Note 4. Loans and Allowance for Loan Losses

For financial reporting purposes, Pinnacle Financial classifies its loan portfolio based on the underlying collateral utilized to secure each loan. This classification is consistent with those utilized in the Quarterly Report of Condition and Income filed by Pinnacle Bank with the Federal Deposit Insurance Corporation (FDIC).

Pinnacle Financial uses five loan categories: commercial real estate mortgage, consumer real estate mortgage, construction and land development, commercial and industrial, and consumer and other.

•

Commercial real estate mortgage loans. Commercial real estate mortgage loans are categorized as such based on investor exposures where repayment is largely dependent upon the operation, refinance, or sale of the underlying real estate. Commercial real estate mortgage loans also includes owner-occupied commercial real estate which Pinnacle Financial believes shares a similar risk profile to Pinnacle Financial's commercial and industrial products.


•	Consumer real estate mortgage loans. Consumer real estate mortgage consists primarily of loans secured by 1-4 family residential properties, including home equity lines of credit.

•

Construction and land development loans. Construction and land development loans include loans where the repayment is dependent on the successful operation of the related real estate project. Construction and land development loans include 1-4 family construction projects and commercial construction endeavors such as warehouses, apartments, office and retail space and land acquisition and development.


•	Commercial and industrial loans. Commercial and industrial loans include loans to business enterprises issued for commercial, industrial and/or other professional purposes.


•	Consumer and other loans. Consumer and other loans include all loans issued to individuals not included in the consumer real estate mortgage classification. Examples of consumer and other loans are automobile loans, credit cards and loans to finance education, among others.

Commercial loans receive risk ratings assigned by a financial advisor subject to validation by Pinnacle Financial's independent loan review department. Risk ratings are categorized as pass, special mention, substandard, substandard-nonaccrual or doubtful-nonaccrual. Pass rated loans include six distinct ratings categories for loans that represent specific attributes. Pinnacle Financial believes that its categories follow those used by Pinnacle Bank's primary regulators. At March 31, 2019, approximately 81.1% of Pinnacle Financial's loan portfolio was analyzed as a commercial loan type with a specifically assigned risk rating. Consumer loans and small business loans are generally not assigned an individual risk rating but are evaluated as either accrual or nonaccrual based on the performance of the individual loans. However, certain consumer real estate-mortgage loans and certain consumer and other loans receive a specific risk rating due to the loan proceeds being used for commercial purposes even though the collateral may be of a consumer loan nature.

Risk ratings are subject to continual review by a financial advisor and a senior credit officer. At least annually, Pinnacle Financial's credit procedures require that every risk rated loan of $1.0 million or more be subject to a formal credit risk review process. Each loan's risk rating is also subject to review by Pinnacle Financial's independent loan review department, which reviews a substantial portion of Pinnacle Financial's risk rated portfolio annually. Included in the coverage are independent loan reviews of loans in targeted higher-risk portfolio segments such as certain commercial and industrial loans, land loans and/or loan types in certain geographies.

The following table presents Pinnacle Financial's loan balances by primary loan classification and the amount within each risk rating category. Pass rated loans include all credits other than those included in special mention, substandard, substandard-nonaccrual and doubtful-nonaccrual which are defined as follows:


•	Special mention loans 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 asset or in Pinnacle Financial's credit position at some future date.

•

Substandard loans are inadequately protected by the current net worth and financial capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize collection of the debt. Substandard loans are characterized by the distinct possibility that Pinnacle Financial could sustain some loss if the deficiencies are not corrected.


•	Substandard-nonaccrual loans are substandard loans that have been placed on nonaccrual status.


•	Doubtful-nonaccrual loans have all the characteristics of substandard-nonaccrual loans with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

The following table outlines the amount of each loan classification categorized into each risk rating category as of March 31, 2019 and December 31, 2018 (in thousands):



	Commercial real estate - mortgage		Consumer real estate - mortgage		Construction and land development		Commercial and industrial		Consumer and other		Total
March 31, 2019
Pass	$	7,252,503	$	2,830,701	$	2,083,602	$	5,259,503	$	349,945	$	17,776,254
Special Mention	51,552		6,916		7,843		41,980		710		109,001
Substandard ⁽¹⁾	76,171		17,880		3,350		96,049		57		193,507
Substandard-nonaccrual	38,920		32,131		2,775		21,988		330		96,144
Doubtful-nonaccrual	—		—		—		—		—		—
Total loans	$	7,419,146	$	2,887,628	$	2,097,570	$	5,419,520	$	351,042	$	18,174,906



	Commercial real estate - mortgage		Consumer real estate - mortgage		Construction and land development		Commercial and industrial		Consumer and other		Total
December 31, 2018
Pass	$	6,998,485	$	2,787,570	$	2,059,376	$	5,148,726	$	352,516	$	17,346,673
Special Mention	55,932		7,902		4,334		24,284		711		93,163
Substandard ⁽¹⁾	78,202		20,906		5,358		75,351		62		179,879
Substandard-nonaccrual	32,335		28,069		3,387		23,060		983		87,834
Doubtful-nonaccrual	—		—		—		—		—		—
Total loans	$	7,164,954	$	2,844,447	$	2,072,455	$	5,271,421	$	354,272	$	17,707,549

(1) Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have doubts about the borrower's ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by Pinnacle Bank's primary regulators for loans classified as substandard, excluding troubled debt restructurings. Potential problem loans, which are not included in nonaccrual loans, amounted to approximately $190.3 million at March 31, 2019, compared to $176.3 million at December 31, 2018.

Loans acquired with deteriorated credit quality are recorded pursuant to the provisions of ASC 310-30, and are referred to as purchase credit impaired loans. The following table provides a rollforward of purchase credit impaired loans from December 31, 2018 through March 31, 2019 (in thousands):



	Gross Carrying Value			Accretable Yield			Nonaccretable Yield			Net Carrying Value
December 31, 2018	$	42,837		$	(114	)	$	(17,394	)	$	25,329
Acquisition	—			—			—			—
Year-to-date settlements	(2,951		)	12			1,312			(1,627		)
March 31, 2019	$	39,886		$	(102	)	$	(16,082	)	$	23,702

Certain of these loans have been deemed to be collateral dependent and, as such, no accretable yield has been recorded for these loans. The carrying value is adjusted for additional draws, pursuant to contractual arrangements, offset by loan paydowns. Year-to-date settlements include both loans that were charged-off as well as loans that were paid off, typically as a result of refinancings at other institutions.

Impaired loans include nonaccrual loans, troubled debt restructurings, and other loans deemed to be impaired but that continue to accrue interest. The following tables detail the recorded investment, unpaid principal balance and related allowance of Pinnacle Financial's impaired loans at March 31, 2019 and December 31, 2018 by loan classification (in thousands):



	At March 31, 2019						At December 31, 2018
	Recorded investment		Unpaid principal balances		Related allowance		Recorded investment		Unpaid principal balances		Related allowance
Impaired loans with an allowance:
Commercial real estate – mortgage	$	18,539	$	18,543	$	1,521	$	14,114	$	14,124	$	724
Consumer real estate – mortgage	24,668		24,784		2,381		19,864		19,991		1,443
Construction and land development	868		864		55		581		579		28
Commercial and industrial	8,802		8,773		1,461		9,252		9,215		1,441
Consumer and other	331		352		100		983		1,005		328
Total	$	53,208	$	53,316	$	5,518	$	44,794	$	44,914	$	3,964

Impaired loans without an allowance:
Commercial real estate – mortgage	$	16,674	$	16,678	$	—	$	14,724	$	14,739	$	—
Consumer real estate – mortgage	10,431		10,466		—		7,247		7,271		—
Construction and land development	—		—		—		1,786		1,786		—
Commercial and industrial	15,691		15,712		—		14,595		14,627		—
Consumer and other	—		—		—		—		—		—
Total	$	42,796	$	42,856	$	—	$	38,352	$	38,423	$	—

Total impaired loans	$	96,004	$	96,172	$	5,518	$	83,146	$	83,337	$	3,964

For the three months ended March 31, 2019, the average balance of impaired loans, was $89.6 million, compared to $64.2 million for the same period in 2018. Pinnacle Financial's policy is that the accrual of interest income will be discontinued when (1) there is a significant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expected or (2) the principal or interest is more than 90 days past due, unless the loan is both well secured and in the process of collection. As such, at the date loans are placed on nonaccrual status, Pinnacle Financial reverses all previously accrued interest income against current year earnings. Pinnacle Financial's policy is that once a loan is placed on nonaccrual status each subsequent payment is reviewed on a case-by-case basis to determine if the payment should be applied to interest or principal pursuant to regulatory guidelines. As detailed in the following table, Pinnacle Financial recognized $87,000 in interest income from cash payments received on nonaccrual loans during the three months ended March 31, 2019 compared to $101,000 during the three months ended March 31, 2018. Had these nonaccruing loans been on accruing status, interest income would have been $1.6 million higher for the three months ended March 31, 2019 compared to $1.4 million higher for the three months ended March 31, 2018.

The following table details the average recorded investment and the amount of interest income recognized on a cash basis for the three months ended March 31, 2019 and 2018, respectively, of impaired loans by loan classification (in thousands):



	For the three months ended March 31,
	2019				2018
	Average recorded investment		Interest income recognized		Average recorded investment		Interest income recognized
Impaired loans with an allowance:
Commercial real estate – mortgage	$	16,327	$	—	$	5,119	$	—
Consumer real estate – mortgage	22,266		—		8,792		—
Construction and land development	724		—		1,451		—
Commercial and industrial	9,027		—		11,220		—
Consumer and other	657		—		390		—
Total	$	49,001	$	—	$	26,972	$	—

Impaired loans without an allowance:
Commercial real estate – mortgage	$	15,699	$	87	$	15,375	$	101
Consumer real estate – mortgage	8,839		—		4,369		—
Construction and land development	893		—		1,322		—
Commercial and industrial	15,143		—		16,185		—
Consumer and other	—		—		—		—
Total	$	40,574	$	87	$	37,251	$	101

Total impaired loans	$	89,575	$	87	$	64,223	$	101

At March 31, 2019 and December 31, 2018, there were $5.5 million and $5.9 million, respectively, of troubled debt restructurings that were performing as of their restructure date and which were accruing interest. Troubled commercial loans are restructured by specialists within Pinnacle Bank's Special Assets Group, and all restructurings are approved by committees and/or credit officers separate and apart from the normal loan approval process. These specialists are charged with reducing Pinnacle Financial's overall risk and exposure to loss in the event of a restructuring by obtaining some or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral release terms, additional collateral or other similar strategies.

During the three months ended March 31, 2019 and 2018, there were no additional troubled debt restructurings or troubled debt restructurings that subsequently defaulted within twelve months of the restructuring. At both March 31, 2019 and December 31, 2018, the allowance for loan losses included no allowance specifically related to accruing troubled debt restructurings, which are classified as impaired loans pursuant to U.S. GAAP, but which continued to accrue interest at contractual rates at those dates.

In addition to the loan metrics above, Pinnacle Financial analyzes its commercial loan portfolio to determine if a concentration of credit risk exists to any industries. Pinnacle Financial utilizes broadly accepted industry classification systems in order to classify borrowers into various industry classifications. Pinnacle Financial has a credit exposure (loans outstanding plus unfunded lines of credit) exceeding 25% of Pinnacle Bank's total risk-based capital to borrowers in the following industries at March 31, 2019 with the comparative exposures for December 31, 2018 (in thousands):



	March 31, 2019
	Outstanding Principal Balances		Unfunded Commitments		Total exposure		Total Exposure at December 31, 2018
Lessors of nonresidential buildings	$	3,208,737	$	894,936	$	4,103,673	$	3,932,059
Lessors of residential buildings	1,038,462		335,860		1,374,322		1,484,697
New Housing For-Sale Builders	509,750		586,983		1,096,733		1,100,989
Hotels (except Casino Hotels) and Motels	825,627		137,885		963,512		920,001

Additionally, Pinnacle Financial monitors two ratios regarding construction and commercial real estate lending as part of its concentration management processes. Both ratios are calculated by dividing certain types of loan balances for each of the two categories by Pinnacle Bank’s total risk-based capital. At March 31, 2019 and December 31, 2018, Pinnacle Bank’s construction and land development loans as a percentage of total risk-based capital were 84.1% and 85.2%, respectively. Non-owner occupied commercial real estate and multifamily loans (including construction and land development loans) as a percentage of total risk-based capital were 282.5% and 277.7% as of March 31, 2019 and December 31, 2018, respectively. Banking regulations have established guidelines for the construction ratio of less than 100% of total risk-based capital and for the non-owner occupied ratio of less than 300% of total risk-based capital. When a bank’s ratios are in excess of one or both of these guidelines, banking regulations generally require an increased level of monitoring in these lending areas by bank management. At March 31, 2019, Pinnacle Bank was within the 100% and 300% guidelines and has established what it believes to be appropriate controls to monitor its lending in these areas as it aims to keep the level of these loans to below the 100% and 300% thresholds.

The table below presents past due balances by loan classification and segment at March 31, 2019 and December 31, 2018, allocated between accruing and nonaccrual status (in thousands):



	Accruing										Nonaccruing
March 31, 2019	30-89 days past due and accruing		90 days or more past due and accruing		Total past due and accruing		Current and accruing		Purchase credit impaired		Nonaccrual ⁽¹⁾		Nonaccruing purchase credit impaired		Total loans
Commercial real estate:
Owner-occupied	$	8,302	$	—	$	8,302	$	2,583,109	$	2,577	$	22,436	$	1,117	$	2,617,541
All other	6,569		—		6,569		4,774,555		5,119		12,601		2,761		4,801,605
Consumer real estate – mortgage	10,982		39		11,021		2,840,793		3,683		27,336		4,795		2,887,628
Construction and land development	795		—		795		2,092,563		1,437		868		1,907		2,097,570
Commercial and industrial	9,068		1,323		10,391		5,386,830		306		21,993		—		5,419,520
Consumer and other	2,736		620		3,356		347,356		—		330		—		351,042
Total	$	38,452	$	1,982	$	40,434	$	18,025,206	$	13,122	$	85,564	$	10,580	$	18,174,906



	Accruing										Nonaccruing
December 31, 2018	30-89 days past due and accruing		90 days or more past due and accruing		Total past due and accruing		Current and accruing		Purchase credit impaired		Nonaccrual ⁽¹⁾		Nonaccruing purchase credit impaired		Total loans
Commercial real estate:
Owner-occupied	$	10,170	$	—	$	10,170	$	2,623,700	$	2,664	$	16,025	$	874	$	2,653,433
All other	1,586		—		1,586		4,488,840		5,659		12,634		2,802		4,511,521
Consumer real estate – mortgage	18,059		—		18,059		2,794,630		3,689		22,564		5,505		2,844,447
Construction and land development	3,759		—		3,759		2,063,201		2,108		2,020		1,367		2,072,455
Commercial and industrial	21,451		1,082		22,533		5,225,205		623		23,022		38		5,271,421
Consumer and other	3,276		476		3,752		349,537		—		983		—		354,272
Total	$	58,301	$	1,558	$	59,859	$	17,545,113	$	14,743	$	77,248	$	10,586	$	17,707,549


(1)	Approximately $47.4 million and $52.5 million of nonaccrual loans as of March 31, 2019 and December 31, 2018, respectively, were performing pursuant to their contractual terms at those dates.

The following table details the changes in the allowance for loan losses for the three months ended March 31, 2019 and 2018, respectively, by loan classification (in thousands):



	Commercial real estate - mortgage			Consumer real estate - mortgage			Construction and land development			Commercial and industrial			Consumer and other			Unallocated			Total
Three months ended March 31, 2019:
Balance at December 31, 2018	$	26,946		$	7,670		$	11,128		$	31,731		$	5,423		$	677		$	83,575
Charged-off loans	(534		)	(350		)	—			(3,352		)	(1,832		)	—			(6,068		)
Recovery of previously charged-off loans	72			369			122			1,598			342			—			2,503
Provision for loan losses	3,683			680			(335		)	2,722			870			(436		)	7,184
Balance at March 31, 2019	$	30,167		$	8,369		$	10,915		$	32,699		$	4,803		$	241		$	87,194

Three months ended March 31, 2018:
Balance at December 31, 2017	$	21,188		$	5,031		$	8,962		$	24,863		$	5,874		$	1,322		$	67,240
Charged-off loans	(728		)	(336		)	(2		)	(2,540		)	(5,063		)	—			(8,669		)
Recovery of previously charged-off loans	1,396			666			565			888			1,187			—			4,702
Provision for loan losses	832			(261		)	591			3,437			3,478			(1,146		)	6,931
Balance at March 31, 2018	$	22,688		$	5,100		$	10,116		$	26,648		$	5,476		$	176		$	70,204

The following table details the allowance for loan losses and recorded investment in loans by loan classification and by impairment evaluation method as of March 31, 2019 and December 31, 2018, respectively (in thousands):



	Commercial real estate - mortgage		Consumer real estate - mortgage		Construction and land development		Commercial and industrial		Consumer and other		Unallocated		Total
March 31, 2019
Allowance for Loan Losses:
Collectively evaluated for impairment	$	28,646	$	5,988	$	10,860	$	31,238	$	4,703			$	81,435
Individually evaluated for impairment	1,521		2,381		55		1,461		100				5,518
Loans acquired with deteriorated credit quality⁽¹⁾	—		—		—		—		—				—
Total allowance for loan losses	$	30,167	$	8,369	$	10,915	$	32,699	$	4,803	$	241	$	87,194

Loans:
Collectively evaluated for impairment	$	7,372,359	$	2,844,051	$	2,093,358	$	5,394,721	$	350,711			$	18,055,200
Individually evaluated for impairment	35,213		35,099		868		24,493		331				96,004
Loans acquired with deteriorated credit quality	11,574		8,478		3,344		306		—				23,702
Total loans	$	7,419,146	$	2,887,628	$	2,097,570	$	5,419,520	$	351,042			$	18,174,906

December 31, 2018
Allowance for Loan Losses:
Collectively evaluated for impairment	$	26,222	$	6,227	$	11,100	$	30,290	$	5,095			$	78,934
Individually evaluated for impairment	724		1,443		28		1,441		328				3,964
Loans acquired with deteriorated credit quality⁽¹⁾	—		—		—		—		—				—
Total allowance for loan losses	$	26,946	$	7,670	$	11,128	$	31,731	$	5,423	$	677	$	83,575

Loans:
Collectively evaluated for impairment	$	7,124,117	$	2,808,142	$	2,066,613	$	5,246,913	$	353,289			$	17,599,074
Individually evaluated for impairment	28,838		27,111		2,367		23,847		983				83,146
Loans acquired with deteriorated credit quality	11,999		9,194		3,475		661		—				25,329
Total loans	$	7,164,954	$	2,844,447	$	2,072,455	$	5,271,421	$	354,272			$	17,707,549

⁽¹⁾ Loans acquired with deteriorated credit quality are recorded at fair value at the time of acquisition. An allowance for loan losses is recorded only in the event of subsequent credit deterioration.

The adequacy of the allowance for loan losses is assessed at the end of each calendar quarter. The level of the allowance is based upon evaluation of the loan portfolio, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrowers' ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, historical loss experience, industry and peer bank loan quality indications and other pertinent factors, including regulatory recommendations. The allowance for loan losses for purchased loans is calculated similarly to the method utilized for legacy Pinnacle Bank loans. Pinnacle Financial's accounting policy is to compare the computed allowance for loan losses for purchased loans on a loan-by-loan basis to any remaining fair value adjustment. If the computed allowance is greater than the remaining fair value adjustment, the excess is added to the allowance for loan losses by a charge to the provision for loan losses.

At March 31, 2019, Pinnacle Bank had granted loans and other extensions of credit amounting to approximately $38.4 million to current directors, executive officers, and their related entities, of which $18.1 million had been drawn upon. At December 31, 2018, Pinnacle Bank had granted loans and other extensions of credit amounting to approximately $37.9 million to directors, executive officers, and their related entities, of which approximately $18.3 million had been drawn upon. None of these loans to directors, executive officers, and their related entities were impaired at March 31, 2019 or December 31, 2018.

At March 31, 2019, Pinnacle Financial had approximately $14.5 million in commercial loans held for sale compared to $16.0 million at December 31, 2018, which primarily included commercial real estate and apartment loans originated for sale to a third-party as part of a multi-family loan program. Such loans are closed under a pass-through commitment structure wherein Pinnacle Bank's loan commitment to the borrower is the same as the third party's take-out commitment to Pinnacle Bank and the third party purchase typically occurs within thirty days of Pinnacle Bank closing with the borrowers.

Residential Lending

At March 31, 2019, Pinnacle Financial had approximately $45.5 million of mortgage loans held-for-sale compared to approximately $31.8 million at December 31, 2018. Total loan volumes sold during the three months ended March 31, 2019 were approximately $193.8 million compared to approximately $247.1 million for the three months ended March 31, 2018. During the three months ended March 31, 2019, Pinnacle Financial recognized $4.9 million in gains on the sale of these loans, net of commissions paid, compared to $3.7 million, net of commissions paid, during the three months ended March 31, 2018.

These mortgage loans held-for-sale are originated internally and are primarily to borrowers in Pinnacle Bank's geographic markets. These sales are typically on a mandatory basis to investors that follow conventional government sponsored entities (GSE) and the Department of Housing and Urban Development/U.S. Department of Veterans Affairs (HUD/VA) guidelines.

Each purchaser of a mortgage loan held-for-sale has specific guidelines and criteria for sellers of loans and the risk of credit loss with regard to the principal amount of the loans sold is generally transferred to the purchasers upon sale. While the loans are sold without recourse, the purchase agreements require Pinnacle Bank to make certain representations and warranties regarding the existence and sufficiency of file documentation and the absence of fraud by borrowers or other third parties such as appraisers in connection with obtaining the loan. If it is determined that the loans sold were in breach of these representations or warranties, Pinnacle Bank has obligations to either repurchase the loan for the unpaid principal balance and related investor fees or make the purchaser whole for the economic benefits of the loan. To date, Pinnacle Bank's liability pursuant to the terms of these representations and warranties has been insignificant to Pinnacle Bank.