WASHINGTON TRUST BANCORP INC (WASH) FY 2022 MD&A

Management's Discussion and Analysis

Liquidity risk is the risk that the Corporation will not have the ability to generate adequate amounts of cash in the most economical way for it to meet its maturing liability obligations and customer loan demand. For detailed disclosure regarding liquidity management, see the “Liquidity and Capital Resources” section below.

Price and market risk refers to the risk of loss arising from adverse changes in interest rates and other relevant market rates and prices, such as equity prices. Interest rate risk, discussed above, is the most significant market risk to which the Corporation is exposed. The Corporation is also exposed to financial market risk and housing market risk.

Compliance risk represents the risk of regulatory sanctions or financial loss resulting from the failure to comply with laws, rules and regulations and standards of good banking practice. Activities which may expose the Corporation to compliance risk include, but are not limited to, those dealing with the prevention of money laundering, privacy and data protection, adherence to all applicable laws and regulations and employment and tax matters.

Strategic and reputation risk represent the risk of loss due to impairment of reputation, failure to fully develop and execute business plans, and failure to assess existing and new opportunities and threats in business, markets and products.

Operational risk is the risk of loss due to human behavior, inadequate or failed internal systems and controls, and external influences such as market conditions, fraudulent activities, natural disasters and security risks.

ERM is an overarching program that includes all areas of the Corporation. A framework approach is utilized to assign responsibility and to ensure that the various business units and activities involved in the risk management life-cycle are effectively integrated. The Corporation has adopted the “three lines of defense” concept that is an industry best practice for ERM. Business units are the first line of defense in managing risk. They are responsible for identifying, measuring, monitoring, and controlling current and emerging risks. They must report on and escalate their concerns. Corporate functions such as Credit Risk Management, Financial Administration, Information Assurance and Compliance, represent the second line of defense. They are responsible for policy setting and for reviewing and challenging the risk management activities of the business units. They collaborate closely with business units on planning and resource allocation with respect to risk management. Internal Audit is a third line of defense. They provide independent assurance to the Board of Directors of the effectiveness of the first and second lines in fulfilling their risk management responsibilities.

For additional factors that could adversely impact Washington Trust’s future results of operations and financial condition, see the section labeled “Risk Factors” in Item 1A of this Annual Report on Form 10-K.

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Management's Discussion and Analysis

Results of Operations

The following table presents a summarized consolidated statement of operations:

The following table presents a summary of performance metrics and ratios:

Net income totaled $71.7 million in 2022, down by 7% from the $76.9 million reported in 2021.

In 2022, growth in net interest income was driven by higher yields on, and growth in, average interest-earning assets, partially offset by a higher cost of funds. The decline in noninterest income largely reflected lower mortgage banking revenues resulting from an overall reduction in mortgage origination and sales activity due to higher market interest rates and changes in the housing markets. Results also benefited from continued strength in asset and credit quality metrics and the recognition of a negative provision for credit losses. The decrease in noninterest expenses largely reflected declines in debt prepayment penalties and volume-related mortgage originator compensation expense.

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Management's Discussion and Analysis

Average Balances/Net Interest Margin - Fully Taxable Equivalent Basis

The following table presents average balance and interest rate information.  Tax-exempt income is converted to an FTE basis using the statutory federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. Unrealized gains (losses) on available for sale securities and changes in fair value on mortgage loans held for sale are excluded from the average balance and yield calculations. Nonaccrual loans, as well as interest recognized on these loans, are included in amounts presented for loans.

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Management's Discussion and Analysis

Interest income amounts presented in the preceding table include the following adjustments for taxable equivalency:

Net Interest Income

Net interest income, the primary source of our operating income, totaled $156.0 million and $141.4 million, respectively, for 2022 and 2021. Net interest income is affected by the level of and changes in interest rates, and changes in the amount and composition of interest-earning assets and interest-bearing liabilities.  Prepayment penalty income associated with loan payoffs is included in net interest income.

The following discussion presents net interest income on an FTE basis by adjusting income and yields on tax-exempt loans and securities to be comparable to taxable loans and securities.

The analysis of net interest income, NIM and the yield on loans may be impacted by the periodic recognition of prepayment penalty fee income associated with commercial loan payoffs. Prepayment penalty fee income amounted to $183 thousand (or 0 basis points benefit to NIM) and $3.2 million (or 6 basis points benefit to NIM), respectively, in 2022 and 2021.

The analysis of net interest income, NIM and the yield on loans is also impacted by changes in the level of net amortization of premiums and discounts on securities and loans, which is included in interest income. Changes in market interest rates affect the level of loan prepayments and the receipt of payments on mortgage-backed securities. Prepayment speeds generally decrease as market interest rates rise and increase as market interest rates decline. Changes in prepayment speeds could increase or decrease the level of net amortization of premiums and discounts, thereby affecting interest income. Additionally, as PPP loans were forgiven by the SBA, related unamortized net fee balances were accelerated and amortized, increasing net interest income. As noted in the Consolidated Statements of Cash Flows, net amortization of premiums and discounts on securities and loans (a net reduction to net interest income) amounted to $2.9 million in 2022, compared to $3.4 million in 2021.

Accelerated amortization of net deferred fee balances on PPP loans forgiven by the SBA amounted to $1.2 million (or 2 basis points benefit to NIM) and $5.4 million (or 10 basis points benefit to NIM), respectively, in 2022 and 2021.

FTE net interest income in 2022 amounted to $157.2 million, up by $14.9 million, or 10%, from 2021. Growth in average interest-earning assets, net of increased average interest-bearing liability balances, contributed $7.8 million of net interest income in 2022. Increases in asset yields outpaced increases in funding costs, contributing $7.1 million of net interest income. See additional discussion regarding interest rate sensitivity under the caption “Asset/Liability Management and Interest Rate Risk.”

NIM was 2.69% in 2022, up by 10 basis points from 2.59% in 2021. It included accelerated amortization of net deferred fee balances on PPP loans that were forgiven by the SBA and loan prepayment fees. Excluding the impact of both these items, NIM amounted to 2.67% in 2022, compared to 2.43% in 2021. NIM benefited from higher market interest rates in 2022.

Total average securities for 2022 increased by $108.0 million, or 11%, from the average balance for 2021, reflecting purchases of debt securities. The FTE rate of return on securities was 1.95% in 2022, up by 54 basis points from 1.41% in 2021, reflecting the impact of higher market interest rates in 2022.

Total average loan balances increased by $310.7 million, or 7%, from the average balance for 2021. This reflected growth in average residential real estate loan balances, partially offset by a decline in average commercial and industrial loans due to PPP loans that were forgiven by the SBA. The yield on total loans in 2022 was 3.75%, up by 39 basis points from 3.36% in 2021. The yield on total loans was impacted by accelerated amortization of net deferred fee balances on PPP loans when such loans were forgiven by the SBA, as well as the periodic recognition of loan prepayment fees. Excluding the impact of these items for both periods, the yield on total loans amounted to 3.71% in 2022, up by 55 basis points, from 3.16% in 2021, reflecting higher market interest rates.

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Management's Discussion and Analysis

The average balance of FHLB advances for 2022 increased by $43.4 million, or 12%, compared to the average balance for 2021. The average rate paid on such advances in 2022 was 2.83%, up 181 basis points from 1.02% in 2021, reflecting increases in market interest rates.

Included in total average interest-bearing deposits were wholesale brokered deposits, which decreased by $237.3 million, or 37%, from 2021. The average rate paid on wholesale brokered deposits in 2022 was 1.04%, up by 85 basis points from 0.19% in 2021, reflecting increases in market interest rates.

Average in-market interest-bearing deposits, which excludes wholesale brokered deposits, increased by $523.7 million, or 16%, from the average balance in 2021, reflecting growth across all deposit categories. The average rate paid on in-market interest-bearing deposits in 2022 was 0.59%, up by 24 basis points from 0.35% in 2021, reflecting recent increases in market interest rates.

The average balance of noninterest-bearing demand deposits for 2022 decreased by $11.2 million, or 1%, from the average balance for 2021.

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Management's Discussion and Analysis

Volume/Rate Analysis - Interest Income and Expense (FTE Basis)

The following table presents certain information on an FTE basis regarding changes in our interest income and interest expense for the period indicated.  The net change attributable to both volume and rate has been allocated proportionately.

Provision for Credit Losses

The provision for credit losses results from management’s review of the adequacy of the ACL. The ACL is management’s estimate, at the reporting date, of expected lifetime credit losses and includes consideration of current forecasted economic conditions. Estimating an appropriate level of ACL necessarily involves a high degree of judgment.

A negative provision for credit losses (or a benefit) of $1.3 million was recognized in earnings in 2022 compared to a negative provision for credit losses (or a benefit) of $4.8 million in 2021. The negative provision recognized in 2022 was reflective of low loss rates and continued strength in asset and credit quality metrics that more than offset negative trends in macroeconomic forecasts and loan growth that was concentrated in residential real estate loans. The negative provision in 2021 reflected an improvement in forecasted economic conditions following higher credit loss provisioning in 2020, which was attributable to the emergence of the COVID-19 pandemic.

Net recoveries totaled $368 thousand, or 0.01% of average loans, in 2022, compared to net charge-offs of $417 thousand, or 0.01% of average loans, in 2021.

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Management's Discussion and Analysis

The ACL on loans was $38.0 million, or 0.74% of total loans, at December 31, 2022, compared to $39.1 million, or 0.91% of total loans, at December 31, 2021. See additional discussion under the caption “Asset Quality” for further information on the ACL on loans.

Noninterest Income

Noninterest income is an important source of revenue for Washington Trust.  The principal categories of noninterest income are shown in the following table:

Noninterest Income Analysis

Revenue from wealth management services represented 62% of total noninterest income in 2022, compared to 47% in 2021. A substantial portion of wealth management revenues is dependent on the value of wealth management AUA and is closely tied to the performance of the financial markets. This portion of wealth management revenues is referred to as “asset-based” and includes trust and investment management fees. Wealth management revenues also include “transaction-based” revenues, such as commissions and other service fees that are not primarily derived from the value of assets.

The categories of wealth management revenues are shown in the following table:

Wealth management revenues for 2022 decreased by $2.5 million, or 6%, from 2021, reflecting a decrease in asset-based revenues. The change in asset-based revenues correlated with the decrease in average AUA balances in 2022. The average balance of AUA in 2022 decreased by 6% from the average balance in 2021.

The following table presents the changes in wealth management AUA balances:

The end of period AUA balance amounted to $6.0 billion at December 31, 2022, down by $1.8 billion, or 23%, from

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Management's Discussion and Analysis

December 31, 2021. This decline was attributable to net investment depreciation as a result of declines in the financial markets and also reflected elevated net client asset outflows.

At the end of the third quarter of 2022, four client-facing wealth management advisors at WTA, our registered investment adviser subsidiary, resigned. These four employees were associated with approximately $1.0 billion of AUA as of September 30, 2022. In the fourth quarter of 2022, client asset withdrawals associated with the departure of the advisors amounted to $604 million, which reduced wealth management revenues by approximately $525 thousand in the fourth quarter. Since the end of 2022 and through February 14, 2023, we have been notified of additional client withdrawals of approximately $76 million. Based on the cumulative withdrawals through February 14, 2023, we estimate a decline in 2023 wealth management revenues of approximately $3.4 million associated with these withdrawals. Washington Trust could experience additional client asset withdrawals in upcoming months associated with the departure of the former advisors. While there are cost savings in salaries and employee benefits expense associated with the departure of these advisors, they currently are being offset by a higher level of legal expenses also associated with this matter.

Mortgage banking revenues represented 14% of total noninterest income in 2022, compared to 33% for 2021. These revenues are dependent on mortgage origination volume and are sensitive to interest rates and the condition of housing markets. The composition of mortgage banking revenues and the volume of loans sold to the secondary market are shown in the following table:

(1)Includes gains on loan sales, commission income on loans originated for others, servicing right gains, and gains (losses) on forward loan commitments.

(2)Represents fair value changes on mortgage loans held for sale and forward loan commitments.

(3)Represents loan servicing fee income, net of servicing right amortization and valuation adjustments.

(4)Includes brokered loans (loans originated for others).

Mortgage banking revenues in 2022 decreased by $19.9 million, or 69%, from 2021. The decline in mortgage banking revenues was mainly attributable to a decline in sales volume and a reduction in the sales yield. Mortgage loans sold to the secondary market totaled $339.7 million in 2022 compared to $953.4 million in 2021, reflecting an overall reduction of mortgage origination and sales activity, as well as a shift to a higher proportion of loans originated for portfolio in 2022. The reduction of mortgage origination and sales activity was driven by increases in market interest rates and changes in the housing markets. Mortgage banking revenues were also impacted by changes in the fair value of mortgage loans held for sale and forward loan commitments, which are primarily based on current market prices in the secondary market and correlate to changes in the size of the mortgage pipeline. In addition, the decline in mortgage banking revenues was partially offset by higher net loan servicing fee income associated with loans sold with servicing retained. The increase in net loan servicing fee income was largely due to lower amortization of servicing rights, reflecting lower prepayment speeds on the serviced mortgage portfolio.

Loan related derivative income decreased by $1.6 million, or 37%, from 2021, largely reflecting a decrease in commercial borrower interest rate derivative transactions.

Other income decreased by $952 thousand, or 37%, from 2021, largely due to $1.0 million of income associated with a litigation settlement that was recognized in 2021.

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Management's Discussion and Analysis

Noninterest Expense

The following table presents noninterest expense comparisons:

Noninterest Expense Analysis

Salaries and employee benefits expense, the largest component of noninterest expense, for 2022 decreased by $3.5 million, or 4%, from 2021, largely reflecting volume-related decreases in mortgage originator compensation expense, lower performance-based compensation costs and lower wealth management compensation expense, partially offset by annual merit increases and higher staffing levels.

Debt prepayment penalty expense amounted to $6.9 million in 2021, due to the prepayment of higher-yielding FHLB advances. There were no such debt prepayments in 2022.

Other expenses for 2022 increased by $1.6 million, or 19% from 2021. Included in other expenses in 2022 was a contribution totaling $600 thousand that Washington Trust made to its charitable foundation. There was no such contribution expense in 2021. Excluding the impact of this item, other expenses was up by $1.0 million, or 12%, from 2021, reflecting increases across a variety of other noninterest expense categories.

Income Taxes

The following table presents the Corporation’s income tax expense and effective tax rate for the periods indicated:

The effective tax rates differed from the federal rate of 21%, primarily due to state income tax expense, partially offset by the benefits of tax-exempt income, income from BOLI, federal tax credits and the recognition of excess tax expense or benefits associated with the settlement of share-based awards.

The Corporation’s net deferred tax assets amounted to $56.4 million at December 31, 2022, compared to $14.0 million at December 31, 2021. The Corporation has determined that a valuation allowance is not required for any of the deferred tax assets since it is more-likely-than-not that these assets will be realized primarily through future reversals of existing taxable temporary differences or by offsetting projected future taxable income. Net deferred tax assets increased in 2022, largely reflecting increases in deferred tax assets associated with the declines in fair value of securities available for sale and cash flow hedges that were primarily attributable to relative changes in market interest rates.

See Note 11 to the Consolidated Financial Statements for additional information regarding income taxes.

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Management's Discussion and Analysis

Segment Reporting

The Corporation manages its operations through two reportable business segments, consisting of Commercial Banking and Wealth Management Services. See Note 18 to the Consolidated Financial Statements for additional disclosure related to business segments.

Commercial Banking

The following table presents a summarized statement of operations for the Commercial Banking business segment:

Net interest income for the Commercial Banking segment increased by $14.5 million, or 10%, from 2021. Growth in net interest income was largely driven by higher yields on, and growth in, average interest-earning assets, partially offset by a higher cost of funds. These increases were partially offset by lower levels of accelerated amortization of net deferred fee balances on PPP loans forgiven by the SBA and prepayment penalty fee income associated with loans payoffs.

A negative provision for credit losses (or a benefit) of $1.3 million was recognized in earnings in 2022, compared to a negative provision for credit losses (or a benefit) of $4.8 million in 2021. See additional discussion under the caption “Provision for Credit Losses.”

Noninterest income derived from the Commercial Banking segment decreased by $21.7 million, or 48%, from 2021, largely reflecting lower mortgage banking revenues and lower loan related derivative income. See additional discussion under the caption “Noninterest Income” above.

Commercial Banking noninterest expenses were down by $6.9 million, or 7%, from 2021. This reflected decreases in debt prepayment penalty expense and salaries and employee benefits, partially offset by increases in outsourced services, advertising and promotion and other expenses. See additional disclosure under the caption “Noninterest Expense” above.

Wealth Management Services

The following table presents a summarized statement of operations for the Wealth Management Services business segment:

Noninterest income for the Wealth Management Services segment decreased by $3.1 million, or 7%, compared to 2021, due to a decrease in asset-based revenues. The decline in revenues in 2022 also included income of $1.0 million associated with a

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Management's Discussion and Analysis

litigation settlement that was recognized in 2021. See further discussion of wealth management revenues under the caption “Noninterest Income” above.

Noninterest expenses for the Wealth Management Services segment increased by $141 thousand, or 0.4%, compared to 2021. Increases in legal, audit and professional fees and other expense were largely offset by a decrease in salaries and employee benefits expense. See additional discussion under the caption “Noninterest Expense” above.

Financial Condition

Summary

The following table presents selected financial condition data:

Total assets amounted to $6.7 billion at December 31, 2022, up by $808.9 million, or 14%, from the end of 2021 due to loan growth.

Cash and due from banks declined by $59.8 million, or 34%, from the end of 2021, reflecting lower cash balances on deposit at correspondent banks and a reduction in cash collateral pledged to derivative counterparties. See Note 9 to the Consolidated Financial Statements for additional disclosure regarding derivative financial instruments.

The securities portfolio decreased by $48.9 million, or 5%, from the end of 2021. A decline in the fair value of available for sale securities primarily attributable to changes in interest rates and routine pay-downs on mortgage-backed securities were partially offset by purchases of debt securities.

Total loans increased by $837.2 million, or 20%, from the balance at December 31, 2021, led by growth in the residential real estate portfolio.

Total deposits increased by $38.9 million, or 1%, from the end of 2021 with growth in in-market deposits, partially offset by a decrease in wholesale brokered deposits. FHLB advances increased by $835.0 million, or 576%, from December 31, 2021, as higher levels of wholesale funding were utilized to fund balance sheet growth.

Shareholders’ equity amounted to $453.7 million at December 31, 2022, down by $111.1 million, or 20%, from the balance at December 31, 2021, largely reflecting a decline in the AOCL component of shareholders’ equity due decreases in the fair value of available for sale debt securities and cash flow hedges that were primarily attributable to changes in market interest rates.

Securities

Investment security activity is monitored by the Investment Committee, the members of which also sit on the ALCO.  Asset and liability management objectives are the primary influence on the Corporation’s investment activities.  However, the Corporation also recognizes that there are certain specific risks inherent in investment activities.  The securities portfolio is managed in accordance with regulatory guidelines and established internal corporate investment policies that provide limitations on specific risk factors such as market risk, credit risk and concentration, liquidity risk and operational risk to help monitor risks associated with investing in securities.  Reports on the activities conducted by the Investment Committee and the ALCO are presented to the Board of Directors on a regular basis.

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Management's Discussion and Analysis

The Corporation’s securities portfolio is managed to generate interest income, to implement interest rate risk management strategies, and to provide a readily available source of liquidity for balance sheet management. Securities are designated as either available for sale, held to maturity or trading at the time of purchase. The Corporation does not maintain a portfolio of trading securities and does not have securities designated as held to maturity. Securities available for sale may be sold in response to changes in market conditions, prepayment risk, rate fluctuations, liquidity, or capital requirements. Debt securities available for sale are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, net of tax, until realized.

Determination of Fair Value

The Corporation uses an independent pricing service to obtain quoted prices. The prices provided by the independent pricing service are generally based on observable market data in active markets. The determination of whether markets are active or inactive is based upon the level of trading activity for a particular security class. Management reviews the independent pricing service’s documentation to gain an understanding of the appropriateness of the pricing methodologies. Management also reviews the prices provided by the independent pricing service for reasonableness based upon current trading levels for similar securities. If the prices appear unusual, they are re-examined and the value is either confirmed or revised. In addition, management periodically performs independent price tests of securities to ensure proper valuation and to verify our understanding of how securities are priced. As of December 31, 2022 and 2021, management did not make any adjustments to the prices provided by the pricing service.

Our fair value measurements generally utilize Level 2 inputs, representing quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, and model-derived valuations in which all significant input assumptions are observable in active markets.

See Notes 3 and 10 to the Consolidated Financial Statements for additional information regarding the determination of fair value of investment securities.

Securities Portfolio

The carrying amounts of securities held are as follows:

The securities portfolio represented 15% of total assets at December 31, 2022, compared to 18% of total assets at December 31, 2021. The largest component of the securities portfolio is mortgage-backed securities, all of which are issued by U.S. government agencies or U.S. government-sponsored enterprises.

The securities portfolio decreased by $48.9 million, or 5%, from the end of 2021. This included a decline of $163.5 million (pretax) in the fair value of available for sale securities and $116.1 million of routine pay-downs on mortgage-backed securities. These were partially offset by purchases of U.S. government agency and U.S. government-sponsored debt securities, including mortgage-backed securities, totaling $234.1 million, with a weighted average yield of 3.58%.

As of December 31, 2022, the carrying amount of available for sale debt securities included net unrealized losses of $172.4 million, compared to net unrealized losses of $8.9 million as of December 31, 2021. The decline in fair value of available for sale debt securities from the end of 2021 was primarily concentrated in obligations of U.S. government agencies and U.S. government-sponsored enterprises, including mortgage-backed securities, and primarily attributable to relative

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Management's Discussion and Analysis

changes in market interest rates since the time of purchase. See Note 3 to the Consolidated Financial Statements for additional information.

Federal Home Loan Bank Stock

The Bank is a member of the FHLB, which is a cooperative that provides services to its member banking institutions. The primary reason for the Bank’s membership is to gain access to a reliable source of wholesale funding in order to manage interest rate risk. The purchase of FHLB stock is a requirement for a member to gain access to funding. The Bank purchases FHLB stock in proportion to the volume of funding received and views the purchases as a necessary long-term investment for the purposes of balance sheet liquidity and not for investment return. The Bank’s investment in FHLB stock totaled $43.5 million at December 31, 2022, compared to $13.0 million at December 31, 2021. See Note 1 to the Consolidated Financial Statements for additional information.

Loans

Total loans amounted to $5.1 billion at December 31, 2022, up by $837.2 million, or 20%, from the end of 2021, led by growth in the residential real estate portfolio.

The following table sets forth the composition of the Corporation’s loan portfolio:

(1)CRE consists of commercial mortgages primarily secured by income-producing property, as well as construction and development loans. Construction and development loans are made to businesses for land development or the on-site construction of industrial, commercial, or residential buildings.

(2)C&I consists of loans to businesses and individuals, a portion of which are fully or partially collateralized by real estate. C&I also includes $1.1 million and $38.0 million, respectively, of PPP loans as of December 31, 2022 and 2021.

(3)Residential real estate consists of mortgage and homeowner construction loans secured by one- to four-family residential properties.

(4)Other consists of loans to individuals secured by general aviation aircraft and other personal installment loans.

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Management's Discussion and Analysis

An analysis of the maturity and interest rate sensitivity of the Corporation’s loan portfolio as of December 31, 2022 follows:

(1)Includes construction and development loans that will convert to repayment terms following the construction period and will be reclassified to either the CRE or C&I category.

(2)Includes homeowner construction loans. Maturities of homeowner construction loans are included based on their contractual conventional mortgage repayment terms following the completion of construction.

Generally, the actual maturity of loans is substantially shorter than their contractual maturity due to prepayments and, in the case of loans secured by real estate, due to payoff of loans upon the sale of the property by the borrower. The average life of loans secured by real estate tends to increase when market loan rates are higher than rates on existing portfolio loans and, conversely, tends to decrease when rates on existing portfolio loans are higher than market loan rates. Under the latter scenario, the average yield on portfolio loans tends to decrease as higher yielding loans are repaid or refinanced at lower rates. Due to the fact that the Bank may, consistent with industry practice, renew a significant portion of commercial loans at or immediately prior to their maturity by renewing the loans on substantially similar or revised terms, the principal repayments actually received by the Bank are anticipated to be significantly less than the amounts contractually due in any particular period. In other circumstances, a loan, or a portion of a loan, may not be repaid due to the borrower’s inability to satisfy the contractual terms of the loan.

Commercial Loans

The commercial loan portfolio represented 49% of total loans at December 31, 2022.

In making commercial loans, we may occasionally solicit the participation of other banks. The Bank also participates in commercial loans originated by other banks. In such cases, these loans are individually underwritten by us using standards similar to those employed for our self-originated loans. Our participation in commercial loans originated by other banks amounted to $510.6 million and $451.6 million, respectively, at December 31, 2022 and 2021. Our participation in commercial loans originated by other banks also includes shared national credits.

Commercial loans fall into two main categories, CRE and C&I loans. CRE loans consist of commercial mortgages secured by real property where the primary source of repayment is derived from rental income associated with the property or the proceeds of the sale, refinancing or permanent financing of the property. CRE loans also include construction loans made to businesses for land development or the on-site construction of industrial, commercial, or residential buildings. C&I loans primarily provide working capital, equipment financing and financing for other business-related purposes. C&I loans are frequently collateralized by equipment, inventory, accounts receivable, and/or general business assets.  A portion of the Bank’s C&I loans is also collateralized by real estate.  C&I loans also include PPP loans that are fully guaranteed by the U.S. government, tax-exempt loans made to states and political subdivisions, as well as industrial development or revenue bonds issued through quasi-public corporations for the benefit of a private or non-profit entity where that entity rather than the governmental entity is obligated to pay the debt service.

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Management's Discussion and Analysis

Commercial Real Estate Loans

CRE loans totaled $1.8 billion at December 31, 2022, up by $190.2 million, or 12%, from the balance at December 31, 2021. In 2022, CRE loan originations and advances totaled approximately $569 million, partially offset by principal payments of approximately $379 million.

Included in the CRE loan portfolio were construction and development loans of $164.1 million and $122.4 million, respectively, as of December 31, 2022 and 2021.

Shared national credit balances outstanding included in the CRE loan portfolio totaled $10.5 million and $3.5 million, respectively, at December 31, 2022 and 2021. The balance was included in the pass-rated category of commercial loan credit quality and current with respect to contractual payment terms at both December 31, 2022 and 2021.

The following table presents a geographic summary of CRE loans by property location:

The following table presents a summary of CRE loans by property type segmentation:

Commercial and Industrial Loans

C&I loans amounted to $656.4 million at December 31, 2022, up by $14.8 million, or 2%, from the balance at December 31, 2021. This included a net reduction of PPP loans of $36.9 million, reflecting loans forgiven by the SBA. Excluding PPP loans, C&I loans increased by $51.7 million in 2022, as loan originations and advances of approximately $142 million were offset by principal payments of approximately $90 million.

Included in C&I loans were PPP loans of $1.1 million and $38.0 million, respectively, as of December 31, 2022 and 2021.

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Management's Discussion and Analysis

Shared national credit balances outstanding included in the C&I loan portfolio totaled $40.9 million and $40.8 million, respectively, at December 31, 2022 and 2021. All of these loans were included in the pass-rated category of commercial loan credit quality and were current with respect to contractual payment terms at both December 31, 2022 and 2021.

The following table presents a summary of C&I loan by industry segmentation:

Residential Real Estate Loans

The residential real estate loan portfolio represented 45% of total loans at December 31, 2022.

Residential real estate loans held in portfolio amounted to $2.3 billion at December 31, 2022, up by $596.0 million, or 35%, from the balance at December 31, 2021, reflecting a higher proportion of loans originated for portfolio than for sale in 2022.

The following is a geographic summary of residential real estate loans by property location:

(1)Includes residential mortgage loans purchased from and serviced by other financial institutions totaling $59.9 million and $78.7 million, respectively, as of December 31, 2022 and 2021.

Residential real estate loans are originated both for sale to the secondary market as well as for retention in the Bank’s loan portfolio. We also originate residential real estate loans for various investors in a broker capacity, including conventional mortgages and reverse mortgages.

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Management's Discussion and Analysis

The table below presents residential real estate loan origination activity:

(1)Includes the full commitment amount of homeowner construction loans.

(2)Includes brokered loans (loans originated for others).

The table below presents residential real estate loan sales activity:

(1)Includes brokered loans (loans originated for others).

Residential real estate loan origination, refinancing and sales activity decreased in 2022 in response to increases in market interest rates.

We have active relationships with various secondary market investors that purchase residential real estate loans we originate. In addition to managing our interest rate risk position and earnings through the sale of these loans, we are also able to manage our liquidity position through timely sales of residential real estate loans to the secondary market.

Loans are sold with servicing retained or released. Loans sold with servicing rights retained result in the capitalization of servicing rights. Loan servicing rights are included in other assets and are subsequently amortized as an offset to mortgage banking revenues over the estimated period of servicing. The net balance of capitalized servicing rights amounted to $9.0 million and $9.8 million, respectively, as of December 31, 2022 and 2021. The balance of residential mortgage loans serviced for others, which are not included in the Consolidated Balance Sheets, amounted to $1.5 billion at both December 31, 2022 and 2021.

Consumer Loans

Consumer loans include home equity loans and lines of credit and personal installment loans. Home equity lines of credit and home equity loans represented 95% of the total consumer portfolio at December 31, 2022. Our home equity line and home equity loan origination activities are conducted primarily in southern New England. The Bank estimates that approximately 55% of the combined home equity lines of credit and home equity loan balances are first lien positions or subordinate to other Washington Trust mortgages.

The consumer loan portfolio totaled $301.4 million at December 31, 2022, up by $36.1 million, or 14%, from December 31, 2021, reflecting increases in home equity lines and loans. Purchased consumer loans, consisting of loans to individuals secured by general aviation aircraft, amounted to $9.6 million and $9.4 million, respectively, at December 31, 2022 and 2021.

Investment in Bank-Owned Life Insurance

BOLI amounted to $102.2 million and $92.6 million, respectively, at December 31, 2022 and 2021. The increase in 2022 included $7.0 million of purchases of BOLI. BOLI provides a means to mitigate increasing employee benefit costs.  The Corporation expects to benefit from the BOLI contracts as a result of the tax-free growth in cash surrender value and death benefits that are expected to be generated over time.  The purchase of the life insurance policy results in an income-earning asset on the Consolidated Balance Sheet that provides monthly tax-free income to the Corporation.  The largest risk to the BOLI program is credit risk of the insurance carriers.  To mitigate this risk, annual financial condition reviews are completed

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Management's Discussion and Analysis

on all carriers.  BOLI is invested in the “general account” of quality insurance companies.  All such general account carriers were rated as investment grade at December 31, 2022 by credit rating agencies such as A.M. Best, Moody’s and S&P.  BOLI is included in the Consolidated Balance Sheet at its cash surrender value.  Increases in BOLI’s cash surrender value are reported as a component of noninterest income in the Consolidated Statements of Income.

Asset Quality

Management continually monitors the asset quality of the loan portfolio using all available information. The Board of Directors monitors credit risk management through two committees, the Finance Committee and the Audit Committee.  The Finance Committee has oversight responsibility for the credit granting function, including approval authority for credit granting policies, review of management’s credit granting activities and approval of large exposure credit requests.  The Audit Committee has oversight responsibility for the risk management program, which includes credit risk management activities performed by management such as the monitoring of the credit quality of the loan portfolio, conducting a credit review program and determining the adequacy of the ACL. The Audit Committee also approves the policy and methodology for establishing the ACL. These committees report the results of their respective oversight functions to the Board of Directors.  In addition, the Board of Directors receives information concerning asset quality measurements and trends on a regular basis.

Nonperforming Assets

Nonperforming assets include nonaccrual loans and OREO.

The following table presents nonperforming assets and additional asset quality data:

Total nonperforming assets decreased by $1.4 million from December 31, 2021, reflecting a decline in nonaccrual loans.

Nonaccrual Loans

Loans, with the exception of certain well-secured loans that are in the process of collection, are placed on nonaccrual status and interest recognition is suspended when such loans are 90 days or more overdue with respect to principal and/or interest, or sooner if considered appropriate by management. Loans are removed from nonaccrual status when they have been current as to principal and interest for a period of time, the borrower has demonstrated an ability to comply with repayment terms,

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Management's Discussion and Analysis

and when, in management’s opinion, the loans are considered to be fully collectible. During 2022, the Corporation made no changes in its practices or policies concerning the placement of loans into nonaccrual status.

Interest income that would have been recognized if loans on nonaccrual status had been current in accordance with their original terms was approximately $640 thousand in 2022, compared to $647 thousand in 2021.  Interest income attributable to these loans included in the Consolidated Statements of Income amounted to approximately $463 thousand and $528 thousand, respectively, in 2022 and 2021.

The following table presents the activity in nonaccrual loans:

The following table presents additional detail on nonaccrual loans:

(1)Percentage of nonaccrual loans to the total loans outstanding within the respective category.

There were no significant commitments to lend additional funds to borrowers whose loans were on nonaccrual status at December 31, 2022.

As of both December 31, 2022 and December 31, 2021, the composition of nonaccrual loans was 100% residential and consumer.

Nonaccrual residential real estate mortgage loans amounted to $11.9 million at December 31, 2022, down by $1.7 million from the end of 2021. As of December 31, 2022, the balance of nonaccrual residential mortgage loans was predominately secured by properties in Massachusetts, Connecticut and Rhode Island. Included in total nonaccrual residential real estate loans at December 31, 2022 were four loans purchased for portfolio and serviced by others amounting to $1.1 million.  Management monitors the collection efforts of its third-party servicers as part of its assessment of the collectability of nonperforming loans.

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Management's Discussion and Analysis

Troubled Debt Restructurings

In the course of resolving problem loans, the Corporation may choose to restructure the contractual terms of certain loans. A loan that has been modified or renewed is considered to be a TDR when two conditions are met: (1) the borrower is experiencing financial difficulty and (2) concessions are made for the borrower’s benefit that would not otherwise be considered for a borrower or a transaction with similar credit risk characteristics. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit the Corporation by increasing the ultimate probability of collection.

TDRs are classified as accruing or non-accruing based on management’s assessment of the collectability of the loan.  Loans that are already on nonaccrual status at the time of the restructuring generally remain on nonaccrual status for approximately six months before management considers such loans for return to accruing status.  Accruing restructured loans are placed into nonaccrual status if and when the borrower fails to comply with the restructured terms and management deems it unlikely that the borrower will return to a status of compliance in the near term and full collection of principal and interest is in doubt.

TDRs are reported as such for at least one year from the date of the restructuring.  In years after the restructuring, a TDR is removed from this classification if the restructuring did not involve a below-market rate concession and the loan is performing in accordance with its modified contractual terms for a reasonable period of time.

As of December 31, 2022, there were no significant commitments to lend additional funds to borrowers whose loans had been restructured in a TDR.

See Note 2 to the Consolidated Financial Statements for discussion on ASU No. 2022-02, a recently issued accounting pronouncement that became effective January 1, 2023. ASU No. 2022-02 updates the accounting treatment and related disclosure requirements for TDRs.

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Management's Discussion and Analysis

The following table sets forth information on TDRs as of the dates indicated. The amounts below consist of unpaid principal balance, net of charge-offs and unamortized deferred loan origination fees and costs. Accrued interest is not included in the carrying amounts set forth below.

As of December 31, 2022, the composition of TDRs was 66% residential and consumer and 34% commercial, compared to 30% residential and consumer and 70% commercial at December 31, 2021.

TDRs amounted to $8.6 million at December 31, 2022, down by $10.6 million from the end of 2021. The net decline largely reflected pay-downs of $8.0 million on two accruing CRE TDR loans associated with one commercial relationship and the declassification from TDR status of one accruing C&I loan with a carrying value of $2.8 million that was declassified in accordance with policy.

The ACL included specific reserves for TDRs of $115 thousand at December 31, 2022, compared to $148 thousand at December 31, 2021.

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Management's Discussion and Analysis

Past Due Loans

The following table presents past due loans by category:

(1)Percentage of past due loans to the total loans outstanding within the respective category.

As of December 31, 2022, the composition of past due loans (loans past due 30 days or more) was 87% residential and consumer and 13% commercial, compared to essentially 100% for residential and consumer at December 31, 2021.

Total past due loans increased by $1.2 million from the end of 2021, largely due to one CRE loan going past due in the fourth quarter. This one loan was brought current in January 2023.

Total past due loans included $7.2 million of nonaccrual loans as of December 31, 2022, compared to $9.4 million of as of December 31, 2021.

All loans 90 days or more past due at December 31, 2022 and 2021 were classified as nonaccrual.

Potential Problem Loans

The Corporation classifies certain loans as “substandard,” “doubtful,” or “loss” based on criteria consistent with guidelines provided by banking regulators.  Potential problem loans include classified accruing commercial loans that were less than 90 days past due at December 31, 2022 and other loans for which known information about possible credit problems of the related borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans as nonperforming at some time in the future.

Potential problem loans are not included in the amounts of nonaccrual or TDRs presented above.  They are assessed for loss exposure using the methods described in Note 4 to the Consolidated Financial Statements under the caption “Credit Quality Indicators.” Management cannot predict the extent to which economic conditions or other factors may impact borrowers and the potential problem loans.  Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on nonaccrual, become restructured, or require increased allowance coverage and provision for credit losses on loans.

Management has identified three loans associated with two C&I relationships with carrying values totaling $927 thousand as potential problem loans at December 31, 2022. There were no potential problem loans identified at December 31, 2021.

Allowance for Credit Losses on Loans

The ACL on loans is management’s estimate of expected lifetime credit losses on loans carried at amortized cost.  The ACL on loans is established through a provision for credit losses recognized in earnings. The ACL on loans is reduced by charge-offs on loans and is increased by recoveries of amounts previously charged off.

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Management's Discussion and Analysis

The Corporation’s general practice is to identify problem credits early and recognize full or partial charge-offs as promptly as practicable when it is determined that the collection of loan principal is unlikely. Full or partial charge-offs on collateral dependent individually analyzed loans are recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. The Corporation does not recognize a recovery when new appraisals indicate a subsequent increase in value.

Appraisals are generally obtained with values determined on an “as is” basis from independent appraisal firms for real estate collateral dependent commercial loans in the process of collection or when warranted by other deterioration in the borrower’s credit status. New appraisals are generally obtained for TDRs or nonaccrual loans or when management believes it is warranted. The Corporation has continued to maintain appropriate professional standards regarding the professional qualifications of appraisers and has an internal review process to monitor the quality of appraisals.

For residential real estate loans and real estate collateral dependent consumer loans that are in the process of collection, valuations are obtained from independent appraisal firms with values determined on an “as is” basis.

The following table presents additional detail on the Corporation’s loan portfolio and associated allowance:

Management employs a process and methodology to estimate the ACL on loans that evaluates both quantitative and qualitative factors. The methodology for evaluating quantitative factors consists of two basic components. The first component involves pooling loans into portfolio segments for loans that share similar risk characteristics. The second component involves individually analyzed loans that do not share similar risk characteristics with loans that are pooled into portfolio segments.

The ACL for individually analyzed loans is measured using a DCF method based upon the loan’s contractual effective interest rate, or at the loan’s observable market price, or, if the loan was collateral dependent, at the fair value of the collateral.

The ACL for pooled loans is measured utilizing a DCF methodology to estimate credit losses for each pooled portfolio segment. The methodology incorporates a probability of default and loss given default framework. Loss given default is estimated based on historical credit loss experience. Probability of default is estimated using a regression model that incorporates econometric factors. Management utilizes forecasted econometric factors with a one-year reasonable and supportable forecast period and one-year straight-line reversion period in order to estimate the probability of default for each loan portfolio segment. The DCF methodology combines the probability of default, the loss given default, prepayment speeds and remaining life of the loan to estimate a reserve for each loan. The sum of all the loan level reserves are aggregated for each portfolio segment and a loss rate factor is derived. Quantitative loss factors for pooled loans are also supplemented by certain qualitative risk factors reflecting management’s view of how losses may vary from those represented by quantitative loss rates.

The ACL on loans amounted to $38.0 million at December 31, 2022, down by $1.1 million, or 3%, from the balance at December 31, 2021. The ACL on loans as a percentage of total loans, also known as the reserve coverage ratio, was 0.74% at December 31, 2022, compared to 0.91% at December 31, 2021.

A negative provision for credit losses (or a benefit) of $1.3 million was recognized in earnings in 2022, compared to a negative provision for credit losses (or a benefit) of $4.8 million recognized in earnings in 2021. The negative provision recognized in 2022 was reflective of low loss rates and continued strength in asset and credit quality metrics that more than offset negative trends in macroeconomic forecasts and loan growth that was concentrated in residential real estate loans. The negative provision in 2021 reflected an improvement in forecasted economic conditions following higher credit loss provisioning in 2020, which was attributable to the emergence of the COVID-19 pandemic.

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Management's Discussion and Analysis

Net recoveries totaled $368 thousand, or 0.01% of average loans, in 2022, compared to net charge-offs of $417 thousand, or 0.01% of average loans, in 2021.

The ACL on loans is an estimate and ultimate losses may vary from management’s estimate. Deteriorating conditions or assumptions could lead to further increases in the ACL on loans; conversely, improving conditions or assumptions could lead to further reductions in the ACL on loans.

The following table presents the allocation of the ACL on loans by portfolio segment. The total ACL on loans is available to absorb losses from any segment of the loan portfolio.

(1)Percentage of loans outstanding in respective category to total loans outstanding.

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Management's Discussion and Analysis

The following table reflects the activity in the ACL on loans during the years presented:

Sources of Funds

Our sources of funds include in-market deposits, wholesale brokered deposits, FHLB advances, other borrowings and proceeds from the sales, maturities and payments of loans and investment securities.  The Corporation uses funds to originate and purchase loans, purchase investment securities, conduct operations, expand the branch network and pay dividends to shareholders.

Deposits

The Corporation offers a wide variety of deposit products to consumer and business customers.  Deposits provide an important source of funding for the Bank, as well as an ongoing stream of fee revenue.

The Bank is a participant in the DDM program, ICS program and the CDARS program. The Bank uses these deposit sweep services to place customer and client funds into interest-bearing demand accounts, money market accounts, and/or time deposits issued by other participating banks. Customer and client funds are placed at one or more participating banks to ensure that each deposit customer is eligible for the full amount of FDIC insurance. As a program participant, we receive

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Management's Discussion and Analysis

reciprocal amounts of deposits from other participating banks. We consider these reciprocal deposit balances to be in-market deposits as distinguished from traditional wholesale brokered deposits.

The following table presents a summary of deposits:

Total deposits amounted to $5.0 billion at December 31, 2022, up by $38.9 million, or 1%, in 2022. The Bank estimates, in accordance with regulatory reporting requirements, that its uninsured deposits amounted to $1.5 billion at December 31, 2022.

In-market deposits were up by $195.9 million, or 4%, from the balance at December 31, 2021, with growth concentrated in money market accounts, while wholesale brokered deposits were down by $157.0 million, or 30% from December 31, 2022.

The following table presents the amount of time certificates of deposit in denominations of $250 thousand or more at December 31, 2022, maturing during the periods indicated:

Borrowings

Borrowings primarily consist of FHLB advances, which are used as a source of funding for liquidity and interest rate risk management purposes.

FHLB advances totaled $980.0 million at December 31, 2022, up by $835.0 million from the balance at the end of 2021, as higher levels of wholesale funding were utilized to fund balance sheet growth.

For additional information regarding FHLB advances see Note 13 to the Consolidated Financial Statements.

Liquidity and Capital Resources

Liquidity Management

Liquidity is the ability of a financial institution to meet maturing liability obligations and customer loan demand.  The Corporation’s primary source of liquidity is in-market deposits, which funded approximately 76% of total average assets in 2022.  While the generally preferred funding strategy is to attract and retain low-cost deposits, the ability to do so is affected

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Management's Discussion and Analysis

by competitive interest rates and terms in the marketplace.  Other sources of funding include discretionary use of purchased liabilities (e.g., FHLB term advances and brokered deposits), cash flows from the investment securities portfolios and loan repayments.  Securities designated as available for sale may also be sold in response to short-term or long-term liquidity needs, although management has no intention to do so at this time.

The Corporation has a detailed liquidity funding policy and a contingency funding plan that provide for the prompt and comprehensive response to unexpected demands for liquidity. Management employs stress testing methodology to estimate needs for contingent funding that could result from unexpected outflows of funds in excess of “business as usual” cash flows.  In management’s estimation, risks are concentrated in two major categories: (1) runoff of in-market deposit balances; and (2) unexpected drawdown of loan commitments.  Of the two categories, potential runoff of deposit balances would have the most significant impact on contingent liquidity.  Our stress test scenarios, therefore, emphasize attempts to quantify deposits at risk over selected time horizons.  In addition to these unexpected outflow risks, several other “business as usual” factors enter into the calculation of the adequacy of contingent liquidity including: (1) payment proceeds from loans and investment securities; (2) maturing debt obligations; and (3) maturing time deposits.  The Corporation has established collateralized borrowing capacity with the FRBB and also maintains additional collateralized borrowing capacity with the FHLB in excess of levels used in the ordinary course of business. Borrowing capacity is impacted by the amount and type of assets available to be pledged.

The table below presents unused funding capacity by source as of the dates indicated:

(1)As of December 31, 2022, 2021 and 2020, loans with a carrying value of $2.4 billion, $2.2 billion and $2.1 billion, respectively, and securities available for sale with a carrying value of $102.1 million, $163.2 million and $128.6 million, respectively, were pledged to the FHLB resulting in this additional borrowing capacity.

(2)As of December 31, 2022, 2021 and 2020, loans with a carrying value of $20.9 million, $8.2 million and $12.6 million, respectively. and securities available for sale with a carrying value of $12.7 million, $13.5 million and $14.9 million, respectively, were pledged to the FRBB resulting in this additional unused borrowing capacity.

In addition to the amounts presented above, the Bank also had access to a $40.0 million unused line of credit with the FHLB.

Additional funding capacity available from the FHLB declined by $974.1 million from December 31, 2021 primarily as new advances were utilized to fund asset growth, mainly loans, during the year. In addition, $215.0 million of availability was utilized in the year to collateralize an institutional deposit through a standby letter of credit with the FHLB.

The ALCO establishes and monitors internal liquidity measures to manage liquidity exposure.  Liquidity remained within target ranges established by the ALCO during 2022.  Based on its assessment of the liquidity considerations described above, management believes the Corporation’s sources of funding meet anticipated funding needs.

Contractual Obligations, Commitments and Off-Balance Sheet Arrangements

In the ordinary course of business, the Corporation enters into contractual obligations that require future cash payments. These include payments related to lease obligations, time deposits with stated maturity dates, and borrowings. For additional information on these arrangements and the expected timing of applicable payments as of December 31, 2022, see the following notes to the Consolidated Financial Statements: Note 7 for leases, Note 12 for time deposits and Note 13 for borrowings.

Also, in the ordinary course of business, the Corporation engages in a variety of financial transactions that, in accordance with GAAP, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts.  These financial transactions include commitments to extend credit, standby letters of credit, forward loan commitments, loan related derivative contracts and interest rate risk management contracts. These transactions involve, to

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Management's Discussion and Analysis

varying degrees, elements of credit, interest rate and liquidity risk. The Corporation’s credit policies with respect to interest rate contracts with commercial borrowers, commitments to extend credit, and standby letters of credit are similar to those used for loans. Some commitments to extend credit and standby letters of credit are expected to expire without being drawn upon, and thus, total amounts do not necessarily represent future cash requirements. Interest rate risk management contracts with other counterparties are generally subject to bilateral collateralization terms. These contracts with various counterparties may subject the Corporation to various cash flow requirements, which may include posting of cash as collateral for arrangements that are in a liability position. For additional information on derivative financial instruments and financial instruments with off-balance sheet risk see Notes 9 and 21 to the Consolidated Financial Statements.

Capital Resources

Total shareholders’ equity amounted to $453.7 million at December 31, 2022, down by $111.1 million from December 31, 2021. The decline reflected a decrease of $137.8 million in the AOCL component of shareholders' equity, due to decreases in the fair value of available for sale debt securities and cash flow hedges primarily attributable to relative changes in market interest rates. The decrease in AOCL was partially offset by an increase of $3.8 million associated with the annual remeasurement of pension plan liabilities. This increase from the annual remeasurement was largely due to an increase in the discount rates used to measure the present value of pension plan liabilities, resulting from higher market interest rates. The decline in total shareholders’ equity also included $37.9 million in dividend declarations and a net increase in treasury stock balances of $7.6 million. These decreases were partially offset by net income of $71.7 million.

The Corporation declared dividends of $2.18 per share in 2022, representing an increase of 8 cent per share, or 4%, over last year. The dividend payout ratio (dividends declared per share to diluted earnings per share) was 53.0% in 2022, compared to 47.8% in 2021.

The ratio of total equity to total assets amounted to 6.81% at December 31, 2022, compared to a ratio of 9.65% at December 31, 2021.  Book value per share was $26.40 at December 31, 2022, compared to $32.59 at December 31, 2021.

The Bancorp and the Bank are subject to various regulatory capital requirements and are considered “well capitalized,” with a total risk-based capital ratio of 12.37% at December 31, 2022, compared to 14.01% at December 31, 2021.

See Note 14 to the Consolidated Financial Statements for additional discussion regarding shareholders’ equity, including the stock repurchase program and regulatory capital requirements.

Asset/Liability Management and Interest Rate Risk

Interest rate risk is the risk of loss to future earnings due to changes in interest rates. The ALCO is responsible for establishing policy guidelines on liquidity and acceptable exposure to interest rate risk. Periodically, the ALCO reports on the status of liquidity and interest rate risk matters to the Bank’s Board of Directors. The objective of the ALCO is to manage assets and funding sources to produce results that are consistent with the Corporation’s liquidity, capital adequacy, growth, risk and profitability goals.

The Corporation utilizes the size and duration of the investment securities portfolio, the size and duration of the wholesale funding portfolio, off-balance sheet interest rate contracts and the pricing and structure of loans and deposits, to manage interest rate risk. The off-balance sheet interest rate contracts may include interest rate swaps, caps and floors. These interest rate contracts involve, to varying degrees, credit risk and interest rate risk. Credit risk is the possibility that a loss may occur if a counterparty to a transaction fails to perform according to terms of the contract. The notional amount of the interest rate contracts is the amount upon which interest and other payments are based. The notional amount is not exchanged, and therefore, should not be taken as a measure of credit risk. See Notes 9 and 21 to the Consolidated Financial Statements for additional information.

The ALCO uses income simulation to measure interest rate risk inherent in the Corporation’s on-balance sheet and off-balance sheet financial instruments at a given point in time by showing the effect of interest rate shifts on net interest income over a 12-month horizon, a 13- to 24-month horizon and a 60-month horizon. The simulations assume that the size and general composition of the Corporation’s balance sheet remain static over the simulation horizons, with the exception of certain deposit mix shifts from low-cost savings to higher-cost time deposits in selected interest rate scenarios. Additionally, the simulations take into account the specific repricing, maturity, call options, and prepayment characteristics of differing financial instruments that may vary under different interest rate scenarios. The characteristics of financial instrument classes are reviewed periodically by the ALCO to ensure their accuracy and consistency.

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Management's Discussion and Analysis

The ALCO reviews simulation results to determine whether the Corporation’s exposure to a decline in net interest income remains within established tolerance levels over the simulation horizons and to develop appropriate strategies to manage this exposure.   As of December 31, 2022 and 2021, net interest income simulations indicated that exposure to changing interest rates over the simulation horizons remained within tolerance levels established by the Corporation. All changes are measured in comparison to the projected net interest income that would result from an “unchanged” rate scenario where both interest rates and the composition of the Corporation’s balance sheet remain stable for a 60-month period.  In addition to measuring the change in net interest income as compared to an unchanged rate scenario, the ALCO also measures the trend of both net interest income and NIM over a 60-month horizon to ensure the stability and adequacy of this source of earnings in different interest rate scenarios.

The ALCO regularly reviews a wide variety of interest rate shift scenario results to evaluate interest rate risk exposure, including scenarios showing the effect of steepening or flattening changes in the yield curve of up to 500 basis points, as well as parallel changes in interest rates of up to 400 basis points.  Because income simulations assume that the Corporation’s balance sheet will remain static over the simulation horizon, the results do not reflect adjustments in strategy that the ALCO could implement in response to rate shifts.

The following table sets forth the estimated change in net interest income from an unchanged rate scenario over the periods indicated for parallel changes in market interest rates using the Corporation’s on- and off-balance sheet financial instruments as of December 31, 2022 and 2021.  Interest rates are assumed to shift by a parallel 100, 200 or 300 basis points upward or 100 basis points downward over a 12-month period, except for savings deposits, which are assumed to shift by lesser amounts due to their relative historical insensitivity to market interest rate movements.  Further, deposits are assumed to have certain minimum rate levels below which they will not fall.  It should be noted that the rate scenarios shown do not necessarily reflect the ALCO’s view of the “most likely” change in interest rates over the periods indicated.

As of December 31, 2022, the ALCO estimates that the negative exposure of net interest income to falling rates as compared to an unchanged rate scenario in Year 1 results from a more rapid decline in earning asset yields compared to rates paid on deposits. If market interest rates were to fall and remain lower for a sustained period, certain savings and time deposit rates could decline more slowly and by a lesser amount than other market interest rates. For simulation purposes, deposit rate changes are anticipated to lag behind other market interest rates in both timing and magnitude. Asset yields would likely decline more rapidly than deposit costs as current asset holdings mature or reprice, since cash flow from mortgage-related prepayments and redemption of callable securities would increase as market interest rates fall. The ALCO estimates that the positive exposure of net interest income to falling rates in Year 2 as compared to an unchanged rate scenario results from a more rapid projected relative rate of decline in funding costs than asset yields.

The relative decline in interest rate sensitivity to rising rates from December 31, 2021, as shown in the above table, was largely attributable to a higher level of longer-term fixed rate assets, as well as an increase in the proportion of wholesale funds to total sources of funds at December 31, 2022. Fixed rate assets would not reprice upward in a rising rate environment. Wholesale funds would reprice more quickly and by a greater amount than the repricing of in-market deposits in response to changes in market interest rates. As market rates increase, ALCO modeling assumes that deposits will shift from low cost to higher cost deposits. This assumption reflects historical operating conditions in rising rate cycles. Although asset yields would increase in a rising interest rate environment, the cumulative impact of relative growth in rate-sensitive higher cost deposit categories and wholesale funds suggests that the increase in the Corporation’s cost of funds could result in a relative decline in net interest income compared to an unchanged rate scenario.

While the ALCO reviews and updates simulation assumptions and also periodically back-tests the simulation results to ensure that the assumptions are reasonable and current, income simulation may not always prove to be an accurate indicator of interest rate risk or future NIM.  Over time, the repricing, maturity and prepayment characteristics of financial instruments

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Management's Discussion and Analysis

and the composition of the Corporation’s balance sheet may change to a different degree than estimated.  Simulation modeling assumes a static balance sheet, with the exception of certain modeled deposit mix shifts from low-cost savings deposits to higher-cost time deposits in rising rate scenarios as noted above.

As part of its policy response to the COVID-19 pandemic in 2020, the Federal Reserve reduced its target range for the Fed Funds rate to 0-0.25%. This, and various Federal stimulus programs, had the effect of attracting low-cost deposits across the banking industry. During 2022, the Federal Reserve reversed policy and increased the target range to 4.25-4.50% as of December 31, 2022. This policy change has resulted in higher rates on existing deposit products. It could also cause low-cost balances to shift into higher yielding alternatives in the future, particularly if interest rates continue rise, and as such the ALCO has modeled deposit shifts out of these low-cost categories into higher-cost alternatives in the rising rate simulation scenarios presented above. Deposit balances may also be subject to possible outflow to non-bank alternatives in a rising rate environment, which may cause interest rate sensitivity to differ from the results as presented. Another significant simulation assumption is the sensitivity of savings deposits to fluctuations in interest rates. Income simulation results assume that changes in both savings deposit rates and balances are related to changes in short-term interest rates. The relationship between short-term interest rate changes and deposit rate and balance changes may differ from the ALCOs estimates used in income simulation.

It should also be noted that the static balance sheet assumption does not necessarily reflect the Corporation’s expectation for future balance sheet growth, which is a function of the business environment and customer behavior.

Mortgage-backed securities and residential real estate loans involve a level of risk that unforeseen changes in prepayment speeds may cause related cash flows to vary significantly in differing rate environments.  Such changes could affect the level of reinvestment risk associated with cash flow from these instruments, as well as their market value.  Changes in prepayment speeds could also increase or decrease the amortization of premium or accretion of discounts related to such instruments, thereby affecting interest income.

The Corporation also monitors the potential change in market value of its available for sale debt securities in changing interest rate environments.  The purpose is to determine market value exposure that may not be captured by income simulation, but which might result in changes to the Corporation’s capital position.  Results are calculated using industry-standard analytical techniques and securities data.

The following table summarizes the potential change in market value of the Corporation’s available for sale debt securities of December 31, 2022 and 2021 resulting from immediate parallel rate shifts:

Impact of Inflation on Changing Prices

The Corporation’s consolidated financial statements and related notes have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical U.S. dollars without considering changes in the relative purchasing power of money over time due to inflation.

A substantial portion of the Corporation’s assets and liabilities are monetary in nature and as a result interest rates have a more significant impact on the overall performance of the Corporation than the general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as inflation. The Federal Reserve’s policy response to counter high levels of inflation has been to increase its Fed Funds target rate, which in turn resulted in higher market interest rates across the economy. While variable-rate assets would reprice upward if interest rates were to continue to rise, interest-bearing liabilities would also reprice upward. Additionally, lower-cost in-market deposits could shift into higher-cost deposit

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Management's Discussion and Analysis

categories in a rising rate environment, which could put pressure on both net interest income and the net interest margin. For additional discussion on interest due to changes in interest rates, see the caption “Asset/Liability Management and Interest Rate Risk” above.

Furthermore, a prolonged period of inflation could cause wages and other costs to increase.

Critical Accounting Policies and Estimates

Estimates and assumptions are necessary in the application of certain accounting policies and procedures and can be susceptible to significant change. Critical accounting policies are defined as those that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the Corporation’s financial condition or results of operations.

Management considers its accounting policy relating to the ACL on loans to be a critical accounting policy.

Allowance for Credit Losses on Loans

The ACL on loans is management’s estimate of expected lifetime credit losses on loans carried at amortized cost. The ACL on loans is established through a provision for credit losses recognized in the Consolidated Statements of Income. Additionally, the ACL on loans is reduced by charge-offs on loans and increased by recoveries of amounts previously charged-off. At December 31, 2022 the ACL on loans totaled $38.0 million, compared to $39.1 million at December 31, 2021. A significant portion of our ACL is allocated to the commercial portfolio (both CRE and C&I). As of December 31, 2022 and 2021, the ACL allocated to the total commercial portfolio was $28.8 million and $29.8 million, respectively.

Management employs a process and methodology to estimate the ACL on loans that evaluates both quantitative and qualitative factors. The methodology for evaluating quantitative factors consists of two basic components; pooling loans into portfolio segments for loans that share similar risk characteristics and identifying individually analyzed loans that do not share similar risk characteristics with loans that are pooled into portfolio segments.

For pooled loan portfolio segments, the Corporation utilizes a DCF methodology to estimate credit losses over the expected life of the loan. The methodology incorporates a probability of default and loss given default framework. Loss given default is estimated based on historical credit loss experience. Probability of default is estimated utilizing a regression model that incorporates econometric factors. The model utilizes forecasted econometric factors with a one-year reasonable and supportable forecast period and one-year straight-line reversion period in order to estimate the probability of default for each loan portfolio segment. The DCF methodology combines the probability of default, the loss given default, prepayment speeds and the remaining life of the loan to estimate a reserve for each loan.

The ACL for individually analyzed loans is measured using a DCF method based upon the loan’s contractual effective interest rate, or at the loan’s observable market price, or, if the loan was collateral dependent, at the fair value of the collateral.

Quantitative loss factors are also supplemented by certain qualitative risk factors reflecting management’s view of how losses may vary from those represented by quantitative loss rates. Qualitative loss factors are applied to each portfolio segment with the amounts determined by historical loan charge-offs of a peer group of similar-sized regional banks.

Because the methodology is based upon historical experience and trends, current economic data, reasonable and supportable forecasts, as well as management’s judgment, factors may arise that result in different estimations. Deteriorating conditions or assumptions could lead to further increases in the ACL on loans; conversely, improving conditions or assumptions could lead to further reductions in the ACL on loans.

In estimating the ACL on loans, management considers the sensitivity of the model and significant judgments and assumptions that could result in an amount that is materially different from management’s estimate. Given the concentration of ACL allocation to the total commercial portfolio and the significant judgments made by management in deriving the qualitative loss factors, management analyzed the impact that changes in judgments could have. The range of impact was an ACL allocated to the total commercial loan portfolio between $18.4 million and $51.7 million at December 31, 2022. The sensitivity and related range of impact is a hypothetical analysis and is not intended to represent management’s judgments or assumptions of qualitative loss factors that were utilized at December 31, 2022 in estimation of the ACL on loans recognized on the Consolidated Balance Sheet.

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Management's Discussion and Analysis

If the assumptions underlying the determination of the ACL prove to be incorrect, the ACL may not be sufficient to cover actual loan losses and an increase to the ACL may be necessary to allow for different assumptions or adverse developments. In addition, a problem with one or more loans could require a significant increase to the ACL.

Recently Issued Accounting Pronouncements

See Note 2 to the Consolidated Financial Statements for details of recently issued accounting pronouncements and their expected impact on the Corporation’s financial statements.