Summary of Significant Accounting Policies (Policies)

6 Months Ended

Jun. 30, 2020

Basis of Presentation and Changes in Significant Accounting Policies

Recent Accounting Pronouncements

Recent Accounting Pronouncements

In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Measurement of Credit Losses on Financial Instruments (Topic 326),” also known as Current Expected Credit Losses, or CECL.  ASU 2016-13 was issued to provide financial statement users with more useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date to enhance the decision making process.  The new methodology reflects expected credit losses based on relevant vintage historical information, supported by reasonable forecasts of projected loss given defaults, which will affect the collectability of the reported amounts.  This new methodology also requires available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs through an other than temporary impairment analysis.  In addition, an allowance must be established for the credit risk related to unfunded commitments.  ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019, and was adopted as of January 1, 2020, by the Company.

Upon issuance of ASU 2016-13, the Company set up a CECL committee, with the goal of establishing a timeline for CECL data collection, implementation, parallel runs, testing, and model validation.  The Company has implemented a software solution provided by a third party vendor to assist in the determination of the allowance for credit losses (“ACL”), and the third party validation process was completed in the fourth quarter of 2019.  The Company accumulated historical data by loan pools and collateral classifications.  All historical data, model assumptions and calculation parameters were analyzed by the third party validation team, and management made enhancements to the software model used based on their recommendations.

Our approach for estimating expected life-time credit losses for loans includes the following components:

● An initial forecast period of one year for all portfolio segments and off-balance-sheet credit exposures. This period reflects management’s expectation of losses based on forward-looking economic scenarios over that time.

● A historical reversion loss forecast period covering the remaining contractual life, adjusted for prepayments, by portfolio segment based on the historical loss rate of loans within those segments.

● The initial loss forecast period and historical reversion loss rate is based on economic conditions at the measurement date.

● We primarily utilized the static pool and migration analysis methods to estimate credit losses. Such methods would obtain estimated life-time credit losses using the conceptual components described above.

Based on our portfolio composition at December 31, 2019, and the economic environment at that time, we recorded an overall increase in our ACL for loans and leases of $5.9 million and an ACL for unfunded commitments of $1.7 million.  Approximately $2.5 million of the increase to the ACL on loans resulted from the transfer of the non-accretable purchase accounting adjustments on purchased credit impaired loans.  There was no impact from adoption of CECL on securities available-for sale. As a result of the adoption of this new standard on January 1, 2020, we recorded a reduction to retained earnings of approximately $3.7 million, which was net of the $1.4

million deferred tax asset impact stemming from adoption.  The Company finalized internal control processes and disclosure documentation related to adoption of this standard during the first quarter of 2020.

As of March 31, 2020, a provision for credit losses was recorded based on the current uncertainty experienced in the macroeconomic environment, primarily due to falling interest rates and the impact of COVID-19.  This additional ACL was not considered part of the ASU 2016-13 adoption, as these changes in the assessment of the ACL occurred after the January 1, 2020, adoption. We recorded a provision for credit losses of $2.1 million during the second quarter of 2020, comprised of $1.4 million of ACL related to loans and leases, and $734,000 of ACL related to unfunded commitments.  We will continue to assess and evaluate the estimated future credit loss impact of current market conditions in subsequent reporting periods, which will be highly dependent on credit quality, macroeconomic forecasts and conditions, the local and national response to the COVID-19 pandemic, as well as the composition of our loans and available-for-sale securities portfolio.

Change in Significant Accounting Policies

Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.  These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

In addition to the significant accounting policies presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, on January 1, 2020, as discussed above, the Company adopted CECL, an expected loss methodology which replaces the incurred loss methodology for determining the Company’s provision for loan losses and allowance for loan and lease losses. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with ASU 2016-02 “Leases (Topic 842)” (“ASU 2016-02”). In addition, CECL made changes to the accounting for available-for-sale debt securities. The allowance for credit losses under CECL is discussed below.

Allowance for Credit Losses

Allowance for Credit Losses

The ACL is an estimate of the expected credit losses on the loans held for investment, unfunded loan commitments, and available-for-sale debt securities portfolios.

Allowance for Credit Losses on Loans

The ACL is calculated according to GAAP standards and is maintained by management at a level believed adequate to absorb estimated credit losses that are expected to occur within the existing loan portfolio through their contractual terms.  The ACL is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on loans.  Determination of the ACL is inherently subjective in nature since it requires significant estimates and management judgment, and includes a level of imprecision given the difficulty of identifying and assessing the factors impacting loan repayment and estimating the timing and amount of losses.  While management utilizes its best judgment and information available, the ultimate adequacy of the ACL is dependent upon a variety of factors beyond the Company’s direct control, including, but not limited to, the performance of the loan portfolio, consideration of current economic trends, changes in interest rates and property values, estimated losses on pools of homogeneous loans based on an analysis that uses historical loss experience for prior periods that are determined to have like characteristics with the current period such as pre-recessionary, recessionary, or recovery periods, portfolio growth and concentration risk, management and staffing changes, the interpretation of loan risk classifications by regulatory authorities and other credit market factors.  While each component of the ACL is determined separately, the entire balance is available for the entire loan portfolio.

The ACL methodology consists of measuring loans on a collective (pool) basis when similar risk characteristics exist.  The Company has identified the following loan portfolios and measures the ACL using the following methods:

● Commercial loans – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative factor adjustment in addition to the loss rates applied, as discussed below.

● Leases – the Company uses a remaining life methodology, also known as WARM (weighted average remaining life), as this segment is relatively new to the Company and more than four years of the Company’s own historical loss data is not available.  In accordance with accounting standards, we used an identified peer group to estimate losses for this portfolio.

● Real estate – commercial (“CRE”) – this loan portfolio is segregated into two  segments:

o CRE owner occupied – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied, as discussed below.

o CRE investor – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied, as discussed below.

● Real estate – construction – the Company uses a static segment analysis, which relies on the Company’s historical loss rates, as well as a qualitative adjustment in addition to the loss rates applied.  

● Real estate-residential  - this loan portfolio is segregated into two segments:

o Residential owner occupied and Residential investor – the Company uses a static segment analysis, applying historical loss rates from periods with like characteristics as the current period, and also a qualitative adjustment in addition to the loss rates applied.

● Multifamily – the Company uses a migration analysis, and within this segment, the Company classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied.

● HELOCs – this portfolio is segregated into two segments, a HELOC legacy segment which uses a static pool analysis, and a HELOC purchased segment, which uses the WARM method, and applies loss rates from the institutions from which the Company purchased the HELOCs, if available.

Purchased credit deteriorated loans (“PCD loans”), are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination. The Company records acquired PCD loans by adding the expected credit losses (i.e., the ACL) to the purchase price of the financial assets rather than recording it through the provision for credit losses in the income statement; thus, the sum of the loans’ purchase price and initial ALLL estimate represents the initial amortized cost basis.    The difference between the initial amortized cost basis and the unpaid principal balance is the non-credit discount or premium.  Subsequent changes in the ACL on PCD loans is recognized through the provision for credit losses.  

The non-credit discount or premium is accreted or amortized into interest income over the remaining life of the PCD loan on a level-yield basis.  In accordance with the transition requirements within the CECL standard, the Company’s purchased credit impaired loans (“PCI loans”) are now treated as PCD loans.  Before January 1, 2020, PCI loans that met the definition of nonperforming loans were excluded from the Company’s nonperforming disclosures, as long as their cash flows and the timing of such cash flows continued to be estimable and probable of collection. As a result of CECL implementation on January 1, 2020, PCD loans that meet the definition of nonperforming loans are now included in the Company’s nonperforming disclosures.

The qualitative factors applied to each loan portfolio consist of the impact of other internal and external qualitative and credit market factors as assessed by management through a detailed loan review, ACL analysis and credit discussions.  These internal and external qualitative and credit market factors include:

● changes in lending policies and procedures, including changes in underwriting standards and collections, charge-offs and recovery practices;

● changes in international, national, regionally and local conditions (specific factors which impact portfolios or discrepancies with national economic factors which are utilized within the economic forecast);

● changes in the experience, depth and ability of lending management;

● changes in the volume and severity of past due loans and other similar loan conditions;

● changes in the nature and volume of the loan portfolio and terms of loans;

● the existence and effect of any concentrations of credit and changes in the levels of such concentrations (this characteristic requires any portfolio exceeding 25% of capital to have a factor considered unless the pool is otherwise well diversified or holds a relatively low inherent risk);

● effects of other external factors, such as competition, legal or regulatory factors, on the level of estimated credit losses;

● changes in the quality of our loan review functions; and

● changes in the value of underlying collateral for collateral dependent loans.

The impact of the above listed internal and external qualitative and credit market risk factors is assessed within predetermined ranges to adjust the ACL totals calculated.

In addition to the pooled analysis performed for the majority of our loan and commitment balances, we also individually review those loans that have collateral dependency or are nonperforming.  Finally, we maintain a component of the ACL for those factors that cannot be quantified in the above analysis or are as yet unknown to us, due to changing economic conditions and other aspects of credit risk; which is known as the Company’s “Other Reserves.”

Loans are charged off against the ACL when management believes the uncollectibility of a loan balance is confirmed, while recoveries of amounts previously charged-off are credited to the ACL.  Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged off.  Approved releases from previously established ACL reserves authorized under our ACL methodology also reduce the ACL.  Additions to the ACL are established through the provision for credit losses on loans, which is charged to expense.

The Company’s ACL methodology is intended to reflect all loan portfolio risk, but management recognizes the inability to accurately depict all future credit losses in a current ACL estimate, as the impact of various factors cannot be fully known.  Accrued interest receivable on loans is excluded from the amortized cost basis of financing receivables for the purpose of determining the allowance for credit losses.  All calculations conform to GAAP.

Allowance for Credit Losses on Unfunded Loan Commitments

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk by a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company.  The ACL related to off-balance sheet credit exposures, which is within other liabilities on the Company’s balance sheet, is estimated at each balance sheet date under the CECL model, and is adjusted as determined necessary through the provision for credit losses on the income statement.  The estimate for ACL on unfunded loan commitments includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life.  

Allowance for Credit Losses on Securities Available-for-Sale

For available-for-sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will sell, the security before recovery of its amortized cost basis.  If either of the aforementioned criteria exists, the Company will record an ACL related to securities available-for-sale with an offsetting entry to the provision for credit losses on securities on the income statement.  If either of these criteria does not exist, the Company will evaluate the securities individually to determine whether the decline in the fair value below the amortized cost basis (impairment) is due to credit-related factors or noncredit-related factors, such as market interest rate fluctuations.  

In evaluating securities available-for sale for potential impairment, the Company considers many factors, including the financial condition and near-term prospects of the issuer, which for debt securities considers external credit ratings and recent downgrades; and its ability and intent to hold the security for a period of time sufficient for a recovery in value.  The Company also considers the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies. The amount of the impairment related to other factors is recognized in other comprehensive income (loss).

Accrued interest receivable on securities available-for-sale is excluded from the amortized cost basis of those securities for the purpose of determining the allowance for credit losses.  All calculations conform to GAAP.  

Risks and Uncertainties

Risks and Uncertainties

In December 2019, a novel strain of coronavirus (COVID-19) was reported to have surfaced in China, and has since spread to many other countries, including the United States. In March 2020, the World Health Organization declared COVID-19 a global pandemic and the United States declared a National Public Health Emergency. The COVID-19 pandemic has severely restricted the level of economic activity in the Company’s markets. In response to the COVID-19 pandemic, the State of Illinois and most other states took preventative or protective actions, such as imposing restrictions on travel and business operations, advising or requiring individuals to limit or forego their time outside of their homes, and ordering temporary closures of businesses that were deemed to be non-essential.  Although many businesses have begun to re-open, some markets, including those in Illinois, have since experienced a resurgence of COVID-19 cases, which may further slow overall economic activity and recovery.  Uncertainty also remains if, how and when schools will re-open and the impact of such re-opening decision on the economy.

The impact of the COVID-19 pandemic is fluid and continues to evolve. The unprecedented and rapid spread of COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower bank equity market valuations and significant volatility and disruption in financial markets.  In addition, due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020, for the first time, and declining further to 0.65% as of June 30, 2020. On March 3, 2020, the Federal Open Market Committee reduced the targeted federal funds interest rate range by 50 basis points to 1.00% to 1.25%. This range was further reduced to 0% to 0.25% percent on March 16, 2020. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on the Company’s business, financial condition and results of operations.  The ultimate extent of the impact of the COVID-19 pandemic on the Company’s business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and the Company’s customers, employees and vendors.

As of June 30, 2020, our consolidated balance sheet included goodwill of $18.6 million.  During the first and second quarter of 2020, we considered whether a quantitative assessment of goodwill was required as a result of the significant economic disruption caused by the COVID-19 pandemic.  Impacts of the economic disruptions were noted from the latter half of March through the second quarter, specifically, the decline in the trading price of our common stock and an increase in the U.S. unemployment rate.  After considering qualitative factors regarding the expected impacts of the pandemic on our business, operations and financial condition, we determined that these conditions did not indicate that it is more likely than not that the Company’s carrying value exceeded our fair value as of June 30, 2020, based on information available at this time, as these negative market indicators were not observed over a sustained period of time. However, further delayed recovery or further deterioration in market conditions related to the general economy, financial markets, and the associated impacts on our customers, employees and vendors, among other factors, could significantly impact the impairment analysis and may result in future goodwill impairment charges that, if incurred, could have a material adverse effect on our results of operations and financial condition.

Subsequent Events

Subsequent Events

On July 21, 2020, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on August 10, 2020, to stockholders of record as of July 31, 2020; dividends of $296,000 are scheduled to be paid to stockholders on August 10, 2020.