

Communications expense increased for the year ended December 31, 2021, when compared to the same periods in 2020, driven by an increase in phone and internet costs.

FDIC insurance increased for the year ended December 31, 2021, compared to the same period in 2020, and increased for the year ended December 31, 2020, compared to the same period in 2019, primarily due to a small bank assessment credit issued by the FDIC and utilized in the second half of 2019 and the first half of 2020.

Amortization of intangibles decreased for the year ended December 31, 2021, compared to the same period in 2020, and decreased for the year ended December 31, 2020, compared to the same period in 2019, due primarily to a decrease in core deposit intangible amortization which is recognized on an accelerated method resulting in a decline in expense over the amortization period.

Loss on redemption of subordinated notes consisted of the remaining unamortized discount of $856,000 and debt issuance costs of $251,000 associated with the notes at the time of redemption on September 30, 2021.

Other noninterest expense decreased for the year ended December 31, 2021, compared to the same period in 2020, primarily due to the impact of the freeze and remeasurement of the Retirement Plan and Restoration Plan in 2020 and a decrease in losses on retired assets associated with a branch closure and branch right sizing during the year ended December 31, 2020. For the year ended December 31, 2020, other noninterest expense increased, compared to the same period in 2019 primarily due to retirement expense related to the Retirement Plan and the Restoration Plan freeze and remeasurement during the second quarter of 2020, as well as a curtailment on the Acquired Retirement Plan.

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INCOME TAXES

Pre-tax income for the year ended December 31, 2021 was $130.8 million compared to $93.5 million for the year ended December 31, 2020, and $87.8 million for the year ended December 31, 2019.

Income tax expense was $17.4 million for the year ended December 31, 2021 and represented an increase of $6.1 million, or 53.7%, compared to the year ended December 31, 2020, and decreased $1.9 million, or 14.3%, to $11.3 million for the year ended December 31, 2020, compared to $13.2 million for the year ended December 31, 2019.  The ETR as a percentage of pre-tax income was 13.3% in 2021, 12.1% in 2020 and 15.1% in 2019. The increase in the ETR for the year ended December 31, 2021, compared to the same period in 2020, was mainly due to a decrease in tax-exempt income as a percentage of pre-tax income. The increase in the income tax expense for the year ended December 31, 2021 is primarily due to the increase in pre-tax income in 2021 and the increase in the ETR. The decrease in the income tax expense and ETR for the year ended December 31, 2020, compared to the same period in 2019, was mainly due to an increase in tax-exempt income as a percentage of pre-tax income.

The ETR differs from the statutory rate of 21% primarily due to the effect of tax-exempt income from municipal loans and securities, as well as BOLI. The net deferred tax liability totaled $17.8 million at December 31, 2021, compared to $15.5 million in 2020. The increase in the net deferred tax liability is primarily the result of an increase in the fair value of the net derivative liability as well as an increase in reversal of provision for credit losses, offset by a decrease in unrealized gains in the AFS securities portfolio. See “Note 15 – Income Taxes” to our consolidated financial statements included in this report. No valuation allowance was recorded at December 31, 2021 or December 31, 2020, as management believes it is more likely than not that all of the deferred tax asset items will be realized in future years.

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LENDING ACTIVITIES

One of our main objectives is to seek attractive lending opportunities in Texas, primarily in the market areas in which we operate.  The majority of our loan originations are made to borrowers who live in and/or conduct business in the market areas of Texas in which we operate or adjoin.

Total loans as of December 31, 2021 decreased $12.6 million, or 0.3%, and the average loan balance outstanding for the year decreased $82.5 million, or 2.2%, compared to 2020.

In April 2020, we began originating loans to qualified small businesses under the PPP administered by the SBA under the provisions of the CARES Act. During 2021 and 2020, we originated $112.3 million and $310.5 million, respectively, of PPP loans included in our commercial loan portfolio with a remaining amortized cost basis at December 31, 2021 and 2020 of $31.0 million and $214.8 million, respectively, representing a decrease of $183.8 million due to forgiveness payments received from loans funded under the CARES Act.

Excluding PPP loans, total loans increased $171.2 million, or 5.0%, due to increases of $302.4 million in commercial real estate loans, $45.7 million in commercial loans (excluding PPP loans) and $34.1 million in municipal loans. The increases were partially offset by decreases of $134.1 million in construction loans, $68.8 million in 1-4 family residential loans and $8.1 million in loans to individuals.

Our greatest concentration of loans is in our real estate portfolio. Management does not consider there to be a concentration of risk in any one industry type.  See “Item 1.  Business – Market Area.”

The aggregate amount of loans that we are permitted to make under applicable bank regulations to any one borrower, including non-affiliate related entities is 25% of Tier 1 capital.  Our legal lending limit at December 31, 2021, was approximately $198.3 million.  Our largest loan relationship at December 31, 2021 was approximately $132.7 million.

The average yield on loans for the year ended December 31, 2021 decreased to 4.03%, compared to 4.30% for the year ended December 31, 2020.  This decrease was due to the lower interest rate environment during 2021.

LOAN PORTFOLIO COMPOSITION AND ASSOCIATED RISK

For purposes of this discussion, our loans are divided into real estate loans, commercial loans, municipal loans and loans to individuals.

REAL ESTATE LOANS

Our real estate loan portfolio consists of construction, 1-4 family residential and commercial real estate loans, and represents our greatest concentration of loans.  We attempt to mitigate the amount of risk associated with this group of loans through the type of loans originated and geographic distribution.  At December 31, 2021, the majority of our real estate loans were collateralized by properties located in our market areas.  Of the $2.70 billion in real estate loans, $651.1 million, or 24.1%, represent loans collateralized by residential dwellings that are primarily owner occupied.  Historically, the amount of losses suffered on this type of loan has been significantly less than those on other properties.  Prior to funding any real estate loan, our loan policy requires an appraisal or evaluation of the property and also outlines the requirements for appraisals on renewals based on the size and complexity of the transaction.

We pursue an aggressive policy of reappraisal on any real estate loan that is in the process of foreclosure and potential exposures are recognized and reserved for or charged off as soon as they are identified.  Our ability to liquidate certain types of properties that may be obtained through foreclosure could adversely affect the volume of our nonperforming real estate loans.

Construction Real Estate Loans

Our construction loans are collateralized by property located primarily in or near the market areas we serve.  A number of our construction loans will be owner occupied upon completion.  Construction loans for non-owner occupied projects are financed, but these typically have cash flows from leases with tenants, secondary sources of repayment, and in some cases, additional collateral.  Our construction loans have both adjustable and fixed interest rates during the construction period.  Construction loans to individuals are typically priced and made with the intention of granting the permanent loan on the completed property.  Commercial construction loans are subject to underwriting standards similar to that of the commercial portfolio.  Owner occupied 1-4 family residential construction loans are subject to the underwriting standards of the permanent loan.

1-4 Family Residential Real Estate Loans

Residential loan originations are generated by our loan officers, in-house origination staff, marketing efforts, present customers, walk-in customers and referrals from real estate agents and builders.  We focus our lending efforts primarily on the origination of loans secured by first mortgages on owner occupied 1-4 family residences.  Substantially all of our 1-4 family

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residential originations are secured by properties located in or near our market areas.  Historically, we have originated a portion of our residential loans for sale into the secondary market.  These loans are reflected on the balance sheet as loans held for sale.  Secondary market investors, other than Fannie Mae, typically pay us a service release premium in addition to a predetermined price based on the interest rate of the loan originated.  We retain liabilities related to early prepayments, defaults, failure to adhere to origination and processing guidelines and other issues.  We have internal controls in place to mitigate many of these liabilities and historically our realized liability has been extremely low.  In addition, many of the retained liabilities expire one year from the date a loan is sold.  We warehouse these loans until they are transferred to the secondary market investor, which usually occurs within 45 days.

Our 1-4 family residential loans generally have maturities ranging from 15 to 30 years.  These loans are typically fully amortizing with monthly payments sufficient to repay the total amount of the loan. Our 1-4 family residential loans are made at both fixed and adjustable interest rates.

Underwriting for 1-4 family residential loans includes debt-to-income analysis, credit history analysis, appraised value and down payment considerations. Changes in the market value of real estate can affect the potential losses in the portfolio.

We also make home equity loans, which are included as part of the 1-4 family residential loans, and at December 31, 2021, these loans totaled $109.1 million.  Under Texas law, these loans, when combined with all other mortgage indebtedness for the property, are capped at 80% of appraised value.

Commercial Real Estate Loans

Commercial real estate loans primarily include loans collateralized by retail, commercial office buildings, multi-family residential buildings, medical facilities and offices, senior living, assisted living and skilled nursing facilities, warehouse facilities, hotels and churches.  Management does not consider there to be a risk in any one industry type. In determining whether to originate commercial real estate loans, we generally consider such factors as the financial condition of the borrower and the debt service coverage of the property.  Commercial real estate loans are made at both fixed and adjustable interest rates for terms generally up to 20 years. Most of our fixed rate commercial real estate loans adjust at least every five years. At December 31, 2021, commercial real estate loans consisted of $1.37 billion of owner and non-owner occupied real estate loans, $209.7 million of loans secured by multi-family properties and $21.8 million of loans secured by farmland.

COMMERCIAL LOANS

Our commercial loans are diversified loan types including short-term working capital loans for inventory and accounts receivable and short- and medium-term loans for equipment or other business capital expansion. Management does not consider there to be a concentration of risk in any one industry type. In our commercial loan underwriting, we assess the creditworthiness, ability to repay and the value and liquidity of the collateral being offered.  Terms of commercial loans are generally commensurate with the useful life of the collateral offered.

Paycheck Protection Program Loans

In April 2020, we began originating loans to qualified small businesses under the PPP administered by the SBA under the provisions of the CARES Act. Loans covered by the PPP may be eligible for loan forgiveness for certain costs incurred related to payroll, group health care benefit costs and qualifying mortgage, rent and utility payments. The remaining loan balance after forgiveness of any amount is still fully guaranteed by the SBA. On December 27, 2020, the Economic Aid Act was signed into law. This second coronavirus relief package granted additional funds for a new round of PPP loans. Additionally, it expanded the eligibility for loans and allowed certain businesses to request a second loan. In return for processing and booking a PPP loan, the SBA paid lenders a processing fee tiered by the size of the loan. These loans are included in commercial loans with an amortized cost basis at December 31, 2021 and 2020 of $31.0 million and $214.8 million, respectively.

Commercial loans decreased $138.1 million, to $419.0 million as of December 31, 2021, due entirely to a $183.8 million decrease in PPP loans as of December 31, 2021 resulting from forgiveness payments received for loans funded under the CARES Act.

MUNICIPAL LOANS

We make loans to municipalities and school districts primarily throughout the state of Texas, with a small percentage originating outside of the state.  The majority of the loans to municipalities and school districts have tax or revenue pledges and in some cases are additionally supported by collateral.  Municipal loans made without a direct pledge of taxes or revenues are usually made based on some type of collateral that represents an essential service.  Lending money directly to these municipalities allows us to earn a higher yield than we could if we purchased municipal securities for similar durations.  Loans to municipalities and school districts increased $34.1 million, to $443.1 million as of December 31, 2021, when compared to 2020.

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LOANS TO INDIVIDUALS

Substantially all originations of our loans to individuals are made to consumers in our market areas.  At December 31, 2021, loans collateralized by titled equipment, which are primarily automobiles, accounted for approximately $54.5 million, or 63.4%, of total loans to individuals.

Home equity loans, which are included in 1-4 family residential loans, have replaced some of the traditional loans to individuals. In addition, we make loans for a full range of other consumer purposes, which may be secured or unsecured depending on the credit quality and purpose of the loan.

Consumer loan terms vary according to the type and value of collateral, length of contract and creditworthiness of the borrower.  The underwriting standards we employ for consumer loans include an application, a determination of the applicant’s payment history on other debts, with the greatest weight being given to payment history with us and an assessment of the borrower’s ability to meet existing obligations and payments on the proposed loan.  Although creditworthiness of the applicant is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, in relation to the proposed loan amount. Most of our loans to individuals are collateralized, which management believes assists in limiting our exposure.

LOAN PORTFOLIOS MOST AT RISK DUE TO ECONOMIC STRESS RESULTING FROM IMPACT OF COVID-19

The banking industry is affected by general economic conditions such as interest rates, inflation, recession, unemployment and other factors beyond our control, including the impact of the COVID-19 pandemic.  During the last 30 years the Texas economy has continued to diversify, decreasing the overall impact of fluctuations in oil and gas prices; however, the oil and gas industry is still a significant component of the Texas economy. Oil prices have experienced a recovery during 2021 following a significant reduction primarily reflective of the economic impact of COVID-19. We cannot predict whether current economic conditions or oil prices will improve, remain the same or decline.

As of December 31, 2021, the Company’s exposure to the oil and gas industry totaled $69.7 million, or 1.91% of gross loans, a decrease of $34.9 million, or 33.3%, from December 31, 2020 year-end levels, and consisted primarily of (i) support/service loans of 1.15%, (ii) upstream of 0.53%, (iii) downstream of 0.15%, and (iv) midstream of 0.08%. Expanded monitoring and analysis of these loans has been implemented to address the uncertainty in oil and gas prices as needed.

The following table sets forth our oil and gas information for the periods presented (dollars in thousands):

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As of December 31, 2021, economic conditions in Texas have returned close to pre-pandemic levels. Commercial activity has improved to levels close to those existing prior to the outbreak of the pandemic. When the pandemic occurred, in addition to the oil and gas industry, we considered the sectors set forth in the table below to be most vulnerable to financial risks from business disruptions caused by the pandemic mitigation efforts based on North American Industry Classification System categories as of December 31, 2021 (dollars in thousands). As of December 31, 2021, our customers in these industries have not experienced long-term business disruptions initially thought possible. We are however continuing to monitor these customers closely.

(1)    Sector classified loans as a percentage of sector total loans.

(2)    Loans in the retail commercial real estate sector are included in our commercial real estate portfolio.

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LOAN MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST RATES

The following tables represent loan maturities and sensitivity to changes in interest rates for our loans (dollars in thousands).  The amounts of these loans outstanding at December 31, 2021, which, based on maturity, are due in (1) one year or less, (2) more than one year but less than five years, (3) more than five years but less than 15 years, and (4) more than 15 years, are shown in the following table.  The amounts due after one year are classified according to the sensitivity to changes in interest rates:

LOANS TO AFFILIATED PARTIES

In the normal course of business, we make loans to certain of our own executive officers and directors and their related interests. These loans totaled $28.3 million and $32.2 million and represented 3.1% and 3.7% of shareholders’ equity as of December 31, 2021 and 2020, respectively.

PCD LOANS

We have purchased certain loans that as of the date of purchase have experienced more-than-insignificant deterioration in credit quality since origination. Management evaluates these loans against a probability threshold to determine if substantially all of the contractually required payments will be received. PCD loans are recorded at the purchase price plus an allowance for credit losses which becomes the PCD loan's initial amortized cost. The non-credit related discount or premium, the difference between the initial amortized cost and the par value, will be amortized into interest income over the life of the loan. Any further changes to the allowance for credit losses are recorded through provision expense. In accordance with the adoption of ASU 2016-13, management did not reassess whether PCI assets met the criteria of PCD assets and elected to not maintain pools of loans as of the date of adoption. All PCD loans are evaluated based upon product type within the underlying segment.

NONPERFORMING ASSETS

Nonperforming assets consist of delinquent loans 90 days or more past due, nonaccrual loans, OREO, repossessed assets and TDR loans.  Nonaccrual loans are loans 90 days or more delinquent and collection in full of both the principal and interest is not expected.  Additionally, some loans that are not delinquent or that are delinquent less than 90 days may be placed on nonaccrual status if it is probable that we will not receive contractual principal and interest payments in accordance with the terms of the respective loan agreements.  When a loan is categorized as nonaccrual, the accrual of interest is discontinued and any accrued balance is reversed for financial statement purposes.  OREO represents real estate taken in full or partial satisfaction of debts previously contracted.  The dollar amount of OREO is based on a current evaluation of the OREO at the

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time it is recorded on our books, net of estimated selling costs.  Updated valuations are obtained as needed and any additional impairments are recognized.  Restructured loans represent loans that have been renegotiated to provide a below market interest rate or deferral of interest or principal because of deterioration in the financial position of the borrowers.  The restructuring of a loan is considered a TDR if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession.  Concessions may include interest rate reductions or below market interest rates, restructuring amortization schedules and other actions intended to minimize potential losses.  Categorization of a loan as nonperforming is not in itself a reliable indicator of potential loan loss.  Other factors, such as the value of collateral securing the loan and the financial condition of the borrower are considered in judgments as to potential loan loss.

Total nonperforming assets at December 31, 2021 were $11.6 million representing a decrease of $5.9 million, or 33.6%, from $17.5 million at December 31, 2020.  From December 31, 2020 to December 31, 2021, nonaccrual loans decreased $5.2 million, or 67.1%, to $2.5 million with decreases in all of the loan categories in nonaccrual status during the year.  Restructured loans decreased $573,000, or 5.9%, to $9.1 million. There were no OREO properties or repossessed assets as of December 31, 2021. As of December 31, 2020, there were $106,000 in OREO properties and $14,000 in repossessed assets. Included in total nonperforming assets are $10.2 million and $10.6 million of loans classified as TDRs at December 31, 2021 and 2020, respectively.

The following table sets forth nonperforming assets and selected asset quality ratios for the periods presented (dollars in thousands):

Nonperforming assets hinder our ability to earn interest income.  Decreases in earnings can result from both the loss of interest income and the costs associated with maintaining the OREO, for taxes, insurance and other operating expenses.

We reversed $15,000 of interest income on nonaccrual loans during the year ended December 31, 2021. We had $1.2 million of loans on nonaccrual for which there was no related allowance for credit losses as of December 31, 2021.

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ALLOWANCE FOR CREDIT LOSSES - LOANS

The following table presents information regarding changes in the allowance for loan losses for the periods presented (in thousands):

Our allowance for loan losses was $35.3 million at December 31, 2021, or 0.97% of loans, a decrease of $13.7 million, or 28.0%, compared to $49.0 million at December 31, 2020.  The decrease is due to an improved economic forecast and improved asset quality.

As discussed in “Note 1 – Summary of Significant Accounting and Reporting Policies” in our consolidated financial statements included in this report, our policies and procedures related to accounting for credit losses changed on January 1, 2020 in connection with the adoption of CECL. CECL is the estimated credit loss over the contractual life of a financial instrument measured upon origination or purchase of the instrument. The CECL model uses historical experience and current conditions for homogeneous pools of loans, and reasonable and supportable forecasts about future events. The impact of varying economic conditions and portfolio stress factors are a component of the credit loss models applied to each portfolio. Reserve factors are specific to the loan segments that share similar risk characteristics based on the probability of default assumptions and loss given default assumptions, over the contractual term. The forecasted periods gradually mean-revert the economic inputs to their long-run historical trends. Management evaluates the economic data points used in the Moody’s forecasting scenarios on a quarterly basis to determine the most appropriate impact to the various portfolio characteristics based on management’s view and applies weighting to various forecasting scenarios as deemed appropriate based on known and expected economic activities. Management also considers and may apply relevant qualitative factors, not previously considered, to determine the appropriate allowance level. The use of the CECL model includes significant judgment by management and may differ from those of our peers due to different historical loss patterns, economic forecasts, and the length of time of the reasonable and supportable forecast period and reversion period.

We utilize Moody’s Analytics economic forecast scenarios and assign probability weighting to those scenarios which best reflect management’s views on the economic forecast. The probability weighting and scenarios utilized for the estimate of the allowance were generally reflective of an improved economic forecast based on known and knowable information as of December 31, 2021.

When determining the appropriate allowance for credit losses on our loan portfolio, our commercial construction and real estate loans, commercial loans and municipal loans utilize the probability of default/loss given default discounted cash flow approach. Reserves on these loans are based upon risk factors including the loan type and structure, collateral type, leverage ratio, refinancing risk and origination quality, among others. Our consumer construction real estate loans, 1-4 family residential loans and our loans to individuals use a loss rate based upon risk factors including loan types, origination year and credit scores. Loans covered by the PPP may be eligible for loan forgiveness. The remaining loan balance after forgiveness of any amount is still fully guaranteed by the SBA and therefore does not have an associated allowance.

Loans evaluated collectively in a pool are monitored to ensure they continue to exhibit similar risk characteristics with other loans in the pool. If a loan does not share similar risk characteristics with other loans, expected credit losses for that loan are evaluated individually.

Our lenders have the primary responsibility for identifying problem loans based on customer financial stress and underlying collateral.  These recommendations are reviewed by senior loan administration, the special assets department and the loan review department on a monthly basis.  The loan review department independently reviews the portfolio on an annual basis in compliance with the board-approved annual loan review scope.  The loan review scope encompasses a number of considerations including the size of the loan, the type of credit extended, the seasoning of the loan and the performance of the loan.  The loan review scope, as it relates to size, focuses more on larger dollar loan relationships, typically aggregate debt of $500,000 or greater.

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At each review, a subjective analysis methodology is used to grade the respective loan.  Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible.  If at the time of the review we determine it is probable we will not collect the principal and interest cash flows contractually due on the loan, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to determine the necessary allowance.  The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them. In addition, a list of specifically reserved loans or loan relationships of $150,000 or more is updated on a quarterly basis in order to properly determine necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loans.

As of December 31, 2021, our review of the loan portfolio indicated that an allowance for loan losses of $35.3 million was appropriate to cover expected losses in the portfolio.  Changes in economic and other conditions, including the application of the CECL model and the economic uncertainty related to COVID-19, may require future adjustments to the allowance for loan losses.

Prior to the adoption of CECL on January 1, 2020, the allowance for loan losses was based on the incurred loss methodology that utilized historical net charge-off data adjusted through qualitative factors to establish general reserve amounts for each class of loans. Specific reserves were identified through the loan review process that is still currently in place. See “Note 6 - Loans and Allowance for Loan Losses” in the 2019 Form 10-K for allowance methodology under the incurred loss model prior to adoption of CECL on January 1, 2020.

Industry and our own experience indicates that a portion of our loans will become delinquent and a portion of our loans will require partial or full charge-off.  Regardless of the underwriting criteria utilized, losses may occur as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of properties used as collateral for loans and problems affecting the credit worthiness of the borrower and the ability of the borrower to make payments on the loan.  Our determination of the appropriateness of the allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions and geographic and industry loan concentration.

The following table presents the allocation of allowance for loan losses for the years presented (dollars in thousands):

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The following table presents information regarding the net charge-offs to average amount of loans outstanding by portfolio segment (dollars in thousands):

For the year ended December 31, 2021, net loan charge-offs decreased $433,000, or 36.0%, to $771,000, compared to $1.2 million for the same period in 2020. For the year ended December 31, 2020, net loan charge-offs decreased $6.1 million, or 83.6%, to $1.2 million, compared to $7.3 million for the same period in 2019, primarily due to a decrease in net charge-offs of $5.2 million for commercial real estate loans.

See “Note 5 – Loans and Allowance for Loan Losses” in our consolidated financial statements included in this report.

ALLOWANCE FOR CREDIT LOSSES - OFF-BALANCE-SHEET CREDIT EXPOSURES

Allowance for off-balance-sheet credit exposures were as follows (in thousands):

Our off-balance-sheet credit exposures include contractual commitments to extend credit and standby letters of credit. For these credit exposures we evaluate the expected credit losses using usage given defaults and credit conversion factors depending on the type of commitment and based upon historical usage rates. These assumptions are reevaluated on an annual basis and adjusted if necessary.  The reversal of provision for the year ended December 31, 2021 of $4.0 million, compared to a provision of $91,000 for the year ended December 31, 2020, was primarily due to an improved economic forecast. For additional information regarding our methodology used to estimate the allowance for credit losses on off-balance-sheet credit exposures, see “Note 17 - Off-Balance-Sheet Arrangements, Commitments and Contingencies” to our consolidated financial statements included in this report.

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SECURITIES ACTIVITY

Our securities portfolio plays a primary role in the management of our interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet.  The securities portfolio generates a substantial percentage of our interest income and serves as a necessary source of liquidity.

Refer to “Note 1 – Summary of Significant Accounting and Reporting Policies” and “Note 4 – Securities” to our consolidated financial statements included in this report for a detailed description of our accounting related to our debt and equity securities.

Management attempts to deploy investable funds into instruments that are expected to provide a reasonable overall return on the portfolio given the current assessment of economic and financial conditions, while maintaining acceptable levels of capital, interest rate and liquidity risk.  At December 31, 2021, the combined investment securities, MBS, FHLB stock and other investments as a percentage of total assets was 39.7% compared to loans, which were 50.2% of total assets.  For a discussion of our strategy in relation to the securities portfolio, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Balance Sheet Strategy.”

Our MBS are all insured or guaranteed by U.S. government agencies and corporations. Our MBS include CMOs, which were developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgages. MBS generally may be prepaid at any time without penalty and can result in significantly increased price and yield volatility.  Most of our MBS were purchased at a premium and should they prepay at a faster rate, our yield on these securities will decrease. Conversely, as prepayments slow, the yield on these MBS will increase. The total unamortized premium for our MBS decreased to $7.0 million at December 31, 2021 compared to $17.0 million at December 31, 2020.

Our investment securities consist primarily of state and political subdivision (municipal bonds) and to a lesser extent corporate bonds. Most of our municipal bonds were issued by the State of Texas or political subdivisions or agencies within the State of Texas and are highly rated. All of our corporate bonds are subordinated debt issued by investment grade U.S. banks.

During 2021, we primarily sold municipal securities, mortgage related securities, treasury notes and corporate bonds that resulted in an overall gain of $3.9 million. During 2020, the sale of AFS securities resulted in an overall gain of $8.3 million.  During 2019, the sale of these AFS securities resulted in an overall gain of $756,000.

The combined investment securities, MBS, FHLB stock and other investments increased to $2.88 billion at December 31, 2021, compared to $2.73 billion at December 31, 2020, an increase of $147.9 million, or 5.4%.  The increase is primarily a result of an increase in our investment securities portfolio of $587.4 million, or 35.4%, partially offset by a decrease in our MBS of $428.6 million, or 41.3%, and a decrease in FHLB stock of $10.9 million, or 43.1%, as of December 31, 2021 when compared to December 31, 2020.

The combined fair value of the AFS and HTM securities portfolio at December 31, 2021 was $2.86 billion, which represented a net unrealized gain as of that date of $113.1 million.  The net unrealized gain was comprised of $118.1 million in unrealized gains and $5.0 million of unrealized losses.  The fair value of the AFS securities portfolio at December 31, 2021 was $2.76 billion, which included a net unrealized gain of $108.7 million.  The net unrealized gain was comprised of $113.7 million of unrealized gains and $5.0 million of unrealized losses.  The majority of the $5.0 million of unrealized losses is reflected in our state and political subdivisions. Net unrealized gains and losses on AFS securities, which is also a component of shareholders’ equity on the consolidated balance sheet, can fluctuate significantly as a result of changes in interest rates and is monitored through the use of shock tests on the AFS securities portfolio using an array of interest rate assumptions.

From time to time, we have transferred securities from AFS to HTM due to overall balance sheet strategies. Any net unrealized gain or loss on the transferred securities included in AOCI at the time of transfer will be amortized over the remaining life of the underlying security as an adjustment to the yield on those securities. Securities transferred with losses included in AOCI continue to be included in management’s assessment for impairment for each individual security. There were no securities transferred from AFS to HTM during the years ended December 31, 2021, 2020, or 2019. There were no sales from the HTM portfolio during the years ended December 31, 2021, 2020 or 2019.  There were $90.8 million and $109.0 million of securities classified as HTM at December 31, 2021 and 2020, respectively.

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The maturities classified according to the sensitivity to changes in interest rates of the December 31, 2021 AFS and HTM investment securities and MBS portfolio and the weighted yields are presented below (dollars in thousands).  Tax-exempt obligations are shown on a taxable-equivalent basis which is a non-GAAP measure. See “Non-GAAP Financial Measures” for more information and a reconciliation to GAAP. MBS are included in maturity categories based on their stated maturity date.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.

At December 31, 2021, there were no holdings of any one issuer, other than the U.S. government, its agencies and its GSEs, in an amount greater than 10% of our shareholders’ equity.

DEPOSITS AND BORROWED FUNDS

We utilize deposits, FHLB borrowings, federal funds purchased and repurchase agreements to assist with our funding needs. Deposits provide us with our primary source of funds and the following table sets forth average deposits and rates paid by category (dollars in thousands):

The table below sets forth the maturity distribution of CDs greater than $250,000 (in thousands):

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Estimated amount of uninsured deposits, including related accrued interest were $2.49 billion and $2.17 billion at December 31, 2021 and 2020, respectively.

Brokered deposits consist of CDs and non-maturity deposits. At December 31, 2021, we had $24.7 million in brokered CDs with a weighted average cost of 25 basis points and remaining maturities of less than seven months. These brokered CDs are reflected in the CDs under $250,000 category. Brokered non-maturity deposits were $270.1 million at December 31, 2021 with a weighted average cost of three basis points. As of December 31, 2020, we had $102.8 million in brokered CDs and $35.1 million in brokered non-maturity deposits. Our current policy allows for maximum brokered deposits of $850 million in brokered deposits.  The potential higher interest costs and lack of customer loyalty are risks associated with the use of brokered deposits.

Borrowing arrangements, consisting primarily of FHLB borrowings, federal funds purchased and repurchase agreements, decreased $488.4 million, or 57.1%, during 2021 compared to 2020, primarily due to the replacement of $265.0 million of FHLB borrowings associated with funding our cash flow hedge swaps with brokered deposits to obtain lower cost funding during the fourth quarter of 2021.

Borrowing arrangements are summarized as follows (dollars in thousands):

(1)The average amount outstanding during the period was computed by dividing the total daily outstanding principal balances by the number of days in the period.

(2)The maximum amount outstanding at any month-end during the period.

(3)The weighted average interest rate during the period was computed by dividing the actual interest expense by the average balance outstanding during the period. The weighted average interest rate on the FHLB borrowings include the effect of interest rate swaps.

(4)Stated rate.

(5)The interest rate on FHLB borrowings includes the effect of interest rate swaps.

Other borrowings may include federal funds purchased, repurchase agreements and borrowings from the FRDW. Southside Bank has three unsecured lines of credit for the purchase of overnight federal funds at prevailing rates with Frost Bank, TIB – The Independent Bankers Bank and Comerica Bank for $40.0 million, $15.0 million and $7.5 million, respectively. There were no federal funds purchased at December 31, 2021, 2020 or 2019. To provide more liquidity in response to the economic impact of the COVID-19 pandemic, the Federal Reserve took steps to encourage broader use of the discount window. At December 31, 2021, the amount of additional funding the Bank could obtain from the FRDW, collateralized by securities, was approximately $473.9 million. There were no borrowings from the FRDW at December 31,

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2021, 2020 or 2019. Southside Bank has a $5.0 million line of credit with Frost Bank to be used to issue letters of credit, and at December 31, 2021, the line had one outstanding letter of credit for $155,000. Southside Bank currently has no outstanding letters of credit from FHLB held as collateral for its public fund deposits.

Southside Bank enters into sales of securities under repurchase agreements. These repurchase agreements totaled $23.2 million at December 31, 2021 and 2020, and $28.4 million at December 31, 2019. At December 31, 2021 these repurchase agreements had maturities of less than one year.  Repurchase agreements are secured by investment and MBS securities and are stated at the amount of cash received in connection with the transaction.

FHLB borrowings represent borrowings with fixed interest rates ranging from 0.13% to 4.799% and with remaining maturities of four days to 6.5 years at December 31, 2021.  FHLB borrowings may be collateralized by FHLB stock, nonspecified loans and/or securities. At December 31, 2021, the amount of additional funding Southside Bank could obtain from FHLB, collateralized by securities, FHLB stock and nonspecified loans and securities, was approximately $1.47 billion, net of FHLB stock purchases required.

In connection with some of our wholesale funds, the Bank has entered into various variable rate agreements and fixed rate short-term pay agreements with an interest rate tied to three-month LIBOR or to one-month LIBOR. In connection with $605.0 million, $670.0 million and $310.0 million of the agreements outstanding at December 31, 2021, 2020, and 2019, respectively, the Bank also entered into various interest rate swap contracts that are treated as cash flow hedges under ASC Topic 815, “Derivatives and Hedging” that are expected to be effective in hedging the variability in future cash flows attributable to fluctuations in the underlying LIBOR interest rate. The interest rate swap contracts had an average interest rate of 1.10% with a remaining average weighted maturity of 3.2 years at December 31, 2021. Refer to “Note 11 – Derivative Financial Instruments and Hedging Activities” in our consolidated financial statements included in this report for a detailed description of our hedging policy and methodology related to derivative instruments.

CAPITAL RESOURCES AND LIQUIDITY

Our total shareholders’ equity at December 31, 2021 increased 4.2%, or $36.9 million, to $912.2 million, or 12.6% of total assets, compared to $875.3 million, or 12.5% of total assets at December 31, 2020. The increase in shareholders’ equity was the result of net income of $113.4 million, net issuance of common stock under employee stock plans of $7.2 million, stock compensation expense of $3.0 million and common stock issued under our dividend reinvestment plan of $1.4 million. These increases were partially offset by cash dividends paid of $44.6 million, the repurchase of $34.1 million of our common stock and other comprehensive loss of $9.4 million.

The Company’s Common Equity Tier 1 capital includes common stock and related paid-in capital, net of treasury stock, and retained earnings. The Bank’s Common Equity Tier 1 capital includes common stock and related paid-in capital, and retained earnings. In connection with the adoption of the Basel III Capital Rules, we elected to opt-out of the requirement to include accumulated other comprehensive income in Common Equity Tier 1. We also elected, for a five-year transitional period, the effects of credit loss accounting under CECL from Common Equity Tier 1, as further discussed below. Common Equity Tier 1 for both the Company and the Bank is reduced by goodwill and other intangible assets, net of associated deferred tax liabilities.

Tier 1 capital includes Common Equity Tier 1 capital and additional Tier 1 capital. For the Company, additional Tier 1 capital at December 31, 2021 included $58.4 million of trust preferred securities. For bank holding companies that had assets of less than $15 billion as of December 31, 2009, trust preferred securities issued prior to May 19, 2010 can be treated as Tier 1 capital to the extent that they do not exceed 25% of Tier 1 capital after the application of capital deductions and adjustments. The Bank did not have any additional Tier 1 capital beyond Common Equity Tier 1 at December 31, 2021.

Total capital includes Tier 1 capital and Tier 2 capital. Tier 2 capital for both the Company and the Bank includes a permissible portion of the allowance for credit losses on loans and off-balance sheet exposures. Tier 2 capital for the Company also includes $98.5 million of qualified subordinated debt as of December 31, 2021. The permissible portion of qualified subordinated notes decreases 20% per year during the final five years of the term of the notes.

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In April 2020, the FDIC, Federal Reserve, and the Office of the Comptroller of the Currency issued supplemental instructions allowing banking organizations that implement CECL before the end of 2020, the option to delay for two years an estimate of the CECL methodologies’ effect on regulatory capital, relative to the incurred loss methodologies effect on capital, followed by a three-year transition period.  We elected to adopt the five-year transition option. Accordingly, a CECL transitional amount totaling $8.2 million has been added back to CET1 as of December 31, 2021. The CECL transitional amount includes $7.8 million related to a cumulative effect of adopting CECL and $340,000 related to the estimated incremental effect of CECL since adoption.

Also in April 2020, we began originating loans to qualified small businesses under the PPP administered by the SBA. Federal bank regulatory agencies have issued an interim final rule that permits banks to neutralize the regulatory capital effects of participating in the Paycheck Protection Program Lending Facility and clarify that PPP loans have a zero percent risk weight under applicable risk-based capital rules. Specifically, a bank may exclude all PPP loans pledged as collateral to the PPP Facility from its average total consolidated assets for the purposes of calculating its leverage ratio, while PPP loans that are not pledged as collateral to the PPP Facility will be included. Our PPP loans are included in the calculation of our leverage ratio as of December 31, 2021, as we did not utilize the PPP Facility for funding purposes.

The FDIA requires bank regulatory agencies to take “prompt corrective action” with respect to FDIC-insured depository institutions that do not meet minimum capital requirements.  A depository institution’s treatment for purposes of the prompt corrective action provisions will depend on how its capital levels compare to various capital measures and certain other factors, as established by regulation.  Prompt corrective action and other discretionary actions could have a direct material effect on our financial statements.

Management believes that, as of December 31, 2021, we met all capital adequacy requirements to which we were subject. It is management’s intention to maintain our capital at a level acceptable to all regulatory authorities and future dividend payments will be determined accordingly.  Regulatory authorities require that any dividend payments made by either us or the Bank not exceed earnings for that year.  Accordingly, shareholders should not anticipate a continuation of the cash dividend payments simply because of the existence of a dividend reinvestment program.  The payment of dividends will depend upon future earnings, our financial condition and other related factors including the discretion of the board of directors.

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To be categorized as well capitalized we must maintain minimum Common Equity Tier 1 risk-based, Tier 1 risk-based, Total capital risk-based and Tier 1 leverage ratios as set forth in the following table (dollars in thousands):

(1)    Refers to quarterly average assets as calculated in accordance with policies established by bank regulatory agencies.

As of December 31, 2021, Southside Bancshares and Southside Bank met all capital adequacy requirements under the Basel III Capital Rules that became fully phased-in as of January 1, 2019. See the section captioned “Supervision and Regulation” in “Item 1. Business” included in this report.

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The table below summarizes our key equity ratios:

EFFECTS OF INFLATION

Our consolidated financial statements and their related notes have been prepared in accordance with GAAP which requires the measurement of financial position and operating results in terms of historical dollars, without considering the change in the relative purchasing power of money over time and due to inflation.  The impact of inflation is reflected in the increased cost of our operations.  Unlike many industrial companies, nearly all of our assets and liabilities are monetary.  As a result, interest rates have a greater impact on our performance than do the effects of general levels of inflation.  Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services.  Inflation can affect the amount of money customers have for deposits, as well as their ability to repay loans.

MANAGEMENT OF LIQUIDITY

Liquidity management involves our ability to convert assets to cash with minimum risk of loss while enabling us to meet our current and future obligations to our customers at any time.  This means addressing (1) the immediate cash withdrawal requirements of depositors and other fund providers; (2) the funding requirements of lines and letters of credit; and (3) the short-term credit needs of customers.  Liquidity is provided by cash, interest earning deposits and short-term investments that can be readily liquidated with a minimum risk of loss.  At December 31, 2021, these investments were 5.9% of total assets, as compared with 7.4% for December 31, 2020, and 7.8% for December 31, 2019.  The decrease to 5.9% at December 31, 2021 as compared to December 31, 2020 and 2019, is reflective of the increase in total assets combined with the decrease in the short-term investment portfolio. Liquidity is further provided through the matching, by time period, of rate sensitive interest earning assets with rate sensitive interest bearing liabilities.  The Bank has three unsecured lines of credit for the purchase of overnight federal funds at prevailing rates with Frost Bank, TIB-The Independent Bankers Bank and Comerica Bank for $40.0 million, $15.0 million and $7.5 million, respectively.  There were no federal funds purchased at December 31, 2021, 2020 or 2019.  To provide more liquidity in response to the economic impact of the COVID-19 pandemic, the Federal Reserve took steps to encourage broader use of the discount window. At December 31, 2021, the amount of additional funding the Bank could obtain from the FRDW, collateralized by securities, was approximately $473.9 million. There were no borrowings from the FRDW at December 31, 2021 or December 31, 2020. At December 31, 2021, the amount of additional funding Southside Bank could obtain from FHLB, collateralized by securities, FHLB stock and nonspecified loans and securities, was approximately $1.47 billion, net of FHLB stock purchases required.  The Bank has a $5.0 million line of credit with Frost Bank to be used to issue letters of credit, and at December 31, 2021, the line had one outstanding letter of credit for $155,000. The Bank currently has no outstanding letters of credit from FHLB held as collateral for its public fund deposits.

Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates.  The ALCO closely monitors various liquidity ratios and interest rate spreads and margins.  The ALCO utilizes a simulation model to perform interest rate simulation tests that apply various interest rate scenarios including immediate shocks and MVPE to assist in determining our overall interest rate risk and the adequacy of our liquidity position.  In addition, the ALCO utilizes this simulation model to determine the impact on net interest income of various interest rate scenarios.  By utilizing this technology, we can determine changes that need to be made to the asset and liability mix to minimize the change in net interest income under these various interest rate scenarios.

In the ordinary course of business we have entered into contractual obligations and have made certain other commitments to make future cash payments. Please refer to the accompanying notes to these consolidated financial statements for the expected timing of such cash payments as of December 31, 2021. These include payments related to (i) borrowings presented in “Note 8 - Borrowing Arrangements” and “Note 9 – Long-Term Debt,” (ii) operating leases presented in “Note 16 - Leases,” (iii) time deposits with stated maturity dates presented in “Note 7 – Deposits” and (iv) commitments to extend credit and standby letters of credit as presented in “Note 17 - Off-Balance-Sheet Arrangements, Commitments and Contingencies.”

Management continually evaluates our liquidity position and currently believes the Company has adequate funding to meet our financial needs.

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