SOUTHSIDE BANCSHARES INC (SBSI) FY 2023 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, 2023 and 2022 and financial condition as of December 31, 2023 and 2022.  This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this report. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2022 Form 10-K for a discussion and analysis of the more significant factors that affected periods prior to 2022.

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, the impacts related to or resulting from 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 significant factor that could cause future results to differ materially from those anticipated by our forward-looking statements include the ongoing impact of higher inflation levels, higher interest rates and general economic and recessionary concerns, all of which could impact economic growth and could cause a reduction in financial transactions and business activities, including decreased deposits and reduced loan originations, our ability to manage liquidity in a rapidly changing and unpredictable market, supply chain disruptions, labor shortages and additional interest rate increases by the Federal Reserve. 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:

•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, as well as the risk of an economic slowdown or recession;

•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 to increase interest rates, the capital requirements promulgated by the Basel Committee, the CARES Act, the Economic Aid Act and other regulatory responses to economic conditions;

•economic or other disruptions caused by acts of terrorism, war or other conflicts, including the Russia-Ukraine and Israeli-Hamas 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, climate change or other catastrophic events;

•potential impacts of the adverse developments in the banking industry highlighted by high-profile bank failures, including impacts on customer confidence, deposit outflows, liquidity and the regulatory response thereto;

•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 may be exacerbated by recent developments in generative artificial intelligence and 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;

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•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;

•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;

•the effect of compliance with legislation or regulatory changes;

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

•increases in our nonperforming assets;

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

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

•our ability to control interest rate risk;

•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;

•potential claims, damages, penalties, fines and reputational damage resulting from pending or future litigation, regulatory proceedings and enforcement actions;

•changes impacting our balance sheet strategy;

•risks related to actual mortgage prepayments diverging from projections;

•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 recessionary concerns;

•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 changes in accounting policies and practices;

•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;

•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;

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

•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 estimates to include the following:

Allowance for Credit Losses.  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. 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

ECONOMIC CONDITIONS

The economic conditions and growth prospects for our markets, even against the headwinds of inflation and potential recessionary concerns, continue to reflect a solid and positive overall outlook. Ongoing elevated inflation levels and higher interest rates could have a negative impact on both our consumer and commercial borrowers. Currently, the Texas markets we serve continue to remain healthy due to both job and population growth.

DEPOSITS

Our deposits increased $351.7 million, or 5.7%, to $6.55 billion at December 31, 2023 from $6.20 billion at December 31, 2022. At December 31, 2023, we had 180,057 total deposit accounts with an average balance of $32,000. Our estimated uninsured deposits was 37.5% of total deposits as of December 31, 2023. When excluding affiliate deposits (Southside-owned deposits) and public fund deposits (all collateralized), our total estimated deposits without insurance or collateral was 19.0% of total deposits as of December 31, 2023.

We continued to increase interest rates paid on deposits during the year in order to retain deposits. Our noninterest bearing deposits represent approximately 21.2% of total deposits. Our cost of interest bearing deposits increased 168 basis points, from 0.66% for the year ended December 31, 2022, to 2.34% for the year ended December 31, 2023. Our cost of total deposits increased 129 basis points, from 0.48% for the year ended December 31, 2022, to 1.77% for the year ended December 31, 2023.

CAPITAL RESOURCES AND LIQUIDITY

Our capital ratios and contingent liquidity sources remain solid. We utilized the Federal Reserve’s BTFP to reduce our overall funding costs and to enhance our interest rate risk position. Advances can be requested under the BTFP until March 11, 2024. As of December 31, 2023, our BTFP borrowings of $117.7 million were at a cost of 4.37%.

The table below shows our total lines of credit, current borrowings as of December 31, 2023, total amounts available for future borrowings, and swapped value (in thousands):

OPERATING RESULTS

During the year ended December 31, 2023, our net income decreased $18.3 million, or 17.5%, to $86.7 million from $105.0 million for the same period in 2022. The decrease in net income was primarily a result of the $10.3 million increase in noninterest expense, the $5.9 million increase in the provision for credit losses and the $5.0 million decrease in noninterest income, partially offset by the $2.7 million increase in net interest income. Earnings per diluted common share decreased $0.44, or 13.5%, to $2.82 for the year ended December 31, 2023, compared to $3.26 for the same period in 2022.

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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, 2023.  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):

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FINANCIAL CONDITION

Our total assets increased $726.3 million, or 9.6%, to $8.28 billion at December 31, 2023 from $7.56 billion at December 31, 2022. Our securities portfolio decreased by $22.4 million, or 0.9%, to $2.60 billion, compared to $2.63 billion at December 31, 2022. The decrease in the securities portfolio was due to the sale of municipal bonds, partially offset by purchases of MBS and to a lesser extent, U.S. Treasury Bills during the year ended December 31, 2023. Our FHLB stock increased $2.7 million, or 29.9%, to $11.9 million from $9.2 million at December 31, 2022, due to the increase in our FHLB borrowings during the year ended December 31, 2023.

Loans at December 31, 2023 were $4.52 billion, an increase of $376.8 million, or 9.1%, compared December 31, 2022, due to increases of $230.1 million in construction loans, $180.7 million in commercial real estate loans and $33.2 million in 1-4 family residential loans. The increases were partially offset by decreases of $45.2 million in commercial loans, $13.1 million in loans to individuals and $8.9 million in municipal loans. Loans held for sale increased $10.2 million, or 1,533.3%, to $10.9 million at December 31, 2023 from $667,000 at December 31, 2022, due to the transfer of an $8.1 million commercial real estate loan relationship to loans held for sale that included a write down of $788,000 to fair value.

Our nonperforming assets at December 31, 2023 decreased $6.9 million, or 63.2%, to $4.0 million and represented 0.05% of total assets, compared to $10.9 million, or 0.14% of total assets, at December 31, 2022.  Nonaccruing loans increased $1.0 million, or 36.6%, to $3.9 million, and the ratio of nonaccruing loans to total loans was 0.09% and 0.07% at December 31, 2023 and December 31, 2022, respectively.  Restructured loans were $13,000 as of December 31, 2023, compared to $7.8 million at December 31, 2022. The decrease in restructured loans was due to the adoption of ASU 2022-22 on January 1, 2023, which allowed for the prospective exclusion of loan modifications that are performing but would have previously required disclosure as troubled debt restructures in nonperforming assets. There were no repossessed assets at December 31, 2023 and $74,000 at December 31, 2022. There was $99,000 and $93,000 of OREO at December 31, 2023 and December 31, 2022, respectively.

Our deposits increased $351.7 million, or 5.7%, to $6.55 billion at December 31, 2023 from $6.20 billion at December 31, 2022, which consisted of an increase of $632.8 million in interest bearing deposits, partially offset by a decrease of $281.2 million in noninterest bearing deposits. The increase in interest bearing deposits was due to the increase in interest rates we paid during 2023 as well as an increase in our brokered deposits of $168.8 million, or 25.6%, to fund our cash flow hedge swaps. Additionally, our public fund deposits increased $305.7 million, or 33.7%, most of which was interest bearing, to $1.21 billion at December 31, 2023, from $907.7 million at December 31, 2022.

Total FHLB borrowings increased $59.3 million, or 38.7%, to $212.6 million at December 31, 2023, from $153.4 million at December 31, 2022.

Other borrowings increased $288.7 million, or 130.5%, to $509.8 million at December 31, 2023, from $221.2 million at December 31, 2022, which consisted of an increase of $112.0 million in borrowings from the FRDW, $117.7 million in borrowings from the BTFP and an increase of $59.0 million in repurchase agreements.

Our total shareholders’ equity at December 31, 2023 increased 3.7%, or $27.3 million, to $773.3 million, or 9.3% of total assets, compared to $746.0 million, or 9.9% of total assets, at December 31, 2022. The increase in shareholders’ equity was the result of net income of $86.7 million, other comprehensive income of $24.0 million, stock compensation expense of $3.6 million, common stock issued under our dividend reinvestment plan of $1.2 million and net issuance of common stock under employee stock plans of $485,000, partially offset by the repurchase of $45.1 million of our common stock and cash dividends paid of $43.6 million.

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.

Due to disruptions in the banking industry during the first quarter of 2023, we increased the balance of securities pledged as collateral at the FRDW in preparation for potential liquidity needs and utilized the BTFP as a source of wholesale funding to reduce interest cost and interest rate risk. We ended the fourth quarter of 2023 with approximately $213.1 million in available liquidity between the FRDW and the BTFP in addition to the approximately $1.95 billion credit line available from FHLB due primarily to the blanket lien on our loan portfolio and to a lesser extent, securities available as collateral. At December 31, 2023, the estimated deposits, without insurance or collateral, to total deposits, excluding affiliate deposits (Southside-owned deposits) was 19.0%, or $1.24 billion.

During the year ended December 31, 2023, we entered into $600 million of additional cash flow hedge swaps, $100 million of which were terminated in the second quarter. We also replaced $60 million of brokered deposits with FHLB advances as the funding source for cash flow hedge swaps, bringing this funding source to $210 million. At December 31, 2023, brokered deposits funded $800 million of our $1.01 billion remaining cash flow hedge swaps. As of December 31, 2023, a pre-tax unrealized gain of $17.3 million was recognized in other comprehensive income, and there was no ineffective portion of these hedges. We continue to evaluate the lowest cost funding sources for our cash flow swaps and will utilize either brokered deposits, FHLB advances or FRDW borrowings, or a combination of the three funding sources. At December 31, 2023, the majority of the securities portfolio was funded by non-maturity deposits, some of which are included in wholesale funding that accounts for approximately 55% of the funding source, of which approximately 69% is swapped at a fixed rate, providing protection from rising interest rates.

We utilize wholesale funding and securities to enhance overall profitability to determine the appropriate leverage 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 brokered market, FHLB and the Federal Reserve through the FRDW and BTFP.  These funds are invested primarily in U.S. agency MBS and long-term municipal securities and to a lesser extent, U.S. Treasury Bills and corporate securities.  Although the securities purchased 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, and the guarantees of the municipalities, (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, municipal and corporate securities, the unpredictable nature of MBS prepayments and credit risks associated with the municipal and corporate 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 decreased slightly from $2.63 billion at December 31, 2022 to $2.60 billion at December 31, 2023. The decrease in the securities portfolio was due to sales of securities and principal payments during the year ended December 31, 2023, which more than offset securities purchased.

During the year ended December 31, 2023, the composition of the securities portfolio continued to change as U.S. Treasury Bills and MBS increased while the remaining categories in the portfolio decreased. The increase in MBS was attributable to purchases of U.S. Agency MBS, partially offset by MBS sales and principal payments. During the year ended December 31, 2023, we purchased $1.43 billion in short-term U.S. Treasury Bills, $614.1 million in MBS and $5.8 million in investment grade subordinated corporate debt. Sales during the year ended December 31, 2023, included $422.3 million in municipal securities, $372.7 million in U.S. Treasury Bills and $346.5 million in MBS to align the investment portfolio with the current balance sheet strategy. During the fourth quarter, sales of AFS securities were due to strategic opportunities related to a drop in treasury rates and reinvestment of the proceeds primarily into higher yielding securities and to a lesser extent, into loans. Sales of AFS securities for the year ended December 31, 2023, resulted in a net realized loss of $16.0 million which was partially offset by the sale of equity securities that resulted in a net gain of $5.1 million for the year ended December 31, 2023.

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At December 31, 2023, securities as a percentage of assets totaled 31.4%, compared to 34.7% at December 31, 2022, due primarily to a $726.3 million, or 9.6%, increase in the total assets, while cash and cash equivalents increased to 6.77% of total assets at December 31, 2023, compared to 2.64% at December 31, 2022. Our balance sheet management strategy is dynamic and is continually evaluated as market conditions warrant.

During the year ended 2022, we entered into partial term fair value hedges for certain of our fixed rate callable AFS municipal securities. The instruments are designated as fair value hedges as the changes in the fair value of the interest rate swap are expected to offset changes in the fair value of the hedged item attributable to changes in the SOFR swap rate, the designated benchmark interest rate. As of December 31, 2023, hedged securities with a carrying amount of $460.4 million are included in our AFS securities portfolio in our consolidated balance sheets representing approximately 36% and 81% of the AFS securities portfolio and the AFS municipal portfolio, respectively. These derivative contracts involve the receipt of floating rate interest from a counterparty in exchange for us making fixed-rate payments over the life of the agreement, without the exchange of the underlying notional value.

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 brokered deposits, FHLB and borrowings from the Federal Reserve through the FRDW and BTFP. Our FHLB borrowings increased 38.7%, or $59.3 million, to $212.6 million at December 31, 2023 from $153.4 million at December 31, 2022.

As of December 31, 2023, our total wholesale funding as a percentage of deposits, not including brokered deposits, increased to 25.5%, from 18.1% at December 31, 2022.

Our brokered deposits may consist of CDs and non-maturity deposits. We had no brokered CDs at December 31, 2023, compared to $220.9 million at December 31, 2022. Our brokered non-maturity deposits increased to $828.0 million at December 31, 2023, of which $800.0 million are related to our cash flow hedges, from $438.4 million at December 31, 2022, with a weighted average cost of 323 basis points and 126 basis points, respectively. Our wholesale funding policy currently allows for maximum brokered deposits of the lesser of $1.20 billion, or 20% of total deposits. Potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered deposits.

In connection with $1.01 billion of our wholesale funds, the Bank has entered into various variable rate agreements and fixed or variable rate short-term pay agreements with an interest rate tied to overnight SOFR. In connection with $1.01 billion and $575.0 million of the agreements outstanding at December 31, 2023 and December 31, 2022, 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 SOFR interest rate. The interest rate swap contracts had an average interest rate of 2.75% with a remaining average weighted maturity of 2.3 years at December 31, 2023. 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. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2022 Form 10-K for a discussion and analysis of the periods prior to 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 year ended December 31, 2023, the Federal Reserve increased the target federal funds rate by 100 basis points to 5.25% to 5.50% but held the rate steady in December 2023 for the third consecutive meeting and has indicated it may cut rates in 2024. The increase in the federal funds rate has increased our net interest income. However, if the federal funds rate increases further and the yield curve remains inverted, it may be less beneficial to our net interest income.

Net interest income was $215.0 million for the year ended December 31, 2023, compared to $212.3 million for the same period in 2022, an increase of $2.7 million, or 1.3%. The increase in net interest income for the year ended December 31, 2023 was due to the increase in the average yield as well as the average balance of interest earning assets, partially offset by the increase in interest expense on our interest bearing liabilities due to the increase in interest rates and an increase in the average balance of our interest bearing liabilities. Total interest income increased $106.8 million, or 42.2%, to $359.7 million for the year ended December 31, 2023, compared to $253.0 million for the same period in 2022. Total interest expense increased $104.1 million, or 256.1%, to $144.7 million for the year ended December 31, 2023, compared to $40.6 million for the same period in 2022. Our net interest margin and net interest margin (FTE), a non-GAAP measure, decreased to 2.92% and 3.09%, respectively, for the year ended December 31, 2023, compared to 3.11% and 3.32%, respectively, for the same period in 2022, and our net interest spread and net interest spread (FTE), also a non-GAAP measure, decreased to 2.25% and 2.42%, respectively, compared to 2.86% and 3.07%, respectively, for the same period in 2022. See “Non-GAAP Financial Measures” for more information and for a reconciliation to GAAP.

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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. See “Non-GAAP Financial Measures” for more information and for a reconciliation to GAAP.

The increase in total interest income for the year ended December 31, 2023 was attributable to the increase in average yield on interest earning assets to 5.06% from 3.92% for the year ended December 31, 2022, as well as a $538.5 million, or 7.9%, increase in the average balance of interest earning assets for the year ended December 31, 2023, compared to the year ended December 31, 2022. The increase in average earning assets was primarily the result of the increase in loans and taxable investment securities, partially offset by the decrease in tax-exempt investment securities.

The increase in total interest expense for the year ended December 31, 2023 was primarily attributable to the increase in interest rates on our interest bearing liabilities to 2.64% from 0.85% for the year ended December 31, 2022, and an increase in the average balance of our interest bearing liabilities of $727.8 million, or 15.3%, when compared to the same period in 2022.

Interest bearing demand, savings and noninterest bearing demand deposits are considered the lowest cost deposits and decreased to 85.9% of total average deposits for the year ended December 31, 2023 from 90.5% for the year ended December 31, 2022.

At December 31, 2023, we had no brokered CDs, compared to brokered CDs being 3.6% of deposits at December 31, 2022.  Our brokered non-maturity deposits increased to 12.6% of deposits at December 31, 2023, compared to 7.1% of deposits at December 31, 2022. Our wholesale funding policy currently allows for maximum brokered deposits of the lesser of $1.20 billion, or 20% of total deposits. 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, 2023, 2022 and 2021.  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, 2023, 2022 and 2021, loans totaling $3.9 million, $2.8 million and $2.5 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, 2023, there was a provision for credit losses of $9.2 million, compared to $3.2 million for the year ended December 31, 2022. The increase in provision expense for the year ended December 31, 2023, compared to 2022, was primarily due to increased economic and repricing concerns forecasted in our CECL model.

As of December 31, 2023, and 2022, our reviews of the loan portfolio indicated that loan loss allowances of $42.7 million and $36.5 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, 2023 and 2022, was $3.9 million and $3.7 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, 2023, 2022 and 2021 (dollars in thousands):

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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, 2023, 2022 and 2021 (dollars in thousands):

The 12.3% decrease in noninterest income for the year ended December 31, 2023, when compared to the same period in 2022, was due to an increase in net loss on sale of securities AFS and a decrease in other noninterest income, partially offset by a net gain on sale of equity securities and an increase in BOLI income.

During the years ended December 31, 2023 and December 31, 2022, we sold MBS, U.S. Treasury securities and municipal securities that resulted in net losses on sale of AFS securities of $16.0 million and $3.8 million, respectively.

During the year ended December 31, 2023, we sold equity securities that resulted in a net gain of $5.1 million.

The increase in BOLI income for the year ended December 31, 2023, when compared to the same period in 2022, was primarily due to death benefits of $3.0 million realized during the year ended December 31, 2023 for former covered officers.

Other noninterest income decreased for the year ended December 31, 2023, when compared to the same period in 2022, primarily due to decreases in investment income, mortgage servicing fee income, merchant services income and mortgage derivative income, partially offset by a gain recognized on the repurchase of $5.0 million of our subordinated notes and an increase in equity investment income.

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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, 2023, 2022 and 2021 (dollars in thousands):

The increase in noninterest expense for the year ended December 31, 2023, when compared to the same period in 2022, was primarily due to increases in other noninterest expense, salaries and employee benefits, software and data processing expense, FDIC insurance and advertising, travel and entertainment.

Salaries and employee benefits expense increased during the year ended December 31, 2023, compared to the same period in 2022, due to an increase in direct salary expense, partially offset by decreases in retirement expense and health insurance expense.

Direct salary expense increased $3.9 million, or 5.5%, for the year ended December 31, 2023, compared to the same period in 2022, primarily due to normal salary increases effective in the first quarter of 2023 and new employees hired during the year.

Retirement expense, included in salaries and employee benefits, decreased $487,000, or 14.5%, for the year ended December 31, 2023, compared to the same period in 2022. This decrease was primarily due to decreases in our split dollar expense, deferred compensation expense, post-retirement benefits expense, partially offset by an increase in our 401(k) matching expense.

Health and life insurance expense, included in salaries and employee benefits, decreased $373,000, or 4.3%, for the year ended December 31, 2023, compared to the same period in 2022, primarily due to a decrease in health claims expense. We have a self-insured health plan which is supplemented with a stop loss policy.

Advertising, travel and entertainment expense increased during the year ended December 31, 2023, compared to the same period in 2022, primarily due to increases in media and other advertising expense, travel related expenses, conference registrations fees and donations.

Software and data processing expense increased for the year ended December 31, 2023, compared to the same period in 2022, due to new software contracts and increases in existing contract renewal costs.

Communications expense decreased for the year ended December 31, 2023, when compared to the same period in 2022, driven by a decrease in phone and internet costs due to a change in vendors.

FDIC insurance increased for the year ended December 31, 2023, when compared to the same period in 2022, due to an increase in the rate assessed by the FDIC and an increase in our assessment base resulting from an increase in our total assets.

Amortization of intangibles decreased for the year ended December 31, 2023, compared to the same period in 2022, 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.

The primary increase in other noninterest expense for the year ended December 31, 2023, when compared to the same period in 2022, was in non-service cost retirement expense related to the Retirement Plan. Several additional expenses

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increased during the year ended December 31, 2023, including advantage check card losses, online banking expense, security expense, dues and assessments, subscriptions and other losses.

INCOME TAXES

Pre-tax income for the year ended December 31, 2023 was $101.1 million, compared to $119.6 million for the year ended December 31, 2022.

Income tax expense was $14.4 million for the year ended December 31, 2023 and represented a decrease of $0.2 million, or 1.2%, from $14.6 million for the year ended December 31, 2022.  The ETR as a percentage of pre-tax income was 14.3% in 2023 and 12.2% in 2022. The increase in the ETR for the year ended December 31, 2023, compared to the same period in 2022, was mainly due to a decrease in tax-exempt income as a percentage of pre-tax income. The decrease in the income tax expense for the year ended December 31, 2023 is primarily due to the decrease in pre-tax income in 2023 offset by an increase in the ETR as compared to the same period in 2022.

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 asset totaled $30.4 million at December 31, 2023, as compared to $34.7 million in 2022. The decrease in the net deferred tax asset is primarily the result of a decrease in unrealized losses 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, 2023 or December 31, 2022, as management believes it is more likely than not that all of the deferred tax asset items will be realized in future years.

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, 2023 increased $376.8 million, or 9.1%, and the average loan balance outstanding for the year increased $381.9 million, or 9.7%, compared to 2022.

From December 31, 2022 to December 31, 2023, construction loans increased $230.1 million, commercial real estate loans increased $180.7 million and 1-4 family residential loans increased $33.2 million. The increases were partially offset by decreases of $45.2 million in commercial loans, $13.1 million in loans to individuals and $8.9 million in municipal loans. Loans held for sale increased $10.2 million, or 1,533.3%, to $10.9 million at December 31, 2023 from $667,000 at December 31, 2022, due to the transfer of an $8.1 million commercial real estate loan relationship to loans held for sale that included a write down of $788,000 to fair value.

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, 2023, was approximately $209.1 million.  Our largest loan relationship at December 31, 2023 was approximately $133.3 million.

The average yield on loans for the year ended December 31, 2023 increased to 5.75%, compared to 4.42% for the year ended December 31, 2022.  This increase was due to the higher interest rate environment during 2023.

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, 2023, the majority of our real estate loans were collateralized by properties located in our market areas.  Of the $3.65 billion in real estate loans, $696.7 million, or 19.1%, 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.

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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 real estate loan 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 mortgage 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 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 residential portfolio.

We also make home equity loans, which are included as part of the 1-4 family residential loans, and at December 31, 2023, these loans totaled $98.5 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 concentration of 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, 2023, commercial real estate loans consisted of $1.79 billion of owner and non-owner occupied real estate loans, $347.5 million of loans secured by multi-family properties and $28.6 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. Commercial loans decreased $45.2 million, or 11.0%, to $366.9 million as of December 31, 2023, when compared to 2022.

MUNICIPAL LOANS

We have made 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

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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.  These loans allow us to earn a higher yield than we could if we purchased municipal securities for similar durations.  Loans to municipalities and school districts decreased $8.9 million, or 2.0%, to $441.2 million as of December 31, 2023, when compared to 2022. Currently, we are not originating municipal loans due to the tight credit spreads and low overall yields. Until municipal loan pricing improves, we do not anticipate originating municipal loans and as a result, expect this portfolio will decline as maturities and scheduled payments occur.

LOANS TO INDIVIDUALS

Substantially all originations of our loans to individuals are made to consumers in our market areas.  At December 31, 2023, loans collateralized by titled equipment, which are primarily automobiles, accounted for approximately $35.0 million, or 56.8%, 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 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, 2023, which, based on maturity, are due in (1) one year or less, (2) after one but within five years, (3) after five years but within 15 years, and (4) after 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:

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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 $13.7 million and $14.2 million and represented 1.8% and 1.9% of shareholders’ equity as of December 31, 2023 and 2022, respectively.

NONPERFORMING ASSETS

Nonperforming assets consist of delinquent loans 90 days or more past due, nonaccrual loans, OREO, repossessed assets and restructured 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 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 modified due to the borrower experiencing financial difficulty to provide 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, 2023 were $4.0 million, representing a decrease of $6.9 million, or 63.2%, from $10.9 million at December 31, 2022.  The decrease in nonperforming assets was primarily due to the adoption of ASU 2022-02 on January 1, 2023, which allowed for the prospective exclusion of loan modifications that are performing but would have previously required disclosure as troubled debt restructures in nonperforming assets. From December 31, 2022 to December 31, 2023, nonaccrual loans increased $1.0 million, or 36.6%, to $3.9 million with increases in nonaccrual 1-4 family residential loans and commercial loans, partially offset by decreases in nonaccrual construction loans, commercial real estate loans and loans to individuals during the year.  Restructured loans decreased $7.8 million, or 99.8%, to $13,000. There was $99,000 in OREO and no repossessed assets as of December 31, 2023. As of December 31, 2022, there was $93,000 in OREO and $74,000 in repossessed assets.

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

(1)    Includes $506,000 and $897,000 of restructured loans as of December 31, 2023 and December 31, 2022, respectively.

(2) Pursuant to our adoption of ASU 2022-02, effective January 1, 2023, we prospectively discontinued the recognition and measurement guidance previously required on troubled debt restructures. As a result, “restructured” loans as of December 31, 2023 exclude any loan modifications that are performing but would have previously required disclosure as troubled debt restructures.

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 actively market all OREO properties and do not hold them for investment purposes.

We reversed $89,000 of interest income on nonaccrual loans during the year ended December 31, 2023. We had $1.0 million of loans on nonaccrual for which there was no related allowance for credit losses as of December 31, 2023.

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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 $42.7 million at December 31, 2023, or 0.94% of loans, an increase of $6.2 million, or 16.9%, compared to $36.5 million at December 31, 2022.  The increase was primarily due to increased economic and repricing concerns forecasted in our CECL model when compared to December 31, 2022.

In accordance with ASC 326, the allowance for credit losses on loans is estimated and recognized upon origination of the loan based on expected credit losses. 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 increased economic and repricing concerns forecasted in our CECL model as of December 31, 2023.

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 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 a senior credit officer, 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.

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

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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, 2023, our review of the loan portfolio indicated that an allowance for loan losses of $42.7 million was appropriate to cover expected losses in the portfolio.  Changes in economic and other conditions, including the application of the CECL model, may require future adjustments to the allowance for loan losses.

Industry and our own experience indicate 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):

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, 2023, net loan charge-offs increased $2.1 million, or 295.1%, to $2.8 million, compared to $696,000 for the same period in 2022.

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

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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.  For the year ended December 31, 2023, we recorded a provision for credit losses for off-balance-sheet exposures of $245,000, compared to $1.3 million for the year ended December 31, 2022. The decrease for the year ended December 31, 2023 was primarily due to a decrease in the commitments compared to 2022. 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 liquidity 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, 2023, the combined investment securities, MBS, FHLB stock and other investments as a percentage of total assets was 31.7% compared to loans, which were 54.7% 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 net unamortized premium for our MBS increased to $9.5 million at December 31, 2023 compared to $1.3 million at December 31, 2022.

Our investment securities consist primarily of state and political subdivision (municipal bonds) and to a lesser extent, U.S. Treasury Bills and 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. Our corporate bonds consist of investment grade bonds, private placement bonds and two bonds totaling approximately $6.4 million, rated one grade below investment grade.

During 2023, we sold municipal securities, mortgage related securities and U.S. Treasury Bills that resulted in an overall loss of $16.0 million, which included a net gain of $6.5 million recorded on the unwind of fair value municipal security hedges in the AFS securities portfolio. The loss on AFS securities was primarily driven by fourth quarter sales of AFS securities with a net loss of $10.4 million for the three months ended December 31, 2023. The fourth quarter sales of AFS securities were due to strategic opportunities related to a drop in treasury rates and reinvestment of the proceeds primarily into higher yielding securities and to a lesser extent, into loans. During 2022, the sale of AFS securities resulted in an overall net loss of $3.8 million.

The combined investment securities, MBS, FHLB stock and other investments decreased to $2.62 billion at December 31, 2023, compared to $2.65 billion at December 31, 2022, a decrease of $21.1 million, or 0.8%.  The decrease is a result of a decrease in our investment securities portfolio of $254.9 million, or 11.8%, partially offset by an increase in our MBS of $232.6 million, or 50.3%, when compared to December 31, 2022.

The combined fair value of the AFS and HTM securities portfolio at December 31, 2023 was $2.46 billion, which represented a net unrealized loss as of that date of $177.1 million.  The net unrealized loss was comprised of $191.3 million of unrealized losses and $14.2 million in unrealized gains.  The fair value of the AFS securities portfolio at December 31, 2023 was $1.30 billion, which included a net unrealized loss of $36.2 million.  The net unrealized loss was comprised of $39.8 million of unrealized losses and $3.7 million of unrealized gains.  The majority of the $39.8 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 transfer 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. During the year ended December 31, 2023, we did not transfer any securities from AFS to HTM. There were $1.25 billion securities transferred from AFS to HTM during the year ended December 31, 2022. We transferred these securities due to overall balance sheet strategies, and our management has the current intent and ability to hold these securities until maturity. There were no sales from the HTM portfolio during the years ended December 31, 2023 or 2022.  There were $1.31 billion and $1.33 billion of securities classified as HTM at December 31, 2023 and 2022, respectively.

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The maturities classified according to the sensitivity to changes in interest rates of the December 31, 2023 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, 2023, 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.

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DEPOSITS AND BORROWED FUNDS

We utilize deposits and primarily borrowings from FHLB, FRDW and BTFP 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):

(1)For the years ended December 31, 2023 and 2022, the average rate on interest bearing demand accounts includes the effect of interest rate swaps.

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

Estimated amount of uninsured deposits, including related accrued interest were $2.45 billion and $2.59 billion at December 31, 2023 and 2022, respectively.

Brokered deposits may consist of CDs and non-maturity deposits. At December 31, 2023, we had no brokered CDs. Brokered non-maturity deposits were $828.0 million at December 31, 2023 with a weighted average cost of 323 basis points. As of December 31, 2022, we had $220.9 million in brokered CDs and $438.4 million in brokered non-maturity deposits. Our current policy allows for maximum brokered deposits of the lesser of $1.20 billion, or 20% of total deposits.  The potential higher interest costs and lack of customer loyalty are risks associated with the use of brokered deposits.

Borrowing arrangements, consisting of FHLB borrowings, repurchase agreements and borrowings from the FRDW and BTFP, increased $348.0 million, or 92.9%, during 2023 compared to 2022, due to a $117.7 million increase in borrowings from the BTFP, a $112.0 million increase in borrowings from the FRDW, a $59.3 million increase in FHLB borrowings and a $59.0 million increase in repurchase agreements.

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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 other borrowings and FHLB borrowings includes 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 Federal Reserve through the FRDW and BTFP. 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, 2023 or December 31, 2022.  To provide more liquidity in response to economic conditions in recent years, the Federal Reserve has encouraged broader use of the discount window. At December 31, 2023, the amount of additional funding the Bank could obtain from the FRDW, collateralized by securities, was approximately $213.1 million. There were $300.0 million in borrowings from the FRDW at December 31, 2023, and $188.0 million at December 31, 2022. To provide more stability and to assure banks have the ability to meet the needs of all of their depositors, the Federal Reserve created the BTFP in the first quarter of 2023. At December 31, 2023, the amount of additional funding the Bank could obtain from the BTFP, collateralized by securities, was approximately $8,000. There were $117.7 million in borrowings from the BTFP at December 31, 2023, with a remaining maturity under three months. 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, 2023, 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 $92.1 million at December 31, 2023 and $33.2 million at December 31, 2022, and had maturities of less than two years.  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 0.57% to 4.80% and with remaining maturities of 22 days to 4.5 years at December 31, 2023.  FHLB borrowings may be collateralized by FHLB stock, nonspecified loans and/or securities. At December 31, 2023, the amount of additional funding Southside Bank could obtain from FHLB, collateralized by securities, FHLB stock and nonspecified loans and securities, was approximately $1.95 billion, net of FHLB stock purchases required.

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CAPITAL RESOURCES AND LIQUIDITY

Our total shareholders’ equity at December 31, 2023 increased 3.7%, or $27.3 million, to $773.3 million, or 9.3% of total assets, compared to $746.0 million, or 9.9% of total assets, at December 31, 2022. The increase in shareholders’ equity was the result of net income of $86.7 million, other comprehensive income of $24.0 million, stock compensation expense of $3.6 million, common stock issued under our dividend reinvestment plan of $1.2 million and net issuance of common stock under employee stock plans of $485,000, partially offset by the repurchase of $45.1 million of our common stock and cash dividends paid of $43.6 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, 2023 included $58.5 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, 2023.

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 $93.9 million of qualified subordinated debt as of December 31, 2023. The permissible portion of qualified subordinated notes decreases 20% per year during the final five years of the term of the notes.

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. In accordance with CECL guidance, a CECL transitional amount totaling $4.1 million has been added back to CET1 as of December 31, 2023, representing 50% of the $8.2 million transitional amount at December 31, 2022.

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, 2023, 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.

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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, 2023, 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, 2023, these investments were 8.9% of total assets, as compared with 2.4% for December 31, 2022.  The increase to 8.9% at December 31, 2023 as compared to December 31, 2022, is reflective of increases in interest earning deposits and the short-term investment portfolio, partially offset by the increase in total assets. 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, 2023 or 2022.  To provide more liquidity in response to economic conditions in recent years, the Federal Reserve has encouraged broader use of the discount window. At December 31, 2023, the amount of additional funding the Bank could obtain from the FRDW, collateralized by securities, was approximately $213.1 million. There were $300.0 million in borrowings from the FRDW at December 31, 2023 and $188.0 million at December 31, 2022. To provide more stability and to assure banks have the ability to meet the needs of all of their depositors, the Federal Reserve created the BTFP in the first quarter of 2023. At December 31, 2023, the amount of additional funding the Bank could obtain from the BTFP, collateralized by securities, was approximately $8,000. There were $117.7 million in borrowings from the BTFP at December 31, 2023. At December 31, 2023, the amount of additional funding Southside Bank could obtain from FHLB, collateralized by securities, FHLB stock and nonspecified loans and securities, was approximately $1.95 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, 2023, 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, 2023. 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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