U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2023

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from         to        .

Commission File No. 000-26719

MERCANTILE BANK CORPORATION

(Exact name of registrant as specified in its charter)

Michigan	38-3360865
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

310 Leonard Street, NW, Grand Rapids, MI 49504

(Address of principal executive offices) (Zip Code)

(616) 406-3000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Exchange Act:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock	MBWM	The Nasdaq Stock Market LLC

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ☒     No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes ☒     No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐	Accelerated filer ☒
Non-accelerated filer ☐	Smaller reporting company ☐
Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Yes ☐     No ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐    No  ☒

At July 31, 2023, there were 16,018,216 shares of common stock outstanding.

MERCANTILE BANK CORPORATION

INDEX

PART I.	Financial Information	Page No.
	Item 1.    Financial Statements
	Consolidated Balance Sheets (Unaudited) – June 30, 2023 and December 31, 2022	1
	Consolidated Statements of Income (Unaudited) - Three and Six Months Ended June 30, 2023 and June 30, 2022	2
	Consolidated Statements of Comprehensive Income (Unaudited) - Three and Six Months Ended June 30, 2023 and June 30, 2022	3
	Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) – Three and Six Months Ended June 30, 2023 and June 30, 2022	4
	Consolidated Statements of Cash Flows (Unaudited) – Six Months Ended June 30, 2023 and June 30, 2022	8
	Notes to Consolidated Financial Statements (Unaudited)	10
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	53
	Item 3. Quantitative and Qualitative Disclosures About Market Risk	71
	Item 4. Controls and Procedures	73
PART II.	Other Information
	Item 1. Legal Proceedings	74
	Item 1A. Risk Factors	74
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	74
	Item 3. Defaults Upon Senior Securities	74
	Item 4. Mine Safety Disclosures	74
	Item 5. Other Information	74
	Item 6. Exhibits	75
	Signatures	76

MERCANTILE BANK CORPORATION

PART I --- FINANCIAL INFORMATION

Item 1. Financial Statements

CONSOLIDATED BALANCE SHEETS

(Unaudited)

	June 30, 2023			December 31, 2022
ASSETS
Cash and due from banks	$	69,133,000		$	61,894,000
Interest-earning deposits		138,663,000			34,878,000
Total cash and cash equivalents		207,796,000			96,772,000
Securities available for sale		608,972,000			602,936,000
Federal Home Loan Bank stock		21,513,000			17,721,000
Mortgage loans held for sale		11,942,000			3,565,000
Loans		4,051,843,000			3,916,619,000
Allowance for credit losses		(44,721,000	)		(42,246,000	)
Loans, net		4,007,122,000			3,874,373,000
Premises and equipment, net		52,291,000			51,476,000
Bank owned life insurance		81,500,000			80,727,000
Goodwill		49,473,000			49,473,000
Core deposit intangible, net		291,000			583,000
Other assets		96,687,000			94,993,000
Total assets	$	5,137,587,000		$	4,872,619,000
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits
Noninterest-bearing	$	1,371,633,000		$	1,604,750,000
Interest-bearing		2,385,156,000			2,108,061,000
Total deposits		3,756,789,000			3,712,811,000
Securities sold under agreements to repurchase		219,457,000			194,340,000
Federal Home Loan Bank advances		467,910,000			308,263,000
Subordinated debentures		49,301,000			48,958,000
Subordinated notes		88,800,000			88,628,000
Accrued interest and other liabilities		76,628,000			78,211,000
Total liabilities		4,658,885,000			4,431,211,000
Commitments and contingent liabilities (Note 8)
Shareholders' equity
Preferred stock, no par value; 1,000,000 shares authorized; none issued		0			0
Common stock, no par value; 40,000,000 shares authorized; 16,018,048 shares issued and outstanding at June 30, 2023 and 15,994,884 shares issued and outstanding at December 31, 2022		292,906,000			290,436,000
Retained earnings		247,313,000			216,313,000
Accumulated other comprehensive gain (loss)		(61,517,000	)		(65,341,000	)
Total shareholders’ equity		478,702,000			441,408,000
Total liabilities and shareholders’ equity	$	5,137,587,000		$	4,872,619,000

See accompanying notes to consolidated financial statements.

1

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

	Three Months Ended June 30, 2023		Three Months Ended June 30, 2022		Six Months Ended June 30, 2023		Six Months Ended June 30, 2022
Interest income
Loans, including fees	$	62,006,000	$	36,003,000	$	119,159,000	$	69,254,000
Securities, taxable		2,207,000		1,898,000		4,338,000		3,563,000
Securities, tax-exempt		904,000		631,000		1,780,000		1,231,000
Interest-earning deposits		801,000		1,018,000		1,125,000		1,384,000
Total interest income		65,918,000		39,550,000		126,402,000		75,432,000
Interest expense
Deposits		12,379,000		1,873,000		20,286,000		3,698,000
Short-term borrowings		914,000		49,000		1,373,000		99,000
Federal Home Loan Bank advances		3,051,000		1,911,000		4,845,000		3,774,000
Subordinated debt and other borrowings		2,023,000		1,391,000		3,963,000		2,650,000
Total interest expense		18,367,000		5,224,000		30,467,000		10,221,000
Net interest income		47,551,000		34,326,000		95,935,000		65,211,000
Provision for credit losses		2,000,000		500,000		2,600,000		600,000
Net interest income after provision for credit losses		45,551,000		33,826,000		93,335,000		64,611,000
Noninterest income
Service charges on deposit and sweep accounts		1,064,000		1,495,000		2,041,000		2,910,000
Credit and debit card income		2,426,000		2,134,000		4,485,000		4,015,000
Mortgage banking income		1,835,000		1,947,000		3,050,000		5,228,000
Interest rate swap fees		748,000		430,000		1,785,000		1,781,000
Payroll services income		572,000		464,000		1,317,000		1,102,000
Earnings on bank owned life insurance		402,000		785,000		802,000		1,072,000
Other income		598,000		486,000		1,117,000		910,000
Total noninterest income		7,645,000		7,741,000		14,597,000		17,018,000
Noninterest expense
Salaries and benefits		16,461,000		15,676,000		33,143,000		31,186,000
Occupancy		2,098,000		2,084,000		4,387,000		4,168,000
Furniture and equipment depreciation, rent and maintenance		878,000		935,000		1,700,000		1,869,000
Data processing costs		2,881,000		3,091,000		6,043,000		6,064,000
Charitable foundation contribution		2,000		500,000		12,000		506,000
Other expense		5,509,000		4,656,000		11,144,000		8,891,000
Total noninterest expenses		27,829,000		26,942,000		56,429,000		52,684,000
Income before federal income tax expense		25,367,000		14,625,000		51,503,000		28,945,000
Federal income tax expense		5,010,000		2,888,000		10,171,000		5,716,000
Net income	$	20,357,000	$	11,737,000	$	41,332,000	$	23,229,000
Basic earnings per share	$	1.27	$	0.74	$	2.58	$	1.47
Diluted earnings per share	$	1.27	$	0.74	$	2.58	$	1.47
Average basic shares outstanding		16,003,372		15,848,681		15,999,775		15,844,763
Average diluted shares outstanding		16,003,372		15,848,681		15,999,775		15,844,763

See accompanying notes to consolidated financial statements.

2

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

	Three Months Ended June 30, 2023			Three Months Ended June 30, 2022			Six Months Ended June 30, 2023			Six Months Ended June 30, 2022
Net income	$	20,357,000		$	11,737,000		$	41,332,000		$	23,229,000
Other comprehensive income (loss):
Unrealized holding gains (losses) on securities available for sale		(6,645,000	)		(19,969,000	)		4,841,000			(55,619,000	)
Tax effect of unrealized holding gains (losses) on securities available for sale		1,395,000			4,193,000			(1,017,000	)		11,680,000
Other comprehensive income (loss), net of tax		(5,250,000	)		(15,776,000	)		3,824,000			(43,939,000	)
Comprehensive income (loss)	$	15,107,000		$	(4,039,000	)	$	45,156,000		$	(20,710,000	)

See accompanying notes to consolidated financial statements.

3

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

($ in thousands except per share amounts)	Preferred Stock		Common Stock		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
Balances, March 31, 2023	$	0	$	291,516	$	232,123		$	(56,267	)	$	467,372
Employee stock purchase plan (443 shares)				13								13
Dividend reinvestment plan (7,821 shares)				232								232
Stock grants to directors for retainer fees (10,455 shares)				317								317
Stock-based compensation expense				828								828
Cash dividends ($0.33 per common share)						(5,167	)					(5,167	)
Net income for the three months ended June 30, 2023						20,357						20,357
Change in net unrealized holding gain (loss) on securities available for sale, net of tax effect									(5,250	)		(5,250	)
Balances, June 30, 2023	$	0	$	292,906	$	247,313		$	(61,517	)	$	478,702

See accompanying notes to consolidated financial statements.

4

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY (Continued)

(Unaudited)

($ in thousands except per share amounts)	Preferred Stock		Common Stock		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
Balances, January 1, 2023	$	0	$	290,436	$	216,313		$	(65,341	)	$	441,408
Employee stock purchase plan (770 shares)				23								23
Dividend reinvestment plan (14,701 shares)				449								449
Stock grants to directors for retainer fees (10,455 shares)				317								317
Stock-based compensation expense				1,681								1,681
Cash dividends ($0.66 per common share)						(10,332	)					(10,332	)
Net income for the six months ended June 30, 2023						41,332						41,332
Change in net unrealized holding gain (loss) on securities available for sale, net of tax effect									3,824			3,824
Balances, June 30, 2023	$	0	$	292,906	$	247,313		$	(61,517	)	$	478,702

See accompanying notes to consolidated financial statements.

5

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY (Continued)

(Unaudited)

($ in thousands except per share amounts)	Preferred Stock		Common Stock		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
Balances, March 31, 2022	$	0	$	286,831	$	181,532		$	(31,892	)	$	436,471
Employee stock purchase plan (336 shares)				11								11
Dividend reinvestment plan (6,835 shares)				213								213
Stock grants to directors for retainer fees (10,837 shares)				347								347
Stock-based compensation expense				797								797
Cash dividends ($0.31 per common share)						(4,817	)					(4,817	)
Net income for the three months ended June 30, 2022						11,737						11,737
Change in net unrealized holding gain (loss) on securities available for sale, net of tax effect									(15,776	)		(15,776	)
Balances, June 30, 2022	$	0	$	288,199	$	188,452		$	(47,668	)	$	428,983

See accompanying notes to consolidated financial statements.

6

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY (Continued)

(Unaudited)

($ in thousands except per share amounts)	Preferred Stock		Common Stock		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
Balances, January 1, 2022	$	0	$	285,752	$	174,536		$	(3,729	)	$	456,559
Adoption of ASU 2016-13						316						316
Employee stock purchase plan (617 shares)				21								21
Dividend reinvestment plan (12,670 shares)				435								435
Stock grants to directors for retainer fees (10,837 shares)				347								347
Stock option exercises (1,355 shares)				36								36
Stock-based compensation expense				1,608								1,608
Cash dividends ($0.62 per common share)						(9,629	)					(9,629	)
Net income for the six months ended June 30, 2022						23,229						23,229
Change in net unrealized holding gain (loss) on securities available for sale, net of tax effect									(43,939	)		(43,939	)
Balances, June 30, 2022	$	0	$	288,199	$	188,452		$	(47,668	)	$	428,983

See accompanying notes to consolidated financial statements.

7

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30, 2023			Six Months Ended June 30, 2022
Cash flows from operating activities
Net income	$	41,332,000		$	23,229,000
Adjustments to reconcile net income to net cash from operating activities
Depreciation and amortization		5,930,000			6,692,000
Provision for credit losses		2,600,000			600,000
Stock-based compensation expense		1,681,000			1,608,000
Stock grants to directors for retainer fee		317,000			347,000
Proceeds from sales of mortgage loans held for sale		70,280,000			135,521,000
Origination of mortgage loans held for sale		(76,088,000	)		(127,413,000	)
Net gain from sales of mortgage loans held for sale		(2,569,000	)		(4,955,000	)
Net gain from sales and valuation write-downs of foreclosed assets		0			(20,000	)
Net loss from sales and write-downs of fixed assets		377,000			391,000
Earnings on bank owned life insurance		(802,000	)		(1,072,000	)
Net (gain) loss on instruments designated at fair value and related derivatives		106,000			(121,000	)
Net change in:
Accrued interest receivable		(1,486,000	)		(1,573,000	)
Other assets		(1,338,000	)		22,000
Accrued interest payable and other liabilities		(2,873,000	)		16,741,000
Net cash from operating activities		37,467,000			49,997,000
Cash flows from investing activities
Loan originations and payments, net		(135,410,000	)		(269,930,000	)
Purchases of securities available for sale		(11,641,000	)		(78,640,000	)
Proceeds from maturities, calls and repayments of securities available for sale		10,198,000			11,641,000
Proceeds from sales of foreclosed assets		0			20,000
Purchases of Federal Home Loan Bank stock		(3,792,000	)		0
Proceeds from Federal Home Loan Bank stock redemption		0			281,000
Proceeds from bank owned life insurance death benefits claim		0			628,000
Net purchases of premises and equipment and lease activity		(4,680,000	)		(399,000	)
Net cash for investing activities		(145,325,000	)		(336,399,000	)

See accompanying notes to consolidated financial statements.

8

MERCANTILE BANK CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

	Six Months Ended June 30, 2023			Six Months Ended June 30, 2022
Cash flows from financing activities
Net (decrease) increase in time deposits		227,531,000			(77,992,000	)
Net decrease in all other deposits		(183,553,000	)		(131,308,000	)
Net increase in securities sold under agreements to repurchase		25,117,000			5,876,000
Maturities of Federal Home Loan Bank advances		(40,353,000	)		(40,000,000	)
Proceeds from Federal Home Loan Bank advances		200,000,000			28,263,000
Net proceeds from subordinated notes issuance		0			14,645,000
Proceeds from stock option exercises, net of cashless exercises		0			36,000
Employee stock purchase plan		23,000			21,000
Dividend reinvestment plan		449,000			435,000
Payment of cash dividends to common shareholders		(10,332,000	)		(9,629,000	)
Net cash (for) from financing activities		218,882,000			(209,653,000	)
Net change in cash and cash equivalents		111,024,000			(496,055,000	)
Cash and cash equivalents at beginning of period		96,772,000			975,160,000
Cash and cash equivalents at end of period	$	207,796,000		$	479,105,000
Supplemental disclosures of cash flows information
Cash paid during the period for:
Interest	$	28,038,000		$	8,780,000
Federal income tax		13,850,000			5,200,000
Noncash financing and investing activities:
Transfers from premises and equipment to other assets		0			2,847,000
Transfers from bank premises to other real estate owned		600,000			0
Transfers from loans to foreclosed assets		61,000			0

See accompanying notes to consolidated financial statements.

9

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation: The unaudited financial statements for the six months ended June 30, 2023 include the consolidated results of operations of Mercantile Bank Corporation and its consolidated subsidiaries. These subsidiaries include Mercantile Bank (“our bank”) and our bank’s subsidiaries, Mercantile Insurance Center, Inc. and Mercantile Community Partners. These consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Item 303(b) of Regulation S-K and do not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for a complete presentation of our financial condition and results of operations. In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) which are necessary in order to make the financial statements not misleading and for a fair presentation of the results of operations for such periods. The results for the period ended June 30, 2023 should not be considered as indicative of results for a full year. For further information, refer to the consolidated financial statements and footnotes included in our annual report on Form 10-K for the year ended December 31, 2022.

We have five separate business trusts that were formed to issue trust preferred securities. Subordinated debentures were issued to the trusts in return for the proceeds raised from the issuance of the trust preferred securities. The trusts are not consolidated, but instead we report the subordinated debentures issued to the trusts as a liability.

Earnings Per Share: Basic earnings per share is based on the weighted average number of common shares and participating securities outstanding during the period. Diluted earnings per share include the dilutive effect of additional potential common shares issuable under our stock-based compensation plans and are determined using the treasury stock method. Our unvested restricted shares, which contain non-forfeitable rights to dividends whether paid or accrued (i.e., participating securities), are included in the number of shares outstanding for both basic and diluted earnings per share calculations. In the event of a net loss, our unvested restricted shares are excluded from the calculation of both basic and diluted earnings per share.

Approximately 350,000 unvested restricted shares were included in determining both basic and diluted earnings per share for the three and six months ended June 30, 2023. Stock options for 5,000 shares of common stock were antidilutive and not included in determining diluted earnings per share for the three and six months ended June 30, 2023.

Approximately 325,000 unvested restricted shares were included in determining both basic and diluted earnings per share for the three and six months ended June 30, 2022. In addition, stock options for approximately 1,000 shares of common stock were included in determining diluted earnings per share for the three and six months ended June 30, 2022. Stock options for approximately 6,000 shares of common stock were antidilutive and not included in determining diluted earnings per share for the three and six months ended June 30, 2022.

(Continued)

10

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

Debt Securities: Debt securities classified as held to maturity are carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities available for sale consist of bonds which might be sold prior to maturity due to a number of factors, including changes in interest rates, prepayment risks, yield, availability of alternative investments or liquidity needs. Debt securities classified as available for sale are reported at their fair value. For available for sale debt securities in an unrealized loss position, we first assess whether we intend to sell, or if it is more likely than not that we will be required to sell the security before recovery of the amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the debt security’s amortized cost basis is written down to fair value through income with the establishment of an allowance. For debt securities available for sale that do not meet the aforementioned criteria, we evaluate whether any decline in fair value is due to credit loss factors. In making this assessment, we consider any changes to the rating of the security by a rating agency and adverse conditions specifically related to the issuer of the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of the cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance is recognized in other comprehensive income.

Changes in the allowance are recorded as provisions for (or reversals of) credit loss expense. Losses are charged against the allowance when the collectability of an available for sale debt security is confirmed or when either of the criteria regarding intent or requirement to sell is met. At June 30, 2023, and December 31, 2022, there was no allowance related to the available for sale debt securities portfolio.

Interest income includes amortization of purchase premiums and accretion of discounts. Premiums on debt securities are amortized to the initial call date, if applicable, or to the maturity date, on the level-yield method. Discounts on debt securities are accreted to the maturity date on the level-yield method. Premiums and discounts on mortgage-backed securities are amortized or accreted based on anticipated prepayments on the level-yield method. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.

Federal Home Loan Bank of Indianapolis (“FHLBI”) stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value.

Loans: Loans that we have the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments. Net unamortized deferred loan fees/(costs) amounted to ($2.2) million and ($1.0) million at June 30, 2023, and December 31, 2022, respectively.

Interest income on commercial loans and mortgage loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer and credit card loans are typically charged off no later than when they are 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal and interest is considered doubtful.

Accrued interest is included in other assets in the Consolidated Balance Sheets. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

(Continued)

11

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. As of June 30, 2023 and December 31, 2022, we determined that the fair value of our mortgage loans held for sale totaled $12.2 million and $3.6 million, respectively.

Mortgage loans held for sale are generally sold with servicing rights retained. Gains and losses on sales of mortgage loans are based on the difference between the selling price, which includes a gain or loss on the interest rate commitment coverage position, and the carrying value of the related loan sold, which is reduced by the cost allocated to the servicing right. Market rate risk on interest rate commitments with borrowers prior to loan closing is mitigated through forward commitments referred to as to-be-announced mortgage-backed securities. These mortgage banking activities are not designated as hedges and are carried at fair value. The net gain or loss on mortgage banking derivatives, which is generally nominal in dollar amount, is included in the gain on sale of loans and recorded as part of mortgage banking income.

Allowance for Credit Losses (“Allowance”): On January 1, 2022, we adopted ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 32): Measurement of Credit Losses on Financial Instruments, as amended, which replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost and certain off-balance sheet credit exposures.

The allowance is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged-off against the allowance when we believe the uncollectability of a loan is confirmed.

We estimate the allowance balance using relevant available information, from internal and external sources, relating to past events, current conditions and reasonable and supportable forecasts. Historical credit loss experience provides the basis for the estimation of expected credit losses. Adjustments to historical loss information are made for changes in current loan-specific risk characteristics such as changes in underwriting standards, portfolio mix, delinquency level or other relevant factors.

We recorded a provision expense of $2.6 million during the first six months of 2023, mainly reflecting allocations necessitated by net loan growth and adjustments to historical loss information to better represent our expectations for future credit losses. Changes to qualitative factors were limited to a reduction of the historical loss information factor which coincided with adjustments to historical loss information.

The allowance is measured on a collective pool basis when similar risk characteristics exist. Loans with similar risk characteristics are grouped into homogenous segments, or pools, for analysis. Commercial loans are divided among five segments based primarily on collateral type, risk characteristics, and primary and secondary sources of repayment. These segments are then further stratified based on the commercial loan grade that is assigned using our standard loan grading paradigm. Retail loans are divided into one of two groups based on if the loan is secured by residential real estate or not.

(Continued)

12

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

Our loan portfolio segments as of June 30, 2023 and December 31, 2022 were as follows:

o Commercial Loans

■ Commercial and Industrial: Risks to this loan category include industry concentration and the practical limitations associated with monitoring the condition of the collateral which often consists of inventory, accounts receivable, and other non-real estate assets. Equipment and inventory obsolescence can also pose a risk. Declines in general economic conditions and other events can cause cash flows to fall to levels insufficient to service debt.

■ Owner Occupied Commercial Real Estate: Risks to this loan category include industry concentration and the inability to monitor the condition of the collateral. Declines in general economic conditions and other events can cause cash flows to fall to levels insufficient to service debt. Also, declines in real estate values and lack of suitable alternative use for the properties are risks for loans in this category.

■ Non-Owner Occupied Commercial Real Estate: Loans in this category are susceptible to declines in occupancy rates, business failure, and general economic conditions. Also, declines in real estate values and lack of suitable alternative use for the properties are risks for loans in this category.

■ Multi-Family and Residential Rental: Risks to this loan category include industry concentration and the inability to monitor the condition of the collateral. Loans in this category are susceptible to weakening general economic conditions and increases in unemployment rates, as well as market demand and supply of similar property and the resulting impact on occupancy rates, market rents, cash flow, and income-based real estate values. Also, the lack of a suitable alternative use for the properties is a risk for loans in this category.

■ Vacant Land, Land Development and Residential Construction: Risks common to commercial construction loans are cost overruns, changes in market demand for property, inadequate long-term financing arrangements, and declines in real estate values. Residential construction loans are susceptible to those same risks as well as those associated with residential mortgage loans. Changes in market demand for property could lead to longer marketing times resulting in higher carrying costs, declining values, and higher interest rates.

o Retail Loans

■ 1-4 Family Mortgages: Residential mortgage loans are susceptible to weakening general economic conditions, increases in unemployment rates, and declining real estate values.

■ Other Consumer Loans: Risks common to these loans include regulatory risks, unemployment, and changes in local economic conditions as well as the inability to monitor collateral consisting of personal property.

The “remaining life methodology” is utilized for substantially all loan pools. This non-discounted cash flow approach projects an estimated future amortized cost basis based on current loan balance, repayment terms, and estimated prepayments. Our historical loss rate is then applied to the monthly estimated future loan balances at the instrument level. The baseline lifetime loss is adjusted for changes in macroeconomic conditions over the reasonable and supportable forecast and reversion periods via a series of macroeconomic forecast inputs, such as gross domestic product, unemployment rates, interest rates, credit spreads, stock market volatility and property price indices, to quantify the impact of current and forecasted economic conditions on expected loan performance.

(Continued)

13

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

We use migration to determine historical loss rates for commercial loans given the comprehensive loan grading process employed by the bank for over two decades, while an open pool approach is best suited for retail loans given the smaller dollar size of the segments. A baseline loss rate is produced at each reporting date for each loan portfolio segment using bank-specific loan charge-off and recovery data over a defined historical look-back period. The look-back period represents the number of data periods that will be used to calculate a baseline loss rate for each loan portfolio segment. We determined that the look-back period commencing on January 1, 2011 through the current reporting date was reasonable and appropriate.

Reasonable and supportable economic forecasts have to be incorporated in determining expected credit losses. The forecast period represents the time frame from the current period end through the point in time that we can reasonably forecast and support entity and environmental factors that are expected to impact the performance of our loan portfolio. Ideally, the economic forecast period would encompass the contractual terms of all loans; however, the ability to produce a forecast that is considered reasonable and supportable becomes more difficult or may not be possible in later periods.

Subsequent to the end of the forecast period, we revert to historical loan data based on an ongoing evaluation of each economic forecast in relation to then current economic conditions as well as any developing loan loss activity and resulting historical data. As of June 30, 2023 and December 31, 2022, we used a one-year reasonable and supportable economic forecast period, with a six-month straight-line reversion period for all loan segments.

We are not required to develop and use our own economic forecast model, and elected to utilize economic forecasts from third-party providers that analyze and develop forecasts of the economy for the entire United States at least quarterly. The economic forecasts used for our June 30, 2023 allowance calculation reflected a decrease in our allowance balance of $0.7 million compared to the forecasts used for our December 31, 2022 allowance calculation. Our methodology does provide for a potential qualitative factor that can be used in the event of local or regional conditions that depart from the conditions and forecasts for the entire country.

During each reporting period, we also consider the need to adjust the historical loss rates as determined by our migration calculations to reflect the extent to which we expect current conditions and reasonable and supportable economic forecasts to differ from the conditions that existed for the period over which the migration-based historical loss information was determined. These qualitative adjustments may increase or decrease our estimate of expected future credit losses.

Traditional qualitative factors include:

o Changes in lending policies and procedures

o Changes in the nature and volume of the loan portfolio and in the terms of loans

o Changes in the experience, ability and depth of lending management and other relevant staff

o Changes in the volume and severity of past due loans, nonaccrual loans and adversely classified loans

o Changes in the quality of the loan review program

o Changes in the value of underlying collateral dependent loans

o Existence and effect of any concentrations of credit and any changes in such

o Effect of other factors such as competition and legal and regulatory requirements

The estimation of future credit losses should reflect consideration of all significant factors that affect the collectability of the loan portfolio at each evaluation date. While our methodology considers both the historical loss rates as well as the traditional qualitative factors, there may be instances or situations where additional qualitative factors need to be considered. Effective January 1, 2022, we established a historical loss information factor to address the relatively low level of loan losses during the look-back period.

(Continued)

14

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

Expected credit losses are estimated over the contractual terms of the loans, adjusted for expected prepayments when appropriate. The contractual term generally excludes potential extensions, renewals and modifications.

Accrued interest receivable for loans is included in other assets on our Consolidated Balance Sheet. We elected not to measure an allowance for accrued interest receivable and instead elected to reverse interest income on loans that are placed on nonaccrual status, which is generally when the loan becomes 90 days past due, or earlier if we believe the collection of interest is doubtful. We believe this policy results in the timely reversal of uncollectable interest.

We are also required to consider expected credit losses associated with loan commitments over the contractual period in which we are exposed to credit risk on the underlying commitments unless the obligation is unconditionally cancellable by us. Any allowance for off-balance sheet credit exposures is reported as an other liability on our Consolidated Balance Sheet and is increased or decreased via other noninterest expense on our Consolidated Statement of Income. The calculation includes consideration of the likelihood that funding will occur and forecasted credit losses on commitments expected to be funded over their estimated lives. The allowance is calculated using the same aggregate reserve rates calculated for the funded portion of loans at the portfolio level applied to the amount of commitments expected to be funded.

Mortgage Banking Activities: Mortgage loans serviced for others totaled $1.37 billion and $1.38 billion as of June 30, 2023 and December 31, 2022, respectively. Mortgage loan servicing rights are recognized as assets based on the allocated value of retained servicing rights on mortgage loans sold. Mortgage loan servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights using groupings of the underlying mortgage loans as to interest rates. Any impairment of a grouping is reported as a valuation allowance.

Servicing fee income is recorded for fees earned for servicing mortgage loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. Amortization of mortgage loan servicing rights is netted against mortgage loan servicing income and recorded in mortgage banking activities in the income statement.

Troubled Debt Restructurings: A loan is accounted for as a troubled debt restructuring if we, for economic or legal reasons, grant a concession to a borrower considered to be experiencing financial difficulties that we would not otherwise consider. A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate or balance of the loan, a reduction of accrued interest, an extension of the maturity date or renewal of the loan at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions. Troubled debt restructurings can be in either accrual or nonaccrual status. Nonaccrual troubled debt restructurings are included in nonperforming loans. Accruing troubled debt restructurings are generally excluded from nonperforming loans as it is considered probable that all contractual principal and interest due under the restructured terms will be collected.

In accordance with current accounting guidance, loans modified as troubled debt restructurings are, by definition, considered to be impaired loans. Impairment for these loans is measured on a loan-by-loan basis. Certain loans modified as troubled debt restructurings may have been previously measured for impairment under a general allowance methodology (i.e., pooling), thus at the time the loan is modified as a troubled debt restructuring the allowance will be impacted by the difference between the results of these two measurement methodologies. Loans modified as troubled debt restructurings that subsequently default are factored into the determination of the allowance in the same manner as other defaulted loans.

(Continued)

15

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

The accounting guidance for troubled debt restructurings by creditors in Subtopic 310-40, Receivables – Troubled Debt Restructurings by Creditors was eliminated upon our adoption of ASU No. 2022-02 Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures effective January 1, 2023.

Derivatives: Derivative financial instruments are recognized as assets or liabilities at fair value. The accounting for changes in the fair value of derivatives depends on the use of the derivatives and whether the derivatives qualify for hedge accounting. Used as part of our asset and liability management to help manage interest rate risk, our derivatives have historically generally consisted of interest rate swap agreements that qualified for hedge accounting. We do not use derivatives for trading purposes.

Changes in the fair value of derivatives that are designated, for accounting purposes, as a hedge of the variability of cash flows to be received on various assets and liabilities and are effective are reported in other comprehensive income. They are later reclassified into earnings in the same periods during which the hedged transaction affects earnings and are included in the line item in which the hedged cash flows are recorded. If hedge accounting does not apply, changes in the fair value of derivatives are recognized immediately in current earnings as interest income or expense. We had no derivative instruments designated as hedges as of June 30, 2023, and December 31, 2022.

Goodwill and Core Deposit Intangible: GAAP requires us to determine the fair value of all the assets and liabilities of an acquired entity, and record their fair value on the date of acquisition. We employ a variety of means in determination of the fair value, including the use of discounted cash flow analysis, market comparisons and projected future revenue streams. For certain items we concluded to have the appropriate expertise to determine the fair value, we may choose to use our own calculation of fair value. In other cases, where the fair value is not readily determined, consultation with outside parties is used to determine fair value. Once valuations have been determined, the net difference between the price paid for the acquired company and the fair value of the balance sheet is recorded as goodwill. Goodwill is assessed at least annually for impairment, with any such impairment recognized in the period identified. A more frequent assessment is performed if there are material changes in the market place or within the organizational structure. We conducted an annual test during 2022 using step zero, with no impairment identified.

The core deposit intangible that arose from the merger with Firstbank was initially measured at fair value and is being amortized into noninterest expense over a ten-year period using the sum-of-the-years-digits methodology.

Revenue from Contracts with Customers: We record revenue from contracts with customers in accordance with Accounting Standards Codification Topic 606, “Revenue from Contracts with Customers” (“Topic 606”). Under Topic 606, we must identify the contract with a customer, identify the performance obligations in the contract, determine the transaction price, allocate the transaction price to the performance obligations in the contract, and recognize revenue when (or as) we satisfy a performance obligation. Significant revenue has not been recognized in the current reporting period that results from performance obligations satisfied in previous periods.

Our primary sources of revenue are derived from interest and dividends earned on loans, securities and other financial instruments that are not within the scope of Topic 606. We have evaluated the nature of our contracts with customers and determined that further disaggregation of revenue from contracts with customers into more granular categories beyond what is presented in the Consolidated Statements of Income was not necessary.

(Continued)

16

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    SIGNIFICANT ACCOUNTING POLICIES (Continued)

We generally satisfy our performance obligations on contracts with customers as services are rendered, and the transaction prices are typically fixed and charged either on a periodic basis (generally monthly) or based on activity. Because performance obligations are satisfied as services are rendered and the transaction prices are fixed, there is little judgment involved in applying Topic 606 that significantly affects the determination of the amount and timing of revenue from contracts with customers.

The following table depicts our sources of noninterest income presented in the Consolidated Statements of Income that are scoped within Topic 606:

	Three Months Ended June 30, 2023		Three Months Ended June 30, 2022		Six Months Ended June 30, 2023		Six Months Ended June 30, 2022
Service charges on deposit and sweep accounts	$	1,064,000	$	1,495,000	$	2,041,000	$	2,910,000
Credit and debit card fees		2,426,000		2,134,000		4,485,000		4,015,000
Payroll processing		572,000		464,000		1,317,000		1,102,000
Customer service fees		187,000		202,000		407,000		444,000

Service Charges on Deposit and Sweep Accounts: We earn fees from deposit and sweep customers for account maintenance, transaction-based and overdraft services. Account maintenance fees, which relate primarily to monthly maintenance, are earned over the course of the month reflecting the period over which we satisfy the performance obligation. Transaction-based fees, which include services such as stop payment and returned item charges, are recognized at the time the transaction is executed as that is the point in time we fulfill the customer request. Service charges on deposit and sweep accounts are withdrawn from the customer account balance.

Credit and Debit Card Fees: We earn interchange income on our cardholder debit and credit card usage. Interchange income is primarily comprised of fees whenever our debit and credit cards are processed through card payment networks such as Visa. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder.

Payroll Processing Fees: We earn fees from providing payroll processing services for our commercial clients. Fees are assessed for processing weekly or bi-weekly payroll files, reports and documents, as well as year-end tax-related files, reports and documents. Fees are recognized and collected as payroll processing services are completed for each payroll run and year-end processing activities.

Customer Service Fees: We earn fees by providing a variety of other services to our customers, such as wire transfers, check ordering, sales of cashier checks and money orders, and rentals of safe deposit boxes. Generally, fees are recognized and collected daily, concurrently with the point in time we fulfill the customer request. Safe deposit box rentals are on annual contracts, with fees generally earned at the time of the contract signing or renewal. Customer service fees are recorded as other noninterest income on our Consolidated Statements of Income.

Standards Recently Adopted: ASU No. 2022-02 Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures. This ASU eliminated the accounting guidance for troubled debt restructurings (“TDRs”) by creditors in Subtopic 310-40, Receivables – Troubled Debt Restructurings by Creditors, while adding disclosures for certain loan restructurings by creditors when a borrower is experiencing financial difficulty. This guidance requires an entity to determine whether the modification results in a new loan or a continuation of an existing loan. Additionally, the ASU requires disclosures of current period gross charge-offs by year of origination for financing receivables. This ASU was effective for fiscal years beginning after December 15, 2022. The prospective adoption of this ASU did not have a material impact on our financial results.

(Continued)

17

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2.    SECURITIES

The amortized cost and fair value of available for sale securities and the related pre-tax gross unrealized gains and losses recognized in accumulated other comprehensive income are as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
June 30, 2023
U.S. Government agency debt obligations	$	454,164,000	$	0	$	(61,070,000	)	$	393,094,000
Mortgage-backed securities		36,374,000		10,000		(5,864,000	)		30,520,000
Municipal general obligation bonds		165,793,000		511,000		(8,739,000	)		157,565,000
Municipal revenue bonds		30,010,000		104,000		(2,821,000	)		27,293,000
Other investments		500,000		0		0			500,000
	$	686,841,000	$	625,000	$	(78,494,000	)	$	608,972,000
December 31, 2022
U.S. Government agency debt obligations	$	453,836,000	$	0	$	(65,092,000	)	$	388,744,000
Mortgage-backed securities		38,002,000		19,000		(6,068,000	)		31,953,000
Municipal general obligation bonds		163,041,000		450,000		(9,058,000	)		154,433,000
Municipal revenue bonds		30,267,000		102,000		(3,063,000	)		27,306,000
Other investments		500,000		0		0			500,000
	$	685,646,000	$	571,000	$	(83,281,000	)	$	602,936,000

Securities with unrealized losses at June 30, 2023 and December 31, 2022, aggregated by investment category and length of time that individual securities have been in a continuous loss position, are as follows:

	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
June 30, 2023
U.S. Government agency debt obligations	$	2,862,000	$	940,000	$	390,232,000	$	60,130,000	$	393,094,000	$	61,070,000
Mortgage-backed securities		27,997,000		5,759,000		1,811,000		105,000		29,808,000		5,864,000
Municipal general obligation bonds		39,970,000		1,476,000		92,626,000		7,263,000		132,596,000		8,739,000
Municipal revenue bonds		7,262,000		810,000		15,628,000		2,011,000		22,890,000		2,821,000
	$	78,091,000	$	8,985,000	$	500,297,000	$	69,509,000	$	578,388,000	$	78,494,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2.    SECURITIES (Continued)

	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
December 31, 2022
U.S. Government agency debt obligations	$	53,019,000	$	5,713,000	$	335,725,000	$	59,379,000	$	388,744,000	$	65,092,000
Mortgage-backed securities		31,127,000		6,068,000		12,000		0		31,139,000		6,068,000
Municipal general obligation bonds		97,252,000		4,516,000		32,870,000		4,542,000		130,122,000		9,058,000
Municipal revenue bonds		12,532,000		1,141,000		10,609,000		1,922,000		23,141,000		3,063,000
	$	193,930,000	$	17,438,000	$	379,216,000	$	65,843,000	$	573,146,000	$	83,281,000

We evaluate securities in an unrealized loss position at least quarterly. Consideration is given to the financial condition of the issuer, and the intent and ability we have to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. For those debt securities whose fair value is less than their amortized cost basis, we also consider our intent to sell the security, whether it is more likely than not that we will be required to sell the security before recovery and if we do not expect to recover the entire amortized cost basis of the security. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred and the results of reviews of the issuer’s financial condition.

At June 30, 2023, 736 debt securities with estimated fair values totaling $578 million had unrealized losses aggregating $78.5 million. At December 31, 2022, 732 debt securities with estimated fair values totaling $573 million had unrealized losses aggregating $83.3 million. At June 30, 2023, unrealized losses aggregating $66.9 million were attributable to bonds issued or guaranteed by agencies of the U.S. federal government, while unrealized losses totaling $11.6 million were associated with bonds issued by state-based municipalities. For available for sale debt securities in an unrealized loss position, we first assess whether we intend to sell, or if it is more likely than not that we will be required to sell the security before recovery of the amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the debt security’s amortized cost basis is written down to fair value through income with the establishment of an allowance. For debt securities available for sale that do not meet the aforementioned criteria, we evaluate whether any decline in fair value is due to credit loss factors. In making this assessment, we consider any changes to the rating of the security by a rating agency and adverse conditions specifically related to the issuer of the security, among other factors.

(Continued)

19

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2.    SECURITIES (Continued)

The amortized cost and fair value of debt securities at June 30, 2023, by maturity, are shown in the following table. The contractual maturity is utilized for U.S. Government agency debt obligations and municipal bonds. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately. Weighted average yields are also reflected, with yields for municipal securities shown at their tax equivalent yield.

	Weighted Average Yield		Amortized Cost		Fair Value
Due in 2023		0.32%	$	12,635,000	$	12,401,000
Due in 2024 through 2028		1.32		319,466,000		291,127,000
Due in 2029 through 2033		2.02		278,432,000		237,792,000
Due in 2034 and beyond		3.64		39,434,000		36,632,000
Mortgage-backed securities		2.15		36,374,000		30,520,000
Other investments		8.50		500,000		500,000
Total available for sale securities		1.77%	$	686,841,000	$	608,972,000

No securities were sold during the first six months of 2023 or the full-year 2022.

Securities issued by the State of Michigan and all its political subdivisions had a combined amortized cost of $196 million and $193 million at June 30, 2023 and December 31, 2022, respectively, with estimated market values of $185 million and $182 million at the respective dates. We had no securities issued by all other states and their political subdivisions as of June 30, 2023, and December 31, 2022. Total securities of any other specific issuer, other than the U.S. Government and its agencies and the State of Michigan and all its political subdivisions, did not exceed 10% of shareholders’ equity.

The carrying value of U.S. Government agency debt obligation securities that are pledged to secure repurchase agreements was $219 million and $194 million at June 30, 2023, and December 31, 2022, respectively. The carrying value of U.S. Government agency debt obligation securities that are pledged to deposits was $58.4 million at June 30, 2023; we had no securities pledged to deposits as of December 31, 2022.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES

Our total loans at June 30, 2023 were $4.05 billion compared to $3.92 billion at December 31, 2022, an increase of $135 million, or 3.5%. The components of our loan portfolio disaggregated by class of loan within the loan portfolio segments at June 30, 2023 and December 31, 2022, and the percentage change in loans from the end of 2022 to the end of the second quarter of 2023, are as follows:

											Percent
	June 30, 2023					December 31, 2022					Increase
	Balance		%			Balance		%			(Decrease)
Commercial:
Commercial and industrial	$	1,212,196,000		29.9	%	$	1,185,083,000		30.3	%		2.3	%
Vacant land, land development, and residential construction		72,682,000		1.8			61,873,000		1.6			17.5
Real estate – owner occupied		659,201,000		16.3			639,192,000		16.3			3.1
Real estate – non-owner occupied *		957,221,000		23.6			979,214,000		25.0			(2.2	)
Real estate – multi-family and residential rental *		287,285,000		7.1			266,468,000		6.8			7.8
Total commercial		3,188,585,000		78.7			3,131,830,000		80.0			1.8
Retail:
1-4 family mortgages		833,198,000		20.6			755,036,000		19.3			10.4
Other consumer loans		30,060,000		0.7			29,753,000		0.7			1.0
Total retail		863,258,000		21.3			784,789,000		20.0			10.0
Total loans	$	4,051,843,000		100.0	%	$	3,916,619,000		100.0	%		3.5	%

(*) We have made certain reclassifications of how multi-family construction loans are disaggregated by loan segment. The table above reflects an increase of $54.5 million in Real Estate – Multi-Family and Residential Rental loans and a corresponding decrease in Real Estate – Non-Owner Occupied loans as of December 31, 2022. All the tables that follow have been adjusted to reflect the reclassifications as of the applicable dates.

Nonperforming loans as of June 30, 2023 and December 31, 2022 were as follows:

	June 30,		December 31,
	2023		2022
Loans past due 90 days or more still accruing interest	$	0	$	0
Nonaccrual loans		2,099,000		7,728,000
Total nonperforming loans	$	2,099,000	$	7,728,000

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

The recorded principal balance of nonperforming loans was as follows:

	June 30,		December 31,
	2023		2022
Commercial:
Commercial and industrial	$	249,000	$	6,024,000
Vacant land, land development, and residential construction		0		0
Real estate – owner occupied		116,000		248,000
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		365,000		6,272,000
Retail:
1-4 family mortgages		1,734,000		1,456,000
Other consumer loans		0		0
Total retail		1,734,000		1,456,000
Total nonperforming loans	$	2,099,000	$	7,728,000

(Continued)

22

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

An age analysis of past due loans is as follows as of June 30, 2023:

	30 – 59 Days Past Due		60 – 89 Days Past Due		Greater Than 89 Days Past Due		Total Past Due		Current		Total Loans		Recorded Balance > 89 Days and Accruing
Commercial:
Commercial and industrial	$	0	$	0	$	249,000	$	249,000	$	1,211,947,000	$	1,212,196,000	$	0
Vacant land, land development, and residential construction		0		0		0		0		72,682,000		72,682,000		0
Real estate – owner occupied		0		0		116,000		116,000		659,085,000		659,201,000		0
Real estate – non- owner occupied		0		0		0		0		957,221,000		957,221,000		0
Real estate – multi-family and residential rental		0		0		0		0		287,285,000		287,285,000		0
Total commercial		0		0		365,000		365,000		3,188,220,000		3,188,585,000		0
Retail:
1-4 family mortgages		602,000		83,000		184,000		869,000		832,329,000		833,198,000		0
Other consumer loans		4,000		4,000		0		8,000		30,052,000		30,060,000		0
Total retail		606,000		87,000		184,000		877,000		862,381,000		863,258,000		0
Total past due loans	$	606,000	$	87,000	$	549,000	$	1,242,000	$	4,050,601,000	$	4,051,843,000	$	0

(Continued)

23

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

An age analysis of past due loans is as follows as of December 31, 2022:

	30 – 59 Days Past Due		60 – 89 Days Past Due		Greater Than 89 Days Past Due		Total Past Due		Current		Total Loans		Recorded Balance > 89 Days and Accruing
Commercial:
Commercial and industrial	$	0	$	5,705,000	$	249,000	$	5,954,000	$	1,179,129,000	$	1,185,083,000	$	0
Vacant land, land development, and residential construction		0		0		0		0		61,873,000		61,873,000		0
Real estate – owner occupied		0		248,000		0		248,000		638,944,000		639,192,000		0
Real estate – non-owner occupied		0		0		0		0		979,214,000		979,214,000		0
Real estate – multi-family and residential rental		0		0		0		0		266,468,000		266,468,000		0
Total commercial		0		5,953,000		249,000		6,202,000		3,125,628,000		3,131,830,000		0
Retail:
1-4 family mortgages		1,334,000		88,000		116,000		1,538,000		753,498,000		755,036,000		0
Other consumer loans		15,000		1,000		0		16,000		29,737,000		29,753,000		0
Total retail		1,349,000		89,000		116,000		1,554,000		783,235,000		784,789,000		0
Total past due loans	$	1,349,000	$	6,042,000	$	365,000	$	7,756,000	$	3,908,863,000	$	3,916,619,000	$	0

Collateral dependent loans are loans for which the repayment is expected to be provided substantially through the operation or sale of the collateral and the borrower is experiencing financial difficulty. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on an internal watch list. Senior management and the Board of Directors review this list regularly. Fair value estimates of collateral on distressed lending relationships, as well as on foreclosed and repossessed assets, are reviewed periodically. We also have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions. Under CECL for collateral dependent loans in instances where the borrower is experiencing financial difficulties, we adopted the practical expedient to measure the allowance based on the fair value of collateral. The allowance is calculated on an individual loan basis based on the shortfall between the fair value of the loan’s collateral and the recorded principal balance. If the fair value of the collateral exceeds the recorded principal balance, no allowance is required. Collateral dependent loans, representing the entire amount of loans on nonaccrual, totaled $2.1 million and $7.7 million as of June 30, 2023 and December 31, 2022, respectively.

(Continued)

24

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Nonaccrual loans as of June 30, 2023 were as follows:

	Amortized		Related
	Cost		Allowance
With no allowance recorded:
Commercial:
Commercial and industrial	$	249,000	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		249,000		0
Retail:
1-4 family mortgages		1,315,000		0
Other consumer loans		0		0
Total retail		1,315,000		0
Total with no allowance recorded	$	1,564,000	$	0
With an allowance recorded:
Commercial:
Commercial and industrial	$	0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		116,000		15,000
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		116,000		15,000
Retail:
1-4 family mortgages		419,000		292,000
Other consumer loans		0		0
Total retail		419,000		292,000
Total with an allowance recorded	$	535,000	$	307,000
Total nonaccrual loans:
Commercial	$	365,000	$	15,000
Retail		1,734,000		292,000
Total nonaccrual loans	$	2,099,000	$	307,000

No interest income was recognized on nonaccrual loans during the first six months of 2023.

(Continued)

25

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Nonaccrual loans as of December 31, 2022 were as follows:

	Amortized		Related
	Cost		Allowance
With no allowance recorded:
Commercial:
Commercial and industrial	$	249,000	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		249,000		0
Retail:
1-4 family mortgages		1,064,000		0
Other consumer loans		0		0
Total retail		1,064,000		0
Total with no allowance recorded	$	1,313,000	$	0
With an allowance recorded:
Commercial:
Commercial and industrial	$	5,775,000	$	2,051,000
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		248,000		32,000
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		6,023,000		2,083,000
Retail:
1-4 family mortgages		392,000		200,000
Other consumer loans		0		0
Total retail		392,000		200,000
Total with an allowance recorded	$	6,415,000	$	2,283,000
Total nonaccrual loans:
Commercial	$	6,272,000	$	2,083,000
Retail		1,456,000		200,000
Total nonaccrual loans	$	7,728,000	$	2,283,000

No interest income was recognized on nonaccrual loans during 2022.

(Continued)

26

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Credit Quality Indicators. We utilize a comprehensive grading system for our commercial loans. All commercial loans are graded on a ten grade rating system. The rating system utilizes standardized grade paradigms that analyze several critical factors such as cash flow, operating performance, financial condition, collateral, industry condition and management. All commercial loans are graded at inception and reviewed and, if appropriate, re-graded at various intervals thereafter. The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers and employ a disciplined and formalized review of the existence of collateral and its value. All commercial loans are graded using the following criteria:

Grade 1.	“Exceptional”  Loans with this rating contain very little, if any, risk.
Grade 2.	“Outstanding”  Loans with this rating have excellent and stable sources of repayment and conform to bank policy and regulatory requirements.
Grade 3.	“Very Good”  Loans with this rating have strong sources of repayment and conform to bank policy and regulatory requirements. These are loans for which repayment risks are acceptable.
Grade 4.	“Good”  Loans with this rating have solid sources of repayment and conform to bank policy and regulatory requirements. These are loans for which repayment risks are modest.
Grade 5.	“Acceptable”  Loans with this rating exhibit acceptable sources of repayment and conform with most bank policies and all regulatory requirements. These are for loans for which repayment risks are satisfactory.
Grade 6.	“Monitor”  Loans with this rating are considered to have emerging weaknesses which may include negative current cash flow, high leverage, or operating losses. Generally, if further deterioration is observed, these credits will be downgraded to the criticized asset report.
Grade 7.	“Special Mention”  Loans with this rating have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.
Grade 8.	“Substandard”  Loans with this rate are inadequately protected by current sound net worth, paying capacity of the obligor, or of the pledged collateral, if any. A Substandard loan normally has one or more well-defined weaknesses that jeopardize the repayment of the debt. They are characterized by the distinct possibility of loss if the deficiencies are not corrected.
Grade 9.	“Doubtful”  Loans with this rating exhibit all the weaknesses inherent in the Substandard classification and where collection or liquidation in full is highly questionable and improbable.
Grade 10.	“Loss”  Loans with this rating are considered uncollectable, and of such little value that continuance as an active asset is not warranted.

The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors’ rights in order to preserve our collateral position. Retail loans that reach 90 days or more past due are generally placed into nonaccrual status and are categorized as nonperforming.

(Continued)

27

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3 .   LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

The following table reflects amortized cost basis of loans and year-to-date loan charge-offs as of June 30, 2023 based on year of origination (dollars in thousands):

	2023		2022		2021		2020		2019		Prior		Term Total		Revolving Loans		Grand Total
Commercial:
Commercial and Industrial:
Grades 1 – 4	$	70,344	$	110,829	$	115,238	$	34,358	$	7,818	$	9,862	$	348,449	$	395,751	$	744,200
Grades 5 – 7		57,388		101,094		39,034		24,439		7,896		186		230,037		211,809		441,846
Grades 8 – 9		9,791		0		266		0		0		0		10,057		16,093		26,150
Total	$	137,523	$	211,923	$	154,538	$	58,797	$	15,714	$	10,048	$	588,543	$	623,653	$	1,212,196
Current year-to-date gross write offs	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	218	$	218
Vacant Land, Land Development and Residential Construction:
Grades 1 – 4	$	12,715	$	22,089	$	3,369	$	2,835	$	0	$	298	$	41,306	$	0	$	41,306
Grades 5 – 7		11,504		15,308		3,373		330		45		546		31,106		174		31,280
Grades 8 – 9		11		0		0		0		0		85		96		0		96
Total	$	24,230	$	37,397	$	6,742	$	3,165	$	45	$	929	$	72,508	$	174	$	72,682
Current year-to-date gross write offs	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	0
Real Estate – Owner Occupied:
Grades 1 – 4	$	143,011	$	115,599	$	83,379	$	51,608	$	18,025	$	18,344	$	429,966	$	0	$	429,966
Grades 5 – 7		60,088		76,351		38,774		30,039		9,739		11,196		226,187		48		226,235
Grades 8 – 9		207		2,635		0		42		0		116		3,000		0		3,000
Total	$	203,306	$	194,585	$	122,153	$	81,689	$	27,764	$	29,656	$	659,153	$	48	$	659,201
Current year-to-date gross write offs	$	0	$	14	$	0	$	0	$	0	$	0	$	14	$	0	$	14
Real Estate – Non-Owner Occupied:
Grades 1 – 4	$	29,085	$	96,215	$	117,813	$	95,378	$	42,493	$	39,708	$	420,692	$	0	$	420,692
Grades 5 – 7		118,268		137,493		136,069		99,324		6,690		26,538		524,382		0		524,382
Grades 8 – 9		0		6,575		5,572		0		0		0		12,147		0		12,147
Total	$	147,353	$	240,283	$	259,454	$	194,702	$	49,183	$	66,246	$	957,221	$	0	$	957,221
Current year-to-date gross write offs	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	0
Real Estate – Multi-Family and Residential Rental:
Grades 1 – 4	$	14,641	$	44,570	$	58,445	$	35,626	$	5,057	$	6,031	$	164,370	$	0	$	164,370
Grades 5 – 7		41,454		48,247		5,536		11,661		2,947		1,778		111,623		0		111,623
Grades 8 – 9		11,250		0		0		0		0		42		11,292		0		11,292
Total	$	67,345	$	92,817	$	63,981	$	47,287	$	8,004	$	7,851	$	287,285	$	0	$	287,285
Current year-to-date gross write offs	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	0	$	0
Total Commercial	$	579,757	$	777,005	$	606,868	$	385,640	$	100,710	$	114,730	$	2,564,710	$	623,875	$	3,188,585
Total Comm current YTD gross write offs	$	0	$	14	$	0	$	0	$	0	$	0	$	14	$	218	$	232

(Continued)

28

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

	2023		2022		2021		2020		2019		Prior		Term Total		Revolving Loans		Grand Total
Retail:
1-4 Family Mortgages:
Performing	$	79,136	$	330,384	$	238,932	$	85,225	$	11,191	$	50,146	$	795,014	$	36,450	$	831,464
Nonperforming		0		82		491		0		12		1,149		1,734		0		1,734
Total	$	79,136	$	330,466	$	239,423	$	85,225	$	11,203	$	51,295	$	796,748	$	36,450	$	833,198
Current year-to-date gross write offs	$	0	$	52	$	0	$	0	$	0	$	239	$	291	$	21	$	312
Other Consumer Loans:
Performing	$	3,106	$	3,368	$	2,043	$	687	$	820	$	441	$	10,465	$	19,595	$	30,060
Nonperforming		0		0		0		0		0		0		0		0		0
Total	$	3,106	$	3,368	$	2,043	$	687	$	820	$	441	$	10,465	$	19,595	$	30,060
Current year-to-date gross write offs	$	0	$	3	$	0	$	0	$	0	$	3	$	6	$	17	$	23
Total Retail	$	82,242	$	333,834	$	241,466	$	85,912	$	12,023	$	51,736	$	807,213	$	56,045	$	863,258
Total Retail Current YTD gross write offs	$	0	$	55	$	0	$	0	$	0	$	242	$	297	$	38	$	335
Grand Total	$	661,999	$	1,110,839	$	848,334	$	471,552	$	112,733	$	166,466	$	3,371,923	$	679,920	$	4,051,843
Grand Total Current YTD gross write offs	$	0	$	69	$	0	$	0	$	0	$	242	$	311	$	256	$	567

There were no revolving loans converted to term loans during the first six months of 2023.

(Continued)

29

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

The following table reflects amortized cost of basis of loans as of December 31, 2022 based on year of origination (dollars in thousands):

	2022		2021		2020		2019		2018		Prior		Term Total		Revolving Loans		Grand Total
Commercial:
Commercial and Industrial:
Grades 1 – 4	$	115,494	$	141,481	$	43,961	$	9,194	$	3,230	$	9,851	$	323,211	$	396,372	$	719,583
Grades 5 – 7		151,783		47,030		31,697		8,870		569		93		240,042		210,363		450,405
Grades 8 – 9		3,784		249		0		0		48		29		4,110		10,985		15,095
Total	$	271,061	$	188,760	$	75,658	$	18,064	$	3,847	$	9,973	$	567,363	$	617,720	$	1,185,083
Vacant Land, Land Development and Residential Construction:
Grades 1 – 4	$	31,756	$	6,196	$	3,428	$	0	$	0	$	331	$	41,711	$	0	$	41,711
Grades 5 – 7		10,270		8,760		351		50		0		626		20,057		0		20,057
Grades 8 – 9		0		0		0		0		14		91		105		0		105
Total	$	42,026	$	14,956	$	3,779	$	50	$	14	$	1,048	$	61,873	$	0	$	61,873
Real Estate – Owner Occupied:
Grades 1 – 4	$	194,072	$	113,528	$	53,630	$	19,670	$	19,279	$	6,162	$	406,341	$	0	$	406,341
Grades 5 – 7		115,720		56,173		33,913		10,245		12,550		1,165		229,766		0		229,766
Grades 8 – 9		2,919		0		44		0		122		0		3,085		0		3,085
Total	$	312,711	$	169,701	$	87,587	$	29,915	$	31,951	$	7,327	$	639,192	$	0	$	639,192
Real Estate – Non-Owner Occupied:
Grades 1 – 4	$	121,281	$	152,035	$	89,125	$	44,196	$	10,079	$	12,018	$	428,734	$	0	$	428,734
Grades 5 – 7		176,217		142,645		133,163		35,200		13,456		37,399		538,080		0		538,080
Grades 8 – 9		6,712		5,688		0		0		0		0		12,400		0		12,400
Total	$	304,210	$	300,368	$	222,288	$	79,396	$	23,535	$	49,417	$	979,214	$	0	$	979,214
Real Estate – Multi-Family and Residential Rental:
Grades 1 – 4	$	39,342	$	49,178	$	36,348	$	5,306	$	3,082	$	4,003	$	137,259	$	0	$	137,259
Grades 5 – 7		56,018		47,474		19,666		3,162		2,557		283		129,160		0		129,160
Grades 8 – 9		0		0		0		0		0		49		49		0		49
Total	$	95,360	$	96,652	$	56,014	$	8,468	$	5,639	$	4,335	$	266,468	$	0	$	266,468
Total Commercial	$	1,025,368	$	770,437	$	445,326	$	135,893	$	64,986	$	72,100	$	2,514,110	$	617,720	$	3,131,830

(Continued)

30

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

	2022		2021		2020		2019		2018		Prior		Term Total		Revolving Loans		Grand Total
Retail:
1-4 Family Mortgages:
Performing	$	313,611	$	242,950	$	91,936	$	12,094	$	14,297	$	41,622	$	716,510	$	37,070	$	753,580
Nonperforming		142		82		0		0		203		1,029		1,456		0		1,456
Total	$	313,753	$	243,032	$	91,936	$	12,094	$	14,500	$	42,651	$	717,966	$	37,070	$	755,036
Other Consumer Loans:
Performing	$	4,349	$	2,870	$	1,040	$	1,074	$	395	$	430	$	10,158	$	19,595	$	29,753
Nonperforming		0		0		0		0		0		0		0		0		0
Total	$	4,349	$	2,870	$	1,040	$	1,074	$	395	$	430	$	10,158	$	19,595	$	29,753
Total Retail	$	318,102	$	245,902	$	92,976	$	13,168	$	14,895	$	43,081	$	728,124	$	56,665	$	784,789
Grand Total	$	1,343,470	$	1,016,339	$	538,302	$	149,061	$	79,881	$	115,181	$	3,242,234	$	674,385	$	3,916,619

There were no revolving loans converted to term loans during 2022.

(Continued)

31

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Activity in the allowance for credit losses during the three months and six months ended June 30, 2023 is as follows (dollars in thousands):

	Commercial and industrial			Commercial vacant land, land development and residential construction			Commercial real estate – owner occupied			Commercial real estate – non-owner occupied			Commercial real estate – multi-family and residential rental		1-4 family mortgages			Other consumer loans			Unallocated			Total
Allowance for credit losses:
Balance at 3-31-23	$	10,181		$	510		$	5,711		$	9,168		$	2,427	$	14,648		$	156		$	76		$	42,877
Provision for credit losses		(3,616	)		(217	)		105			(479	)		1,268		4,973			21			(55	)		2,000
Charge-offs		(182	)		0			0			0			0		(270	)		(9	)		0			(461	)
Recoveries		89			11			22			0			5		147			31			0			305
Ending balance	$	6,472		$	304		$	5,838		$	8,689		$	3,700	$	19,498		$	199		$	21		$	44,721
Balance at 12-31-22	$	10,203		$	490		$	5,914		$	9,242		$	2,191	$	14,027		$	160		$	19		$	42,246
Provision for credit losses		(3,623	)		(198	)		(132	)		(553	)		1,497		5,591			16			2			2,600
Charge-offs		(218	)		0			(14	)		0			0		(312	)		(23	)		0			(567	)
Recoveries		110			12			70			0			12		192			46			0			442
Ending balance	$	6,472		$	304		$	5,838		$	8,689		$	3,700	$	19,498		$	199		$	21		$	44,721

(Continued)

32

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Activity in the allowance for credit losses during the three months and six months ended June 30, 2022 is as follows (dollars in thousands):

	Commercial and industrial			Commercial vacant land, land development and residential construction			Commercial real estate – owner occupied			Commercial real estate – non-owner occupied			Commercial real estate – multi-family and residential rental			1-4 family mortgages			Other consumer loans			Unallocated			Total
Allowance for credit losses:
Balance at 3-31-22	$	8,413		$	455		$	5,803		$	9,932		$	1,666		$	8,562		$	191		$	131		$	35,153
Provision for credit losses		150			(10	)		(251	)		(683	)		(33	)		1,464			(28	)		(109	)		500
Charge-offs		0			0			0			0			0			0			(15	)		0			(15	)
Recoveries		45			1			26			0			6			241			17			0			336
Ending balance	$	8,608		$	446		$	5,578		$	9,249		$	1,639		$	10,267		$	165		$	22		$	35,974
Balance at 12-31-21	$	10,782		$	420		$	6,045		$	12,990		$	2,006		$	2,449		$	626		$	45		$	35,363
Adoption of ASU 2016-13		(1,571	)		(43	)		(560	)		(2,534	)		(621	)		5,395			(411	)		(55	)		(400	)
Provision for credit losses		(592	)		96			35			(1,207	)		240			2,057			(61	)		32			600
Charge-offs		(171	)		(29	)		0			0			0			(2	)		(18	)		0			(220	)
Recoveries		160			2			58			0			14			368			29			0			631
Ending balance	$	8,608		$	446		$	5,578		$	9,249		$	1,639		$	10,267		$	165		$	22		$	35,974

(Continued)

33

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

The following table presents the financial effect by type of modification made to borrowers experiencing financial difficulty and loan segment:

	Interest Rate Reduction		Term Extension		Principal Forgiveness
Commercial:
Commercial and industrial	$	0	$	10,520,000	$	0
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		0		207,000		0
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total commercial	$	0	$	10,727,000	$	0
Retail:
1-4 family mortgages		0		0		0
Other consumer loans		0		0		0
Total retail	$	0	$	0	$	0
Total loans	$	0	$	10,727,000	$	0

Loans listed under Term Extension were generally granted a series of short-term maturity extensions as part of workout process and associated forbearance agreements.

The following table presents the period-end amortized cost basis of loans that have been modified in the past twelve months to borrowers experiencing financial difficulty by payment status and loan segment:

	Current		30 – 89 Days Past Due		90 + Days Past Due		Total
Commercial:
Commercial and industrial	$	10,520,000	$	0	$	0	$	10,520,000
Vacant land, land development and residential construction		0		0		0		0
Real estate – owner occupied		207,000		0		0		207,000
Real estate – non-owner occupied		0		0		0		0
Real estate – multi-family and residential rental		0		0		0		0
Total commercial	$	10,727,000	$	0	$	0	$	10,727,000
Retail:
1-4 family mortgages		0		0		0		0
Other consumer loans		0		0		0		0
Total retail	$	0	$	0	$	0	$	0
Total loans	$	10,727,000	$	0	$	0	$	10,727,000

(Continued)

34

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Loans modified as troubled debt restructurings during the three months ended June 30, 2022 were as follows:

	Number of Contracts		Pre- Modification Recorded Principal Balance		Post- Modification Recorded Principal Balance
Commercial:
Commercial and industrial		2	$	6,573,000	$	6,573,000
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		0		0		0
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total commercial		2		6,573,000		6,573,000
Retail:
1-4 family mortgages		1		84,000		84,000
Other consumer loans		0		0		0
Total retail		1		84,000		84,000
Total loans		3	$	6,657,000	$	6,657,000

Loans modified as troubled debt restructurings during the six months ended June 30, 2022 were as follows:

	Number of Contracts		Pre- Modification Recorded Principal Balance		Post- Modification Recorded Principal Balance
Commercial:
Commercial and industrial		2	$	6,573,000	$	6,573,000
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		0		0		0
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total commercial		2		6,573,000		6,573,000
Retail:
1-4 family mortgages		3		212,000		212,000
Other consumer loans		0		0		0
Total retail		3		212,000		212,000
Total loans		5	$	6,785,000	$	6,785,000

(Continued)

35

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.    LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

The following loans, modified as troubled debt restructurings within the previous twelve months, became over 30 days past due within the three months ended June 30, 2022 (amounts as of period end):

	Number of Contracts		Recorded Principal Balance
Commercial:
Commercial and industrial		0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		0		0
Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0
Total		0	$	0

The following loans, modified as troubled debt restructurings within the previous twelve months, became over 30 days past due within the six months ended June 30, 2022 (amounts as of period end):

	Number of Contracts		Recorded Principal Balance
Commercial:
Commercial and industrial		0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		0		0
Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0
Total		0	$	0

(Continued)

36

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Activity for loans categorized as troubled debt restructurings during the three months ended June 30, 2022 is as follows:

	Commercial and Industrial		Commercial Vacant Land, Land Development, and Residential Construction		Commercial Real Estate - Owner Occupied			Commercial Real Estate - Non-Owner Occupied			Commercial Real Estate - Multi-Family and Residential Rental
Commercial Loan Portfolio:
Beginning Balance	$	2,829,000	$	0	$	89,000		$	143,000		$	90,000
Charge-Offs		0		0		0			0			0
Payments (net)		536,000		0		(2,000	)		(4,000	)		(2,000	)
Transfers to ORE		0		0		0			0			0
Net Additions/Deletions		6,573,000		0		0			0			0
Ending Balance	$	9,938,000	$	0	$	87,000		$	139,000		$	88,000

	Retail			Retail
	1-4 Family			Other Consumer
	Mortgages			Loans
Retail Loan Portfolio:
Beginning Balance	$	2,346,000		$	13,000
Charge-Offs		0			0
Payments (net)		(91,000	)		(10,000	)
Transfers to ORE		0			0
Net Additions/Deletions		84,000			0
Ending Balance	$	2,339,000		$	3,000

(Continued)

37

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3.     LOANS AND ALLOWANCE FOR CREDIT LOSSES (Continued)

Activity for loans categorized as troubled debt restructurings during the six months ended June 30, 2022 is as follows:

	Commercial and Industrial		Commercial Vacant Land, Land Development, and Residential Construction		Commercial Real Estate - Owner Occupied			Commercial Real Estate - Non-Owner Occupied			Commercial Real Estate - Multi-Family and Residential Rental
Commercial Loan Portfolio:
Beginning Balance	$	4,973,000	$	0	$	10,435,000		$	146,000		$	91,000
Charge-Offs		0		0		0			0			0
Payments (net)		324,000		0		(9,679,000	)		(7,000	)		(3,000	)
Transfers to ORE		0		0		0			0			0
Net Additions/Deletions		4,641,000		0		(669,000	)		0			0
Ending Balance	$	9,938,000	$	0	$	87,000		$	139,000		$	88,000

	Retail			Retail
	1-4 Family			Other Consumer
	Mortgages			Loans
Retail Loan Portfolio:
Beginning Balance	$	627,000		$	1,202,000
Charge-Offs		0			0
Payments (net)		(169,000	)		(12,000	)
Transfers to ORE		0			0
Net Additions/Deletions (1)		1,881,000			(1,187,000	)
Ending Balance	$	2,339,000		$	3,000

(1) Includes $1.2 million in the transfer of home equity lines of credit from other consumer loans to 1-4 family mortgages in association with the adoption of the CECL methodology effective January 1, 2022.

(Continued)

38

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4.    PREMISES AND EQUIPMENT, NET

Premises and equipment are comprised of the following:

	June 30, 2023		December 31, 2022
Land and improvements	$	13,060,000	$	13,532,000
Buildings		56,637,000		53,865,000
Furniture and equipment		23,689,000		22,941,000
		93,386,000		90,338,000
Less: accumulated depreciation		41,095,000		38,862,000
Premises and equipment, net	$	52,291,000	$	51,476,000

Depreciation expense totaled $1.4 million and $1.5 million during the second quarters of 2023 and 2022, respectively. Depreciation expense totaled $2.9 million during the first six months of 2023, compared to $3.1 million during the first six months of 2022.

We enter into facility leases in the normal course of business. As of June 30, 2023, we were under lease contracts for eleven of our banking facilities. The leases have maturity dates ranging from February, 2024 through December, 2029, with a weighted average life of 2.4 years as of June 30, 2023. All of our leases have multiple three- to five-year extensions; however, these were not factored in the lease maturities and weighted average lease term as it was not reasonably certain we would exercise the options on the dates we entered into the lease agreements.

Leases are classified as either operating or finance leases at the lease commencement date, with all of our current leases determined to be operating leases. Lease expense for operating leases is recognized on a straight-line basis over the lease term. Right-of-use assets represent our right to use an underlying asset for the lease term, while lease liabilities represent our obligation to make lease payments arising from the lease. Right-of-use assets and lease liabilities are recognized at the lease commencement date at the estimated present value of lease payments over the lease term. We use our incremental borrowing rate, on a collateralized basis, at lease commencement to calculate the present value of lease payments. The weighted average discount rate for leases was 5.8% as of June 30, 2023.

The right-of-use assets, included in premises and equipment, net on our Consolidated Balance Sheets, and the lease liabilities, included in other liabilities on our Consolidated Balance Sheets, totaled $3.8 million and $3.5 million as of June 30, 2023, and December 31, 2022, respectively. As permitted by applicable accounting standards, we have elected not to recognize short-term leases with original terms of twelve months or less on our Consolidated Balance Sheet. Total operating lease expense associated with the leases aggregated $0.5 million and $0.2 million during the second quarters of 2023 and 2022, respectively, and $0.9 million and $0.4 million during the first six months of 2023 and 2022, respectively.

(Continued)

39

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4.    PREMISES AND EQUIPMENT, NET (Continued)

Future lease payments were as follows as of June 30, 2023:

2023	$	604,000
2024		1,012,000
2025		578,000
2026		479,000
2027		434,000
Thereafter		1,638,000
Total undiscounted lease payments		4,745,000
Less effect of discounting		(995,000	)
Present value of future lease payments (lease liability)		3,750,000

5.    DEPOSITS

Our total deposits at June 30, 2023 totaled $3.76 billion, an increase of $44.0 million, or 1.2%, from December 31, 2022. The components of our outstanding balances at June 30, 2023 and December 31, 2022, and percentage change in deposits from the end of 2022 to the end of the second quarter of 2023, are as follows:

	June 30, 2023					December 31, 2022					Percent Increase
	Balance		%			Balance		%			(Decrease)
Noninterest-bearing checking	$	1,371,633,000		36.5	%	$	1,604,750,000		43.2	%		(14.5	)%
Interest-bearing checking		541,168,000		14.4			575,028,000		15.5			(5.9	)
Money market		927,143,000		24.7			776,723,000		20.9			19.4
Savings		314,606,000		8.4			381,602,000		10.3			(17.6	)
Time, under $100,000		144,052,000		3.8			113,099,000		3.0			27.4
Time, $100,000 and over		346,908,000		9.2			261,609,000		7.1			32.6
Total local deposits		3,645,510,000		97.0			3,712,811,000		100.0			(1.8	)
Out-of-area time, $100,000 and over		111,279,000		3.0			0		0.0			N/A
Total deposits	$	3,756,789,000		100.0	%	$	3,712,811,000		100.0	%		1.2	%

(Continued)

40

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

6.    SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase (“repurchase agreements”) are offered principally to certain large deposit customers. Information relating to our repurchase agreements follows:

	Six Months Ended			Twelve Months Ended
	June 30, 2023			December 31, 2022
Outstanding balance at end of period	$	219,457,000		$	194,340,000
Average interest rate at end of period		1.52	%		0.75	%
Average daily balance during the period	$	213,853,000		$	200,499,000
Average interest rate during the period		1.17	%		0.15	%
Maximum daily balance during the period	$	262,992,000		$	235,577,000

Repurchase agreements have maturities of one business day. Repurchase agreements are treated as financings, and the obligations to repurchase securities sold are reflected as liabilities on our Consolidated Balance Sheets. Repurchase agreements are secured by U.S. Government agency securities with an aggregate fair value equal to the aggregate outstanding balance of the repurchase agreements. The securities, which are included in securities available for sale on our Consolidated Balance Sheets, are held in safekeeping by a correspondent bank.

7.    FEDERAL HOME LOAN BANK OF INDIANAPOLIS ADVANCES

FHLBI bullet advances totaled $440 million at June 30, 2023, and were scheduled to mature at varying dates from July 2023 through June 2028, with fixed rates of interest from 0.55% to 5.05% and averaging 2.79%. FHLBI bullet advances totaled $280 million at December 31, 2022, and were scheduled to mature at varying dates from January 2023 through June 2027, with fixed rates of interest from 0.55% to 3.13% and averaging 1.84%.

Maturities of FHLBI bullet advances as of June 30, 2023 were as follows:

2023	$	40,000,000
2024		90,000,000
2025		80,000,000
2026		80,000,000
2027		90,000,000
Thereafter		60,000,000

(Continued)

41

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

7.    FEDERAL HOME LOAN BANK OF INDIANAPOLIS ADVANCES (Continued)

FHLBI amortizing advances totaled $27.9 million as of June 30, 2023, with an average rate of 2.52% and with final maturities in 2042. FHLBI amortizing advances totaled $28.3 million as of December 31, 2022, with an average rate of 2.52% and with final maturities in 2042. FHLBI amortizing advances are obtained periodically to assist in managing interest rate risk associated with certain longer-term fixed rate commercial loans, with annual principal payments that closely align with the scheduled amortization of the underlying commercial loans.

Scheduled principal payments on FHLBI amortizing advances as of June 30, 2023 were as follows:

2023	$	0
2024		826,000
2025		862,000
2026		899,000
2027		938,000
Thereafter		24,385,000

Each advance is payable at its maturity date, and is subject to a prepayment fee if paid prior to the maturity date. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2023 totaled $860 million, with remaining availability based on collateral of $386 million.

8.    COMMITMENTS AND OFF-BALANCE SHEET RISK

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Loan commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Standby letters of credit are conditional commitments issued by our bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. Our maximum exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Collateral, such as accounts receivable, securities, inventory, and property and equipment, is generally obtained based on management’s credit assessment of the borrower.

We are required to consider expected credit losses associated with loan commitments over the contractual period in which we are exposed to credit risk on the underlying commitments unless the obligation is unconditionally cancellable by us. Any allowance for off-balance sheet credit exposures is reported as an other liability on our Consolidated Balance Sheet and is increased or decreased via other noninterest expense on our Consolidated Statement of Income. The calculation includes consideration of the likelihood that funding will occur and forecasted credit losses on commitments expected to be funded over their estimated lives. The allowance is calculated using the same aggregate reserve rates calculated for the funded portion of loans at the portfolio level applied to the amount of commitments expected to be funded.

(Continued)

42

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

8.    COMMITMENTS AND OFF-BALANCE SHEET RISK (Continued)

For commercial lines of credit, retail lines of credit and credit card average outstanding balances, we determined allowance requirements by calculating the difference between the average percent outstanding of the funded commitments over the past several years to actual percent outstanding at the end of the period and applying the respective expected loss allocation factors to the difference as this difference represents the average of unfunded commitments we expect to eventually be drawn upon. The calculated allowance aggregated $0.6 million and $0.1 million as of June 30, 2023 and December 31, 2022, respectively. We do not reserve for residential mortgage construction loans, as the loans are for one year or less and draws are governed by the receipt and satisfactory review of contractor and subcontractor sworn statements, lien waivers and title insurance company endorsements. Letters of credit are rarely drawn.

At June 30, 2023, and December 31, 2022, the rates on existing off-balance sheet instruments were substantially equivalent to current market rates, considering the underlying credit standing of the counterparties.

A summary of the contractual amounts of our financial instruments with off-balance sheet risk at June 30, 2023 and December 31, 2022 is as follows: 

	June 30,		December 31,
	2023		2022
Commercial unused lines of credit	$	1,526,800,000	$	1,283,703,000
Unused lines of credit secured by 1–4 family residential properties		73,379,000		71,972,000
Credit card unused lines of credit		133,235,000		123,687,000
Other consumer unused lines of credit		63,090,000		75,747,000
Commitments to make loans		350,611,000		329,646,000
Standby letters of credit		24,147,000		23,539,000
	$	2,171,262,000	$	1,908,294,000

9.    DERIVATIVES AND HEDGING ACTIVITIES

We are exposed to certain risks arising from both business operations and economic conditions. We principally manage the exposure to a wide variety of operational risks through core business activities. Economic risks, including interest rate, liquidity and credit risk, are primarily administered via the amount, sources and duration of assets and liabilities. Derivative financial instruments may also be used to assist in managing economic risks.

Derivatives not designated as hedges are not speculative and result from a service provided to certain commercial loan borrowers. We execute interest rate swaps with commercial banking customers desiring longer-term fixed rate loans, while simultaneously entering into interest rate swaps with correspondent banks to offset the impact of the interest rate swaps with the commercial banking customers. The net result is the desired floating rate loans and a minimization of the risk exposure of the interest rate swap transactions.

As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the commercial banking customer interest rate swaps and the offsetting interest rate swaps with the correspondent banks are recognized directly to earnings. Fees paid to us by the correspondent banks are recognized as noninterest income on our Consolidated Statements of Income on the settlement date.

(Continued)

43

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

9.    DERIVATIVES AND HEDGING ACTIVITIES (Continued)

The fair values of derivative instruments as of June 30, 2023, are reflected in the following table.

	Notional Amount		Balance Sheet Location	Fair Value
Derivative Assets
Interest rate swaps	$	548,224,000	Other Assets	$	26,880,000
Derivative Liabilities
Interest rate swaps		548,224,000	Other Liabilities		27,190,000

The effect of interest rate swaps that are not designated as hedging instruments resulted in expense of $0.1 million during the first six months of 2023 that was recorded in other noninterest expense on our Consolidated Statements of Income. The fair value of interest rate swaps in a liability position, which includes accrued interest, was $27.2 million as of June 30, 2023. We have master netting arrangements with our correspondent banks that allow us to net receivables and payables. The netting agreement also allows us to net related cash collateral received and transferred up to the fair value exposure amount. We have elected to not offset these transactions on the Consolidated Balance Sheets. As of June 30, 2023, the gross amount of derivative assets subject to master netting agreements presented on the Consolidated Balance Sheets was $25.8 million, while cash collateral reflecting cash requirements from our counterparties to us totaled $27.0 million, providing for an over-collateralized position on the Consolidated Balance Sheets of $1.2 million. As of June 30, 2023, the gross amount of derivative liabilities subject to master netting agreements presented on the Consolidated Balance Sheets was $1.4 million, while cash collateral reflecting cash requirements from us to our counterparties totaled $1.2 million, and the net amount of derivative liabilities not offset on the Consolidated Balance Sheets was $0.2 million. Cash collateral amounts, which are based on daily fair value calculations, are adjusted daily if fair value changes exceed an aggregate of $250,000. Interest rate swaps entered into with commercial loan customers had notional amounts aggregating $548 million as of June 30, 2023. Associated credit exposure is generally mitigated by securing the interest rates swaps with the underlying collateral of the loan instruments.

The fair values of derivative instruments as of December 31, 2022, are reflected in the following table.

	Notional Amount		Balance Sheet Location	Fair Value
Derivative Assets
Interest rate swaps	$	401,572,000	Other Assets	$	25,697,000
Derivative Liabilities
Interest rate swaps		401,572,000	Other Liabilities		25,900,000

(Continued)

44

MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

9.    DERIVATIVES AND HEDGING ACTIVITIES (Continued)

The effect of interest rate swaps that are not designated as hedging instruments resulted in income of less than $0.1 million during the year-ended December 31, 2022 that was recorded in other noninterest expense on our Consolidated Statements of Income. The fair value of interest rate swaps in a liability position, which includes accrued interest, was $25.9 million as of December 31, 2022. We have master netting arrangements with our correspondent banks that allow us to net receivables and payables. The netting agreement also allows us to net related cash collateral received and transferred up to the fair value exposure amount. We have elected to not offset these transactions on the Consolidated Balance Sheets. As of December 31, 2022, the gross amount of derivative assets subject to master netting agreements presented on the Consolidated Balance Sheets was $25.3 million, while cash collateral reflecting cash requirements from our counterparties to us totaled $25.2 million, and the net amount of derivative assets not offset in the Consolidated Balance Sheets was $0.1 million. As of December 31, 2022, the gross amount of derivative liabilities subject to master netting agreements presented on the Consolidated Balance Sheets was $0.4 million, while cash collateral reflecting cash requirements from us to our counterparties totaled $0.4 million, and the net amount of derivative liabilities not offset on the Consolidated Balance Sheets was $0. Cash collateral amounts, which are based on daily fair value calculations, are adjusted daily if fair value changes exceed an aggregate of $250,000. Interest rate swaps entered into with commercial loan customers had notional amounts aggregating $402 million as of December 31, 2022. Associated credit exposure is generally mitigated by securing the interest rates swaps with the underlying collateral of the loan instruments.

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

10.  FAIR VALUES OF FINANCIAL INSTRUMENTS

The carrying amounts, estimated fair values and level within the fair value hierarchy of financial instruments were as follows as of June 30, 2023 and December 31, 2022 (dollars in thousands):

	Level in	June 30, 2023				December 31, 2022
	Fair
	Value	Carrying		Fair		Carrying		Fair
	Hierarchy	Values		Values		Values		Values
Financial assets:
Cash and cash equivalents	Level 1	$	207,796	$	207,796	$	96,772	$	96,772
Securities available for sale	(1)		608,972		608,972		602,936		602,936
FHLBI stock	(2)		21,513		21,513		17,721		17,721
Loans, net	Level 3		4,007,122		3,993,406		3,874,373		3,800,042
Mortgage loans held for sale	Level 2		11,942		12,202		3,565		3,643
Mortgage servicing rights	Level 3		11,201		18,676		11,837		17,727
Accrued interest receivable	Level 2		16,962		16,962		15,476		15,476
Interest rate swaps	Level 2		26,880		26,880		25,697		25,697
Financial liabilities:
Deposits	Level 2		3,756,789		3,735,556		3,712,811		3,379,403
Repurchase agreements	Level 2		219,457		219,457		194,340		194,340
FHLBI advances	Level 2		467,910		447,929		308,263		292,044
Subordinated debentures	Level 2		49,301		55,991		48,958		49,531
Subordinated notes	Level 2		88,800		75,911		88,628		75,024
Accrued interest payable	Level 2		5,652		5,652		3,223		3,223
Interest rate swaps	Level 2		27,190		27,190		25,900		25,900

(1) See Note 11 for a description of the fair value hierarchy as well as a disclosure of levels for classes of financial assets and liabilities.

(2) It is not practical to determine the fair value of FHLBI stock due to transferability restrictions; therefore, fair value is estimated at carrying amount.

Carrying amount is the estimated fair value for cash and cash equivalents, FHLBI stock, accrued interest receivable and payable, noninterest-bearing checking accounts and securities sold under agreements to repurchase. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. Fair value for loans is based on an exit price model as required by ASU 2016-01, taking into account inputs such as discounted cash flows, probability of default and loss given default assumptions. As of December 31, 2022, the fair value for deposit accounts other than noninterest-bearing checking accounts is based on discounted cash flows using current market rates applied to the estimated life, while as of June 30, 2023, the fair value only for time deposits is based on discounted cash flows using current market rates applied to the estimated life. The fair value of mortgage servicing rights is estimated using a valuation model that calculates the present value of estimated future net servicing cash flows, taking into consideration expected mortgage loan prepayment rates, discount rates, servicing costs and other economic factors, which are determined based on current market conditions. The fair values of subordinated debentures, subordinated notes, and FHLBI advances are based on current rates for similar financing. The fair values of interest rate swaps are based on discounted cash flows using forecasted yield curves, along with insignificant unobservable inputs, such as borrower credit spreads. The fair value of other off-balance sheet items is estimated to be nominal.

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

11.  FAIR VALUES

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability, or in the absence of a principal market, the most advantageous market for the asset or liability. The price of the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

We are required to use valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability based on market data obtained from independent sources, or unobservable, meaning those that reflect our own assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. In that regard, we utilize a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that we have the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means.

Level 3: Significant unobservable inputs that reflect our own conclusions about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of our valuation methodologies used to measure and disclose the fair values of our financial assets and liabilities that are recorded at fair value on a recurring or nonrecurring basis:

Securities available for sale. Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based on quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models. Level 2 securities include U.S. Government agency debt obligations, mortgage-backed securities issued or guaranteed by U.S. Government agencies, and municipal general obligation and revenue bonds. Level 3 securities include bonds issued by certain relatively small municipalities located within our markets that have very limited marketability due to their size and lack of ratings from a recognized rating service. We carry these bonds at historical cost, which we believe approximates fair value, unless our periodic financial analysis or other information that becomes known to us necessitates an impairment. There was no such impairment as of June 30, 2023, or December 31, 2022. We have no Level 1 securities available for sale.

Derivatives. We measure fair value utilizing models that use primarily market observable inputs, such as forecasted yield curves. Insignificant unobservable inputs, such as borrower credit spreads, are also utilized.

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

11.  FAIR VALUES (Continued)

Mortgage loans held for sale. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors, and are measured on a nonrecurring basis. Fair value is based on independent quoted market prices, where applicable, or the prices for other mortgage whole loans with similar characteristics. As of June 30, 2023 and December 31, 2022, we determined the fair value of our mortgage loans held for sale to be $12.2 million and $3.6 million, respectively.

Loans. We do not record loans at fair value on a recurring basis. However, from time to time, we record nonrecurring fair value adjustments to collateral dependent loans to reflect partial write-downs or specific reserves that are based on the observable market price or current estimated value of the collateral. These loans are reported in the nonrecurring table below at initial recognition of significant borrower distress and on an ongoing basis until recovery or charge-off. The fair values of distressed loans are determined using either the sales comparison approach or income approach; respective unobservable inputs for the approaches consist of adjustments for differences between comparable sales and the utilization of appropriate capitalization rates.

Foreclosed Assets. At time of foreclosure or repossession, foreclosed and repossessed assets are adjusted to fair value less costs to sell upon transfer of the loans to foreclosed and repossessed assets, establishing a new cost basis. We subsequently adjust estimated fair value of foreclosed assets on a nonrecurring basis to reflect write-downs based on revised fair value estimates. The fair values of parcels of other real estate owned are determined using either the sales comparison approach or income approach; respective unobservable inputs for the approaches consist of adjustments for differences between comparable sales and the utilization of appropriate capitalization rates.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The balances of assets and liabilities measured at fair value on a recurring basis as of June 30, 2023 are as follows:

	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale securities
U.S. Government agency debt obligations	$	393,094,000	$	0	$	393,094,000	$	0
Mortgage-backed securities		30,520,000		0		30,520,000		0
Municipal general obligation bonds		157,565,000		0		157,041,000		524,000
Municipal revenue bonds		27,293,000		0		27,293,000		0
Other investments		500,000		0		500,000		0
Interest rate swaps		26,880,000		0		26,880,000		0
Total assets	$	635,852,000	$	0	$	635,328,000	$	524,000
Interest rate swaps		27,190,000		0		27,190,000		0
Total liabilities	$	27,190,000	$	0	$	27,190,000	$	0

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

11.  FAIR VALUES (Continued)

There were no sales, purchases or transfers in or out of Level 3 during the first six months of 2023. The $0.1 million reduction in Level 3 municipal general obligation bonds during the first six months of 2023 reflects the scheduled maturities of such bonds.

The balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2022 are as follows:

	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale securities
U.S. Government agency debt obligations	$	388,744,000	$	0	$	388,744,000	$	0
Mortgage-backed securities		31,953,000		0		31,953,000		0
Municipal general obligation bonds		154,433,000		0		153,855,000		578,000
Municipal revenue bonds		27,306,000		0		27,306,000		0
Other investments		500,000		0		500,000		0
Interest rate swaps		25,697,000		0		25,697,000		0
Total assets	$	628,633,000	$	0	$	628,055,000	$	578,000
Interest rate swaps		25,900,000		0		25,900,000		0
Total liabilities	$	25,900,000	$	0	$	25,900,000	$	0

There were no sales, purchases or transfers in or out of Level 3 during 2022. The $0.1 million reduction in Level 3 municipal general obligation bonds during 2022 reflects the scheduled maturities of such bonds.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The balances of assets and liabilities measured at fair value on a nonrecurring basis as of June 30, 2023 are as follows:

			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Collateral dependent loans	$	638,000	$	0	$	0	$	638,000
Foreclosed assets		661,000		0		0		661,000
Total	$	1,299,000	$	0	$	0	$	1,299,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

11.  FAIR VALUES (Continued)

The balances of assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2022 are as follows:

			Quoted
			Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Collateral dependent loans	$	5,290,000	$	0	$	0	$	5,290,000
Foreclosed assets		0		0		0		0
Total	$	5,290,000	$	0	$	0	$	5,290,000

The carrying values are based on the estimated value of the property or other assets. Fair value estimates of collateral on nonperforming loans and foreclosed assets are reviewed periodically. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside appraisals and internal evaluations based on identifiable trends within our markets, such as sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address current distressed market conditions. We generally assign a discount factor range of 25% to 35% for commercial real estate dependent loans and foreclosed assets, and a discount factor range of 25% to 50% for residential-related properties. In a vast majority of cases, we assign a 10% discount factor for estimated selling costs.

12.  REGULATORY MATTERS

We are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.

The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If an institution is not well capitalized, regulatory approval is required to accept brokered deposits. Subject to limited exceptions, no institution may make a capital distribution if, after making the distribution, it would be undercapitalized. If an institution is undercapitalized, it is subject to close monitoring by its principal federal regulator, its asset growth and expansion are restricted, and plans for capital restoration are required. In addition, further specific types of restrictions may be imposed on the institution at the discretion of the federal regulator. As of June 30, 2023 and December 31, 2022, our bank was in the well capitalized category under the regulatory framework for prompt corrective action. There are no conditions or events since June 30, 2023, that we believe have changed our bank’s categorization.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

12.  REGULATORY MATTERS (Continued)

Our actual capital levels (dollars in thousands) and the minimum levels required to be categorized as adequately and well capitalized were:

											Minimum Required
											to be Well
						Minimum Required					Capitalized Under
						for Capital					Prompt Corrective
	Actual					Adequacy Purposes					Action Regulations
	Amount		Ratio			Amount		Ratio			Amount		Ratio
June 30, 2023
Total capital (to risk weighted assets)
Consolidated	$	671,323		14.0	%	$	382,755		8.0	%	$	NA	NA
Bank		654,817		13.7			382,567		8.0			478,209		10.0	%
Tier 1 capital (to risk weighted assets)
Consolidated		537,802		11.2			287,066		6.0		NA		NA
Bank		610,096		12.8			286,926		6.0			382,567		8.0
Common equity tier 1 (to risk weighted assets)
Consolidated		490,575		10.3			215,300		4.5		NA		NA
Bank		610,096		12.8			215,194		4.5			310,836		6.5
Tier 1 capital (to average assets)
Consolidated		537,802		10.7			200,511		4.0		NA		NA
Bank		610,096		12.2			200,414		4.0			250,518		5.0
December 31, 2022
Total capital (to risk weighted assets)
Consolidated	$	634,729		14.0	%	$	362,675		8.0	%	$	NA	NA
Bank		618,709		13.7			362,490		8.0			453,112		10.0	%
Tier 1 capital (to risk weighted assets)
Consolidated		503,855		11.1			272,007		6.0		NA		NA
Bank		576,463		12.7			271,868		6.0			362,490		8.0
Common equity tier 1 (to risk weighted assets)
Consolidated		456,970		10.1			204,005		4.5		NA		NA
Bank		576,463		12.7			203,901		4.5			294,523		6.5
Tier 1 capital (to average assets)
Consolidated		503,855		10.1			199,647		4.0		NA		NA
Bank		576,463		11.6			199,563		4.0			249,453		5.0

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

12.  REGULATORY MATTERS (Continued)

Our consolidated capital levels as of June 30, 2023 and December 31, 2022 include $47.2 million and $46.9 million, respectively, of trust preferred securities. Under applicable Federal Reserve guidelines, the trust preferred securities constitute a restricted core capital element. The guidelines provide that the aggregate amount of restricted core elements that may be included in our Tier 1 capital must not exceed 25% of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Our ability to include the trust preferred securities in Tier 1 capital in accordance with the guidelines is not affected by the provision of the Dodd-Frank Act generally restricting such treatment, because (i) the trust preferred securities were issued before May 19, 2010, and (ii) our total consolidated assets as of December 31, 2009 were less than $15.0 billion. As of June 30, 2023 and December 31, 2022, all $47.2 million and $46.9 million, respectively, of the trust preferred securities were included in our consolidated Tier 1 capital.

Under the final BASEL III capital rules that became effective on January 1, 2015, there is a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not meet this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in cash dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement was phased in over three years beginning in 2016. The capital buffer requirement raised the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5% and the total capital ratio to 10.5% on a fully phased-in basis on January 1, 2019. We believe that, as of June 30, 2023, our bank meets all capital adequacy requirements under the BASEL III capital rules on a fully phased-in basis.

Our and our bank’s ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. On January 12, 2023, our Board of Directors declared a cash dividend on our common stock in the amount of $0.33 per share that was paid on March 15, 2023 to shareholders of record as of March 3, 2023. On April 13, 2023, our Board of Directors declared a cash dividend on our common stock in the amount of $0.33 per share that was paid on June 14, 2023, to shareholders of record as of June 2, 2023.

As of June 30, 2023, we had the ability to repurchase up to $6.8 million in common stock shares from time to time in open market transactions at prevailing market prices or by other means in accordance with applicable regulations as part of a $20.0 million common stock repurchase program announced in May 2021. No shares were repurchased during the first six months of 2023. Historically, stock repurchases have been funded from cash dividends paid to us from our bank. Additional repurchases may be made in future periods under the authorized plan or a new plan, which would also likely be funded from cash dividends paid to us from our bank. The actual timing, number and value of shares repurchased will be determined by us in our discretion and will depend on a number of factors, including the stock price, capital position, financial performance, general market and economic conditions, alternative uses of capital and applicable legal requirements.

13.  SUBSEQUENT EVENTS

On July 13, 2023, our Board of Directors declared a cash dividend on our common stock in the amount of $0.34 per share that will be paid on September 13, 2023, to shareholders of record as of September 1, 2023.

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MERCANTILE BANK CORPORATION

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “is likely,” “plans,” “projects,” “indicates,” “strategy,” “future,” “likely,” “may,” “should,” “will,” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.

Future Factors include, among others, adverse changes in interest rates and interest rate relationships; increasing rates of inflation and slower growth rates or recession; significant declines in the value of commercial real estate; market volatility; demand for products and services; climate impacts; labor markets; the degree of competition by traditional and non-traditional financial services companies; changes in banking regulation or actions by bank regulators; changes in tax laws and other laws and regulations applicable to us; changes in prices, levies, and assessments; the impact of technological advances; potential cyber-attacks, information security breaches, and other criminal activities; litigation liabilities; governmental and regulatory policy changes; the outcomes of existing or future contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; damage to our reputation resulting from adverse publicity, regulatory actions, litigation, operational failures, and the failure to meet client expectations and other facts; the transition from Libor to SOFR; changes in the national and local economies; unstable political and economic environments; disease outbreaks, such as the Covid-19 pandemic or similar public health threats, and measures implemented to combat them; and other risk factors, including those described in our annual report on Form 10-K for the year ended December 31, 2022. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.

Introduction

The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, including Mercantile Bank (“our bank”) and our bank’s subsidiaries, Mercantile Insurance Center, Inc., and Mercantile Community Partners, at June 30, 2023 and December 31, 2022 and the results of operations for the three months and six months ended June 30, 2023 and June 30, 2022. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to “us,” “we,” “our” or “the company” include Mercantile Bank Corporation and its consolidated subsidiaries referred to above.

Critical Accounting Policies 

Accounting principles generally accepted in the United States of America (“GAAP”) are complex and require us to apply significant judgment to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a discussion of our significant accounting estimates, see Note 1 of the Notes to our Consolidated Financial Statements included in our Form 10-K for the fiscal year ended December 31, 2022 (Commission file number 000-26719). Our critical accounting policies are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.

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MERCANTILE BANK CORPORATION

Allowance for Credit Losses (“Allowance”): On January 1, 2022, we adopted ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 32): Measurement of Credit Losses on Financial Instruments, as amended, which replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost and certain off-balance sheet credit exposures.

The allowance is maintained at a level we believe is adequate to absorb estimated credit losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Credit losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results. The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance, while recoveries of loans previously charged-off are added to the allowance.

See Note 1- Significant Accounting Policies in this Quarterly Report on Form 10-Q for further detailed descriptions of our estimation process and methodology related to the allowance. See also Note 3 – Loans and Allowance for Credit Losses in this Quarterly Report on Form 10-Q for further information regarding our loan portfolio and allowance.

Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage loan prepayment speeds, the remaining life of the mortgage loan pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from servicing each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance.

Goodwill: Accounting rules require us to determine the fair value of all the assets and liabilities of an acquired entity, and to record their fair value on the date of acquisition. We employ a variety of means in determining fair value, including the use of discounted cash flow analysis, market comparisons and projected future revenue streams. For those items for which we conclude that we have the appropriate expertise to determine fair value, we may choose to use our own calculation of fair value. In other cases, where the fair value is not readily determined, consultation with outside parties is used to determine fair value. Once valuations have been determined, the net difference between the price paid for the acquired entity and the fair value of the balance sheet is recorded as goodwill. Goodwill is assessed at least annually for impairment, with any such impairment recognized in the period identified. A more frequent assessment is performed if there are material changes in the market place or within the organizational structure.

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MERCANTILE BANK CORPORATION

Financial Overview

We reported net income of $20.4 million, or $1.27 per diluted share, for the second quarter of 2023, compared with net income of $11.7 million, or $0.74 per diluted share, during the second quarter of 2022. Net income for the first six months of 2023 totaled $41.3 million, or $2.58 per diluted share, compared to $23.2 million, or $1.47 per diluted share, during the first six months of 2022. The improved operating results were in large part driven by higher net interest income stemming from a higher net interest margin and ongoing loan growth, and continued strength in loan quality metrics providing for limited provision expense.

Commercial loans increased $56.8 million during the first six months of 2023, providing for an annualized growth rate of about 4%. While we experienced strong loan funding activities, the full pay-offs and partial paydowns of certain larger commercial lending relationships, primarily reflecting customers selling businesses and assets, refinancing debt on the secondary market, and using excess cash flows generated within their operations to make unscheduled principal payments and line of credit reductions, aggregated $174 million during the first six months of 2023. As a percentage of total commercial loans, commercial and industrial loans and owner occupied commercial real estate (“CRE”) loans combined equaled 58.7% as of June 30, 2023, compared to 58.2% as of December 31, 2022. The new commercial loan pipeline remains strong, and at June 30, 2023, we had $327 million in unfunded loan commitments on commercial construction and development loans that are in the construction phase.

Residential mortgage loans, excluding home equity lines of credit, increased $78.7 million during the first six months of 2023, representing a growth rate of about 22% on an annualized basis. With increased residential mortgage loan rates during 2022 and the first half of 2023, we have witnessed a shift in borrowers primarily selecting adjustable rate residential mortgage loans compared to fixed rate residential mortgage loans in the previous couple of years. Generally, we sell fixed rate residential mortgage loans to third-party investors, while we maintain adjustable rate residential mortgage loans on our balance sheet. During the first six months of 2023, approximately 40% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to a similar level in 2022 but approaching 70% in 2021. The shift in production mix has resulted in residential mortgage loans comprising a larger percentage of total loans, increasing from about 13% at year-end 2021 to about 20% as of June 30, 2023. The shift in product mix also impacts the timing of revenue recognition; it takes an estimated 24 months for the amount of interest income earned on a residential mortgage loan that is retained on our balance sheet to approximate the amount of the immediately recorded gain on sale of a residential mortgage loan that has been sold to an investor.

The overall quality of our loan portfolio remains strong, with nonperforming loans equaling only 0.05% of total loans as of June 30, 2023. Accruing loans past due 30 to 89 days remain very low, and foreclosed properties excluding a former branch facility totaled less than $0.1 million as of June 30, 2023. Gross loan charge-offs totaled $0.6 million during the first six months of 2023, while recoveries of prior period loan charge-offs aggregated $0.5 million.

We recorded provisions for credit losses of $2.0 million and $2.6 million during the second quarter and first six months of 2023, respectively, compared to $0.5 million and $0.6 million during the respective time periods in 2022. The provisions made during the 2023 periods mainly reflect adjustments to historical baseline loss allocations to better represent our expectations for future credit losses. Changes to qualitative factors were limited to a reduction of the historical loss information factor which coincided with the adjustments to the historical baseline loss allocations. Reserve allocations associated with net loan growth during both 2023 periods were largely mitigated by lower reserve allocations stemming from modestly improved economic forecasts. The elimination of certain specific reserve allocations had a positive impact on provision expense during the second quarter of 2023.

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MERCANTILE BANK CORPORATION

Interest-earning deposits, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During the first six months of 2023, the average balance of these funds equaled $48.1 million, or 1.0% of average earning assets, compared to $657 million, or 13.6% of average earning assets, during the first six months of 2022. Typically, we maintain interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated level during the first six months of 2022 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus payments and reduced business and consumer investing and spending during 2021 and into 2022. The level of interest-earning deposits was on a declining trend throughout 2022 as excess monies were used to fund loan growth and securities purchases, as well as out-of-area deposit and Federal Home Loan Bank of Indianapolis (“FHLBI”) advance maturities. We also experienced a decline in local deposits throughout 2022. Interest-earning deposits totaled $34.9 million at year-end 2022.

Interest-earning deposits totaled $139 million as of June 30, 2023, an increase of $104 million from December 31, 2022, and approximately $91 million higher than the average balance during the first six months of 2023. We obtained $111 million in brokered deposits and $90.0 million in FHLBI advances during the second quarter of 2023, combined with $70.0 million in FHLBI advances during the first quarter of 2023, to offset the impact of loan fundings and net deposit withdrawals during the first half of 2023, and to rebuild our on-balance sheet liquidity position.

Total deposits increased $44.0 million during the first six months of 2023, totaling $3.76 billion at June 30, 2023. Local deposits decreased $67.3 million, while out-of-area deposits increased $111 million. The reduction in local deposits largely occurred during the first few months of 2023, reflecting a typical level of customers’ tax and bonus payments and partnership distributions. Local deposits increased $47.5 million during the second quarter of 2023.

Net interest income increased $13.3 million and $30.7 million during the second quarter and first six months of 2023, respectively, compared to the respective time periods in 2022. Interest income was $26.4 million and $51.0 million higher during the second quarter and first six months of 2023, respectively, when compared to the same time periods in 2022, in large part reflecting an increasing rate environment. Interest expense was $13.1 million and $20.3 million higher during the second quarter and first six months of 2023, respectively, when compared to the respective time periods in 2022, primarily reflecting an increasing interest rate environment.

Noninterest income decreased $0.1 million and $2.4 million during the second quarter and first six months of 2023, respectively, compared to the respective time periods in 2022. Mortgage banking income was essentially unchanged during the second quarter of 2023 when compared to the second quarter of 2022; however, it declined $2.2 million during the first six months of 2023 when compared to the first six months of 2022, in large part reflecting increased residential mortgage loan rates beginning in late 2021 and continuing into 2022 which substantially reduced the volume of refinance activity starting during the latter half of the first quarter of 2022. We continued to record growth in treasury management-related fee income categories, such as credit and debit card income and payroll processing, while service charges on accounts have declined due to increased earnings credit rates on noninterest-bearing checking accounts.

Noninterest expense increased $0.9 million and $3.7 million during the second quarter and first six months of 2023, respectively, compared to the respective time periods in 2022. The increased costs primarily resulted from higher compensation costs, increased reserve allocations for unfunded loan commitments and higher interest rate swap cash collateral holding costs.

Financial Condition

Our total assets increased $265 million during the first six months of 2023, and totaled $5.14 billion as of June 30, 2023. Total loans were up $135 million, and interest-earning deposits increased $104 million. FHLBI advances were up $160 million, and total deposits increased $44.0 million.

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MERCANTILE BANK CORPORATION

Commercial loans increased $56.8 million during the first six months of 2023, providing for an annualized growth rate of about 4%. While we experienced strong loan funding activities, the full pay-offs and partial paydowns of certain larger commercial lending relationships, primarily reflecting customers selling businesses and assets, refinancing debt on the secondary market, and using excess cash flows generated within their operations to make unscheduled principal payments and line of credit reductions, aggregated $174 million during the first six months of 2023. Commercial and industrial loans increased $27.1 million, multi-family and residential rental property loans grew $20.8 million, owner-occupied CRE loans were up $20.0 million, and vacant land, land development and residential construction loans increased $10.8 million, while non-owner occupied CRE loans were down $22.0 million. As a percentage of total commercial loans, commercial and industrial loans and owner occupied CRE loans combined equaled 58.7% as of June 30, 2023, compared to 58.2% as of December 31, 2022. Commercial loans totaled $3.19 billion, or 78.7% of total loans, as of June 30, 2023, compared to $3.13 billion, or 80.0% of total loans, as of December 31, 2022.

As of June 30, 2023, we had $327 million in unfunded commitments on commercial construction and development loans that are in the construction phase which are expected to be drawn over the next 12 to 18 months. Our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods, including approximately $351 million in new lending commitments, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report ongoing additional opportunities they are currently discussing with existing and potentially new borrowers. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship, as well as concentration limits we have established within our commercial loan portfolio. Usage of existing commercial lines of credit averaged 41% during the first six months of 2023, which was within our historical range of 40% to 45%.

Residential mortgage loans, excluding home equity lines of credit, increased $78.7 million during the first six months of 2023, representing a growth rate of about 22% on an annualized basis. With increased residential mortgage loan rates during 2022 and the first half of 2023, we have witnessed a shift in borrowers primarily selecting adjustable rate residential mortgage loans compared to fixed rate residential mortgage loans in the previous couple of years. Generally, we sell fixed rate residential mortgage loans to third-party investors, while we maintain adjustable rate residential mortgage loans on our balance sheet. During the first six months of 2023, approximately 40% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to a similar level in 2022 but approaching 70% in 2021. The shift in production mix has resulted in residential mortgage loans comprising a larger percentage of total loans, increasing from about 13% at year-end 2021 to about 20% as of June 30, 2023. The shift in product mix also impacts the timing of revenue recognition; it takes an estimated 24 months for the amount of interest income earned on a residential mortgage loan that is retained on our balance sheet to approximate the amount of the immediately recorded gain on sale of a residential mortgage loan that has been sold to an investor.

Home equity lines of credit declined $0.6 million and other consumer-related loans increased $0.3 million during the first six months of 2023, and at June 30, 2023 totaled $36.8 million and $30.1 million, respectively, or an aggregate 1.7% of total loans. These loan segments equated to 1.7% of total loans as of December 31, 2022. We expect both loan portfolio segments to remain relatively steady in dollar amount but decline as a percent of total loans in future periods as the commercial and residential mortgage loan portfolios grow.

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MERCANTILE BANK CORPORATION

The following table summarizes our loan portfolio over the past twelve months:

	June 30, 2023		March 31, 2023		December 31, 2022		September 30, 2022		June 30, 2022
Commercial:
Commercial & Industrial	$	1,212,196,000	$	1,173,440,000	$	1,185,083,000	$	1,213,631,000	$	1,187,650,000
Land Development & Construction		72,682,000		66,233,000		61,873,000		60,970,000		57,808,000
Owner Occupied Commercial RE		659,201,000		630,187,000		639,192,000		643,577,000		598,593,000
Non-Owner Occupied Commercial RE		957,221,000		975,735,000		979,214,000		963,144,000		974,009,000
Multi-Family & Residential Rental		287,285,000		294,825,000		266,468,000		263,741,000		253,700,000
Total Commercial		3,188,585,000		3,140,420,000		3,131,830,000		3,145,063,000		3,071,760,000
Retail:
1-4 Family Mortgages		833,198,000		795,007,000		755,036,000		705,441,000		623,599,000
Other Consumer Loans		30,060,000		30,101,000		29,753,000		30,454,000		28,441,000
Total Retail		863,258,000		825,108,000		784,789,000		735,895,000		652,040,000
Total	$	4,051,843,000	$	3,965,528,000	$	3,916,619,000	$	3,880,958,000	$	3,723,800,000

Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions or other factors. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require modification in the future, are included on an internal watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on nonperforming loans, as well as on foreclosed and repossessed assets, are reviewed periodically. We also have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.

Nonperforming loans totaled $2.1 million, or 0.1% of total loans, as of June 30, 2023, compared to $7.7 million, or 0.2% of total loans, as of December 31, 2022. Nonperforming assets, comprised of nonaccrual loans, loans past due 90 days or more and accruing interest and foreclosed properties, totaled $2.8 million (0.1% of total assets) as of June 30, 2023, compared to $7.7 million (0.2% of total assets) as of December 31, 2022. The volume of nonperforming assets has remained under 0.3% of total assets since year-end 2015. Given the low levels of nonperforming loans and accruing loans 30 to 89 days delinquent, combined with what we believe are strong credit administration practices, we are pleased with the overall quality of the loan portfolio.

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MERCANTILE BANK CORPORATION

The following tables provide a breakdown of nonperforming assets by collateral type:

NONPERFORMING LOANS
	June 30, 2023		March 31, 2023		December 31, 2022		September 30, 2022		June 30, 2022
Residential Real Estate:
Land Development	$	2,000	$	8,000	$	29,000	$	30,000	$	30,000
Construction		0		0		124,000		0		0
Owner Occupied / Rental		1,732,000		1,891,000		1,304,000		1,138,000		1,508,000
		1,734,000		1,899,000		1,457,000		1,168,000		1,538,000
Commercial Real Estate:
Land Development		0		0		0		0		0
Construction		0		0		0		0		0
Owner Occupied		116,000		229,000		248,000		0		0
Non-Owner Occupied		0		0		0		0		0
		116,000		229,000		248,000		0		0
Non-Real Estate:
Commercial Assets		249,000		5,654,000		6,023,000		248,000		248,000
Consumer Assets		0		0		0		0		1,000
		249,000		5,654,000		6,023,000		248,000		249,000
Total	$	2,099,000	$	7,782,000	$	7,728,000	$	1,416,000	$	1,787,000

OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS
	June 30, 2023		March 31, 2023		December 31, 2022		September 30, 2022		June 30, 2022
Residential Real Estate:
Land Development	$	0	$	0	$	0	$	0	$	0
Construction		0		0		0		0		0
Owner Occupied / Rental		61,000		61,000		0		0		0
		61,000		61,000		0		0		0
Commercial Real Estate:
Land Development		0		0		0		0		0
Construction		0		0		0		0		0
Owner Occupied		600,000		600,000		0		0		0
Non-Owner Occupied		0		0		0		0		0
		600,000		600,000		0		0		0
Non-Real Estate:
Commercial Assets		0		0		0		0		0
Consumer Assets		0		0		0		0		0
		0		0		0		0		0
Total	$	661,000	$	661,000	$	0	$	0	$	0

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MERCANTILE BANK CORPORATION

The following tables provide a reconciliation of nonperforming assets:

NONPERFORMING LOANS RECONCILIATION
	2nd Qtr			1st Qtr			4th Qtr			3rd Qtr			2nd Qtr
	2023			2023			2022			2022			2022
Beginning balance	$	7,782,000		$	7,728,000		$	1,416,000		$	1,787,000		$	1,612,000
Additions, net of transfers to ORE		273,000			662,000			6,368,000			0			309,000
Returns to performing status		0			(31,000	)		0			(160,000	)		0
Principal payments		(5,525,000	)		(515,000	)		(56,000	)		(211,000	)		(134,000	)
Loan charge-offs		(431,000	)		(62,000	)		0			0			0
Total	$	2,099,000		$	7,782,000		$	7,728,000		$	1,416,000		$	1,787,000

OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS RECONCILIATION
	2nd Qtr		1st Qtr		4th Qtr		3rd Qtr		2nd Qtr
	2023		2023		2022		2022		2022
Beginning balance	$	661,000	$	0	$	0	$	0	$	0
Additions		0		661,000		0		0		0
Sale proceeds		0		0		0		0		0
Valuation write-downs		0		0		0		0		0
Total	$	661,000	$	661,000	$	0	$	0	$	0

Loan charge-offs totaled $0.5 million during the second quarter of 2023, and aggregated $0.6 million during the first six months of 2023, while recoveries of prior period loan charge-offs equaled $0.3 million and $0.5 million during the respective time periods. Net loan charge-offs, as a percentage of average total loans, equaled an annualized 0.02% and 0.01% during the second quarter and first six months of 2023, respectively. We continue our collection efforts on charged-off loans, and expect to record recoveries in future periods; however, given the nature of these efforts, it is not practical to forecast the dollar amount and timing of the recoveries.

The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential mortgage loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors’ rights in order to preserve our collateral position.

See Note 1- Significant Accounting Policies in this Quarterly Report on Form 10-Q for further detailed descriptions of our estimation process and methodology related to the allowance. See also Note 3 – Loans and Allowance for Credit Losses in this Quarterly Report on Form 10-Q for further information regarding our loan portfolio and allowance.

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MERCANTILE BANK CORPORATION

The allowance equaled $44.7 million, or 1.10% of total loans, or over 2,000% of nonperforming loans, as of June 30, 2023. As of June 30, 2023, the allowance was comprised of $44.2 million in general reserves relating to performing loans and $0.5 million in specific reserves on other loans, primarily nonperforming loans. Loans with an aggregate carrying value of $0.4 million as of June 30, 2023 had been subject to previous partial charge-offs aggregating $0.3 million over the past several years. As of June 30, 2023, there were no specific reserves allocated to loans that had been subject to a previous partial charge-off.

Although we believe the allowance is adequate to absorb loan losses in our loan portfolio as they arise, there can be no assurance that we will not sustain loan losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.

Securities available for sale increased $6.0 million during the first six months of 2023, totaling $609 million as of June 30, 2023. There were no purchases or maturities of U.S. Government agency bonds during the first six months of 2023. There were no purchases of U.S. Government agency guaranteed mortgage-backed securities during the first six months of 2023; however, we did receive $1.6 million of principal paydowns on U.S. Government agency guaranteed mortgage-backed securities. Purchases of municipal bonds totaled $11.6 million during the first six months of 2023; proceeds from matured municipal bonds totaled $8.6 million. At June 30, 2023, the portfolio was primarily comprised of U.S. Government agency bonds (65%), municipal bonds (30%) and U.S. Government agency guaranteed mortgage-backed securities (5%). All of our securities are currently designated as available for sale, and are therefore stated at fair value. The fair value of securities designated as available for sale at June 30, 2023 totaled $609 million, including a net unrealized loss of $77.9 million. The net unrealized loss equaled $82.7 million as of December 31, 2022. After we considered whether the securities were issued by the federal government or its agencies and whether downgrades by bond rating agencies had occurred, we determined that the unrealized losses were due to changing interest rate environment. We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function. We expect any upcoming purchases to generally consist of municipal bonds, with the securities portfolio maintained at about 12% of total assets.

Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies and municipal bonds are generally determined on a monthly basis with the assistance of a third-party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. The market value of certain non-rated securities issued by relatively small municipalities generally located within our markets is estimated at carrying value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines.

FHLBI stock totaled $21.5 million as of June 30, 2023, compared to $17.7 million as of December 31, 2022. The $3.8 million increase reflects additional stock purchased in association with an increase in outstanding advances during the first six months of 2023. Our investment in FHLBI stock is necessary to engage in their advance and other financing programs. We have regularly received quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods.

Interest-earning deposits, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During the first six months of 2023, the average balance of these funds equaled $48.1 million, or 1.0% of average earning assets, compared to $657 million, or 13.6% of average earning assets, during the first six months of 2022. Typically, we maintain interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated level during the first six months of 2022 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus payments and reduced business and consumer investing and spending during 2021 and into 2022. The level of interest-earning deposits was on a declining trend throughout 2022 as excess monies were used to fund loan growth and securities purchases, as well as out-of-area deposit and FHLBI advance maturities. We also experienced a decline in local deposits throughout 2022. Interest-earning deposits totaled $34.9 million at year-end 2022.

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MERCANTILE BANK CORPORATION

Interest-earning deposits totaled $139 million as of June 30, 2023, an increase of $104 million from December 31, 2022, and approximately $91 million higher than the average balance during the first six months of 2023. We obtained $111 million in brokered deposits and $90.0 million in FHLBI advances during the second quarter of 2023, combined with $70.0 million in FHLBI advances during the first quarter of 2023, to offset the impact of loan fundings and net deposit withdrawals during the first half of 2023, and to rebuild our on-balance sheet liquidity position.

Net premises and equipment equaled $52.3 million at June 30, 2023, an increase of $0.8 million from December 31, 2022. We recorded a reduction of $1.0 million associated with the planned sale of a former branch facility during the first six months of 2023, comprised of a $0.6 million transfer to foreclosed assets and a write-down of $0.4 million. Depreciation expense totaled $2.9 million during the first six months of 2023, while investments associated with the construction and opening of new facilities and the renovation of existing facilities totaled $4.7 million.

Total deposits increased $44.0 million during the first six months of 2023, totaling $3.76 billion at June 30, 2023. Local deposits decreased $67.3 million, while out-of-area deposits increased $111 million. The reduction in local deposits largely occurred during the initial months of 2023, reflecting a typical level of customers’ tax and bonus payments and partnership distributions. Local deposits increased $47.5 million during the second quarter of 2023. Wholesale funds, comprised of out-of-area deposits and FHLBI advances, totaled $579 million, or about 13% of total funds, as of June 30, 2023, compared to $308 million, or about 7% of total funds, at December 31, 2022.

Noninterest-bearing deposits decreased $233 million during the first six months of 2023, in large part reflecting the aforementioned customary level of customers’ tax and bonus payments and partnership distributions during the initial months of 2023, but also includes transfers to interest-bearing deposits and withdrawals associated with the sales of businesses. Interest-bearing checking accounts and savings deposits were down $33.9 million and $67.0 million during the first six months of 2023, respectively, primarily reflecting the transfers of funds to higher-paying money market deposit accounts and time deposits. Money market deposit accounts were up $150 million and local time deposits increased $116 million during the first six months of 2023.

Sweep accounts increased $25.1 million during the first six months of 2023, totaling $219 million as of June 30, 2023. The aggregate balance of this funding type is subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances maintained by many of the customers. The average balance of sweep accounts equaled $214 million during the first six months of 2023, with a high balance of $263 million and a low balance of $181 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts and savings deposits into overnight interest-bearing repurchase agreements. Such sweep accounts are not deposit accounts and are not afforded federal deposit insurance, and are accounted for as secured borrowings. All of our repurchase agreements are accounted for as secured borrowings.

FHLBI advances increased $160 million during the first six months of 2023, totaling $468 million as of June 30, 2023. Bullet advances aggregating $200 million were obtained during the first six months of 2023, consisting of $160 million to fund loan growth and rebuild on-balance sheet liquidity, and $40.0 million to replace FHLBI bullet advance maturities. Payments on amortizing FHLBI advances totaled $0.4 million during the first six months of 2023. Bullet FHLBI advances are generally obtained to provide funds for loan growth and are used to assist in managing interest rate risk, while amortizing FHLBI advances are generally acquired to match-fund specific longer-term fixed rate commercial loans, with the dollar amount and amortization structure of the underlying advances reflective of the associated commercial loans. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2023 totaled $860 million, with remaining availability based on collateral equaling $386 million.

Shareholders’ equity was $479 million at June 30, 2023, compared to $441 million at December 31, 2022. Positively impacting shareholders’ equity during the first six months of 2023 was net income of $41.3 million, which was partially offset by the payment of cash dividends totaling $10.3 million. A $3.8 million after-tax increase in the market value of our available for sale securities portfolio, reflecting a decline in market interest rates, positively impacted shareholders’ equity during the first six months of 2023.

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MERCANTILE BANK CORPORATION 

Liquidity

Liquidity is measured by our ability to raise funds through deposits, borrowed funds, and capital, or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-earning deposits. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.

To assist in providing needed funds and managing interest rate risk, we periodically obtain monies from wholesale funding sources. Wholesale funds, comprised of out-of-area deposits and advances from the FHLBI, totaled $579 million, or about 13% of combined deposits and borrowed funds, as of June 30, 2023, compared to $308 million, or about 7% of combined deposits and borrowed funds, as of December 31, 2022.

Sweep accounts increased $25.1 million during the first six months of 2023, totaling $219 million as of June 30, 2023. The aggregate balance of this funding type is subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances maintained by many of the customers. The average balance of sweep accounts equaled $214 million during the first six months of 2023, with a high balance of $263 million and a low balance of $181 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts and savings deposits into overnight interest-bearing repurchase agreements. Such sweep accounts are not deposit accounts and are not afforded federal deposit insurance, and are accounted for as secured borrowings. All of our repurchase agreements are accounted for as secured borrowings.

Information regarding our repurchase agreements as of June 30, 2023 and during the first six months of 2023 is as follows:

Outstanding balance at June 30, 2023	$	219,457,000
Weighted average interest rate at June 30, 2023		1.52	%
Maximum daily balance six months ended June 30, 2023	$	262,992,000
Average daily balance for six months ended June 30, 2023	$	213,853,000
Weighted average interest rate for six months ended June 30, 2023		1.17	%

FHLBI advances increased $160 million during the first six months of 2023, totaling $468 million as of June 30, 2023. Bullet advances aggregating $200 million were obtained during the first six months of 2023, consisting of $160 million to fund loan growth and rebuild on-balance sheet liquidity, and $40.0 million to replace FHLBI bullet advance maturities. Payments on amortizing FHLBI advances totaled $0.4 million during the first six months of 2023. Bullet FHLBI advances are generally obtained to provide funds for loan growth and are used to assist in managing interest rate risk, while amortizing FHLBI advances are generally acquired to match-fund specific longer-term fixed rate commercial loans, with the dollar amount and amortization structure of the underlying advances reflective of the associated commercial loans. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2023 totaled $860 million, with remaining availability based on collateral equaling $386 million.

We also have the ability to borrow up to an aggregate $70.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. We accessed one of the lines of credit during the first six months of 2023, with an average balance of $4.8 million. In contrast, our interest-earning deposit balance with the Federal Reserve Bank of Chicago averaged $42.1 million during the first six months of 2023. We also have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Using certain municipal bonds as collateral, we could have borrowed up to $26.7 million as of June 30, 2023. We did not utilize this line of credit during the first six months of 2023 or at any time during the previous 14 fiscal years, and do not plan to access this line of credit in future periods.

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MERCANTILE BANK CORPORATION

The following table reflects, as of June 30, 2023, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:

	One Year		One to		Three to		Over
	or Less		Three Years		Five Years		Five Years		Total
Deposits without a stated maturity	$	3,154,550,000	$	0	$	0	$	0	$	3,154,550,000
Time deposits		432,582,000		106,508,000		63,149,000		0		602,239,000
Short-term borrowings		219,457,000		0		0		0		219,457,000
Federal Home Loan Bank advances		90,826,000		171,762,000		181,917,000		23,405,000		467,910,000
Subordinated debentures		0		0		0		49,301,000		49,301,000
Subordinated notes		0		0		0		88,800,000		88,800,000
Other borrowed money		0		0		0		1,090,000		1,090,000
Property leases		1,174,000		1,279,000		820,000		1,472,000		4,745,000

In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As of June 30, 2023, we had a total of $2.15 billion in unfunded loan commitments and $24.1 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $1.80 billion were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $351 million were for loan commitments generally expected to be accepted and closed and become funded within the next 12 to 18 months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management.

While we have observed the well-publicized liquidity problems at certain financial institutions during the first six months of 2023, we do not believe that we are subject to the same circumstances that apparently caused those crises. We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, changes in economic or market conditions, a reduction in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. We have developed contingency funding plans that provide a framework for meeting liquidity disruptions.

Capital Resources

Shareholders’ equity was $479 million at June 30, 2023, compared to $441 million at December 31, 2022. Positively impacting shareholders’ equity during the first six months of 2023 was net income of $41.3 million, which was partially offset by the payment of cash dividends totaling $10.3 million. A $3.8 million after-tax increase in the market value of our available for sale securities portfolio, reflecting a decline in market interest rates, positively impacted shareholders’ equity during the first six months of 2023.

We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Under the final BASEL III capital rules that became effective on January 1, 2015, there is a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not meet this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in cash dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement was phased in over three years beginning in 2016. The capital buffer requirement raised the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5% and the total capital ratio to 10.5% on a fully phased-in basis on January 1, 2019. We believe that, as of June 30, 2023, our bank met all capital adequacy requirements under the BASEL III capital rules on a fully phased-in basis.

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MERCANTILE BANK CORPORATION

As of June 30, 2023, our bank’s total risk-based capital ratio was 13.7%, unchanged from December 31, 2022. Our bank’s total regulatory capital increased $36.1 million during the first six months of 2023, in large part reflecting net income totaling $46.5 million, which was partially offset by cash dividends paid to us aggregating $13.0 million. Our bank’s total risk-based capital ratio was also impacted by a $251 million increase in total risk-weighted assets, primarily resulting from net growth in commercial and residential mortgage loans. As of June 30, 2023, our bank’s total regulatory capital equaled $655 million, or $177 million in excess of the 10.0% minimum that is among the requirements to be categorized as “well capitalized.” Our and our bank’s capital ratios as of June 30, 2023 and December 31, 2022 are disclosed in Note 12 of the Notes to Consolidated Financial Statements.

Results of Operations

We recorded net income of $20.4 million, or $1.27 per basic and diluted share, for the second quarter of 2023, compared with net income of $11.7 million, or $0.74 per basic and diluted share, for the second quarter of 2022. We recorded net income of $41.3 million, or $2.58 per basic and diluted share, for the first six months of 2023, compared with net income of $23.2 million, or $1.47 per basic and diluted share, for the first six months of 2022. Diluted earnings per share increased $0.53, or 71.6%, during the second quarter of 2023, and $1.11, or 75.5%, during the first six months of 2023 compared with the respective prior-year periods.

The higher levels of net income during the second quarter and first six months of 2023 compared to the respective prior-year periods resulted from increased net interest income, which more than offset higher overhead costs and credit loss provisions, as well as lower noninterest income. The increases in net interest income during the 2023 periods mainly resulted from significantly improved net interest margins and loan growth. The higher levels of overhead costs during the 2023 periods primarily reflected increases in compensation costs, credit reserves for unfunded loan commitments, interest rate swap credit reserves and associated collateral interest costs, and Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums. The credit loss provisions recorded during the current-year periods mainly reflected allocations commanded by net loan growth and adjustments to historical loss factors to better represent our expectations for future credit losses. Continuing strong loan quality measures, including low levels of loan charge-offs, during the 2023 and 2022 periods largely mitigated additional reserves associated with these factors. Excluding the impact of a bank owned life insurance claim recorded during the second quarter of 2022, noninterest income increased $0.4 million, or 6.0%, during the second quarter of 2023 compared with the prior-year second quarter. The higher level of noninterest income mainly stemmed from increased interest rate swap income, credit and debit card income, and payroll servicing fees, which more than offset decreased service charges on accounts and mortgage banking income. The lower level of noninterest income during the first six months of 2023 primarily reflected decreases in mortgage banking income and service charges on accounts, which more than offset increases in credit and debit card income and payroll servicing fees.

Interest income during the second quarter of 2023 was $65.9 million, an increase of $26.4 million, or 66.7%, from the $39.5 million earned during the second quarter of 2022. The increase mainly resulted from a higher yield on average earning assets. The yield on average earning assets was 5.61% during the second quarter of 2023, up from 3.32% during the respective 2022 period. The higher yield primarily resulted from an increased yield on loans, reflecting the rising interest rate environment. The yield on loans was 6.19% during the second quarter of 2023, up from 3.97% during the prior-year second quarter mainly due to higher interest rates on variable-rate commercial loans stemming from the Federal Open Market Committee (“FOMC”) significantly raising the targeted federal funds rate in an effort to curb elevated inflation levels. The FOMC increased the targeted federal funds rate by 475 basis points during the period of May 2022 through May 2023. During the period of March 2022 through June 2023, variable-rate commercial loans represented approximately 64% of total commercial loans on an average basis. A change in earning asset mix, comprised of a decrease in lower-yielding interest-earning deposits and an increase in higher-yielding loans as a percentage of earning assets, along with increased yields on securities and interest-earning deposits, reflecting the rising interest rate environment, also contributed to the higher yield on average earning assets. On average, lower-yielding interest-earning deposits represented 1.4% of earning assets during the second quarter of 2023, down from 11.1% during the respective 2022 period, while higher-yielding loans represented 85.2% of earning assets during the current-year second quarter, up from 76.0% during the second quarter of 2022.

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MERCANTILE BANK CORPORATION

A significant volume of excess on-balance sheet liquidity, which initially surfaced in the second quarter of 2020 in large part due to government stimulus programs related to the Covid-19 environment, negatively impacted the yield on average earning assets by 28 basis points during the second quarter of 2022. The excess funds, consisting almost entirely of low-yielding deposits with the Federal Reserve Bank of Chicago, were mainly a product of local deposit growth and the Paycheck Protection Program.

Average earning assets equaled $4.72 billion during the second quarter of 2023, down $62.6 million, or 1.3%, from the level of $4.78 billion during the second quarter of 2022; average loans and average securities were up $384 million and $18.9 million, respectively, while average interest-earning deposits were down $466 million.

Interest income during the first six months of 2023 was $126 million, an increase of $51.0 million, or 67.6%, from the $75.4 million earned during the first six months of 2022. The increase primarily resulted from a higher yield on average earning assets. The yield on average earning assets was 5.48% during the first six months of 2023, up from 3.16% during the respective 2022 period. The higher yield mainly resulted from an increased yield on loans, reflecting the rising interest rate environment. The yield on loans was 6.05% during the first six months of 2023, up from 3.92% during the first six months of 2022 primarily due to higher interest rates on variable-rate commercial loans stemming from FOMC rate hikes. A change in earning asset mix, comprised of a decrease in lower-yielding interest-earning deposits and an increase in higher-yielding loans as a percentage of earning assets, along with increased yields on securities and interest-earning deposits, depicting the rising interest rate environment, also contributed to the higher yield on average earning assets. On average, lower-yielding interest-earning deposits represented 1.0% of earning assets during the first six months of 2023, down from 13.6% during the respective 2022 period, while higher-yielding loans represented 85.4% of earning assets during the first six months of 2023, up from 73.7% during the first six months of 2022. The significant volume of excess on-balance sheet liquidity negatively impacted the yield on average earning assets by 37 basis points during the first six months of 2022.

Average earning assets equaled $4.65 billion during the first six months of 2023, down $178 million, or 3.7%, from the level of $4.83 billion during the first six months of 2022; average interest-earning deposits declined $609 million, average loans increased $414 million, and average securities were up $16.6 million.

Interest expense during the second quarter of 2023 was $18.4 million, an increase of $13.2 million, or 252%, from the $5.2 million expensed during the second quarter of 2022. The increase is mainly attributable to a higher average weighted cost of interest-bearing liabilities, which rose from 0.72% during the second quarter of 2022 to 2.37% during the current-year second quarter primarily due to increased costs of deposits and borrowings. Reflecting the rising interest rate environment, the cost of interest-bearing, non-time deposits increased from 0.24% during the second quarter of 2022 to 1.85% during the second quarter of 2023, while the cost of time deposits increased from 0.83% to 3.27% during the respective periods. The higher cost of interest-bearing, non-time deposits primarily resulted from increased rates paid on money market accounts. The cost of borrowed funds increased from 1.90% during the second quarter of 2022 to 2.90% during the second quarter of 2023 mainly due to higher costs of sweep accounts, FHLBI advances, and subordinated debentures. The cost of sweep accounts increased from 0.10% during the second quarter of 2022 to 1.45% during the second quarter of 2023, while the cost of FHLBI advances increased from 2.02% to 2.68% during the respective periods, reflecting the rising interest rate environment. The cost of subordinated debentures was 9.57% during the second quarter of 2023, up from 4.63% during the respective 2022 period due to increases in the 90-Day Libor Rate.

A change in funding mix, consisting of increases in higher-costing time deposits and borrowings as a percentage of interest-bearing liabilities, also contributed to the higher cost of interest-bearing liabilities during the second quarter of 2023. Average interest-bearing liabilities totaled $3.11 billion during the current-year second quarter, compared to $2.91 billion during the second quarter of 2022, representing an increase of $198 million, or 6.8%.

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MERCANTILE BANK CORPORATION

Interest expense during the first six months of 2023 was $30.5 million, an increase of $20.3 million, or 198%, from the $10.2 million expensed during the first six months of 2022. The increase is attributable to a higher average weighted cost of interest-bearing liabilities, which rose from 0.69% during the first six months of 2022 to 2.06% during the first six months of 2023 primarily due to increased costs of deposits and borrowings. Reflecting the rising interest rate environment, the cost of interest-bearing, non-time deposits increased from 0.22% during the first six months of 2022 to 1.56% during the first six months of 2023, while the cost of time deposits increased from 0.86% to 2.84% during the respective periods. The higher cost of interest-bearing, non-time deposits primarily resulted from increased rates paid on money market accounts. The cost of borrowed funds increased from 1.86% during the first six months of 2022 to 2.73% during the first six months of 2023 mainly due to higher costs of subordinated debentures, sweep accounts, and FHLBI advances. The cost of subordinated debentures was 9.31% during the first six months of 2023, up from 4.22% during the respective 2022 period due to increases in the 90-Day Libor Rate. The cost of sweep accounts increased from 0.10% during the first six months of 2022 to 1.17% during the first six months of 2023, while the cost of FHLBI advances increased from 2.01% to 2.44% during the respective periods, reflecting the rising interest rate environment.

A change in funding mix, consisting of increases in higher-costing time deposits and borrowings as a percentage of interest-bearing liabilities, also contributed to the higher cost of interest-bearing liabilities during the first six months of 2023. Average interest-bearing liabilities totaled $2.98 billion during the first six months of 2023, down slightly from $2.99 billion during the respective 2022 period.

Net interest income during the second quarter of 2023 was $47.6 million, an increase of $13.3 million, or 38.5%, from the $34.3 million earned during the respective 2022 period. The increase primarily resulted from a significantly improved net interest margin. The net interest margin increased from 2.88% in the second quarter of 2022 to 4.05% in the current-year second quarter due to a higher yield on average earning assets, which more than offset an increase in the cost of funds. The increased yield primarily stemmed from a higher yield on commercial loans. The cost of funds equaled 1.56% in the second quarter of 2023, up from 0.44% in the second quarter of 2022 primarily due to higher costs of deposits and borrowed funds, reflecting the impact of the rising interest rate environment, and a change in funding mix, consisting of a decrease in lower-cost non-time deposits and increases in higher-cost time deposits and borrowings as a percentage of interest-bearing liabilities. The significant level of excess on-balance sheet liquidity negatively impacted the net interest margin by 23 basis points during the second quarter of 2022.

Net interest income during the first six months of 2023 was $95.9 million, an increase of $30.7 million, or 47.1%, from the $65.2 million earned during the first six months of 2022. The increase mainly resulted from a substantially improved net interest margin. The net interest margin increased from 2.73% in the first six months of 2022 to 4.16% in the respective 2023 period due to a higher yield on average earning assets, which more than offset an increase in the cost of funds. The increased yield on average earning assets primarily resulted from a higher yield on commercial loans. The cost of funds equaled 1.32% during the first six months of 2023, up from 0.43% during the respective prior-year period mainly due to higher costs of deposits and borrowed funds, reflecting the impact of the increasing interest rate environment, and a change in funding mix, consisting of a decrease in lower-cost non-time deposits and increases in higher-cost time deposits and borrowings as a percentage of interest-bearing liabilities. The significant level of excess on-balance sheet liquidity negatively impacted the net interest margin by 32 basis points during the first six months of 2022.

The following tables set forth certain information relating to our consolidated average interest-earning assets and interest-bearing liabilities and reflect the average yield on assets and average cost of liabilities for the second quarters and first six months of 2023 and 2022. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. Tax-exempt securities interest income and yield for the second quarters and first six months of 2023 and 2022 have been computed on a tax equivalent basis using a marginal tax rate of 21.0%. Securities interest income was increased by $60,000 in the second quarter of both 2023 and 2022 and $120,000 in the first six months of both 2023 and 2022 for this non-GAAP, but industry standard, adjustment. These adjustments equated to increases in our net interest margin of less than one basis point for each of the 2023 and 2022 periods.

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MERCANTILE BANK CORPORATION

	Quarters ended June 30,
	2 0 2 3								2 0 2 2
	Average					Average			Average					Average
	Balance			Interest		Rate			Balance			Interest		Rate
	(dollars in thousands)
ASSETS
Loans	$	4,017,690		$	62,006		6.19	%	$	3,633,587		$	36,003		3.97	%
Investment securities		634,607			3,171		2.00			615,733			2,589		1.68
Interest-earning deposits		64,958			801		4.88			530,571			1,018		0.76
Total interest - earning assets		4,717,255			65,978		5.61			4,779,891			39,610		3.32
Allowance for credit losses		(44,025	)							(35,681	)
Other assets		315,244								333,248
Total assets	$	4,988,474							$	5,077,458
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing deposits	$	2,278,877		$	12,379		2.18	%	$	2,201,797		$	1,873		0.34	%
Short-term borrowings		237,270			914		1.55			193,735			49		0.10
Federal Home Loan Bank advances		450,767			3,051		2.68			373,911			1,911		2.02
Other borrowings		139,068			2,023		5.75			138,127			1,391		4.04
Total interest-bearing liabilities		3,105,982			18,367		2.37			2,907,570			5,224		0.72
Noninterest-bearing deposits		1,361,901								1,706,349
Other liabilities		46,608								34,666
Shareholders’ equity		473,983								428,873
Total liabilities and shareholders’ equity	$	4,988,474							$	5,077,458
Net interest income				$	47,611							$	34,386
Net interest rate spread							3.24	%							2.60	%
Net interest spread on average assets							3.82	%							2.72	%
Net interest margin on earning assets							4.05	%							2.88	%

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MERCANTILE BANK CORPORATION

	Six months ended June 30,
	2 0 2 3								2 0 2 2
	Average					Average			Average					Average
	Balance			Interest		Rate			Balance			Interest		Rate
	(dollars in thousands)
ASSETS
Loans	$	3,973,255		$	119,159		6.05	%	$	3,559,461		$	69,254		3.92	%
Investment securities		631,137			6,238		1.98			614,532			4,914		1.60
Interest-earning deposits		48,113			1,125		4.65			656,682			1,384		0.42
Total interest - earning assets		4,652,505			126,522		5.48			4,830,675			75,552		3.16
Allowance for credit losses		(43,553	)							(35,486	)
Other assets		313,590								327,569
Total assets	$	4,922,542							$	5,122,758
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing deposits	$	2,231,902		$	20,286		1.83	%	$	2,282,667		$	3,698		0.33	%
Short-term borrowings		218,678			1,373		1.27			196,328			99		0.10
Federal Home Loan Bank advances		394,708			4,845		2.44			373,290			3,774		2.01
Other borrowings		138,944			3,963		5.67			137,004			2,650		3.90
Total interest-bearing liabilities		2,984,232			30,467		2.06			2,989,289			10,221		0.69
Noninterest-bearing deposits		1,426,331								1,666,125
Other liabilities		48,169								28,034
Shareholders’ equity		463,810								439,310
Total liabilities and shareholders’ equity	$	4,922,542							$	5,122,758
Net interest income				$	96,055							$	65,331
Net interest rate spread							3.42	%							2.47	%
Net interest spread on average assets							3.93	%							2.57	%
Net interest margin on earning assets							4.16	%							2.73	%

Provisions for credit losses of $2.0 million and $0.5 million were recorded during the second quarters of 2023 and 2022, respectively. A provision for credit losses of $2.6 million was recorded during the first six months of 2023, compared with a provision of $0.6 million during the first six months of 2022. The provision expense recorded during the 2023 periods mainly reflected allocations necessitated by net loan growth and adjustments to historical loss factors to better represent our expectations for future credit losses. The provision expense recorded during the prior-year periods primarily reflected allocations required by net loan growth, increased specific reserves for certain problem commercial loan relationships, and a higher reserve for residential mortgage loans stemming from slower principal prepayment rates and the associated extended average life of the portfolio. Ongoing strong loan quality metrics, including low levels of loan charge-offs, during the 2023 and 2022 periods largely mitigated additional reserves associated with the previously mentioned factors.

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MERCANTILE BANK CORPORATION

Noninterest income during the second quarter of 2023 was $7.6 million, compared to $7.7 million during the respective 2022 period, while noninterest income during the first six months of 2023 was $14.6 million, compared to $17.0 million during the first six months of 2022. Noninterest income during the second quarter and first six months of 2022 included a $0.5 million bank owned life insurance claim. Excluding the impact of this transaction, noninterest income increased $0.4 million, or 6.0%, during the second quarter of 2023 compared with the prior-year second quarter, and decreased $1.9 million, or 11.5%, during the first six months of 2023 compared with the first six months of 2022. The higher level of noninterest income during the second quarter of 2023 primarily stemmed from increased interest rate swap income, credit and debit card income, and payroll servicing fees, which more than offset decreased service charges on accounts and mortgage banking income. Growth in credit and debit card income and payroll servicing fees during the first six months of 2023 was outweighed by lower levels of mortgage banking income and service charges on accounts, resulting in a decline in noninterest income compared to the respective prior-year period. The declines in service charges on accounts reflected increased earnings credit rates in response to the increasing interest rate environment, while the reductions in mortgage banking income reflected higher residential mortgage loan rates stemming from the rising interest rate environment, resulting in significantly lower levels of refinance activity.

Noninterest expense totaled $27.8 million during the second quarter of 2023, compared to $26.9 million during the prior-year second quarter. Noninterest expense totaled $56.4 million during the first six months of 2023, compared to $52.7 million during the first six months of 2022. The increases in noninterest expense mainly resulted from larger compensation costs, including salary increases and higher bonus and commercial lender incentive accruals, which outweighed reductions in residential mortgage lender commissions and incentives. The higher levels of salary expense primarily stemmed from annual merit pay increases and market adjustments, as well as lower residential mortgage loan deferred salary costs. The reduced residential mortgage lender commissions and incentives mainly resulted from decreased loan production. The increases in overhead costs also resulted from the recording of increased credit reserves for unfunded loan commitments and higher levels of FDIC deposit insurance premiums, reflecting a higher industry-wide assessment rate, interest rate swap credit reserves and associated collateral interest costs, and health insurance accruals. Overhead costs during the first six months of 2023 included a $0.4 million write-down of a former branch facility in the first quarter of the year, while overhead costs during the second quarter and first six months of 2022 included a $0.4 million expense associated with the sale of a branch facility.

During the second quarter of 2023, we recorded income before federal income tax of $25.4 million and a federal income tax expense of $5.0 million. During the second quarter of 2022, we recorded income before federal income tax of $14.6 million and a federal income tax expense of $2.9 million. During the first six months of 2023, we recorded income before federal income tax of $51.5 million and a federal income tax expense of $10.2 million. During the first six months of 2022, we recorded income before federal income tax of $28.9 million and a federal income tax expense of $5.7 million. The increase in federal income tax expense in both 2023 periods resulted from higher levels of income before federal income tax. Our effective tax rate was 19.8% during the second quarter and first six months of 2023 and the respective 2022 periods.

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MERCANTILE BANK CORPORATION

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on our interest-earning assets over the interest paid on our interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness.

Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal control procedures are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality.

We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to our net interest margin during periods of changing market interest rates.

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MERCANTILE BANK CORPORATION

The following table depicts our GAP position as of June 30, 2023:

	Within			Three to			One to			After
	Three			Twelve			Five			Five
	Months			Months			Years			Years			Total
Assets:
Commercial loans	$	2,075,911,000		$	101,646,000		$	888,657,000		$	179,209,000		$	3,245,423,000
Residential real estate loans		56,645,000			19,615,000			208,513,000			509,009,000			793,782,000
Consumer loans		2,279,000			511,000			8,936,000			912,000			12,638,000
Securities (1)		23,997,000			31,668,000			243,153,000			331,667,000			630,485,000
Interest-earning deposits		134,661,000			1,252,000			2,750,000			0			138,663,000
Allowance for credit losses		0			0			0			0			(44,721,000	)
Other assets		0			0			0			0			361,317,000
Total assets		2,293,493,000			154,692,000			1,352,009,000			1,020,797,000		$	5,137,587,000
Liabilities:
Interest-bearing checking		541,168,000			0			0			0			541,168,000
Savings deposits		314,606,000			0			0			0			314,606,000
Money market accounts		927,143,000			0			0			0			927,143,000
Time deposits under $100,000		26,241,000			83,253,000			34,558,000			0			144,052,000
Time deposits $100,000 & over		80,036,000			243,052,000			135,099,000			0			458,187,000
Short-term borrowings		219,457,000			0			0			0			219,457,000
Federal Home Loan Bank advances		10,000,000			80,826,000			353,679,000			23,405,000			467,910,000
Other borrowed money		50,391,000			0			88,800,000			0			139,191,000
Noninterest-bearing checking		0			0			0			0			1,371,633,000
Other liabilities		0			0			0			0			75,538,000
Total liabilities		2,169,042,000			407,131,000			612,136,000			23,405,000			4,658,885,000
Shareholders' equity		0			0			0			0			478,702,000
Total liabilities & shareholders' equity		2,169,042,000			407,131,000			612,136,000			23,405,000		$	5,137,587,000
Net asset (liability) GAP	$	124,451,000		$	(252,439,000	)	$	739,873,000		$	997,392,000
Cumulative GAP	$	124,451,000		$	(127,988,000	)	$	611,885,000		$	1,609,277,000
Percent of cumulative GAP to total assets		2.4	%		(2.5	%)		11.9	%		31.3	%

⁽¹⁾ Mortgage-backed securities are categorized by average life calculations based upon prepayment trends as of June 30, 2023.

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The second interest rate risk measurement we use is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates.

Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors.

We conducted multiple simulations as of June 30, 2023, in which it was assumed that changes in market interest rates occurred ranging from up 300 basis points to down 300 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested dollar and percentage changes in net interest income over the next twelve months in comparison to the $199 million in net interest income projected using our balance sheet amounts and anticipated replacement rates as of June 30, 2023. The resulting estimates are generally within our policy parameters established to manage and monitor interest rate risk.

	Dollar Change			Percent Change
	In Net			In Net
Interest Rate Scenario	Interest Income			Interest Income
Interest rates down 300 basis points	$	(19,900,000	)		(10.0	%)
Interest rates down 200 basis points		(15,500,000	)		(7.8	)
Interest rates down 100 basis points		(6,700,000	)		(3.4	)
Interest rates up 100 basis points		6,500,000			3.3
Interest rates up 200 basis points		13,600,000			6.8
Interest rates up 300 basis points		20,800,000			10.4

The resulting estimates have been significantly impacted by the current interest rate and economic environments, as adjustments have been made to critical model inputs with regards to traditional interest rate relationships. This is especially important as it relates to floating rate commercial loans, which comprise a sizable portion of our balance sheet.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; level of nonperforming assets; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.

Item 4. Controls and Procedures

As of June 30, 2023, an evaluation was performed under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of June 30, 2023.

There have been no changes in our internal control over financial reporting during the quarter ended June 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may be involved in various legal proceedings that are incidental to our business. In our opinion, we are not a party to any current legal proceedings that are material to our financial condition, either individually or in the aggregate.

Item 1A. Risk Factors.

There have been no material changes in our risk factors from those previously disclosed in our annual report on Form 10-K for the year ended December 31, 2022.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

We made no unregistered sales of equity securities during the quarter ended June 30, 2023.

Issuer Purchases of Equity Securities

On May 27, 2021, we announced that our Board of Directors had authorized a program to repurchase up to $20.0 million of our common stock from time to time in open market transactions at prevailing market prices or by other means in accordance with applicable regulations. The actual timing, number and value of shares repurchased under the program will be determined by management in its discretion and will depend on a number of factors, including the market price of our stock, general market and economic conditions, our capital position, financial performance and alternative uses of capital, and applicable legal requirements. The program may be discontinued at any time. No shares were repurchased during the first six months of 2023. Historically, stock repurchases have been funded from cash dividends paid to us from our bank. Additional repurchases may be made in future periods under the authorized plan or a new plan, which would also likely be funded from cash dividends paid to us from our bank. As of June 30, 2023, repurchases aggregating $6.8 million were available to be made under the current repurchase program.

Repurchases made during the second quarter of 2023 are detailed in the table below.

Period	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares or Approximate Dollar Value that May Yet Be Purchased Under the Plans or Programs
April 1 – 30		0	$	0		0	$	6,818,000
May 1 – 31		0		0		0		6,818,000
June 1 – 30		0		0		0		6,818,000
Total		0	$	0		0	$	6,818,000

Item 3. Defaults Upon Senior Securities.

Not applicable.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

Not applicable.

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MERCANTILE BANK CORPORATION

Item 6. Exhibits

EXHIBIT NO.	EXHIBIT DESCRIPTION
3.1	Articles of Incorporation of Mercantile Bank Corporation, including all amendments thereto, incorporated by reference to Exhibit 3.1 of our Form S-4 Registration Statement filed February 16, 2022
3.2	Our Amended and Restated Bylaws dated as of February 26, 2015 are incorporated by reference to Exhibit 3.1 to our Current Report on Form 8-K filed February 26, 2015
10.1	2023 Mercantile Executive Officer Bonus Plan, incorporated by reference to Exhibit 10.1 of our Form 8-K filed June 22, 2023
31	Rule 13a-14(a) Certifications
32.1	Section 1350 Chief Executive Officer Certification
32.2	Section 1350 Chief Financial Officer Certification
101	The following financial information from Mercantile’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2023, formatted in Inline XBRL (eXtensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Changes in Shareholders’ Equity, (v) the Consolidated Statements of Cash Flows, and (vi) the Notes to Consolidated Financial Statements
104	Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on August 4, 2023.

MERCANTILE BANK CORPORATION

By: /s/ Robert B. Kaminski, Jr.

Robert B. Kaminski, Jr.

President and Chief Executive Officer

(Principal Executive Officer)

By: /s/ Charles E. Christmas

Charles E. Christmas

Executive Vice President, Chief Financial Officer and Treasurer

(Principal Financial and Accounting Officer)

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