UMB FINANCIAL CORP (UMBF) FY 2022 MD&A

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

Management’s Discussion and Analysis

This Management’s Discussion and Analysis highlights the material changes in the results of operations and changes in financial condition for each of the three years in the period ended December 31, 2022.  It should be read in conjunction with the accompanying Consolidated Financial Statements, Notes to Consolidated Financial Statements, and other financial statistics appearing elsewhere in this Annual Report on Form 10-K. Results of operations for the periods included in this review are not necessarily indicative of results to be attained during any future period.

CAUTIONARY NOTICE ABOUT FORWARD-LOOKING STATEMENTS

From time to time the Company has made, and in the future will make, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements often use words such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project,” “outlook,” “forecast,” “target,” “trend,” “plan,” “goal,” or other words of comparable meaning or future-tense or conditional verbs such as “may,” “will,” “should,” “would,” or “could.” Forward-looking statements convey the Company’s expectations, intentions, or forecasts about future events, circumstances, results, or aspirations.

This report, including any information incorporated by reference in this report, contains forward-looking statements. The Company also may make forward-looking statements in other documents that are filed or furnished with the SEC. In addition, the Company may make forward-looking statements orally or in writing to investors, analysts, members of the media, or others.

All forward-looking statements, by their nature, are subject to assumptions, risks, and uncertainties, which may change over time and many of which are beyond the Company’s control. You should not rely on any forward-looking statement as a prediction or guarantee about the future.  Actual future objectives, strategies, plans, prospects, performance, conditions, or results may differ materially from those set forth in any forward-looking statement. While no list of assumptions, risks, or uncertainties could be complete, some of the factors that may cause actual results or other future events, circumstances, or aspirations to differ from those in forward-looking statements include:

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Any forward-looking statement made by the Company or on its behalf speaks only as of the date that it was made. The Company does not undertake to update any forward-looking statement to reflect the impact of events, circumstances, or results that arise after the date that the statement was made, except as required by applicable securities laws. You, however, should consult further disclosures (including disclosures of a forward-looking nature) that the Company may make in any subsequent Annual Report on Form 10-K, Quarterly Report on Form 10-Q, or Current Report on Form 8-K.

Results of Operations

Overview

For over two years, the Company has experienced the impacts of the COVID-19 global pandemic (the COVID-19 pandemic, or the pandemic).  Such impacts have included significant volatility in the global stock and fixed income markets, the enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the American Rescue Plan Act of 2021, the Paycheck Protection Program (PPP) administered by the Small Business Administration, and a variety of rulings from the Company’s banking regulators.

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The Company continues to actively monitor developments related to COVID-19 and its impact to its business, customers, employees, counterparties, vendors, and service providers. During 2022, the Company’s results of operations included continued maintenance of the allowance for credit losses (ACL) at a level appropriate given the state of key macroeconomic variables utilized in the econometric models.  Additionally, the Company continued to see impacts of the volatile equity and debt markets in its fee-based businesses, as well as the impacts of the recent interest rate increases in net interest income.

The COVID-19 pandemic has necessitated certain actions related to the way the Company operates its business. The Company is carefully monitoring the activities of its vendors and other third-party service providers to mitigate the risks associated with any potential service disruptions. The length of time it may be required to operate under such circumstances and future degrees of disruption remain uncertain. While the Company has not experienced material adverse disruptions to its internal operations due to the pandemic, it continues to review evolving risks and developments.

The Company focuses on the following four core financial objectives.  Management believes these objectives will guide its efforts to achieve its vision, to deliver the Unparalleled Customer Experience, all while seeking to improve net income and strengthen the balance sheet while undertaking prudent risk management.

The first financial objective is to continuously improve operating efficiencies. The Company has focused on identifying efficiencies that simplify its organizational and reporting structures, streamline back-office functions and take advantage of synergies and newer technologies among various platforms and distribution networks.  The Company has identified and expects to continue identifying ongoing efficiencies through the normal course of business that, when combined with increased revenue, will contribute to improved operating leverage.  For 2022, total revenue increased 14.4%, and noninterest expense increased 7.7%, as compared to the previous year.  Revenue for 2022 included a $66.2 million gain realized on the sale of the Company’s Visa Inc. Class B common shares.  Revenue for 2021 included a loss on the Company’s investment in Tattooed Chef, Inc. (TTCF) of $15.4 million.   The Company continues to invest in technological advances that it believes will help management drive operating leverage in the future through improved data analysis and automation. The Company also continues to evaluate core systems and will invest in enhancements that it believes will yield operating efficiencies.

The second financial objective is to increase net interest income through profitable loan and deposit growth and the optimization of the balance sheet.  For 2022, net interest income increased $98.3 million, or 12.1%, as compared to the previous year. The Company has shown increased net interest income through the effects of increased volume and mix of average earning assets, coupled with higher interest rates.  This increase was partially offset by higher interest-bearing deposit rates and lower PPP income. There was a decrease of $37.7 million in interest income for loans recorded under the PPP in 2022 as compared to 2021.  Average earning assets increased $2.1 billion, or 6.2%, compared to 2021.  Average loan balances increased $2.2 billion and average securities increased $1.8 billion, partially offset by a decrease in average interest-bearing due from banks of $1.7 billion from prior year. Average PPP loans decreased $755.1 million as compared to 2021.  The funding for these assets was driven primarily by a 2.8% increase in average interest-bearing liabilities and 17.9% increase in noninterest-bearing deposits.  Net interest margin, on a tax-equivalent basis, increased 13 basis points compared to the same period in 2021 in large part due to an increase in the benefit of free funds with the increase in short-term interest rates, coupled with the repricing of earning assets.  This increase was partially offset by lower liquidity and the repricing of interest-bearing liabilities.  Net interest spread contracted by 22 basis points during the same period.

The third financial objective is to grow the Company’s revenue from noninterest sources.  The Company seeks to grow noninterest revenues throughout all economic and interest rate cycles, while positioning itself to benefit in periods of economic growth.  Noninterest income increased $87.1 million, or 18.6%, to $554.2 million for the year ended December 31, 2022, compared to the same period in 2021.  The increase for 2022 was driven by a $66.2 million gain realized on the sale of the Company’s Visa Inc. Class B common shares, coupled with a loss of $15.4 million on the Company’s investment in TTCF recognized in 2021. The increase was also driven by increased 12b-1 and money market income. These changes are discussed in greater detail below under Noninterest income. For the year ended December 31, 2022, noninterest income represented 37.8% of total revenues, as compared to 36.4% for 2021.

The fourth financial objective is effective capital management.  The Company places a significant emphasis on maintaining a strong capital position, which management believes promotes investor confidence, provides access to funding sources under favorable terms, and enhances the Company’s ability to capitalize on business growth and

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acquisition opportunities. The Company continues to maximize shareholder value through a mix of reinvesting in organic growth, evaluating acquisition opportunities that complement the Company’s strategies, increasing dividends over time, and appropriately utilizing a share repurchase program.  At December 31, 2022, the Company had a total risk-based capital ratio of 12.50% and $2.7 billion in total shareholders’ equity, a decrease of $478.3 million, or 15.2%, compared to total shareholders’ equity at December 31, 2021, driven by increased accumulated other comprehensive losses. The Company repurchased 333,185 thousand shares of common stock at an average price of $96.03 per share during 2022 and declared $72.6 million in dividends, which represents a 7.9% increase compared to dividends declared during 2021.

Earnings Summary

The Company recorded consolidated net income of $431.7 million for the year ended December 31, 2022.  This represents a 22.3% increase over 2021.  Net income for 2021 was $353.0 million, or an increase of 23.2% compared to 2020.  Basic earnings per share for the year ended December 31, 2022, were $8.93 per share compared to $7.31 per share in 2021, an increase of 22.2%.  Basic earnings per share were $5.95 per share in 2020, or an increase of 22.9% from 2020 to 2021. Fully diluted earnings per share increased 22.4% from 2021 to 2022 and increased 22.1% from 2020 to 2021.  Return on average assets and return on average common shareholder’s equity for the year ended December 31, 2022 were 1.15% and 15.83%, respectively, compared to 1.00% and 11.43%, respectively, for the year ended December 31, 2021.  Return on average assets and return on average common shareholder’s equity for the year ended December 31, 2020 were 1.00% and 10.21%, respectively.

The Company’s net interest income increased to $913.8 million in 2022 compared to $815.5 million in 2021 and $731.2 million in 2020.  In total, net interest income increased $98.3 million, as compared to 2021, primarily driven by a favorable volume variance of $109.6 million, offset by a $11.3 million rate variance.  See Table 2.  The favorable volume variance on earning assets was predominantly driven by an increase of $2.1 billion, or 6.2%, in average earning assets.  In 2022, average loan balances increased $2.2 billion and average securities balances increased $1.8 billion, partially offset by a decrease of $1.7 billion in average interest-bearing due from banks, as compared to 2021.  Net interest margin, on a fully tax-equivalent basis (FTE), increased to 2.63% for 2022, compared to 2.50% for the same period in 2021, driven by the benefit of free funds, higher asset yields, offset by increased cost of interest-bearing liabilities. Net interest spread contracted by 22 basis points during the same period.  The Company has seen an increase in the benefit from interest-free funds as compared to 2021 driven by the increase in short-term interest rates. The impact of this benefit increased 35 basis points compared to 2021 and is illustrated on Table 3.  The magnitude and duration of this impact will be largely dependent upon the FRB’s policy decisions and market movements. See Table 18 in Item 7A for an illustration of the impact of an interest rate increase or decrease on net interest income as of December 31, 2022.

The provision for credit losses totaled $37.9 million for the year ended December 31, 2022, which is an increase of $17.9 million, or 89.5%, compared to the same period in 2021.  This change is the result of applying the CECL methodology for computing the allowance for credit losses, coupled with the impacts of loan growth, portfolio metric changes, and changes in macro-economic metrics in the current period as compared to the prior period. See further discussion in “Provision and Allowance for Credit Losses” in this report.

The Company had an increase of $87.1 million, or 18.6%, in noninterest income in 2022, as compared to 2021, and a decrease of $93.0 million, or 16.6%, in 2021, compared to 2020.  The increase in 2022 is primarily driven by increased investment securities gains, net of $53.4 million and brokerage fees of $30.8 million.  The decrease in 2021 is primarily attributable to a decrease of $115.6 million in investment securities gains, net, offset by an increase in trust and securities processing of $29.5 million. The change in noninterest income in 2022 from 2021, and 2021 from 2020 is illustrated in Table 6.

Noninterest expense increased in 2022 by $64.5 million, or 7.7%, compared to 2021 and increased by $11.6 million, or 1.4%, in 2021 compared to 2020.  The increase in 2022 is primarily driven by increases in salary and employee benefits expense, processing fees, other miscellaneous expense, bankcard expense, marketing and business development expense, and legal and consulting expense. The increase in 2021 is primarily driven by increases in processing fees and salary and employee benefit expense, offset by lower operating losses and equipment expense.  The increase in noninterest expense in 2022 from 2021, and 2021 from 2020 is illustrated in Table 7.

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Net Interest Income

Net interest income is a significant source of the Company’s earnings and represents the amount by which interest income on earning assets exceeds the interest expense paid on liabilities.  The volume of interest earning assets and the related funding sources, the overall mix of these assets and liabilities, and the interest rates paid on each affect net interest income.  Table 2 summarizes the change in net interest income resulting from changes in volume and rates for 2022, 2021 and 2020.

Net interest margin, presented in Table 1, is calculated as net interest income on a fully tax-equivalent basis as a percentage of average earning assets.  Net interest income is presented on a tax-equivalent basis to adjust for the tax-exempt status of earnings from certain loans and investments, which are primarily obligations of state and local governments.  A critical component of net interest income and related net interest margin is the percentage of earning assets funded by interest-free sources.  Table 3 analyzes net interest margin for the three years ended December 31, 2022, 2021 and 2020.  Net interest income, average balance sheet amounts and the corresponding yields earned and rates paid for the years 2020 through 2022 are presented in Table 1 below.

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The following table presents, for the periods indicated, the average earning assets and resulting yields, as well as the average interest-bearing liabilities and resulting yields, expressed in both dollars and rates.

Table 1

THREE YEAR AVERAGE BALANCE SHEETS/YIELDS AND RATES (tax-equivalent basis)

(in millions)

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THREE YEAR AVERAGE BALANCE SHEETS/YIELDS AND RATES (tax-equivalent basis)

(in millions)

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Table 2

RATE-VOLUME ANALYSIS (in thousands)

This analysis attributes changes in net interest income either to changes in average balances or to changes in average interest rates for earning assets and interest-bearing liabilities.  The change in net interest income that is due to both volume and interest rate has been allocated to volume and interest rate in proportion to the relationship of the absolute dollar amount of the change in each.  All interest rates are presented on a tax-equivalent basis and give effect to tax-exempt interest income net of the disallowance of interest expense for federal income tax purposes, related to certain tax-free assets.  The loan average balances and rates include nonaccrual loans.

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Table 3

ANALYSIS OF NET INTEREST MARGIN (in thousands)

The Company experienced an increase in net interest income of $98.3 million, or 12.1%, for the year ended December 31, 2022, compared to 2021.  This follows an increase of $84.3 million, or 11.5%, for the year ended December 31, 2021, compared to 2020.  Average earning assets for the year ended December 31, 2022 increased by $2.1 billion, or 6.2%, compared to the same period in 2021.  Net interest margin, on a tax-equivalent basis, increased to 2.63% for 2022 compared to 2.50% in 2021.

The Company funds a significant portion of its balance sheet with noninterest-bearing demand deposits.  Noninterest-bearing demand deposits represented 40.6%, 45.9% and 36.5% of total outstanding deposits as of December 31, 2022, 2021 and 2020, respectively.  The decrease in 2022 is driven by the increase in short-term interest rates. As illustrated in Table 3, the impact from these interest-free funds was 43 basis points in 2022, as compared to eight basis points in 2021 and 15 basis points in 2020.

The Company experienced an increase in net interest income during 2022 due to a volume variance of $109.6 million, offset by a negative rate variance of $11.3 million.  The average rate on earning assets during 2022 has increased by 62 basis points, while the average rate on interest-bearing liabilities increased by 84 basis points, resulting in a 22 basis-point decrease in spread.  The volume of loans has increased from an average of $16.6 billion in 2021 to an average of $18.8 billion in 2022, driven by organic loan growth.  The volume of interest-bearing liabilities increased from $20.6 billion in 2021 to $21.1 billion in 2022.  The Company expects to see continued volatility in the economic markets and governmental responses to inflation, geopolitical tensions, supply chain constraints, and the COVID-19 pandemic. These changing economic conditions and governmental responses could have impacts on the balance sheet and income statement of the Company in 2023.  Loan-related earning assets tend to generate a higher spread than those earned in the Company’s investment portfolio.  By design, the Company’s investment portfolio is moderate in duration and liquid in its composition of assets.

During 2023, approximately $1.1 billion of available-for-sale securities are expected to have principal repayments.  This includes approximately $235 million which will have principal repayments during the first quarter of 2023.  The available-for-sale investment portfolio had an average life of 62.3 months, 67.6 months, and 70.1 months as of December 31, 2022, 2021, and 2020, respectively.

Provision and Allowance for Credit Losses

The ACL represents management’s judgment of total expected losses included in the Company’s loan portfolio as of the balance sheet date.  The Company’s process for recording the ACL is based on the evaluation of the Company’s lifetime historical loss experience, management’s understanding of the credit quality inherent in the loan portfolio, and the impact of the current economic environment, coupled with reasonable and supportable economic forecasts.

A mathematical calculation of an estimate is made to assist in determining the adequacy and reasonableness of management’s recorded ACL.  To develop the estimate, the Company follows the guidelines in Accounting Standards Codification (ASC) Topic 326, Financial Instruments – Credit Losses (ASC 326).  The estimate reserves for assets held at amortized cost and any related credit deterioration in the Company’s available-for-sale debt security portfolio.  Assets held at amortized cost include the Company’s loan book and held-to-maturity security portfolio.

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The process involves the consideration of quantitative and qualitative factors relevant to the specific segmentation of loans.  These factors have been established over decades of financial institution experience and include economic observation and loan loss characteristics.  This process is designed to produce a lifetime estimate of the losses, at a reporting date, that includes evaluation of historical loss experience, current economic conditions, reasonable and supportable forecasts, and the qualitative framework outlined by the Office of the Comptroller of the Currency in the published 2020 Interagency Policy Statement.  This process allows management to take a holistic view of the recorded ACL reserve and ensure that all significant and pertinent information is considered.

The Company considers a variety of factors to ensure the safety and soundness of its estimate including a strong internal control framework, extensive methodology documentation, credit underwriting standards which encompass the Company’s desired risk profile, model validation, and ratio analysis.  If the Company’s total ACL estimate, as determined in accordance with the approved ACL methodology, is either outside a reasonable range based on review of economic indicators or by comparison of historical ratio analysis, the ACL estimate is an outlier and management will investigate the underlying reason(s).  Based on that investigation, issues or factors that previously had not been considered may be identified in the estimation process, which may warrant adjustments to estimated credit losses.

The ending result of this process is a recorded consolidated ACL that represents management’s best estimate of the total expected losses included in the loan portfolio, held-to-maturity securities, and credit deterioration in available-for-sale securities.

Table 4 presents the components of the allowance by loan portfolio segment.  The Company manages the ACL against the risk in the entire loan portfolio and therefore, the allocation of the ACL to a particular loan segment may change in the future.  Management of the Company believes the present ACL is adequate considering the Company’s loss experience, delinquency trends and current economic conditions.  Future economic conditions and borrowers’ ability to meet their obligations, however, are uncertainties which could affect the Company’s ACL and/or need to change its current level of provision.  For more information on loan portfolio segments and ACL methodology refer to Note 3, “Loans and Allowance for Credit Losses,” in the Notes to the Consolidated Financial Statements.

Table 4

ALLOCATION OF ALLOWANCE FOR CREDIT LOSSES ON LOANS (in thousands)

This table presents an allocation of the allowance for credit losses on loans and percent of loans to total loans by loan portfolio segment, which represents the total expected losses derived by both quantitative and qualitative methods. The amounts presented are not necessarily indicative of actual future charge-offs in any particular category and are subject to change.

Table 5 presents a summary of the Company’s ACL for the years ended December 31, 2022 and 2021.  Also, please see “Quantitative and Qualitative Disclosures About Market Risk – Credit Risk Management” in this report for information relating to nonaccrual, past due, restructured loans, and other credit risk matters.  For more information on loan portfolio segments and ACL methodology refer to Note 3, “Loans and Allowance for Credit Losses,” in the Notes to the Consolidated Financial Statements.

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As illustrated in Table 5 below, the ACL decreased as a percentage of total loans to 0.91% as of December 31, 2022, compared to 1.13% as of December 31, 2021.  The provision for credit losses, including provision for off-balance sheet credit exposures, totaled $37.9 million for the year ended December 31, 2022, which is an increase of $17.9 million, or 89.5%, compared to the same period in 2021.  The provision for credit losses, including provision for off-balance sheet credit exposures, totaled $20.0 million for the year ended December 31, 2021.  This increase is the result of the impacts of loan growth, portfolio metric changes, and changes in macro-economic metrics in the current period as compared to the prior period.

Table 5

ANALYSIS OF ALLOWANCE FOR CREDIT LOSSES (in thousands)

Noninterest Income

A key objective of the Company is the growth of noninterest income to provide a diverse source of revenue not directly tied to interest rates.  Fee-based services are typically non-credit related and are not generally affected by fluctuations in interest rates.  Noninterest income increased in 2022 by $87.1 million, or 18.6%, compared to 2021 and decreased in 2021 by $93.0 million, or 16.6%, compared to 2020.  The increase in 2022 is primarily attributable to an increase in investment securities gains, net, coupled with an increase in brokerage fee income and trust and securities processing income. These were partially offset by a decrease in other miscellaneous income. The decrease in 2021 is primarily attributable to a decrease in investment securities gains, net, and brokerage income, partially offset by increased fund services income, corporate trust income, and bankcard income. Changes in Noninterest income are presented in Table 6 below.

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The Company’s fee-based services offer multiple products and services, which management believes will more closely align with customer product demands.  The Company is currently emphasizing fee-based services including trust and securities processing, bankcard, securities trading and brokerage and cash and treasury management.  Management believes that it can offer these products and services both efficiently and profitably, as most have common platforms and support structures.

Table 6

SUMMARY OF NONINTEREST INCOME (in thousands)

Noninterest income and the year-over-year changes in noninterest income are summarized in Table 6 above.  The dollar change and percent change columns highlight the respective net increase or decrease in the categories of noninterest income in 2022 compared to 2021, and in 2021 compared to 2020.

Trust and securities processing income consists of fees earned on personal and corporate trust accounts, custody of securities services, trust investments and wealth management services, and mutual fund assets servicing.  This income category increased by $13.1 million, or 5.8% in 2022, compared to 2021, and increased by $29.5 million, or 15.1%, in 2021, compared to 2020.  During 2022, fund services income increased $12.9 million and corporate trust income increased $6.5 million, partially offset by a decrease in wealth management income of $6.3 million.  During 2021, fund services income increased $27.5 million and corporate trust income increased $5.8 million, offset by a decrease in wealth management income of $3.8 million.  The recent volatile markets have impacted the income in this category.  Since trust and securities processing fees are primarily asset-based, which are highly correlated to the change in market value of the assets, the related income will be affected by changes in the securities markets.  Management continues to emphasize sales of services to both new and existing clients as well as increasing and improving the distribution channels.

Trading and investment banking income decreased $7.7 million, or 25.0%, in 2022 compared to 2021 and decreased $2.0 million, or 6.1%, in 2021 compared to 2020.  These decreases were driven by lower trading volume and lower market values.

Service charges on deposits income decreased $0.9 million, or 1.0%, in 2022 compared to 2021 and increased $2.2 million, or 2.6%, in 2021 compared to 2020.  The decrease in 2022 compared to 2021 was driven by decreased healthcare services income, partially offset by increased consumer service charge income.  The increase in 2021 compared to 2020 was driven by increased corporate service charge income.

Brokerage fees increased $30.8 million, or 253.5%, in 2022 compared to 2021 and decreased $12.2 million, or 50.0%, in 2021 compared to 2020.  The increase in 2022 compared to 2021 was driven by increased 12b-1 and money market fees driven by the increase in short-term interest rates. The decrease in 2021 compared to 2020 was due to lower money market and 12b-1 income driven by a decrease in volume and interest rates.

Bankcard fees increased $8.9 million, or 13.7%, in 2022 compared to 2021, and increased $4.0 million, or 6.7%, in 2021 compared to 2020.  These increases were primarily driven by increased interchange income, offset by increased rewards and rebate expense.

Investment securities gains, net increased $53.4 million in 2022 compared to 2021 but decreased $115.6 million in 2021 compared to 2020. The increase for 2022 was driven by a $66.2 million gain realized on the sale of

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the Company’s Visa Inc. Class B common shares, coupled with a loss of $15.4 million on the Company’s investment in TTCF recognized in 2021. The decrease in 2021 was driven by the $108.8 million gain on the Company’s investment in TTCF in 2020 and the loss of $15.4 million in 2021 noted above.

Other noninterest income decreased $10.5 million, or 24.5%, in 2022 compared to 2021 and increased $1.1 million, or 2.7%, in 2021 compared to 2020.  The decrease in 2022 was primarily driven by market value changes in company-owned life insurance income.  The increase in 2021 was primarily driven by the gain on sale of the Company’s membership interests in PCM during the first quarter of 2021.

Noninterest Expense

Noninterest expense increased in 2022 by $64.5 million, or 7.7%, compared to 2021 and increased in 2021 by $11.6 million, or 1.4%, compared to 2020.  From 2021 to 2022 the increase was driven by increases in salary and employee benefits expense, processing fees, other miscellaneous expense, bankcard expense, and marketing and business development expense.  From 2020 to 2021 the increase was driven by processing fees and salary and employee benefits expense, offset by other miscellaneous expense and equipment expense.  Table 7 below summarizes the components of noninterest expense and the respective year-over-year changes for each category.

Table 7

SUMMARY OF NONINTEREST EXPENSE (in thousands)

Salaries and employee benefits expense increased $20.0 million, or 4.0%, in 2022 compared to 2021 and $9.0 million, or 1.8%, in 2021 compared to 2020.  In 2022, salary and wage expense increased $17.5 million, or 5.9% and bonus and commission expense increased $4.4 million, or 3.5%, driven by business volumes and revenue growth, and higher company performance. These increases were offset by a decrease in employee benefits expense of $1.9 million, or 2.3%.  In 2021, bonus and commission expense increased $8.7 million, or 7.5%, driven by business volumes and revenue growth, and higher company performance.  Salary and wage expense increased $1.7 million, or 0.6%.  These increases were offset by a decrease in employee benefits expense of $1.4 million, or 1.7%.

Equipment expense decreased $4.1 million, or 5.3%, in 2022 compared to 2021, and decreased $7.3 million, or 8.5%, from 2020 to 2021.  The decreases in both years were driven by lower software expense related to a transition to cloud-based computing solutions.

Marketing and business development expense increased $7.2 million, or 38.7%, in 2022 compared to 2021, and increased $3.9 million, or 26.3%, in 2021 compared to 2020.  The increases in both years were driven by the timing of advertising and business development projects and higher travel expenses as compared to the prior year.

Processing fees expense increased $14.7 million, or 21.7%, in 2022 compared to 2021, and increased $13.4 million, or 24.6%, in 2021 compared to 2020.  The increases in 2022 and 2021 were primarily driven by the transition to cloud computing solutions and ongoing investments in digital channel and integrated platform solutions to support business growth and the continued modernization of core systems.

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Legal and consulting expense increased $6.7 million, or 20.6%, in 2022 compared to 2021 and increased $2.6 million, or 8.9%, in 2021 compared to 2020.  These increases were primarily driven by higher consulting expense due to the timing of multiple projects.

Bankcard expense increased $7.2 million, or 37.7%, in 2022 compared to 2021 and increased $0.2 million, or 1.0%, in 2021 compared to 2020.  The increase in 2022 compared to 2021 was driven by higher card administration costs coupled with higher fraud losses.

Other noninterest expense increased $9.0 million, or 26.4%, in 2022 compared to 2021 and decreased $9.2 million, or 21.3%, in 2021 compared to 2020.  The increase in 2022 was driven by higher operational losses and increased charitable contributions expense.  The decrease in 2021 was driven by lower operational losses, partially offset by higher charitable contributions expense.

Income Taxes

Income tax expense totaled $100.3 million, $76.0 million, and $52.4 million in 2022, 2021, and 2020 respectively. These amounts equate to effective tax rates of 18.9%, 17.7%, and 15.5% for 2022, 2021 and 2020, respectively. The increase in the effective tax rate from 2021 to 2022 is primarily attributable to a smaller portion of pre-tax income being earned from tax-exempt municipal securities.  The increase in the effective tax rate from 2020 to 2021 is primarily attributable to a smaller portion of pre-tax income being earned from tax-exempt municipal securities and higher state and local income taxes.

For further information on income taxes refer to Note 16, “Income Taxes,” in the Notes to the Consolidated Financial Statements.

Business Segments

The Company has strategically aligned its operations into the following three reportable segments: Commercial Banking, Institutional Banking, and Personal Banking (collectively, the Business Segments). Senior executive officers regularly evaluate Business Segment financial results produced by the Company’s internal reporting system in deciding how to allocate resources and assess performance for individual Business Segments.  The management accounting system assigns balance sheet and income statement items to each Business Segment using methodologies that are refined on an ongoing basis. For comparability purposes, amounts in all periods are based on methodologies in effect at December 31, 2022.  Previously reported results have been reclassified in this Form 10-K to conform to the Company’s current organizational structure.

Table 8

COMMERCIAL BANKING OPERATING RESULTS (in thousands)

For the year ended December 31, 2022, Commercial Banking net income increased $4.6 million, or 1.6%, to $286.3 million compared to the same period in 2021.  Net interest income increased $16.0 million, or 2.8%, for the year ended December 31, 2022, compared to the same period last year, primarily driven by strong loan growth, earning asset mix changes, and the increase in short-term interest rates.  Provision for credit losses increased $17.3 million as compared to 2021, driven by loan growth, portfolio metric changes, and changes in macro-economic metrics in 2022 as compared to 2021.  Noninterest income increased $38.2 million, or 45.2%, over the same period in 2021.  This increase was primarily due to an allocated portion of the gain on the sale of Visa Inc. Class B

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common shares, partially offset by the decline in company-owned life insurance for the year ended December 31, 2022 as compared to the prior year.  Additionally, there were increases of $9.7 million in other investment security gains and $4.6 million in other income, driven by the gain on the sale of the Company’s factoring loan portfolio, and $3.8 million in bankcard income, primarily due to increased interchange income. Noninterest expense increased $26.5 million, or 8.6%, as compared to the same period in 2021.  This increase was driven by a $17.3 million increase in technology, service, and overhead expenses, an increase of $3.1 million in marketing and business development, an increase of $2.1 million in salary and employee benefits expense, an increase of $1.5 million in regulatory fees, an increase of $0.9 million in bankcard expense, and an increase of $0.9 million in operational losses as compared to 2021.

Table 9

INSTITUTIONAL BANKING OPERATING RESULTS (in thousands)

For the year ended December 31, 2022, Institutional Banking net income increased $75.2 million, or 133.7%, compared to the same period last year.  Net interest income increased $72.0 million, or 82.2%, compared to the same period last year, due to an increase in funds transfer pricing due to the increase in interest rates.  Noninterest income increased $50.3 million, or 18.4%, primarily due to increases of $31.1 million in brokerage fees, $12.9 million in fund services income, $6.5 million in corporate trust income, $3.0 million in bankcard fees, and an allocated portion of the gain on the sale of Visa Inc. Class B common shares.  These increases were partially offset by decreases of $7.7 million and $3.0 million in bond trading income and service charges on deposits, respectively, coupled with a decline in company-owned life insurance compared to the same period last year.  Noninterest expense increased $28.8 million, or 9.9% as compared to 2021.  This increase was primarily driven by increases of $18.3 million in salary and employee benefits expense, $4.7 million in bankcard expense, $4.5 million in technology, service, and overhead expenses, $2.6 million in marketing and business development, and $1.1 million in processing fees. These increases were partially offset by a decrease of $2.6 million in operational losses.

Table 10

PERSONAL BANKING OPERATING RESULTS (in thousands)

For the year ended December 31, 2022, Personal Banking net income decreased $1.1 million, or 7.5%, as compared to the same period last year.  Net interest income increased $10.2 million, or 6.9%, compared to the same period last year due to increased loan balances and the impact of higher short-term interest rates.  Provision for credit losses increased $0.7 million for the period, driven by loan growth, portfolio metric changes, and changes in macro-economic metrics in 2022 as compared to 2021.  Noninterest income decreased $1.5 million, or 1.3%,

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primarily driven by decreases of $6.2 million in wealth management income, $3.9 million on gains on the sale of mortgage loans, and $3.3 million in investment security gains. These decreases were partially offset by an increase in noninterest income due to an allocated portion of the gain on the sale of Visa Inc. Class B common shares, partially offset by the decline in company-owned life insurance.  Noninterest expense increased $9.2 million, or 3.9%, primarily due to increases of $8.5 million in technology, service, and overhead expenses, $4.6 million in processing fees, $1.5 million in bankcard expense, and $1.1 million in operational losses, partially offset by a decrease of $5.7 million in salaries and employee benefits.

Balance Sheet Analysis

Loans and Loans Held For Sale

Loans represent the Company’s largest source of interest income.  Loan balances held for investment increased by $3.9 billion, or 22.5%, in 2022.  This increase was primarily driven by an increase of $1.9 billion, or 26.8%, in commercial loans, $1.3 billion, or 21.5%, in commercial real estate loans, and $403.2 million, or 17.4% in consumer real estate loans.

Commercial & industrial loans and commercial real estate loans continue to represent the largest segments of the Company’s loan portfolio, comprising approximately 43.8% and 36.2%, respectively, of total loans and loans held for sale at the end of 2022 and 42.3% and 36.5%, respectively, of total loans and loans held for sale at the end of 2021.

Commercial loans represent the largest percent of total loans.  Commercial loans at December 31, 2022 have increased $1.9 billion, or 26.8%, as compared to December 31, 2021, to 43.8% of total loans.  Commercial loans represented 42.3% of total loans at December 31, 2021.

As a percentage of total loans, commercial real estate comprises 36.2% of total loans compared to 36.5% in 2021.  Commercial real estate loans increased $1.3 billion, or 21.5%, compared to 2021.  Generally, these loans are made for investment and real estate development or working capital and business expansion purposes and are primarily secured by real estate with a maximum loan-to-value of 80%.  Most of these properties are non-owner occupied and have guarantees as additional security.

Consumer real estate loans increased $403.2 million, or 17.4%, compared to 2021.  These loans represented 12.9% of total loans as of December 31, 2022, compared to 13.5% as of December 31, 2021.

For further information on loan portfolio segments refer to Note 3, “Loans and Allowance for Credit Losses,” in the Notes to the Consolidated Financial Statements.

Nonaccrual, past due and restructured loans are discussed under “Quantitative and Qualitative Disclosure about Market Risk – Credit Risk Management” in Item 7A of this report.

Investment Securities

The Company’s investment portfolio contains trading, available-for-sale (AFS), and held-to-maturity (HTM) securities as well as FRB stock, Federal Home Loan Bank (FHLB) stock, and other miscellaneous investments.  Investment securities totaled $13.2 billion as of December 31, 2022 and $13.8 billion as of December 31, 2021 and comprised 36.5% and 33.8% of the Company’s earning assets, respectively, as of those dates.

During 2022, securities with an amortized cost of $4.1 billion and a fair value of $3.8 billion were transferred from the AFS classification to the HTM classification as the Company has the positive intent and ability to hold these securities to maturity.  The transfers of securities were made at fair value at the time of transfer.  See further information in Note 4, “Securities” in the Notes to the Consolidated Financial Statements.

The Company’s AFS securities portfolio comprised 52.9% of the Company’s investment securities portfolio at December 31, 2022, compared to 86.7% at December 31, 2021.  The Company’s AFS securities portfolio provides liquidity as a result of the composition and average life of the underlying securities.  This liquidity can be used to fund loan growth or to offset the outflow of traditional funding sources.  The average life of the AFS securities portfolio decreased from 67.6 months at December 31, 2021 to 62.3 months at December 31, 2022. In addition to providing a potential source of liquidity, the AFS securities portfolio can be used as a tool to manage interest rate

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sensitivity.  The Company’s goal in the management of its AFS securities portfolio is to maximize return within the Company’s parameters of liquidity goals, interest rate risk and credit risk.

Management expects collateral pledging requirements for public funds, loan demand, and deposit funding to be the primary factors impacting changes in the level of AFS securities.  There were $10.3 billion of AFS securities pledged to secure U.S. Government deposits, other public deposits, certain trust deposits, derivative transactions, and repurchase agreements at December 31, 2022.

The Company’s HTM securities portfolio consists of U.S. agency-backed securities, mortgage-backed securities, general obligation bonds, and private placement bonds.  The Company’s HTM portfolio, net of the ACL totaled $5.9 billion as of December 31, 2022, an increase of $4.4 billion from December 31, 2021.  The average life of the HTM portfolio was 9.3 years at December 31, 2022, compared to 5.2 years at December 31, 2021.

The securities portfolio generates the Company’s second largest component of interest income.  The AFS, HTM, and Other securities portfolios achieved an average yield on a tax-equivalent basis of 2.33% for 2022, compared to 2.16% in 2021.  Securities available for sale had a net unrealized loss of $771.6 million at year-end, compared to a net unrealized gain of $153.9 million the preceding year. This market value change primarily reflects the impact of a shorter average life and increasing market interest rates as of December 31, 2022, compared to December 31, 2021.  These amounts are reflected, on an after-tax basis, in the Company’s Accumulated other comprehensive income (loss) in shareholders’ equity, as an unrealized loss of $514.6 million at year-end 2022, compared to an unrealized gain of $118.5 million for 2021. The AFS securities portfolio contains securities that have unrealized losses (see the table of these securities in Note 4, “Securities,” in the Notes to the Consolidated Financial Statements).  The unrealized losses in the Company’s investments were caused by changes in interest rates, and not from a decline in credit of the underlying issuers.  The U.S. Treasury, U.S. Agency, and Government Sponsored Entity (GSE) mortgage-backed securities are all considered to be agency-backed securities with no risk of loss as they are either explicitly or implicitly guaranteed by the U.S. government. The changes in fair value in the agency-backed portfolios are solely driven by change in interest rates caused by changing economic conditions. The Company has no knowledge of any underlying credit issues and the cash flows underlying the debt securities have not changed and are not expected to be impacted by changes in interest rates.  As of December 31, 2022, the Company does not believe the decline in value in these portfolios is related to credit impairments and instead is due to increasing market interest rates.  For the State and political subdivision portfolio, the majority of the Company’s holdings are in general obligation bonds, which have a very low historical default rate due to issuers generally having unlimited taxing authority to service the debt.  For the State and political, Corporates, and Collateralized loan obligations portfolios, the Company has a robust process for monitoring credit risk, including both pre-purchase and ongoing post-purchase credit reviews and analysis.  The Company monitors credit ratings of all bond issuers in these segments and reviews available financial data, including market and sector trends.  The Company does not have the intent to sell these securities and does not believe it is more likely than not that the Company will be required to sell these securities before a recovery of amortized cost.  As of December 31, 2022, there is no ACL related to the Company’s available-for-sale securities as the decline in fair value did not result from credit issues.

Included in Tables 11 and 12 are analyses of the fair value and average yield (tax-equivalent basis) of securities available for sale and securities held to maturity.

Table 11

SECURITIES AVAILABLE FOR SALE (in thousands)

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Table 12

SECURITIES HELD TO MATURITY (in thousands)

The table below provides detailed information for Other securities at December 31, 2022 and 2021:

Table 13

OTHER SECURITIES (in thousands)

Equity securities with readily determinable fair values are generally traded on an exchange and market prices are readily available.  Equity securities without readily determinable fair values are generally carried at cost less impairment.  Unrealized gains or losses on equity securities with and without readily determinable fair values are recognized in the Investment Securities gains, net line of the Company’s Consolidated Statements of Income.

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For further information on the Company’s investment securities, refer to Note 4, “Securities,” in the Notes to the Consolidated Financial Statements.

Other Earning Assets

Federal funds transactions essentially are overnight loans between financial institutions, which allow for either the daily investment of excess funds or the daily borrowing of another institution’s funds in order to meet short-term liquidity needs.  The net borrowed position was $55.5 million at December 31, 2022 compared to $12.6 million at December 31, 2021.

The Bank buys and sells federal funds as agent for non-affiliated banks.  Because the transactions are pursuant to agency arrangements, these transactions do not appear on the balance sheet and averaged $262.9 million in 2022 and $394.7 million in 2021.

At December 31, 2022, the Company held securities purchased under agreements to resell of $951.6 million compared to $1.2 billion at December 31, 2021.  The Company uses these instruments as short-term secured investments, in lieu of selling federal funds, or to acquire securities required for collateral purposes.  Balances will fluctuate based on the Company’s liquidity and investment decisions as well as the Company’s correspondent bank borrowing levels.  These investments averaged $959.2 million in 2022 and $1.2 billion in 2021.

The Company also maintains an active securities trading inventory.  The average holdings in the securities trading inventory in 2022 were $12.1 million, compared to $23.5 million in 2021, and were recorded at fair market value.  As discussed in “Quantitative and Qualitative Disclosures About Market Risk – Trading Account” in Part II, Item 7A, the Company offsets the trading account securities by the sale of exchange-traded financial futures contracts, with both the trading account and futures contracts marked to market daily.

Interest-bearing due from banks totaled $1.2 billion as of December 31, 2022 compared to $8.8 billion as of December 31, 2021 and includes amounts due from the FRB and interest-bearing accounts held at other financial institutions.  The amount due from the FRB averaged $2.3 billion and $4.0 billion during the years ended December 31, 2022 and 2021, respectively.  The decrease in the FRB balance from 2021 to 2022 is primarily due to a decrease in deposit balances.  The interest-bearing accounts held at other financial institutions totaled $121.7 million and $41.2 million at December 31, 2022 and 2021, respectively.

Deposits and Borrowed Funds

Deposits represent the Company’s primary funding source for its asset base.  In addition to the core deposits garnered by the Company’s retail branch structure, the Company continues to focus on its cash management services, as well as its asset management and mutual fund servicing businesses in order to attract and retain additional core deposits.  Deposits totaled $32.6 billion at December 31, 2022 and $35.6 billion at December 31, 2021, a decrease of $3.0 billion, or 8.3%. Deposits averaged $31.3 billion in 2022, and $28.9 billion in 2021.

Noninterest-bearing demand deposits averaged $13.3 billion in 2022 and $11.3 billion in 2021.  These deposits represented 42.3% of average deposits in 2022, compared to 38.9% in 2021.  The Company’s large commercial customer base provides a significant source of noninterest-bearing deposits.  Many of these commercial accounts do not earn interest; however, they receive an earnings credit to offset the cost of other services provided by the Company.

Table 14

MATURITIES OF UNINSURED TIME DEPOSITS (in thousands)

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As of December 31, 2022, there were $24.7 billion of uninsured deposits, as compared to $27.4 billion as of December 31, 2021.

Table 15

ANALYSIS OF AVERAGE DEPOSITS (in thousands)

Capital Resources and Liquidity

The Company places a significant emphasis on the maintenance of a strong capital position, which it believes promotes investor confidence, provides access to funding sources under favorable terms, and enhances the Company’s ability to capitalize on business growth and acquisition opportunities.  Higher levels of liquidity, however, bear corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher expenses for extended liability maturities.  The Company manages capital for each subsidiary based upon the subsidiary’s respective risks and growth opportunities as well as regulatory requirements.

Total shareholders’ equity decreased $478.3 million, or 15.2% to $2.7 billion at December 31, 2022 as compared to December 31, 2021. The decrease in shareholders’ equity from 2021 to 2022 is largely due to a decrease in Accumulated other comprehensive income (AOCI) related to the increase in losses on the securities portfolio driven by increased market interest rates.

The Board authorized, at its April 26, 2022, April 27, 2021, and April 28, 2020 meetings, the repurchase of up to two million shares of the Company’s common stock during the twelve months following each meeting (each a Repurchase Authorization).  During 2022 and 2021, the Company acquired 333,185 shares and 67,671 shares, respectively, of its common stock pursuant to the applicable Repurchase Authorization. The Company has not made any repurchase of its securities other than pursuant to the Repurchase Authorizations.

Risk-based capital guidelines established by regulatory agencies set minimum capital standards based on the level of risk associated with a financial institution’s assets.  The Company has implemented the Basel III regulatory capital rules adopted by the FRB.  Basel III capital rules include a minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5% and a minimum tier 1 risk-based capital ratio of 6%.  A financial institution’s total capital is also required to equal at least 8% of risk-weighted assets.

The risk-based capital guidelines indicate the specific risk weightings by type of asset.  Certain off-balance sheet items (such as standby letters of credit and binding loan commitments) are multiplied by credit conversion factors to translate them into balance sheet equivalents before assigning them specific risk weightings.  The Company is also required to maintain a leverage ratio equal to or greater than 4%.  The leverage ratio is tier 1 core

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capital to total average assets less goodwill and intangibles.  The Company's capital position as of December 31, 2022 is summarized in the table below and exceeded regulatory requirements.

Table 16

RISK-BASED CAPITAL (in thousands)

This table computes risk-based capital in accordance with current regulatory guidelines.  These guidelines as of December 31, 2022, excluded net unrealized gains or losses on securities available for sale and net unrealized losses on securities held to maturity transferred from the available-for-sale category from the computation of regulatory capital and the related risk-based capital ratios.

For further discussion of regulatory capital requirements, see Note 10, “Regulatory Requirements” within the Notes to Consolidated Financial Statements under Item 8.

Repurchase agreements are transactions involving the exchange of investment funds by the customer for securities by the Company, under an agreement to repurchase the same issues at an agreed-upon price and date.

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Securities sold under agreements to repurchase and federal funds purchased totaled $2.2 billion at December 31, 2022, and $3.2 billion at December 31, 2021. Repurchase agreements and federal funds purchased averaged $2.8 billion in 2022 and $2.6 billion in 2021.  The Company enters into these transactions with its downstream correspondent banks, commercial customers, and various trust, mutual fund, and local government relationships.

The Company is a member bank with the FHLB of Des Moines, and through this relationship, the Company owns $10.0 million of FHLB stock and has access to additional liquidity and funding sources through FHLB advances.  The Company’s borrowing capacity is dependent upon the amount of collateral the Company places at the FHLB.  Based on the collateral pledged, the Company had $1.9 billion of borrowing capacity at the FHLB at December 31, 2022.  The Company had no outstanding advances at FHLB Des Moines as of December 31, 2022.

To enhance general working capital needs, the Company has a revolving line of credit with Wells Fargo Bank, N.A. which allows the Company to borrow up to $30.0 million for general working capital purposes. The interest rate applied to borrowed balances will be at the Company’s option, either 1.4% above SOFR or 1.75% below the prime rate on the date of an advance. The Company pays a 0.4% unused commitment fee for unused portions of the line of credit. The Company had no advances outstanding at December 31, 2022.

Long-term debt totaled $381.3 million at December 31, 2022, compared to $271.5 million at December 31, 2021.  In September 2022, the Company issued $110.0 million in aggregate subordinated notes due in September 2032.  The Company received $107.9 million, after deducting underwriting discounts and commissions and offering expenses, and used the proceeds from the offering for general corporate purposes, including, among other uses, contributing Tier 1 capital into the Bank.  The subordinated notes were issued with a fixed-to-fixed rate of 6.25% and an effective rate of 6.64% due to issuance costs, with an interest rate reset date of September 2027.

In September 2020, the Company issued $200.0 million in aggregate subordinated notes due in September 2030.  The Company received $197.7 million, after deducting underwriting discounts and commissions and offering expenses, and used the proceeds from the offering for general corporate purposes, including, among other uses, contributing Tier 1 capital into the Bank. The subordinated notes were issued with a fixed-to-fixed rate of 3.70% and an effective rate of 3.93%, due to issuance costs, with an interest rate reset date of September 2025.

The remainder of the Company’s long-term debt was assumed from the acquisition of Marquette Financial Companies in 2015 and consists of debt obligations payable to four unconsolidated trusts (Marquette Capital Trust I, Marquette Capital Trust II, Marquette Capital Trust III, and Marquette Capital Trust IV) that previously issued trust preferred securities.  These long-term debt obligations had an aggregate contractual balance of $103.1 million and had a carrying value of $74.6 million at December 31, 2022 and $73.2 million at December 31, 2021.  Interest rates on trust preferred securities are tied to the three-month LIBOR with spreads ranging from 133 basis points to 160 basis points and reset quarterly. The trust preferred securities have maturity dates ranging from January 2036 to September 2036.  For further information on long-term debt refer to Note 9, “Borrowed Funds,” in the Notes to the Consolidated Financial Statements.

The Company has material off-balance sheet arrangements in the form of loan commitments, commercial and standby letters of credit, futures contracts and forward exchange contracts, which have maturity dates rather than payment due dates.  These commitments and contingent liabilities are not required to be recorded on the Company’s balance sheet.  Since commitments associated with letters of credit and lending and financing arrangements may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements.  See Table 17 below, as well as Note 15, “Commitments, Contingencies and Guarantees” in the Notes to Consolidated Financial Statements under Item 8 for detailed information and further discussion of these arrangements.  Management does not anticipate any material losses from its off-balance sheet arrangements.

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Table 17

COMMITMENTS, MATERIAL CASH REQUIREMENTS AND OFF-BALANCE SHEET ARRANGEMENTS (in thousands)

The table below details the commitments, material cash requirements, and off-balance sheet arrangements for the Company as of December 31, 2022 and includes principal payments only.  The Company has no capital leases or long-term purchase obligations.

As of December 31, 2022, the Company’s total liabilities for unrecognized tax benefits were $9.4 million.  The Company cannot reasonably estimate the settlement of these liabilities.  Therefore, these liabilities have been excluded from the table above.  See Note 16, “Income Taxes,” in the Notes to the Consolidated Financial Statements for information regarding the liabilities associated with unrecognized tax benefits.

For further discussion of capital and liquidity, see the “Quantitative and Qualitative Disclosures about Market Risk – Liquidity Risk” in Item 7A of this report.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).  The preparation of these Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting period.  On an on-going basis, management evaluates its estimates and judgments, including those related to customers and suppliers, allowance for credit losses, bad debts, investments, financing operations, long-lived assets, taxes, other contingencies and litigation.  Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which have formed the basis for making such judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.  Under different assumptions or conditions, actual results may differ from the recorded estimates.

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Management believes that the Company’s critical accounting policies and estimates are those relating to the allowance for credit losses.

Allowance for Credit Losses

The Company’s ACL represents management’s judgment of the total expected losses included in the Company’s assets held at amortized cost. The Company’s process for recording the ACL is based on the evaluation of the Company’s lifetime historical loss experience, management’s understanding of the credit quality inherent in the loan portfolio, and the impact of the current economic environment, coupled with reasonable and supportable economic forecasts.

A mathematical calculation of an estimate is made to assist in determining the adequacy and reasonableness of management’s recorded ACL.  To develop the estimate, the Company follows the guidelines in ASC Topic 326, Financial Instruments – Credit Losses.  The estimate reserves for assets held at amortized cost, which include the Company’s loan and held-to-maturity security portfolios.

The estimation process involves the consideration of quantitative and qualitative factors relevant to the specific segmentation of loans.  These factors have been established over decades of financial institution experience and include economic observation and loan loss characteristics.  This process is designed to produce a lifetime estimate of the losses, at a reporting date, that is based on evaluation of historical loss experience, current economic conditions, reasonable and supportable forecasts, and the qualitative framework outlined by the Office of the Comptroller of the Currency in the published 2020 Interagency Policy Statement.  This process allows management to take a holistic view of the recorded ACL reserve and ensure that all significant and pertinent information is considered in its estimate.

The Company considers a variety of factors to ensure the safety and soundness of its estimate including a strong internal control framework, extensive methodology documentation, credit underwriting standards which encompass the Company’s desired risk profile, model validation, and ratio analysis.  If the Company’s total ACL estimate, as determined in accordance with the approved ACL methodology, is either outside a reasonable range based on review of economic indicators or by comparison of historical ratio analysis, the ACL estimate is an outlier and management will investigate the underlying reason(s).  Based on that investigation, issues or factors that previously had not been considered may be identified in the estimation process, which may warrant adjustments to estimated credit losses.

The ending result of this process is a recorded consolidated ACL that represents management’s best estimate of the total expected losses included in the loan and held-to-maturity security portfolios considering available information, from internal and external sources, relevant to assessing exposure to credit loss over the contractual term of the instrument.  While management utilizes its best judgment and information available, the ultimate adequacy of the ACL is dependent upon a variety of factors beyond the Company’s control, including the performance of its portfolios, the economy, and changes in interest rates. As such, significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance.  Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on the Company’s Provision for credit losses and ACL reported in its Consolidated Income Statements and Consolidated Balance Sheets, respectively.

For more information on loan portfolio segments, the Company’s ACL methodology, and management’s assumptions in estimating the ACL, refer to the section captioned “Allowance for Credit Losses” within Note 3, “Loans and Allowance for Credit Losses,” in the Notes to the Consolidated Financial Statements.