UNITED STATES

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 September 30, 2023

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-39036

ALERUS FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	45-0375407
(State or other jurisdiction of incorporation or	(I.R.S. Employer Identification No.)
organization)

401 Demers Avenue
Grand Forks, ND	58201
(Address of principal executive offices)	(Zip Code)

(701) 795-3200

(Registrant’s telephone number, including area code)

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


Title of each class	Trading symbol	Name of each exchange on which registered
Common Stock, par value $1.00 per share	ALRS	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 (§232.405 of this chapter) 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, 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. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ⌧

The number of shares of the registrant’s common stock outstanding at October 31, 2023 was 19,776,006.

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Alerus Financial Corporation and Subsidiaries

Table of Contents

		Page
Part 1:	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements	1
	Consolidated Balance Sheets as of September 30, 2023 and December 31, 2022	1
	Consolidated Statements of Income for the three and nine months ended September 30, 2023 and 2022	2
	Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2023 and 2022	3
	Consolidated Statements of Changes in Stockholders’ Equity for the three and nine months ended September 30, 2023 and 2022	4
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2023 and 2022	6
	Notes to Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	45
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	69
Item 4.	Controls and Procedures	71

Part 2:	OTHER INFORMATION
Item 1.	Legal Proceedings	71
Item 1A.	Risk Factors	71
Item 2.	Unregistered Sales of Equity Securities, Use of Proceeds, and Issuer Purchases of Equity Securities	71
Item 3.	Defaults Upon Senior Securities	72
Item 4.	Mine Safety Disclosures	72
Item 5.	Other Information	72
Item 6.	Exhibits	73

Signatures		74

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PART 1. FINANCIAL INFORMATION

Item 1 - Consolidated Financial Statements

Alerus Financial Corporation and Subsidiaries

Consolidated Balance Sheets


	September 30,		December 31,
(dollars in thousands, except share and per share data)	2023		2022
Assets	(Unaudited)		(Audited)
Cash and cash equivalents	$	64,724	$	58,242
Investment securities
Available-for-sale, at fair value		640,001		717,324
Held-to-maturity, at carrying value (allowance for credit losses on investments of $218 September 30, 2023)		303,268		321,902
Loans held for sale		16,346		9,488
Loans		2,606,430		2,443,994
Allowance for credit losses on loans		(36,290)		(31,146)
Net loans		2,570,140		2,412,848
Land, premises and equipment, net		17,182		17,288
Operating lease right-of-use assets		5,986		5,419
Accrued interest receivable		15,561		12,869
Bank-owned life insurance		33,012		33,991
Goodwill		46,783		47,087
Other intangible assets		18,482		22,455
Servicing rights		2,214		2,643
Deferred income taxes, net		47,978		42,369
Other assets		87,461		75,712
Total assets	$	3,869,138	$	3,779,637
Liabilities and Stockholders’ Equity
Deposits
Noninterest-bearing	$	717,990	$	860,987
Interest-bearing		2,154,194		2,054,497
Total deposits		2,872,184		2,915,484
Short-term borrowings		515,470		378,080
Long-term debt		58,928		58,843
Operating lease liabilities		6,286		5,902
Accrued expenses and other liabilities		66,868		64,456
Total liabilities		3,519,736		3,422,765
Stockholders’ equity
Preferred stock, $1 par value, 2,000,000 shares authorized: 0 issued and outstanding		—		—
Common stock, $1 par value, 30,000,000 shares authorized: 19,847,706 and 19,991,681 issued and outstanding		19,848		19,992
Additional paid-in capital		151,875		155,095
Retained earnings		291,162		280,426
Accumulated other comprehensive income (loss)		(113,483)		(98,641)
Total stockholders’ equity		349,402		356,872
Total liabilities and stockholders’ equity	$	3,869,138	$	3,779,637

See accompanying notes to consolidated financial statements (unaudited)

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Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Income (Unaudited)


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars and shares in thousands, except per share data)	2023		2022		2023		2022
Interest Income
Loans, including fees	$	34,986	$	25,379	$	99,187	$	60,659
Investment securities
Taxable		6,146		5,939		18,222		17,447
Exempt from federal income taxes		182		209		558		638
Other		724		748		2,221		1,021
Total interest income		42,038		32,275		120,188		79,765
Interest Expense
Deposits		14,436		1,852		36,218		3,494
Short-term borrowings		6,528		1,516		15,684		1,794
Long-term debt		679		591		1,999		1,712
Total interest expense		21,643		3,959		53,901		7,000
Net interest income		20,395		28,316		66,287		72,765
Provision for credit losses		—		—		550		—
Net interest income after provision for credit losses		20,395		28,316		65,737		72,765
Noninterest Income
Retirement and benefit services		18,605		16,597		49,977		50,536
Wealth management		5,271		4,852		15,915		15,726
Mortgage banking		2,510		3,782		7,132		14,751
Service charges on deposit accounts		328		377		940		1,152
Other		1,693		1,402		5,475		3,541
Total noninterest income		28,407		27,010		79,439		85,706
Noninterest Expense
Compensation		19,071		21,168		57,076		61,467
Employee taxes and benefits		4,895		5,079		15,472		17,028
Occupancy and equipment expense		1,883		1,925		5,619		5,713
Business services, software and technology expense		4,774		5,373		15,367		15,082
Intangible amortization expense		1,324		1,324		3,972		3,430
Professional fees and assessments		1,716		3,126		4,397		6,913
Marketing and business development		692		890		2,026		2,304
Supplies and postage		410		588		1,275		1,806
Travel		322		291		876		826
Mortgage and lending expenses		689		409		1,401		1,577
Other		1,484		2,594		4,022		4,676
Total noninterest expense		37,260		42,767		111,503		120,822
Income before income taxes		11,542		12,559		33,673		37,649
Income tax expense		2,381		2,940		7,222		8,553
Net income	$	9,161	$	9,619	$	26,451	$	29,096
Per Common Share Data
Basic earnings per common share	$	0.46	$	0.48	$	1.31	$	1.58

Diluted earnings per common share	$	0.45	$	0.47	$	1.30	$	1.56
Dividends declared per common share	$	0.19	$	0.18	$	0.56	$	0.52
Average common shares outstanding		19,872		19,987		19,977		18,186
Diluted average common shares outstanding		20,095		20,230		20,193		18,431

See accompanying notes to consolidated financial statements (unaudited)

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Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Comprehensive Income (Unaudited)


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands)	2023		2022		2023		2022
Net Income	$	9,161	$	9,619	$	26,451	$	29,096
Other Comprehensive Income (Loss), Net of Tax
Net change in unrealized gains (losses) on available-for-sale securities		(19,074)		(43,305)		(23,782)		(131,424)
Accretion of losses on debt securities reclassified to held-to-maturity		(80)		(91)		(251)		(290)
Net change in unrealized gain (losses) on cash flow hedging derivatives		1,216		—		1,216		—
Reclassification adjustment for losses (gains) realized in income		(205)		—		(205)		—
Net change in unrealized gain (losses) on other derivatives		1,132		—		3,206		—
Total other comprehensive income (loss), before tax		(17,011)		(43,396)		(19,816)		(131,714)
Income tax expense (benefit) related to items of other comprehensive income (loss)		(4,270)		(10,892)		(4,974)		(33,060)
Other comprehensive income (loss), net of tax		(12,741)		(32,504)		(14,842)		(98,654)
Total comprehensive income (loss)	$	(3,580)	$	(22,885)	$	11,609	$	(69,558)

See accompanying notes to consolidated financial statements (unaudited)

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Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)


	Three months ended September 30, 2023
							Accumulated
			Additional				Other
	Common		Paid-in		Retained		Comprehensive
(dollars and shares in thousands)	Stock		Capital		Earnings		Income (Loss)		Total
Balance as of June 30, 2023	$	19,915	$	152,673	$	285,839	$	(100,742)	$	357,685
Net income		—		—		9,161		—		9,161
Other comprehensive income (loss)		—		—		—		(12,741)		(12,741)
Common stock repurchased		(70)		(1,172)		—		—		(1,242)
Common stock dividends		—		—		(3,838)		—		(3,838)
Share‑based compensation expense		—		377		—		—		377
Vesting of restricted stock		3		(3)		—		—		—
Balance as of September 30, 2023	$	19,848	$	151,875	$	291,162	$	(113,483)	$	349,402


	Nine months ended September 30, 2023
							Accumulated
			Additional				Other
	Common		Paid-in		Retained		Comprehensive
(dollars in thousands)	Stock		Capital		Earnings		Income (Loss)		Total
Balance as of December 31, 2022	$	19,992	$	155,095	$	280,426	$	(98,641)	$	356,872
Cumulative effect of change in accounting principles, net of tax		—		—		(4,452)		—		(4,452)
Balance as of January 1, 2023		19,992		155,095		275,974		(98,641)		352,420
Net income		—		—		26,451		—		26,451
Other comprehensive income (loss)		—		—		—		(14,842)		(14,842)
Common stock repurchased		(257)		(4,299)		—		—		(4,556)
Common stock dividends		—		—		(11,263)		—		(11,263)
Share‑based compensation expense		18		1,174		—		—		1,192
Vesting of restricted stock		95		(95)		—		—		—
Balance as of September 30, 2023	$	19,848	$	151,875	$	291,162	$	(113,483)	$	349,402


	Three months ended September 30, 2022
							Accumulated
			Additional				Other
	Common		Paid-in		Retained		Comprehensive
(dollars in thousands)	Stock		Capital		Earnings		Income (Loss)		Total
Balance as of June 30, 2022	$	17,306	$	93,129	$	267,128	$	(70,405)	$	307,158
Net income		—		—		9,619		—		9,619
Other comprehensive income (loss)		—		—		—		(32,504)		(32,504)
Common stock repurchased		—		—		—		—		—
Common stock dividends		—		—		(3,615)		—		(3,615)
Stock issuance from the acquisition of Metro Phoenix Bank		2,681		61,149		—		—		63,830
Share‑based compensation expense		—		351		—		—		351
Vesting of restricted stock		—		—		—		—		—
Balance as of September 30, 2022	$	19,987	$	154,629	$	273,132	$	(102,909)	$	344,839

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	Nine months ended September 30, 2022
							Accumulated
			Additional				Other
	Common		Paid-in		Retained		Comprehensive
(dollars in thousands)	Stock		Capital		Earnings		Income (Loss)		Total
Balance as of December 31, 2021	$	17,213	$	92,878	$	253,567	$	(4,255)	$	359,403
Net income		—		—		29,096		—		29,096
Other comprehensive income (loss)		—		—		—		(98,654)		(98,654)
Common stock repurchased		(24)		(673)		—		—		(697)
Common stock dividends		—		—		(9,531)		—		(9,531)
Stock issuance from the acquisition of Metro Phoenix Bank		2,681		61,149		—		—		63,830
Share‑based compensation expense		10		1,382		—		—		1,392
Vesting of restricted stock		107		(107)		—		—		—
Balance as of September 30, 2022	$	19,987	$	154,629	$	273,132	$	(102,909)	$	344,839

See accompanying notes to consolidated financial statements (unaudited)

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Alerus Financial Corporation and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)


	Nine months ended
	September 30,
(dollars in thousands)	2023		2022
Operating Activities
Net income	$	26,451	$	29,096
Adjustments to reconcile net income to net cash provided (used) by operating activities
Deferred income taxes		857		(1,215)
Provision for credit losses		550		—
Depreciation and amortization		6,378		6,116
Amortization and accretion of premiums/discounts on investment securities		1,652		2,778
Amortization of operating lease right-of-use assets		1,756		(65)
Share‑based compensation expense		1,192		1,392
Originations on loans held for sale		(239,004)		(353,547)
Proceeds on loans held for sale		238,028		383,740
(Increase) in value of bank-owned life insurance		(653)		(621)
Realized loss (gain) on sale of fixed assets		(71)		(33)
Realized loss (gain) on derivative instruments		531		1,031
Realized loss (gain) on loans sold		(5,922)		(10,062)
Realized loss (gain) on sale of foreclosed assets		(27)		(9)
Realized loss (gain) on BOLI mortality		(1,196)		—
Realized loss (gain) on servicing rights		(28)		(683)
Net change in:
Accrued interest receivable		(2,692)		(1,628)
Other assets		4,784		(13,903)
Accrued expenses and other liabilities		(1,986)		12,348
Net cash provided (used) by operating activities		30,600		54,735
Investing Activities
Proceeds from maturities of investment securities available-for-sale		46,655		88,417
Purchases of investment securities available-for-sale		—		(96,968)
Proceeds from calls of investment securities held-to-maturity		242		827
Proceeds from maturities and paydowns of investment securities held-to-maturity		17,125		23,422
Net (increase) decrease in loans		(161,606)		(290,565)
Net (increase) decrease in FHLB stock		(5,953)		—
Net cash received (paid) for business combinations		—		101,585
Proceeds from BOLI mortality claim		2,828		—
Purchases of premises and equipment		(1,731)		(1,081)
Proceeds from sales of foreclosed assets		51		143
Net cash provided (used) by investing activities		(102,389)		(174,220)
Financing Activities
Net increase (decrease) in deposits		(43,300)		(312,425)
Net increase (decrease) in short-term borrowings		137,390		253,830
Repayments of long-term debt		—		(182)
Cash dividends paid on common stock		(11,263)		(9,185)
Repurchase of common stock		(4,556)		(697)
Net cash provided (used) by financing activities		78,271		(68,659)
Net change in cash and cash equivalents		6,482		(188,144)
Cash and cash equivalents at beginning of period		58,242		242,311
Cash and cash equivalents at end of period	$	64,724	$	54,167

See accompanying notes to consolidated financial statements (unaudited)

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	Nine months ended
	September 30,
	2023		2022
Supplemental Cash Flow Disclosures
Interest paid	$	50,969	$	7,269
Income taxes paid		6,637		8,713
Cash dividends declared, not paid		3,838		3,615
Supplemental Disclosures of Noncash Investing and Financing Activities
Loan collateral transferred to foreclosed assets		3		153
Right-of-use assets obtained in exchange for new operating lease liabilities, net		1,938		1,452
Change in fair value hedges presented within residential real estate loans and other assets		3,206		—

See accompanying notes to consolidated financial statements (unaudited)

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Alerus Financial Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

NOTE 1 Significant Accounting Policies

Organization

Alerus Financial Corporation, or the Company, is a financial holding company organized under the laws of the state of Delaware. The Company and its subsidiaries operate as a diversified financial services company headquartered in Grand Forks, North Dakota. Through its subsidiary, Alerus Financial, National Association, or the Bank, the Company provides financial solutions to businesses and consumers through four distinct business lines—banking, retirement and benefit services, wealth management, and mortgage.

Basis of Presentation

The accompanying unaudited consolidated financial statements and notes thereto of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, or SEC, and conform to practices within the banking industry and include all of the information and disclosures required by generally accepted accounting principles in the United States of America, or GAAP, for interim financial reporting. The accompanying unaudited consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that are necessary for a fair presentation of financial results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results for the full year or any other period. The Company has also evaluated all subsequent events for potential recognition and disclosure through the date of the filing of this Quarterly Report on Form 10-Q. These interim unaudited financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto as of and for the year ended December 31, 2022, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 13, 2023.

Principles of Consolidation

The accompanying unaudited consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. The Company’s principal operating subsidiary is the Bank.

In the normal course of business, the Company may enter into a transaction with a variable interest entity or VIE. VIE’s are legal entities whose investors lack the ability to make decisions about the entity’s activities, or whose equity investors do not have the right to receive the residual returns of the entity. The applicable accounting guidance requires the Company to perform ongoing quantitative and qualitative analysis to determine whether it must consolidate any VIE. The Company does not have any ownership interest in, or exert any control, over any VIE, and thus no VIE’s are included in the consolidated financial statements.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change in the near term include the valuation of investment securities, determination of the allowance for credit losses, valuation of reporting units for the purpose of testing goodwill and other intangible assets for impairment, valuation of deferred tax assets, and fair values of financial instruments.

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Reclassifications

Certain items previously reported have been reclassified to conform to the current period’s reporting format. Such reclassifications did not affect net income or stockholders’ equity.

Emerging Growth Company

The Company qualifies as an “emerging growth company” under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, even if the Company complies with the greater obligations of public companies that are not emerging growth companies, the Company may avail itself of the reduced requirements applicable to emerging growth companies from time to time in the future, so long as the Company is an emerging growth company. The Company will continue to be an emerging growth company until the earliest to occur of: (1) the end of the fiscal year following the fifth anniversary of the date of the first sale of common equity securities under the Company’s Registration Statement on Form S-1, which was declared effective by the SEC on September 12, 2019; (2) the last day of the fiscal year in which the Company has $1.235 billion or more in annual revenues; (3) the date on which the Company is deemed to be a “large accelerated filer” under the Securities Exchange Act of 1934, as amended, or the Exchange Act; or (4) the date on which the Company has, during the previous three-year period, issued publicly or privately, more than $1.0 billion in non-convertible debt securities. The last year the Company qualifies as an emerging growth company is 2024.

Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933 for complying with new or revised accounting standards. As an emerging growth company, the Company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. The Company elected to take advantage of the benefits of this extended transition period.

Allowance for credit losses

Investment securities available-for-sale. For available-for-sale investment securities in an unrealized loss position, the Company evaluates the securities to determine whether the decline in fair value below the amortized cost basis, or impairment, is due to credit-related factors or noncredit-related factors. Any impairment that is not credit related is recognized in other comprehensive income (loss), net of applicable taxes. Credit-related impairment is recognized as an allowance for credit losses, or ACL, related to investment securities available-for-sale on the balance sheet, limited to the amount by which the amortized cost basis exceeds the fair value, with a corresponding adjustment to earnings. Both the ACL and the adjustment to net income may be reversed if conditions change. However, if the Company intends to sell an impaired available-for-sale investment security or is required to sell such a security before recovering its amortized cost basis, the entire impairment amount must be recognized in earnings with a corresponding adjustment to the security’s amortized cost basis. Because the security’s amortized cost basis is adjusted to fair value, there is no ACL in this situation.

In evaluating available-for-sale securities in unrealized loss positions for impairment and the criteria regarding its intent or requirement to sell such securities, the Company considers the extent to which fair value is less than amortized cost, 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 issuers’ financial condition, among other factors.

Accrued interest receivable is excluded from the estimate of credit losses.

Investment securities held-to-maturity. Management measures expected credit losses on held-to-maturity investment securities on a collective basis by major security type. The Company evaluates held-to-maturity investment

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securities by credit rating and an external study, updated annually, that includes historical information such as probability of default and loss going back several years. Accrued interest receivable on held-to-maturity investment securities is excluded from the estimate of credit losses.

Loans held for investment. Under the current expected credit loss, or CECL, accounting standard the ACL is a valuation estimated at each balance sheet date and deducted from the amortized cost basis of loans held for investment to present the net amount expected to be collected.

The Company estimates the ACL based on the underlying assets’ amortized cost basis, which is the amount at which the financing receivable is originated or acquired, adjusted for collection of cash and charge-offs, as well as applicable accretion or amortization of premium, discount and net deferred fees or costs. In the event that collection of principal becomes uncertain, the Company has policies in place to reverse accrued interest in a timely manner. Therefore, the Company has made the policy election to exclude accrued interest from the measurement of ACL.

Expected credit losses are reflected in the ACL through a charge to provision for credit losses when the Company deems all or a portion of the financial asset will be uncollectible; the appropriate amount is written off and the ACL is reduced by the same amount. The Company applies judgement to determine when a financial asset is deemed uncollectible; however, generally, an asset will be considered uncollectible no later than when all efforts of collection have been exhausted. Subsequent recoveries, if any, are credited to the ACL when received.

Upon the adoption of the CECL accounting standard, the Company elected to maintain pools of loans that were previously accounted for under ASC 310-30 and will continue to account for these pools as a unit of account. Upon the adoption of the CECL accounting standard, the ACL was determined for each pool and added to the pools’ carrying amount to establish a new amortized cost basis. Loans that do not share similar risk characteristics are evaluated on an individual basis.

Management estimates the ACL using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable supportable forecasts. Historical loss experience provides the basis for estimation of expected credit losses. Adjustments to historical loss information are made for differences in the current loan-specific risk characteristics such as different underwriting standards, portfolio mix, delinquency level, or life of the loan, as well as changes in environmental conditions, levels of economic activity, unemployment rates, property values and other relevant factors. The calculation also contemplates that the Company may not be able to make or obtain such forecasts for the entire life of the financial assets and requires a reversion to historical loss information.

Ongoing impacts of the CECL accounting standard will be dependent upon changes in economic conditions and forecasts, originated and acquired loan portfolio composition, credit performance trends, portfolio duration and other forecasts.

Loans that do not share risk characteristics are evaluated on an individual basis. Loans evaluated individually are not also included in the collective evaluation. The ACL on individually evaluated loans is recognized on the basis of the present value of expected future cash flows discounted at the effective interest rate, the fair value of collateral adjusted of estimated costs to sell, or observable market price as of the relevant date.

Reserve for off-balance sheet credit exposures. In estimating expected credit losses for off-balance sheet credit exposures, the Company is required to estimate expected credit losses over the contractual period in which it is exposed to credit risk via a present contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the issuer. To be considered unconditionally cancellable for accounting purposes, the Company must have the ability to, at any time, with or without cause, refuse to extend credit under the commitment. Off-balance sheet credit exposure segments share the same risk characteristics as portfolio loans. The Company incorporates a probability of funding and utilizes the ACL loss rates to calculate the reserve. The reserve for off-balance sheet credit exposure is carried on the balance sheet in accrued expenses and other liabilities rather than as a component of the allowance. The reserve for off-balance sheet credit exposure is adjusted as a provision for off-balance sheet credit exposure reported as a component of the provision for credit loss expense in the accompanying unaudited Consolidated Statements of Income.

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NOTE 2 Recent Accounting Pronouncements

The following Financial Accounting Standards Board, or FASB, Accounting Standards Updates, or ASUs, are divided into pronouncements which have been adopted by the Company since January 1, 2023, and those which are not yet effective and have been evaluated or are currently being evaluated by management as of September 30, 2023.

Adopted Pronouncements

On January 1, 2023, the Company adopted ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The measurement of expected credit losses under the CECL accounting standard is applicable to financial assets measured at amortized cost, including loan receivables. 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 agreements). In addition, ASC 326 made changes to the accounting for held-to-maturity debt securities. One such change is to require credit losses to be presented as an allowance, rather than as a write-down.

The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost, off-balance sheet credit exposures, and held-to-maturity securities. Results for reporting periods beginning after December 31, 2022, are presented under ASC 326, while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded a net decrease to retained earnings of $4.5 million as of January 1, 2023, for the cumulative effect of adopting ASC 326.

The Company adopted ASC 326 using the prospective transition approach for financial assets purchased with credit deterioration previously classified as purchased credit impaired and accounted for under ASC 310-30. In accordance with the standard, management did not reassess whether purchased credit impaired, or PCI, assets met the criteria of purchased credit deteriorated, or PCD, assets as of the date of adoption.

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The following table illustrates the impact of ASC 326:


	January 1, 2023
	As reported				Pre-tax impact of
(dollars in thousands)	under		Pre-ASC 326		ASC 326
Assets:	ASC 326		Adoption		Adoption
Investments
Held-to-maturity
Obligations of state and political agencies	$	110	$	—	$	110
Mortgage backed securities
Residential agency		62		—		62
Total allowance for held-to-maturity investment securities		172		—		172
Loans
Commercial
Commercial and industrial		8,296		9,158		(862)
Real estate construction		3,964		1,446		2,518
Commercial real estate		12,264		12,688		(424)
Total commercial		24,524		23,292		1,232
Consumer
Residential real estate first mortgage		7,849		5,769		2,080
Residential real estate junior lien		1,222		1,289		(67)
Other revolving and installment		424		528		(104)
Total consumer		9,495		7,586		1,909
Unallocated		984		268		716
Total allowance for loans		35,003		31,146		3,857
Allowance for credit losses on loans and investments securities	$	35,175	$	31,146	$	4,029
Liabilities:
Allowance for credit losses on unfunded commitments	$	5,159	$	3,244	$	1,915

In March 2022, the FASB issued ASU No. 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method, which clarifies the guidance on fair value hedge accounting of interest rate risk portfolios of financial assets. ASU 2022-01 updates guidance in Topic 815, to expand the scope of the current last-of-layer method to allow multiple hedged layers to be designated for a single closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments on a prospective basis. Additionally, ASU 2022-01 clarifies that basis adjustments related to existing portfolio layer hedge relationships should not be considered when measuring credit losses on the financial assets included in the closed portfolio. Further, ASU 2022-01 clarifies that any reversal of fair value hedge basis adjustments associated with an actual breach should be recognized in interest income immediately. ASU 2022-01 was effective for fiscal years beginning after December 15, 2022, with early adoption permitted. The Company adopted ASU 2022-01 effective January 1, 2023, and entered into a fair value hedge agreement on February 10, 2023 and adopted the portfolio layer method of accounting for this transaction. This adoption had no impact on our consolidated financial statements as the Company did not have any hedged assets using the last-of-layer hedge accounting method.

In March 2022, the FASB issued ASU No. 2022-02, Financial Instruments – Credit Losses Troubled Debt Restructurings and Vintage Disclosures. The amendments in this update eliminate the accounting guidance for Troubled Debt Restructurings, or TDRs, by creditors in Subtopic 310-40. Receivables – Troubled Debt Restructurings by Creditors, while enhancing the disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. For public business entities, this amendment also has vintage disclosures that require that an entity disclose current-period gross write-offs by year of origination for financing receivables and net investments in leases within the scope of Subtopic 326-20 Financial Instruments – Credit Losses – Measured at Amortized Cost. For entities that had not yet adopted the amendment in ASU 2016-13, the effective date for the amendments in this update are same as the effective date for ASU 2016-13. The Company adopted this ASU on January 1, 2023, and had no loans experience financial difficulty in the current period.

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NOTE 3 Investment Securities

The following tables present amortized cost, gross unrealized gains and losses, allowance for credit losses, and fair value of the available-for-sale investment securities and the amortized cost, gross unrealized gains and losses and fair value of held-to-maturity securities as of September 30, 2023 and December 31, 2022:


	September 30, 2023
	Amortized		Unrealized		Unrealized		Allowance for		Fair
(dollars in thousands)	Cost		Gains		Losses		Credit Losses		Value
Available-for-sale
U.S. Treasury and agencies	$	2,679	$	9	$	(23)	$	—	$	2,665
Mortgage backed securities
Residential agency		656,845		—		(135,222)		—		521,623
Commercial		66,980		—		(8,295)		—		58,685
Asset backed securities		27		—		—		—		27
Corporate bonds		69,495		—		(12,494)		—		57,001
Total available-for-sale investment securities		796,026		9		(156,034)		—		640,001
Held-to-maturity
Obligations of state and political agencies		130,088		—		(18,651)		115		111,437
Mortgage backed securities
Residential agency		173,398		—		(36,596)		103		136,802
Total held-to-maturity investment securities		303,486		—		(55,247)		218		248,239
Total investment securities	$	1,099,512	$	9	$	(211,281)	$	218	$	888,240


	December 31, 2022
	Amortized		Unrealized		Unrealized		Allowance for		Fair
(dollars in thousands)	Cost		Gains		Losses		Credit Losses		Value
Available-for-sale
U.S. Treasury and agencies	$	3,518	$	19	$	(17)		N/A	$	3,520
Mortgage backed securities
Residential agency		705,845		2		(118,168)		N/A		587,679
Commercial		70,669		—		(7,111)		N/A		63,558
Asset backed securities		34		—		—		N/A		34
Corporate bonds		69,501		—		(6,968)		N/A		62,533
Total available-for-sale investment securities		849,567		21		(132,264)		N/A		717,324
Held-to-maturity
Obligations of state and political agencies		137,787		—		(17,736)		N/A		120,051
Mortgage backed securities
Residential agency		184,115		—		(33,254)		N/A		150,861
Total held-to-maturity investment securities		321,902		—		(50,990)		N/A		270,912
Total investment securities	$	1,171,469	$	21	$	(183,254)		N/A	$	988,236

The adequacy of the allowance for credit losses on investment securities is assessed at the end of each quarter. The Company does not believe that the available-for-sale debt securities that were in an unrealized loss position as of September 30, 2023, represent a credit loss impairment. As of September 30, 2023, and December 31, 2022, the gross unrealized loss positions were primarily related to mortgage-backed securities issued by U.S. government agencies or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. Total gross unrealized losses were attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to the credit quality of the investment securities. The Company does not intend to sell the investment securities that were in an unrealized loss position and it is not more likely than not that the Company will be required to sell the investment securities before recovery of their amortized cost basis, which may be at maturity.

The allowance for credit losses on held-to-maturity debt securities is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable supportable forecasts. Using a probability of default and loss on given default analysis an allowance for credit losses was established in the amount of $218 thousand as of September 30, 2023.

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Accrued interest receivable on available-for-sale investment securities and held-to-maturity investment securities is recorded in accrued interest receivable and is excluded from the estimate of credit losses. As of September 30, 2023, the accrued interest receivable on available-for-sale investment securities and held-to-maturity investment securities totaled $2.4 million and $1.0 million, respectively. As of December 31, 2022, the accrued interest receivable on available-for-sale investment securities and held-to-maturity investment securities totaled $1.9 million and $1.5 million, respectively.

The following table presents investment securities available-for-sale in an unrealized loss position for which an allowance for credit losses has not been recorded as of September 30, 2023:


	September 30, 2023
	Less than 12 Months				Over 12 Months				Total
	Unrealized		Fair		Unrealized		Fair		Unrealized		Fair
(dollars in thousands)	Losses		Value		Losses		Value		Losses		Value
Available-for-sale
U.S. Treasury and agencies	$	—	$	—	$	(23)	$	389	$	(23)	$	389
Mortgage backed securities
Residential agency		(9)		577		(135,213)		484,451		(135,222)		485,028
Commercial		—		—		(8,295)		58,684		(8,295)		58,684
Asset backed securities		—		7		—		19		—		26
Corporate bonds		—		—		(12,494)		57,001		(12,494)		57,001
Total available-for-sale investment securities	$	(9)	$	584	$	(156,025)	$	600,544	$	(156,034)	$	601,128

Gross unrealized losses on investment securities and the fair value of the related securities aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2022, were as follows:


	December 31, 2022
	Less than 12 Months				Over 12 Months				Total
	Unrealized		Fair		Unrealized		Fair		Unrealized		Fair
(dollars in thousands)	Losses		Value		Losses		Value		Losses		Value
Available-for-sale
U.S. Treasury and agencies	$	(17)	$	509	$	—	$	—	$	(17)	$	509
Mortgage backed securities
Residential agency		(10,457)		79,693		(107,711)		507,418		(118,168)		587,111
Commercial		(4,835)		50,437		(2,276)		13,120		(7,111)		63,557
Asset backed securities		—		32		—		2		—		34
Corporate bonds		(4,452)		48,048		(2,516)		14,484		(6,968)		62,532
Total available-for-sale investment securities		(19,761)		178,719		(112,503)		535,024		(132,264)		713,743
Held-to-maturity
Obligations of state and political agencies		(3,336)		18,788		(14,400)		98,762		(17,736)		117,550
Mortgage backed securities
Residential agency		—		—		(33,254)		150,861		(33,254)		150,861
Total held-to-maturity investment securities		(3,336)		18,788		(47,654)		249,623		(50,990)		268,411
Total investment securities	$	(23,097)	$	197,507	$	(160,157)	$	784,647	$	(183,254)	$	982,154

Unrealized losses on available-for-sale investment securities have not been recognized into income because the issuers’ bonds are of high credit quality. Furthermore, the Company does not intend to sell, and it is likely that management will not be required to sell, the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates. The issuers continue to make timely principal and interest payments on their bonds. The Company expects that it could see a continued increase in unrealized losses if the Federal Reserve continues to raise interest rates.

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The following table presents amortized cost and fair value of available-for-sale investment securities and the carrying value and fair value of held-to-maturity investment securities as of September 30, 2023, by contractual maturity:


	Held-to-maturity				Available-for-sale
	Carrying		Fair		Amortized		Fair
(dollars in thousands)	Value		Value		Cost		Value
Due within one year or less	$	5,981	$	5,875	$	—	$	—
Due after one year through five years		51,009		45,878		17,119		15,706
Due after five years through ten years		60,325		49,427		80,670		66,779
Due after 10 years		12,773		10,257		41,392		35,893
		130,088		111,437		139,181		118,378
Mortgage-backed securities
Residential agency		173,398		136,802		656,845		521,623
Total investment securities	$	303,486	$	248,239	$	796,026	$	640,001

Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

Investment securities with a total carrying value of $381.4 million and $260.7 million were pledged as of September 30, 2023 and December 31, 2022, respectively, to secure public deposits and for other purposes required or permitted by law.

The company had no sales or calls of available-for-sale investment securities, for the three and nine months ended September 30, 2023 and 2022.

Proceeds from the call of held-to-maturity investment securities, for the three and nine months ended September 30, 2023 and 2022, are displayed in the table below:


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands)	2023		2022		2023		2022
Proceeds	$	116	$	101	$	242	$	827
Realized gains		—		—		—		—
Realized losses		—		—		—		—

As of September 30, 2023 and December 31, 2022, the carrying value of the Company’s Federal Reserve stock and Federal Home Loan Bank of Des Moines, or FHLB, stock was as follows:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Federal Reserve	$	4,623	$	4,595
FHLB		25,316		19,362

These securities can only be redeemed or sold at their par value and only to the respective issuing institution or to another member institution. The Company records these non-marketable equity securities as a component of other assets and periodically evaluates these securities for impairment. Management considers these non-marketable equity securities to be long-term investments. Accordingly, when evaluating these securities for impairment, management considers the ultimate recoverability of the par value rather than recognizing temporary declines in value.

Visa Class B Restricted Shares

In 2008, the Company received Visa Class B restricted shares as part of Visa’s initial public offering. These shares are transferable only under limited circumstances until they can be converted into the publicly traded Class A common shares. This conversion will not occur until the settlement of certain litigation which will be indemnified by Visa members, including the Company. Visa funded an escrow account from its initial public offering to settle these

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litigation claims. Should this escrow account be insufficient to cover these litigation claims, Visa is entitled to fund additional amounts to the escrow account by reducing each member bank’s Class B conversion ratio to unrestricted Class A shares. As of September 30, 2023, the conversion ratio was 1.5902. Based on the existing transfer restriction and the uncertainty of the outcome of the Visa litigation mentioned above, the 6,924 Class B shares (11,010 Class A equivalents) that the Company owned as of September 30, 2023 and December 31, 2022, were carried at a zero cost basis.

NOTE 4 Loans and Allowance for Credit Losses

The following table presents total loans outstanding, by portfolio segment, as of September 30, 2023 and December 31, 2022:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Commercial
Commercial and industrial	$	582,387	$	583,876
Real estate construction		97,742		97,810
Commercial real estate		1,025,014		881,670
Total commercial		1,705,143		1,563,356
Consumer
Residential real estate first mortgage		717,793		679,551
Residential real estate junior lien		152,677		150,479
Other revolving and installment		30,817		50,608
Total consumer		901,287		880,638
Total loans	$	2,606,430	$	2,443,994

Total loans included net deferred loan fees and costs of $0.5 million and $0.9 million at September 30, 2023 and December 31, 2022, respectively. Unearned discounts associated with the acquisition of Metro Phoenix Bank totaled $5.2 million as of September 30, 2023.

Accrued interest receivable on loans is recorded within accrued interest receivable, and totaled $11.5 million at September 30, 2023 and $9.2 million at December 31, 2022.

Management monitors the credit quality of its loan portfolio on an ongoing basis. Measurements of delinquency and past due status are based on the contractual terms of each loan. Past due loans are reviewed regularly to identify loans for nonaccrual status.

The following tables present a past due aging analysis of total loans outstanding, by portfolio segment, as of September 30, 2023 and December 31, 2022:


	September 30, 2023
					90 Days
	Accruing		30 - 89 Days		or More				Total
(dollars in thousands)	Current		Past Due		Past Due		Nonaccrual		Loans
Commercial
Commercial and industrial	$	572,898	$	2,929	$	—	$	6,560	$	582,387
Real estate construction		97,627		—		—		115		97,742
Commercial real estate		1,024,118		—		—		896		1,025,014
Total commercial		1,694,643		2,929		—		7,571		1,705,143
Consumer
Residential real estate first mortgage		716,799		108		—		886		717,793
Residential real estate junior lien		151,593		538		—		546		152,677
Other revolving and installment		30,635		178		—		4		30,817
Total consumer		899,027		824		—		1,436		901,287
Total loans	$	2,593,670	$	3,753	$	—	$	9,007	$	2,606,430

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	December 31, 2022
					90 Days
	Accruing		30 - 89 Days		or More				Total
(dollars in thousands)	Current		Past Due		Past Due		Nonaccrual		Loans
Commercial
Commercial and industrial	$	580,288	$	2,426	$	—	$	1,162	$	583,876
Real estate construction		97,370		—		—		440		97,810
Commercial real estate		879,830		368		—		1,472		881,670
Total commercial		1,557,488		2,794		—		3,074		1,563,356
Consumer
Residential real estate first mortgage		677,471		1,545		—		535		679,551
Residential real estate junior lien		149,918		377		—		184		150,479
Other revolving and installment		50,360		247		—		1		50,608
Total consumer		877,749		2,169		—		720		880,638
Total loans	$	2,435,237	$	4,963	$	—	$	3,794	$	2,443,994

In calculating expected credit losses, the Company includes loans on nonaccrual status and loans 90 days or more past due and still accruing. The following table presents the amortized cost basis on nonaccrual status loans and loans 90 days or more past due and still accruing as of September 30, 2023 and December 31, 2022:


	As of September 30, 2023
	Nonaccrual				90 Days
	with no Allowance				or More
(dollars in thousands)	for Credit Losses		Nonaccrual		Past Due
Commercial
Commercial and industrial	$	—	$	6,560	$	—
Real estate construction		115		115		—
Commercial real estate		—		896		—
Total commercial		115		7,571		—
Consumer
Residential real estate first mortgage		880		886		—
Residential real estate junior lien		46		546		—
Other revolving and installment		—		4		—
Total consumer		926		1,436		—
Total loans	$	1,041	$	9,007	$	—


	December 31, 2022
	Nonaccrual				90 Days
	with no Allowance				or More
(dollars in thousands)	for Credit Losses		Nonaccrual		Past Due
Commercial
Commercial and industrial	$	638	$	1,162	$	—
Real estate construction		—		440		—
Commercial real estate		576		1,472		—
Total commercial		1,214		3,074		—
Consumer
Residential real estate first mortgage		535		535		—
Residential real estate junior lien		184		184		—
Other revolving and installment		1		1		—
Total consumer		720		720		—
Total loans	$	1,934	$	3,794	$	—

Loans with a carrying value of $1.9 billion as of September 30, 2023 and $1.5 billion as of December 31, 2022, were pledged to secure public deposits, and for other purposes required or permitted by law.

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A loan for which the terms have been modified resulting in a concession represents a loan experiencing financial difficulty. Loans experiencing financial difficulty can include modifications for an interest rate reduction below current market rates, a forgiveness of principal balance, an extension of the loan term, an-other than significant payment delay, or some combination of similar types of modifications. During the three and nine months ended September 30, 2023, the Company did not provide any modifications to loans under these circumstances that were experiencing financial difficulty.

The Company’s consumer loan portfolio is primarily comprised of secured loans that are evaluated at origination on a centralized basis against standardized underwriting criteria. The Company generally does not risk rate consumer loans unless a default event such as bankruptcy or extended nonperformance takes place. Credit quality for the consumer loan portfolio is measured by delinquency rates, nonaccrual amounts and actual losses incurred.

The Company assigns a risk rating to all commercial loans, except pools of homogeneous loans, and performs detailed internal and external reviews of risk rated loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. These risk ratings are also subject to examination by the Company’s regulators. During the internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which the borrowers operate and the estimated fair values of collateral securing the loans. These credit quality indicators are used to assign a risk rating to each individual loan.

The Company’s ratings are aligned to pass and criticized categories. The criticized category includes special mention, substandard, and doubtful risk ratings. The risk ratings are defined as follows:

Pass: A pass loan is a credit with no existing or known potential weaknesses deserving of management’s close attention.

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, this potential weakness may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date. Special mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification.

Substandard: Loans classified as substandard are not adequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Well-defined weaknesses include a borrower’s lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time, or the failure to fulfill economic expectations. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or repayment in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss: Loans classified as loss are considered uncollectible and charged off immediately.

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The following table sets forth the amortized cost basis of loans by credit quality indicator and vintage based on the most recent analysis performed, as of September 30, 2023:


													Revolving
(dollars in thousands)	Term Loans Amortized Cost Basis by Origination Year												Loans Amortized
As of September 30, 2023	2023		2022		2021		2020		2019		Prior		Cost Basis		Total
Commercial and industrial
Pass	$	104,091	$	107,346	$	75,494	$	67,184	$	37,877	$	50,189	$	108,524	$	550,705
Special mention		—		—		—		—		—		—		273		273
Substandard		117		5,052		377		8,064		104		2,214		15,481		31,409
Doubtful		—		—		—		—		—		—		—		—
Subtotal		104,208		112,398		75,871		75,248		37,981		52,403		124,278		582,387
Real estate construction
Pass		14,284		39,029		18,594		144		9,506		1,054		—		82,611
Special mention		—		15,131		—		—		—		—		—		15,131
Substandard		—		—		—		—		—		—		—		—
Doubtful		—		—		—		—		—		—		—		—
Subtotal		14,284		54,160		18,594		144		9,506		1,054		—		97,742
Commercial real estate
Pass		151,721		277,347		140,323		158,590		108,798		164,538		16,765		1,018,082
Special mention		—		—		—		—		—		—		—		—
Substandard		—		97		886		—		4,157		1,792		—		6,932
Doubtful		—		—		—		—		—		—		—		—
Subtotal		151,721		277,444		141,209		158,590		112,955		166,330		16,765		1,025,014
Residential real estate first mortgage
Pass		58,972		203,782		222,783		109,029		33,356		89,480		284		717,686
Special mention		—		—		—		—		—		—		—		—
Substandard		—		—		—		—		—		107		—		107
Doubtful		—		—		—		—		—		—		—		—
Subtotal		58,972		203,782		222,783		109,029		33,356		89,587		284		717,793
Residential real estate junior lien
Pass		17,021		16,755		6,452		4,908		1,779		6,299		97,541		150,755
Special mention		—		—		—		—		—		—		—		—
Substandard		—		—		—		—		—		331		1,591		1,922
Doubtful		—		—		—		—		—		—		—		—
Subtotal		17,021		16,755		6,452		4,908		1,779		6,630		99,132		152,677
Other revolving and installment
Pass		5,786		6,936		1,319		5,159		2,000		1,442		8,175		30,817
Special mention		—		—		—		—		—		—		—		—
Substandard		—		—		—		—		—		—		—		—
Doubtful		—		—		—		—		—		—		—		—
Subtotal		5,786		6,936		1,319		5,159		2,000		1,442		8,175		30,817
Total Loans
Pass		351,875		651,195		464,965		345,014		193,316		313,002		231,289		2,550,656
Special mention		—		15,131		—		—		—		—		273		15,404
Substandard		117		5,149		1,263		8,064		4,261		4,444		17,072		40,370
Doubtful		—		—		—		—		—		—		—		—
Total loans	$	351,992	$	671,475	$	466,228	$	353,078	$	197,577	$	317,446	$	248,634	$	2,606,430

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The following table sets forth the risk category of loans by class of loans and credit quality indicator used on the most recent analysis performed as of December 31, 2022:


	December 31, 2022
			Criticized
			Special
(dollars in thousands)	Pass		Mention		Substandard		Doubtful		Total
Commercial
Commercial and industrial	$	558,694	$	21,969	$	3,213	$	—	$	583,876
Real estate construction		97,548		—		262		—		97,810
Commercial real estate		873,270		—		8,400		—		881,670
Total commercial		1,529,512		21,969		11,875		—		1,563,356
Consumer
Residential real estate first mortgage		678,743		63		745		—		679,551
Residential real estate junior lien		149,847		—		632		—		150,479
Other revolving and installment		50,607		—		1		—		50,608
Total consumer		879,197		63		1,378		—		880,638
Total loans	$	2,408,709	$	22,032	$	13,253	$	—	$	2,443,994

The adequacy of the allowance for credit losses on loans is assessed at the end of each quarter. The allowance for credit losses is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable supportable forecasts. Historical data is evaluated in multiple components of the expected credit loss, including the reasonable and supportable forecast of each loan segment. Historical experience is used to infer probability of default and loss given the reasonable and supportable forecast period. Qualitative reserves reflect management’s overall estimate of the extent to which current expected credit losses on collectively evaluated loans will differ from historical loss experience. The analysis takes into consideration other analytics performed within the organization, such as enterprise and concentration management, along with other credit-related analytics as deemed appropriate.

The following tables present, by loan portfolio segment, a summary of the changes in the allowance for credit losses on loans for the three and nine months ended September 30, 2023 and 2022:


	Three months ended September 30, 2023
	Beginning		Provision for		Loan		Loan		Ending
(dollars in thousands)	Balance		Credit Losses		Charge-offs		Recoveries		Balance
Commercial
Commercial and industrial	$	7,813	$	442	$	(134)	$	456	$	8,577
Real estate construction		3,646		1,063		—		—		4,709
Commercial real estate		12,965		(270)		—		11		12,706
Total commercial		24,424		1,235		(134)		467		25,992
Consumer
Residential real estate first mortgage		7,901		(389)		(9)		254		7,757
Residential real estate junior lien		1,351		(14)		—		—		1,337
Other revolving and installment		293		(58)		(8)		24		251
Total consumer		9,545		(461)		(17)		278		9,345
Unallocated		1,727		(774)		—		—		953
Total	$	35,696	$	—	$	(151)	$	745	$	36,290

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	Nine months ended September 30, 2023
	Beginning		Adoption		Provision for		Loan		Loan		Ending
(dollars in thousands)	Balance		of ASC 326		Credit Losses⁽¹⁾		Charge-offs		Recoveries		Balance
Commercial
Commercial and industrial	$	9,158	$	(862)	$	(275)	$	(394)	$	950	$	8,577
Real estate construction		1,446		2,518		745		—		—		4,709
Commercial real estate		12,688		(424)		408		—		34		12,706
Total commercial		23,292		1,232		878		(394)		984		25,992
Consumer
Residential real estate first mortgage		5,769		2,080		(339)		(9)		256		7,757
Residential real estate junior lien		1,289		(67)		140		(77)		52		1,337
Other revolving and installment		528		(104)		(188)		(36)		51		251
Total consumer		7,586		1,909		(387)		(122)		359		9,345
Unallocated		268		716		(31)		—		—		953
Total	$	31,146	$	3,857	$	460	$	(516)	$	1,343	$	36,290

(1)	The difference in the credit loss expense reported herein compared to the Consolidated Statements of Income is associated with the credit loss expense of $44 thousand related to off-balance sheet credit exposures and $46 thousand related to investment securities held-to-maturity.


	Three months ended September 30, 2022
	Beginning		Provision for		Loan		Loan		Ending
(dollars in thousands)	Balance		Loan Losses		Charge-offs		Recoveries		Balance
Commercial
Commercial and industrial	$	10,333	$	(845)	$	(672)	$	105	$	8,921
Real estate construction		878		378		—		76		1,332
Commercial real estate		10,834		1,335		—		101		12,270
Total commercial		22,045		868		(672)		282		22,523
Consumer
Residential real estate first mortgage		6,175		(584)		—		—		5,591
Residential real estate junior lien		1,467		(109)		—		7		1,365
Other revolving and installment		634		(75)		(75)		53		537
Total consumer		8,276		(768)		(75)		60		7,493
Unallocated		1,052		(100)		—		—		952
Total	$	31,373	$	—	$	(747)	$	342	$	30,968


	Nine months ended September 30, 2022
	Beginning		Provision for		Loan		Loan		Ending
(dollars in thousands)	Balance		Loan Losses		Charge-offs		Recoveries		Balance
Commercial
Commercial and industrial	$	8,925	$	1,011	$	(1,336)	$	321	$	8,921
Real estate construction		783		473		—		76		1,332
Commercial real estate		12,376		(229)		—		123		12,270
Total commercial		22,084		1,255		(1,336)		520		22,523
Consumer
Residential real estate first mortgage		6,532		(941)		—		—		5,591
Residential real estate junior lien		1,295		(151)		—		221		1,365
Other revolving and installment		481		65		(130)		121		537
Total consumer		8,308		(1,027)		(130)		342		7,493
Unallocated		1,180		(228)		—		—		952
Total	$	31,572	$	—	$	(1,466)	$	862	$	30,968

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The following table presents, by loan portfolio segment, a summary of charge-offs, by vintage, for the nine months ended September 30, 2023:


	Gross Charge-offs for nine months ended September 30, 2023
(dollars in thousands)	2023		2022		2021		2020		2019		Prior		Total
Commercial
Commercial and industrial	$	39	$	—	$	28	$	11	$	247	$	69	$	394
Real estate construction		—		—		—		—		—		—		—
Commercial real estate		—		—		—		—		—		—		—
Total commercial		39		—		28		11		247		69		394
Consumer
Residential real estate first mortgage		—		—		9		—		—		—		9
Residential real estate junior lien		—		—		—		—		—		77		77
Other revolving and installment		—		2		—		27		4		3		36
Total consumer		—		2		9		27		4		80		122
Total loans	$	39	$	2	$	37	$	38	$	251	$	149	$	516

The following tables present the amortized cost and related allowance for credit losses on loans, by portfolio segment, as of September 30, 2023 and December 31, 2022:


	September 30, 2023
	Amortized Cost						Allowance for Credit Losses on Loans
	Individually		Collectively				Individually		Collectively
	Evaluated for		Evaluated for				Evaluated for		Evaluated for
(dollars in thousands)	Impairment		Impairment		Total		Impairment		Impairment		Total
Commercial
Commercial and industrial	$	6,559	$	575,828	$	582,387	$	1,352	$	7,225	$	8,577
Real estate construction		115		97,627		97,742		—		4,709		4,709
Commercial real estate		896		1,024,118		1,025,014		—		12,706		12,706
Total commercial		7,570		1,697,573		1,705,143		1,352		24,640		25,992
Consumer
Residential real estate first mortgage		886		716,907		717,793		—		7,757		7,757
Residential real estate junior lien		547		152,130		152,677		—		1,337		1,337
Other revolving and installment		4		30,813		30,817		—		251		251
Total consumer		1,437		899,850		901,287		—		9,345		9,345
Unallocated		—		—		—		—		—		953
Total loans	$	9,007	$	2,597,423	$	2,606,430	$	1,352	$	33,985	$	36,290


	December 31, 2022
	Recorded Investment						Allowance for Loan Losses
	Individually		Collectively				Individually		Collectively
(dollars in thousands)	Evaluated		Evaluated		Total		Evaluated		Evaluated		Total
Commercial
Commercial and industrial	$	1,313	$	582,563	$	583,876	$	275	$	8,883	$	9,158
Real estate construction		262		97,548		97,810		97		1,349		1,446
Commercial real estate		1,472		880,198		881,670		582		12,106		12,688
Total commercial		3,047		1,560,309		1,563,356		954		22,338		23,292
Consumer
Residential real estate first mortgage		535		679,016		679,551		—		5,769		5,769
Residential real estate junior lien		184		150,295		150,479		—		1,289		1,289
Other revolving and installment		1		50,607		50,608		—		528		528
Total consumer		720		879,918		880,638		—		7,586		7,586
Unallocated		—		—		—		—		—		268
Total loans	$	3,767	$	2,440,227	$	2,443,994	$	954	$	29,924	$	31,146

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The following table presents the amortized cost basis of collateral dependent loans, by the primary collateral type, which are individually evaluated to determine expected credit losses, and the related ACL allocated to these loans, as of September 30, 2023:


	As of September 30, 2023
	Primary Type of Collateral
									Allowance for
(dollars in thousands)	Real estate		Equipment		Other		Total		Credit Losses
Commercial
Commercial and industrial	$	—	$	—	$	—	$	—	$	—
Commercial real estate		572		—		—		572		572
Total commercial		572		—		—		572		572
Consumer
Residential real estate first mortgage		886		—		—		886		3
Residential real estate junior lien		46		—		—		46		—
Other revolving and installment		—		—		4		4		2
Total consumer		932		—		4		936		5
Total loans	$	1,504	$	—	$	4	$	1,508	$	577

Pre-ASC 326 Adoption impaired loan disclosures

The table below summarizes key information on impaired loans as of December 31, 2022:


	December 31, 2022
	Recorded		Unpaid		Related
(dollars in thousands)	Investment		Principal		Allowance
Impaired loans with a valuation allowance
Commercial and industrial	$	675	$	711	$	275
Real estate construction		262		440		97
Commercial real estate		896		900		582
Residential real estate first mortgage		—		—		—
Total impaired loans with a valuation allowance		1,833		2,051		954
Impaired loans without a valuation allowance
Commercial and industrial		638		767		—
Real estate construction		—		—		—
Commercial real estate		576		660		—
Residential real estate first mortgage		535		573		—
Residential real estate junior lien		184		218		—
Other revolving and installment		1		1		—
Total impaired loans without a valuation allowance		1,934		2,219		—
Total impaired loans
Commercial and industrial		1,313		1,478		275
Real estate construction		262		440		97
Commercial real estate		1,472		1,560		582
Residential real estate first mortgage		535		573		—
Residential real estate junior lien		184		218		—
Other revolving and installment		1		1		—
Total impaired loans	$	3,767	$	4,270	$	954

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The table below presents the average recorded investment in impaired loans and interest income for the three and nine months ended September 30, 2022:


	Three months ended September 30,
	2022
	Average
	Recorded		Interest
(dollars in thousands)	Investment		Income
Impaired loans with a valuation allowance
Commercial and industrial	$	722	$	3
Commercial real estate		—		—
Residential real estate first mortgage		—		—
Residential real estate junior lien		—		—
Other revolving and installment		—		—
Total impaired loans with a valuation allowance		722		3
Impaired loans without a valuation allowance
Commercial and industrial		1,371		7
Commercial real estate		801		2
Residential real estate first mortgage		2,032		—
Residential real estate junior lien		189		—
Other revolving and installment		8		—
Total impaired loans without a valuation allowance		4,401		9
Total impaired loans
Commercial and industrial		2,093		10
Commercial real estate		801		2
Residential real estate first mortgage		2,032		—
Residential real estate junior lien		189		—
Other revolving and installment		8		—
Total impaired loans	$	5,123	$	12


	Nine Months Ended September 30,
	2022
	Average
	Recorded		Interest
(dollars in thousands)	Investment		Income
Impaired loans with a valuation allowance
Commercial and industrial	$	833	$	8
Commercial real estate		—		—
Residential real estate first mortgage		—		—
Residential real estate junior lien		—		—
Other revolving and installment		—		—
Total impaired loans with a valuation allowance		833		8
Impaired loans without a valuation allowance
Commercial and industrial		1,291		21
Commercial real estate		805		5
Residential real estate first mortgage		2,108		—
Residential real estate junior lien		193		—
Other revolving and installment		11		—
Total impaired loans without a valuation allowance		4,408		26
Total impaired loans
Commercial and industrial		2,124		29
Commercial real estate		805		5
Residential real estate first mortgage		2,108		—
Residential real estate junior lien		193		—
Other revolving and installment		11		—
Total impaired loans	$	5,241	$	34

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NOTE 5 Goodwill and Other Intangible Assets

The following table summarizes the carrying amount of goodwill, by segment, as of September 30, 2023 and December 31, 2022:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Banking	$	35,260	$	35,260
Retirement and benefit services		11,523		11,827
Total goodwill	$	46,783	$	47,087

Goodwill is evaluated for impairment on an annual basis, at a minimum, and more frequently when the economic environment warrants. The Company determined that there was no goodwill impairment as of September 30, 2023.

The gross carrying amount and accumulated amortization for each type of identifiable intangible asset, as of September 30, 2023 and December 31, 2022, were as follows:


	September 30, 2023						December 31, 2022
(dollars in thousands)	Gross Carrying Amount		Accumulated Amortization		Total		Gross Carrying Amount		Accumulated Amortization		Total
Identifiable customer intangibles	$	41,423	$	(28,951)	$	12,472	$	41,423	$	(25,927)	$	15,496
Core deposit intangible assets		7,592		(1,582)		6,010		7,592		(633)		6,959
Total intangible assets	$	49,015	$	(30,533)	$	18,482	$	49,015	$	(26,560)	$	22,455

Amortization of intangible assets was $1.3 million for both the three months ended September 30, 2023 and 2022. Amortization of intangible assets was $4.0 million and $3.4 million for the nine months ended September 30, 2023 and 2022, respectively.

NOTE 6 Loan Servicing

Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of loans serviced for others totaled $373.8 million and $357.2 million as of September 30, 2023 and December 31, 2022, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and collection and foreclosure processing. Loan servicing income is recorded on an accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees, and is net of fair value adjustments to capitalized mortgage servicing rights.

The following table summarizes the Company’s activity related to servicing rights for the three and nine months ended September 30, 2023 and 2022:


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands)	2023		2022		2023		2022
Balance, beginning of period	$	2,351	$	2,064	$	2,643	$	1,880
Additions		—		604		23		622
Amortization		(140)		(110)		(458)		(367)
Fair value adjustments		3		222		6		645
Balance, end of period	$	2,214	$	2,780	$	2,214	$	2,780

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The following is a summary of key data and assumptions used in the valuation of servicing rights as of September 30, 2023 and December 31, 2022. Increases or decreases in any one of these assumptions would result in lower or higher fair value measurements.


	September 30,			December 31,
(dollars in thousands)	2023			2022
Fair value of servicing rights	$	2,214		$	2,643
Weighted-average remaining term, years		18.8			20.5
Prepayment speeds		5.9	%		6.9	%
Discount rate		11.1	%		10.5	%

NOTE 7 Leases

Substantially all of the leases in which the Company is the lessee are comprised of real property for offices and office equipment rentals with terms extending through 2037. Portions of certain properties are subleased for terms extending through 2024. Substantially all of the Company’s leases are classified as operating leases. The Company has no existing finance leases.

The Company elected not to include short-term leases (i.e., leases with initial terms of twelve months or less), or equipment leases (deemed immaterial) on the consolidated financial statements. The following table presents the classification of the Company’s right-of-use, or ROU, assets and lease liabilities on the consolidated financial statements as of September 30, 2023 and December 31, 2022:


		September 30,		December 31,
(dollars in thousands)		2023		2022
Lease Right-of-Use Assets	Classification
Operating lease right-of-use assets	Operating lease right-of-use assets	$	5,986	$	5,419
Lease Liabilities
Operating lease liabilities	Operating lease liabilities	$	6,286	$	5,902

The calculated amount of the ROU assets and lease liabilities in the table above are impacted by the length of the lease term and the discount rate used to present value the minimum lease payments. The Company’s lease agreements often include one or more options to renew at the Company’s discretion. If at lease inception, the Company considers the exercising of a renewal option to be reasonably certain, the Company will include the extended term in the calculation of the ROU asset and lease liability. The Company utilizes its incremental borrowing rate at lease inception, on a collateralized basis, over a similar term for the discount rate. For the Company’s only finance lease, the Company utilized its incremental borrowing rate at lease inception.


	September 30,		December 31,
	2023		2022
Weighted-average remaining lease term, years
Operating leases	7.2		5.0
Weighted-average discount rate
Operating leases	3.9	%	3.1	%

As the Company elected, for all classes of underlying assets, not to separate lease and non-lease components and instead to account for them as a single lease component, the variable lease cost primarily represents variable payments such as common area maintenance and utilities. Variable lease cost also includes payments for usage or maintenance of those capitalized equipment operating leases.

Table of Contents

The following table presents lease costs and other lease information for the three and nine months ended September 30, 2023 and 2022:


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands)	2023		2022		2023		2022
Lease costs
Operating lease cost	$	503	$	425	$	1,438	$	1,250
Variable lease cost		219		187		918		550
Short-term lease cost		46		188		128		276
Finance lease cost
Interest on lease liabilities		—		2		—		7
Amortization of right-of-use assets		—		29		—		87
Sublease income		(50)		(63)		(169)		(179)
Net lease cost	$	718	$	768	$	2,315	$	1,991
Other information
Cash paid for amounts included in the measurement of lease liabilities operating cash flows from operating leases	$	499	$	400	$	1,275	$	1,184
Right-of-use assets obtained in exchange for new operating lease liabilities		(1,240)		1,065		1,938		1,452

Future minimum payments for finance and operating leases with initial or remaining terms of one year or more as of September 30, 2023 were as follows:


	Operating
(dollars in thousands)	Leases
Twelve months ended
September 30, 2024	$	1,667
September 30, 2025		1,278
September 30, 2026		1,064
September 30, 2027		516
September 30, 2028		311
Thereafter		1,830
Total future minimum lease payments	$	6,666
Amounts representing interest		(380)
Total operating lease liabilities	$	6,286

NOTE 8 Deposits

The components of deposits in the consolidated balance sheets as of September 30, 2023 and December 31, 2022 were as follows:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Noninterest-bearing	$	717,990	$	860,987
Interest-bearing
Interest-bearing demand		759,812		706,275
Savings accounts		88,341		99,882
Money market savings		959,106		1,035,981
Time deposits		346,935		212,359
Total interest-bearing		2,154,194		2,054,497
Total deposits	$	2,872,184	$	2,915,484

Certificates of deposit in excess of $250,000 totaled $98.7 million and $51.1 million at September 30, 2023 and December 31, 2022, respectively.

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NOTE 9 Short-Term Borrowings

Short-term borrowings at September 30, 2023 and December 31, 2022 consisted of the following:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Fed funds purchased	$	315,470	$	153,080
FHLB short-term advances		200,000		225,000
Total	$	515,470	$	378,080

The following table presents information related to short-term borrowings for the three and nine months ended September 30, 2023 and 2022:


	Three months ended
	September 30,
(dollars in thousands)	2023			2022
Fed funds purchased
Balance as of end of period	$	315,470		$	53,830
Average daily balance		312,121			84,149
Maximum month-end balance		315,470			78,015
Weighted-average rate
During period		5.50	%		3.71	%
End of period		5.53	%		3.25	%
FHLB short-term advances
Balance as of end of period	$	200,000		$	200,000
Average daily balance		173,913			168,750
Maximum month-end balance		200,000			200,000
Weighted-average rate
During period		5.46	%		1.71	%
End of period		5.50	%		3.20	%


	Nine months ended
	September 30,
(dollars in thousands)	2023			2022
Fed funds purchased
Balance as of end of period	$	315,470		$	53,830
Average daily balance		320,861			55,527
Maximum month-end balance		492,060			117,350
Weighted-average rate
During period		5.23	%		2.47	%
End of period		5.53	%		3.25	%
FHLB short-term advances
Balance as of end of period	$	200,000		$	200,000
Average daily balance		84,982			60,073
Maximum month-end balance		225,000			200,000
Weighted-average rate
During period		5.22	%		1.71	%
End of period		5.50	%		3.20	%

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NOTE 10 Long-Term Debt

Long-term debt as of September 30, 2023 and December 31, 2022 consisted of the following:


	September 30, 2023
						Period End
	Face		Carrying			Interest		Maturity
(dollars in thousands)	Value		Value		Interest Rate	Rate		Date	Call Date
Subordinated notes payable	$	50,000	$	50,000	Fixed	3.50	%	3/30/2031	3/31/2026
Junior subordinated debenture (Trust I)		4,124		3,571	Three-month CME SOFR + 0.26% + 3.10%	8.76	%	6/26/2033	6/26/2008
Junior subordinated debenture (Trust II)		6,186		5,357	Three-month CME SOFR + 0.26% + 1.80%	7.47	%	9/15/2036	9/15/2011
Total long-term debt	$	60,310	$	58,928


	December 31, 2022
						Period End
	Face		Carrying			Interest		Maturity
(dollars in thousands)	Value		Value		Interest Rate	Rate		Date	Call Date
Subordinated notes payable	$	50,000	$	50,000	Fixed	3.50	%	3/30/2031	3/31/2026
Junior subordinated debenture (Trust I)		4,124		3,537	Three-month LIBOR + 3.10%	7.82	%	6/26/2033	6/26/2008
Junior subordinated debenture (Trust II)		6,186		5,306	Three-month LIBOR + 1.80%	6.57	%	9/15/2036	9/15/2011
Total long-term debt	$	60,310	$	58,843

NOTE 11 Financial Instruments with Off-Balance Sheet Risk

In the normal course of business, the Company has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying consolidated financial statements. The Company exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making such commitments as it does for instruments that are included in the statements of financial condition.

A summary of the contractual amounts of the Company’s exposure to off-balance sheet risk as of September 30, 2023 and December 31, 2022, respectively, was as follows:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Commitments to extend credit	$	786,233	$	806,431
Standby letters of credit		9,734		13,089
Total	$	795,967	$	819,520

The Company had an allowance for loan losses on unfunded commitments of $3.2 million as of December 31, 2022. Upon the adoption of the CECL accounting standard, the Company recorded an additional $1.9 million reserve for unfunded commitments. For the nine months ending September 30, 2023, the Company recorded an additional $304 thousand in provision for credit losses on unfunded commitments for a total of $5.2 million of allowance for credit losses on unfunded commitments as of September 30, 2023.

Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established in the contract. 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. The Company evaluates each client’s creditworthiness on a case by case basis. The amount of collateral obtained, if deemed necessary by the Company upon

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extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income producing commercial properties.

The Company was not required to perform on any financial guarantees and did not incur any losses on its commitments during the past two years.

The Company utilizes standby letters of credit issued by either the FHLB or the Bank of North Dakota to secure public unit deposits. The Company had no letters of credit outstanding with the FHLB as of September 30, 2023 or December 31, 2022. With the Bank of North Dakota, the Company had a no letters of credit outstanding as of September 30, 2023 and December 31, 2022. Letters of credit with the Bank of North Dakota were collateralized by loans pledged to the Bank of North Dakota in the amount of $400.3 million and $215.5 million as of September 30, 2023 and December 31, 2022, respectively.

NOTE 12 Share-Based Compensation

On May 6, 2019, the Company’s stockholders approved the Alerus Financial Corporation 2019 Equity Incentive Plan. This plan gives the compensation committee the ability to grant a wide variety of equity awards, including stock options, stock appreciation rights, restricted stock, restricted stock units and cash incentive awards in such forms and amounts as it deems appropriate to accomplish the goals of the plan. Any shares subject to an award that is cancelled, forfeited, or expires prior to exercise or realization, either in full or in part, shall again become available for issuance under the plan. However, shares subject to an award shall not again be made available for issuance or delivery under the plan if such shares are (a) tendered in payment of the exercise price of a stock option, (b) delivered to, or withheld by, the Company to satisfy any tax withholding obligation, or (c) covered by a stock-settled stock appreciation right or other awards and were not issued upon the settlement of the award. Shares vest, become exercisable and contain such other terms and conditions as determined by the compensation committee and set forth in individual agreements with the participant receiving the award. The plan authorizes the issuance of up to 1,100,000 shares of common stock. As of September 30, 2023, 781,839 shares of common stock are still available for issuance under the plan.

The compensation expense relating to awards under these plans was $377 thousand and $351 thousand for the three months ended September 30, 2023 and 2022. The compensation expense relating to awards under these plans was $1.2 million and $1.4 million for the nine months ended September 30, 2023 and 2022, respectively.

The following table presents the activity in the stock plans for the nine months ended September 30, 2023 and 2022:


	Nine months ended September 30,
	2023			2022
		Weighted-			Weighted-
		Average Grant			Average Grant
	Awards	Date Fair Value		Awards	Date Fair Value
Restricted Stock and Restricted Stock Unit Awards
Outstanding at beginning of period	238,929	$	23.66	260,850	$	21.04
Granted	115,174		20.00	102,265		25.44
Vested	(93,767)		21.34	(107,370)		19.19
Forfeited or cancelled	(26,840)		21.33	(10,624)		23.71
Outstanding at end of period	233,496	$	23.05	245,121	$	23.57

As of September 30, 2023, there was $3.0 million of unrecognized compensation expense related to non-vested awards granted under the plans. The expense is expected to be recognized over a weighted-average period of 2.4 years.

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NOTE 13 Income Taxes

The components of income tax expense (benefit) for the three and nine months ended September 30, 2023 and 2022 were as follows:


	Three months ended September 30,
	2023				2022
			Percent of				Percent of
(dollars in thousands)	Amount		Pretax Income		Amount		Pretax Income
Taxes at statutory federal income tax rate	$	2,424	21.0	%	$	2,637	21.0	%
Tax effect of:
Tax exempt income		(189)	(1.6)	%		(133)	(1.1)	%
State income taxes, net of federal benefits		499	4.3	%		406	3.2	%
Nondeductible items and other		(353)	(3.1)	%		30	0.2	%
Applicable income taxes	$	2,381	20.6	%	$	2,940	23.3	%


	Nine months ended September 30,
	2023				2022
			Percent of				Percent of
(dollars in thousands)	Amount		Pretax Income		Amount		Pretax Income
Taxes at statutory federal income tax rate	$	7,071	21.0	%	$	7,906	21.0	%
Tax effect of:
Tax exempt income		(489)	(1.5)	%		(372)	(1.0)	%
State income taxes, net of federal benefits		1,445	4.3	%		1,515	4.0	%
Nondeductible items and other		(805)	(2.4)	%		(496)	(1.3)	%
Applicable income taxes	$	7,222	21.4	%	$	8,553	22.7	%

It is the opinion of management that the Company has no significant uncertain tax positions that would be subject to change upon examination.

NOTE 14 Tax Credit Investments

The Company invests in qualified affordable housing projects for the purpose of community reinvestment and obtaining tax credits. The Company’s tax credit investments are limited to existing lending relationships with well-known developers and projects within the Company’s market area.

The following table presents a summary of the Company’s investments in qualified affordable housing project tax credits as of September 30, 2023 and December 31, 2022:


		September 30, 2023				December 31, 2022
(dollars in thousands)		Investment		Unfunded Commitment		Investment		Unfunded Commitment
Investment	Accounting Method
Low income housing tax credit	Proportional amortization	$	17,906	$	12,719	$	17,906	$	15,559
Total		$	17,906	$	12,719	$	17,906	$	15,559

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The following table presents a summary of the amortization expense and tax benefit recognized for the Company’s qualified affordable housing projects for the three and nine months ended September 30, 2023 and 2022:


	Three months ended September 30,
	2023				2022
	Amortization		Tax Benefit		Amortization		Tax Benefit
(dollars in thousands)	Expense (1)		Recognized (2)		Expense (1)		Recognized (2)
Low income housing tax credit	$	245	$	(435)	$	109	$	(146)
Total	$	245	$	(435)	$	109	$	(146)

(1)	The amortization expense for low income housing tax credits were included in the income tax expense.

(2)	All of the tax benefits recognized were included in income tax expense.


	Nine months ended September 30,
	2023				2022
	Amortization		Tax Benefit		Amortization		Tax Benefit
(dollars in thousands)	Expense (1)		Recognized (2)		Expense (1)		Recognized (2)
Low income housing tax credit	$	884	$	(1,171)	$	220	$	(303)
Total	$	884	$	(1,171)	$	220	$	(303)

(1)	The amortization expense for low income housing tax credits were included in income tax expense.

(2)	All of the tax benefits recognized were included in income tax expense.

NOTE 15 Segment Reporting

Operating segments are components of an enterprise, which are evaluated regularly by the “chief operating decision maker” in deciding how to allocate resources and assess performance. The Company’s chief operating decision maker is the President and Chief Executive Officer of the Company. Reportable segments are determined based on the services offered, the significance of the services offered, the significance of those services to the Company’s financial statements, and management’s regular review of the operating results of those services. The Company operates through four operating segments: Banking, Retirement and Benefit Services, Wealth Management, and Mortgage.

The financial information presented for each segment includes net interest income, provision for credit losses, direct noninterest income, and direct noninterest expense, before indirect allocations. Corporate Administration includes the indirect overhead and is set forth in the table below. The segment net income before taxes represents direct revenue and expense before indirect allocations and income taxes.

The following table presents key metrics related to the Company’s segments for the periods presented:


	Three months ended September 30, 2023
			Retirement and		Wealth				Corporate
(dollars in thousands)	Banking		Benefit Services		Management		Mortgage		Administration		Consolidated
Net interest income (loss)	$	20,818	$	—	$	—	$	255	$	(678)	$	20,395
Provision for credit losses		—		—		—		—		—		—
Noninterest income (loss)		2,150		18,605		5,271		2,510		(129)		28,407
Intercompany revenue (expense)		(9,371)		4,264		4,624		483		—		—
Noninterest expense		10,728		9,354		2,722		3,245		11,211		37,260
Net income (loss) before taxes	$	2,869	$	13,515	$	7,173	$	3	$	(12,018)	$	11,542

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	Nine months ended September 30, 2023
			Retirement and		Wealth				Corporate
(dollars in thousands)	Banking		Benefit Services		Management		Mortgage		Administration		Consolidated
Net interest income (loss)	$	67,650	$	—	$	—	$	635	$	(1,998)	$	66,287
Provision for credit losses		550		—		—		—		—		550
Noninterest income		6,308		49,977		15,915		7,132		107		79,439
Intercompany revenue (expense)		(15,351)		6,936		4,200		994		3,221		—
Noninterest expense		36,231		24,954		6,335		9,912		34,071		111,503
Net income (loss) before taxes	$	21,826	$	31,959	$	13,780	$	(1,151)	$	(32,741)	$	33,673


	Three months ended September 30, 2022
			Retirement and		Wealth				Corporate
(dollars in thousands)	Banking		Benefit Services		Management		Mortgage		Administration		Consolidated
Net interest income (loss)	$	28,512	$	—	$	—	$	393	$	(589)	$	28,316
Provision for credit losses		—		—		—		—		—		—
Noninterest income		1,723		16,597		4,852		3,782		56		27,010
Intercompany revenue (expense)		(4,562)		1,868		(170)		1,386		1,478		—
Noninterest expense		15,428		7,998		1,406		5,869		12,066		42,767
Net income (loss) before taxes	$	10,245	$	10,467	$	3,276	$	(308)	$	(11,121)	$	12,559


	Nine months ended September 30, 2022
			Retirement and		Wealth				Corporate
(dollars in thousands)	Banking		Benefit Services		Management		Mortgage		Administration		Consolidated
Net interest income (loss)	$	72,816	$	—	$	—	$	1,660	$	(1,711)	$	72,765
Provision for credit losses		—		—		—		—		—		—
Noninterest income		4,602		50,536		15,726		14,751		91		85,706
Intercompany revenue (expense)		(8,664)		2,695		(1,028)		3,214		3,783		—
Noninterest expense		39,639		23,855		4,034		17,926		35,368		120,822
Net income (loss) before taxes	$	29,115	$	29,376	$	10,664	$	1,699	$	(33,205)	$	37,649

Banking

The Banking division offers a complete line of loan, deposit, cash management, and treasury services through fourteen offices in North Dakota, Minnesota, and Arizona. These products and services are supported through web and mobile based applications. The majority of the Company’s assets and liabilities are in the Banking segment’s balance sheet.

Retirement and Benefit Services

Retirement and Benefit Services provides the following services nationally: recordkeeping and administration services to qualified retirement plans; recordkeeping, and administration services to other types of retirement plans; investment fiduciary services to retirement plans; health savings accounts, flex spending accounts, and COBRA recordkeeping and administration services. The division operates within each of the banking markets, as well as in Lansing, Michigan and Littleton, Colorado.

Wealth Management

The Wealth Management division provides advisory and planning services, investment management, and trust and fiduciary services to clients across the Company’s footprint.

Mortgage

The Mortgage division offers first and second mortgage loans through a centralized mortgage unit in Minneapolis, Minnesota, as well as through the Banking office locations.

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NOTE 16 Earnings Per Share

The calculation of basic and diluted earnings per share using the two-class method for the three and nine months ended September 30, 2023 and 2022 are presented below:


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars and shares in thousands, except per share data)	2023		2022		2023		2022
Net income	$	9,161	$	9,619	$	26,451	$	29,096
Dividends and undistributed earnings allocated to participating securities		67		90		186		312
Net income available to common shareholders	$	9,094	$	9,529	$	26,265	$	28,784
Weighted-average common shares outstanding for basic earnings per share		19,872		19,987		19,977		18,186
Dilutive effect of stock-based awards		223		243		216		245
Weighted-average common shares outstanding for diluted earnings per share		20,095		20,230		20,193		18,431
Earnings per common share:
Basic earnings per common share	$	0.46	$	0.48	$	1.31	$	1.58
Diluted earnings per common share	$	0.45	$	0.47	$	1.30	$	1.56

NOTE 17 Derivative Instruments

The company uses a variety of derivative instruments to mitigate exposure to both market and credit risks inherent in its business activities. The Company manages these risks as part of its overall asset and liability management process and through its policies and procedures. Derivatives represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based on a notional amount and an underlying as specified in the contract.

Derivatives are often measured in terms of notional amount, but this amount is generally not exchanged, and it is not recorded on the Company’s consolidated balance sheet. The notional amount is the basis to which the underlying is applied to determine required payments under the derivative contract. The underlying is a referenced interest rate, security price, credit spread, or other index. Residential and commercial real estate loan commitments associated with loans to be sold also qualify as derivative instruments.

Derivatives Designated as Hedging Instruments

The Company uses derivative instruments to hedge its exposure to economic risks, including interest rate, liquidity and credit risk. Certain hedging relationships are formally designated and qualify for hedge accounting under GAAP. On the date the Company enters into a derivative contract designated as a hedging instrument, the derivative is designated as either a fair value hedge, cash flow hedge, or a net investment hedge. When a derivative is designated as a fair value, cash flow, or net investment hedge, the Company performs an assessment, at inception and, at a minimum, quarterly thereafter, to determine the effectiveness of the derivative in offsetting changes in the value or cash flows of the hedged item(s). As of September 30, 2023, the Company only uses fair value and cash flow hedges.

Fair value hedges: These derivatives are interest rate swaps the Company uses to hedge the change in fair value related to interest rate changes of its underlying mortgage-backed investment securities and mortgage loan pools. The interest rate swaps are carried on the Company’s Consolidated Balance Sheet at their fair value in other assets (when the fair value is positive) or in accrued expenses and other liabilities (when the fair value is negative). The changes in fair value of the interest rate swaps are recorded in interest income. The unrealized gains or losses due to changes in fair value of the interest rate swaps due to changes in benchmark interest rates are recorded as an adjustment to the hedged instruments and offset in the same interest income line items.

Cash flow hedges: These derivatives are interest rate swaps the Company uses to hedge the variability of expected future cash flows due to market interest changes. The interest rate swap is carried on the Company’s consolidated balance sheet at its fair value in other assets (when the fair value is positive) or in accrued expenses and

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other liabilities (when the fair value is negative). Changes in fair value of derivatives designated as cash flow hedges are recorded in other comprehensive income (loss) until the cash flows of the hedged items are realized. If a derivative designated as a cash flow hedge is terminated or ceases to be highly effective, the gain or loss in other comprehensive income (loss) is amortized to earnings over the period the forecasted hedged transactions impact earnings. If a hedged forecasted transaction is no longer probable, hedge accounting is ceased and any gain or loss included in other comprehensive income (loss) is reported in earnings immediately, unless the forecasted transaction is at least reasonably possible of occurring, whereby the amounts remain within accumulated other comprehensive income (loss). There were no cash flow hedges at December 31, 2022. The Company estimates that an additional $1.0 million will be reclassified as a decrease to interest expense over the next 12 months. All cash flow hedges were highly effective for the three months ended September 30, 2023. As of September 30, 2023, the maximum length of time over which forecasted transactions are hedged is 15 months.

Derivatives Not Designated as Hedging Instruments

Interest rate swaps: The Company periodically enters into commercial loan interest rate swap agreements in order to provide commercial loan customers with the ability to convert from variable to fixed interest rates. These derivative contracts relate to transactions in which the Company enters into an interest rate swap with a customer, while simultaneously entering into an offsetting interest rate swap with an institutional counterparty.

Interest rate lock commitments, forward loan sales commitments and to be announced (TBA) mortgage backed securities: The Company enters into forward delivery contracts to sell mortgage loans at specific prices and dates in order to hedge the interest rate risk in its portfolio of mortgage loans held for sale and its residential mortgage interest rate lock commitments.

The following table presents the total notional amounts and gross fair values of the Company’s derivatives as of September 30, 2023 and December 31, 2022:


		September 30, 2023				December 31, 2022
		Fair		Notional		Fair		Notional
(dollars in thousands)		Value		Amount		Value		Amount
Designated as hedging instruments:	Consolidated Balance Sheet Location
Fair value hedges:
Interest rate swaps	Other assets	$	3,899	$	600,000	$	—	$	—
Cash flow hedges:
Interest rate swaps	Other assets		1,011		200,000		—		—
Total derivatives designated as hedging instruments		$	4,910	$	800,000	$	—	$	—
Not designated as hedging instruments:
Asset Derivatives
Interest rate swaps	Other assets	$	6,819	$	67,716	$	6,277	$	43,430
Interest rate lock commitments	Other assets		247		23,352		121		10,462
Forward loan sales commitments	Other assets		62		3,467		7		351
To-be-announced mortgage backed securities	Other assets		155		41,250		—		—
Total asset derivatives not designated as hedging instruments		$	7,283	$	135,785	$	6,405	$	54,243
Liability Derivatives
Interest rate swaps	Accrued expenses and other liabilities	$	6,820	$	67,716	$	6,277	$	43,430
To-be-announced mortgage backed securities	Accrued expenses and other liabilities		—		—		26		25,750
Total liability derivatives not designated as hedging instruments		$	6,820	$	67,716	$	6,303	$	69,180

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The following table shows the effective portion of the gains (losses) recognized in other comprehensive income (loss) and the gains (losses), before tax, reclassified from other comprehensive income (loss) into earnings for the periods indicated:

Three months ended September 30,

Nine months ended September 30,

Gains (Losses)

Recognized in

Reclassified

Recognized in

Reclassified

Other

from Other

Other

from Other

Comprehensive

Income

Income (Loss)

Income

Income (Loss)

(dollars in thousands)

(Loss)

into Earnings

(Loss)

into Earnings

Derivatives designated as hedging instruments

2023

Cash flow hedges:

Interest rate swaps

1,216

205

1,216

205

The following table shows the effect of fair value and cash flow hedge accounting on derivatives designated as hedging instruments in the Consolidated Statements of Income:


	Location and Amount of Gains (Losses) Recognized in Income
	Interest Income				Interest Expense
	Loans,		Investment
	including		securities -		Short-term
(dollars in thousands)	fees		Taxable		borrowings
Three months ended September 30, 2023
Total amounts in the Consolidated Statements of Income	$	34,986	$	6,146	$	6,528
Fair value hedges:
Interest rate swaps		71		606		—
Cash flow hedges:
Interest rate swaps		—		—		(205)
Nine months ended September 30, 2023
Total amounts in the Consolidated Statements of Income	$	99,187	$	18,222	$	15,684
Fair value hedges:
Interest rate swaps		71		1,229		—
Cash flow hedges:
Interest rate swaps		—		—		(205)

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The following table shows the notional amount, carrying amount and associated cumulative basis adjustments related to the application of hedge accounting that is included in the carrying amount of hedged assets and liabilities in fair value hedging relationships at September 30, 2023:


	September 30, 2023
					Cumulative Fair
					Value Hedging
					Adjustment in the
			Carrying Amount		Carrying Amount of
	Notional		of Hedged Assets/		Hedged Assets/
(dollars in thousands)	Amount		Liabilities		Liabilities
Mortgage-backed securities
Residential agency ⁽¹⁾	$	200,000	$	196,793	$	(3,207)
Mortgage loan pools ⁽²⁾		400,000		399,284		(716)
Total	$	600,000	$	596,077	$	(3,923)

(1)	Includes amounts related to residential agency mortgage-backed securities currently designated as the hedged item in a fair value hedge using the portfolio layer method. At September 30, 2023, the amortized cost of the closed portfolios used in these hedging relationships was $331 million.

(2)

These amounts include the amortized cost basis of residential real estate loans that were used to designate hedging relationships in which the hedged item is the stated amount of assets in the closed portfolio anticipated to be outstanding for the designated hedged period. At September 30, 2023, the amortized cost basis of the residential real estate loans used in these hedging relationships was $706.8 million.

The gain (loss) recognized on derivatives not designated as hedging relationships for the three and nine months ended September 30, 2023 and 2022 was as follows:



(dollars in thousands)		Three months ended September 30,				Nine months ended September 30,
Derivatives not designated as hedging instruments	Consolidated Statements of Income Location	2023		2022		2023		2022
Interest rate swaps	Other noninterest income	$	121	$	1	$	121	$	2
Interest rate lock commitments	Mortgage banking		(342)		(1,724)		87		(1,871)
Forward loan sales commitments	Mortgage banking		(9)		(532)		55		(480)
To-be-announced mortgage backed securities	Mortgage banking		221		1,317		350		5,066
Total gain (loss) from derivatives not designated as hedging instruments		$	(9)	$	(938)	$	613	$	2,717

The Company has third party agreements that require a minimum dollar transfer amount upon a margin call. These requirements are dependent on certain specified credit measures. The amount of collateral posted with third parties was $290 thousand at September 30, 2023 and $309 thousand at December 31, 2022. The amount of collateral posted with third parties was deemed to be sufficient as of those dates to collateralize both the fair market value change as well as any additional amounts that may be required as a result of a change in the specified credit measures.

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The following table presents the Company’s derivative positions and the potential effect of netting arrangements on its financial position as of the dates indicated:


							Gross Amount
							Not Offset in the
							Consolidated
							Balance Sheets
	Gross Amount		Gross Amount		Net Amount
	Recognized in the		Offset in the		Presented in the
	Consolidated		Consolidated		Consolidated		Cash Collateral
(dollars in thousands)	Balance Sheets		Balance Sheets		Balance Sheets		Pledged (Received)		Net Amount
September 30, 2023
Derivative assets:
Interest rate swaps - Company ⁽¹⁾	$	4,910	$	—	$	4,910	$	(10,150)	$	(5,240)
Interest rate swaps - customer ⁽¹⁾		6,819		—		6,819		—		6,819
To-be-announced mortgage backed securities		155		—		155		—		155
Total	$	11,884	$	—	$	11,884	$	(10,150)	$	1,734
Derivative liabilities:
Interest rate swaps - customer ⁽¹⁾	$	6,820	$	—	$	6,820	$	—	$	6,820
To-be-announced mortgage backed securities		—		—		—		290		(290)
Total	$	6,820	$	—	$	6,820	$	290	$	6,530
December 31, 2022
Derivative assets:
Interest rate swaps - Company ⁽¹⁾	$	—	$	—	$	—	$	—	$	—
Interest rate swaps - customer ⁽¹⁾		6,277		—		6,277		(6,030)		247
To-be-announced mortgage backed securities		—		—		—		—		—
Total	$	6,277	$	—	$	6,277	$	(6,030)	$	247
Derivative liabilities:
Interest rate swaps - customer ⁽¹⁾	$	6,277	$	—	$	6,277	$	—	$	6,277
To-be-announced mortgage backed securities		26		—		26		309		(283)
Total	$	6,303	$	—	$	6,303	$	309	$	5,994

(1)	The Company maintains a master netting arrangement with each counterparty and settles collateral on a net basis for all interest rate swaps.

NOTE 18 Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of common equity tier 1, tier 1, and total capital (as defined in the regulations) to risk weighted assets (as defined) and of tier 1 capital (as defined) to average assets (as defined). Management believes at September 30, 2023 and December 31, 2022, each of the Company and the Bank had met all of the capital adequacy requirements to which it was subject.

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The following table presents the Company’s and the Bank’s actual capital amounts and ratios as of September 30, 2023 and December 31, 2022:


	September 30, 2023
										Minimum to be
						Requirements				Well Capitalized
						for Capital				Under Prompt
	Actual				Adequacy Purposes				Corrective Action
(dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
Common equity tier 1 capital to risk weighted assets
Consolidated	$	402,118	13.01	%	$	139,056	4.50	%	$	N/A	N/A
Bank		391,239	12.68	%		138,838	4.50	%		200,544	6.50	%
Tier 1 capital to risk weighted assets										.
Consolidated		411,046	13.30	%		185,408	6.00	%		N/A	N/A
Bank		391,239	12.68	%		185,117	6.00	%		246,823	8.00	%
Total capital to risk weighted assets
Consolidated		497,554	16.10	%		247,210	8.00	%		N/A	N/A
Bank		427,747	13.86	%		246,823	8.00	%		308,529	10.00	%
Tier 1 capital to average assets
Consolidated		411,046	11.14	%		147,625	4.00	%		N/A	N/A
Bank		391,239	10.72	%		146,043	4.00	%		182,554	5.00	%


	December 31, 2022
										Minimum to be
						Requirements				Well Capitalized
						for Capital				Under Prompt
	Actual				Adequacy Purposes				Corrective Action
(dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
Common equity tier 1 capital to risk weighted assets
Consolidated	$	389,335	13.39	%	$	130,862	4.50	%	$	N/A	N/A
Bank		370,749	12.76	%		130,791	4.50	%		188,920	6.50	%
Tier 1 capital to risk weighted assets										.
Consolidated		398,179	13.69	%		174,482	6.00	%		N/A	N/A
Bank		370,749	12.76	%		174,388	6.00	%		232,517	8.00	%
Total capital to risk weighted assets
Consolidated		479,325	16.48	%		232,643	8.00	%		N/A	N/A
Bank		401,895	13.83	%		232,517	8.00	%		290,646	10.00	%
Tier 1 capital to average assets
Consolidated		398,179	11.25	%		141,514	4.00	%		N/A	N/A
Bank		370,749	10.48	%		141,440	4.00	%		176,800	5.00	%

The Bank is subject to certain restrictions on the amount of dividends that it may pay without prior regulatory approval. The Company and the Bank are subject to the rules of the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act rules. The rules include a 2.5 percent capital conservation buffer that is added to the minimum requirements for capital adequacy purposes. A banking organization with a conservation buffer of less than the required amount will be subject to the limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. As of September 30, 2023, the capital ratios for the Company and the Bank were sufficient to meet the conservation buffer. In addition, the Company must adhere to various U.S. Department of Housing and Urban Development, or HUD, regulatory guidelines including required minimum capital and liquidity to maintain their Federal Housing Administration approval status. Failure to comply with the HUD guidelines could result in withdrawal of this certification. As of September 30, 2023 and December 31, 2022, the Company was in compliance with the aforementioned guidelines.

NOTE 19 Stock Repurchase Program

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February 28, 2024. The Program does not obligate the Company to repurchase any shares of its common stock and there is no assurance that the Company will do so. For the nine months ended September 30, 2023, the Company repurchased 238,474 shares of common stock under the Program. The Company also repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units.

NOTE 20 Fair Value of Assets and Liabilities

The Company categorizes its assets and liabilities measured at estimated fair value into a three level hierarchy based on the priority of the inputs to the valuation technique used to determine estimated fair value. The estimated fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used in the determination of the estimated fair value measurement fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the estimated fair value measurement. Assets and liabilities valued at estimated fair value are categorized based on the following inputs to the valuation techniques as follows:

Level 1—Inputs that utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that an entity has the ability to access.

Level 2—Inputs that include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Estimated fair values for these instruments are estimated using pricing models, quoted prices of investment securities with similar characteristics, or discounted cash flows.

Level 3—Inputs that are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. Subsequent to initial recognition, the Company may re-measure the carrying value of assets and liabilities measured on a nonrecurring basis to estimated fair value. Adjustments to estimated fair value usually result when certain assets are impaired. Such assets are written down from their carrying amounts to their estimated fair value.

Professional standards allow entities the irrevocable option to elect to measure certain financial instruments and other items at estimated fair value for the initial and subsequent measurement on an instrument-by-instrument basis. The Company adopted the policy to value certain financial instruments at estimated fair value. The Company has not elected to measure any existing financial instruments at estimated fair value; however, it may elect to measure newly acquired financial instruments at estimated fair value in the future.

Recurring Basis

The Company uses estimated fair value measurements to record estimated fair value adjustments to certain assets and liabilities and to determine estimated fair value disclosures.

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The following tables present the balances of the assets and liabilities measured at estimated fair value on a recurring basis as of September 30, 2023 and December 31, 2022:


	September 30, 2023
(dollars in thousands)	Level 1		Level 2		Level 3		Total
Available-for-sale
U.S. treasury and government agencies	$	—	$	2,665	$	—	$	2,665
Mortgage backed securities
Residential agency		—		521,623		—		521,623
Commercial		—		58,685		—		58,685
Asset backed securities		—		27		—		27
Corporate bonds		—		57,001		—		57,001
Total available-for-sale investment securities	$	—	$	640,001	$	—	$	640,001
Other assets
Derivatives	$	—	$	12,193	$	—	$	12,193
Other liabilities
Derivatives	$	—	$	6,820	$	—	$	6,820


	December 31, 2022
(dollars in thousands)	Level 1		Level 2		Level 3		Total
Available-for-sale
U.S. treasury and government agencies	$	—	$	3,520	$	—	$	3,520
Mortgage backed securities
Residential agency		—		587,679		—		587,679
Commercial		—		63,558		—		63,558
Asset backed securities		—		34		—		34
Corporate bonds		—		62,533		—		62,533
Total available-for-sale investment securities	$	—	$	717,324	$	—	$	717,324
Other assets
Derivatives	$	—	$	6,405	$	—	$	6,405
Other liabilities
Derivatives	$	—	$	6,303	$	—	$	6,303

The following is a description of the valuation methodologies used for instruments measured at estimated fair value on a recurring basis, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Investment Securities, Available-for-Sale

Generally, debt securities are valued using pricing for similar securities, recently executed transactions, and other pricing models utilizing observable inputs and therefore are classified as Level 2.

Derivatives

All of the Company’s derivatives are traded in over-the-counter markets where quoted market prices are not readily available. For these derivatives, estimated fair value is measured using internally developed models that use primarily market observable inputs, such as yield curves and option volatilities, and accordingly, classify as Level 2. Examples of Level 2 derivatives are basic interest rate swaps and forward contracts.

Nonrecurring Basis

Certain assets are measured at estimated fair value on a nonrecurring basis. These assets are not measured at estimated fair value on an ongoing basis; however, they are subject to estimated fair value adjustments in certain circumstances, such as when there is evidence of impairment or a change in the amount of previously recognized impairment.

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Net impairment related to nonrecurring estimated fair value measurements of certain assets as of September 30, 2023 and December 31, 2022 consisted of the following:


	September 30, 2023
(dollars in thousands)	Level 1		Level 2		Level 3		Total		Impairment
Loans held for sale	$	—	$	16,346	$	—	$	16,346	$	—
Individually evaluated		—		—		2,390		2,390		288
Servicing rights		—		—		2,214		2,214		—


	December 31, 2022
(dollars in thousands)	Level 1		Level 2		Level 3		Total		Impairment
Loans held for sale	$	—	$	9,488	$	—	$	9,488	$	—
Individually evaluated		—		—		2,813		2,813		954
Foreclosed assets		—		—		30		30		—
Servicing rights		—		—		2,643		2,643		—

Loans Held for Sale

Loans originated and held for sale are carried at the lower of cost or estimated fair value. The Company obtains quotes or bids on these loans directly from purchasing financial institutions. Typically, these quotes include a premium on the sale and thus these quotes indicate estimated fair value of the held for sale loans is greater than cost.

Impairment losses for loans held for sale that are carried at the lower of cost or estimated fair value represent additional net write-downs during the period to record these loans at the lower of cost or estimated fair value, subsequent to their initial classification as loans held for sale.

The valuation techniques and significant unobservable inputs used to measure Level 3 estimated fair values as of September 30, 2023 and December 31, 2022, were as follows:


			September 30, 2023
(dollars in thousands)							Weighted
Asset Type	Valuation Technique	Unobservable Input	Fair Value		Range		Average
Individually evaluated	Appraisal value	Property specific adjustment	$	2,390	N/A		N/A
Foreclosed assets	Appraisal value	Property specific adjustment		3	N/A		N/A
Servicing rights	Discounted cash flows	Prepayment speed assumptions		2,214	84-125		101
		Discount rate			11.1	%	11.1	%


			December 31, 2022
(dollars in thousands)							Weighted
Asset Type	Valuation Technique	Unobservable Input	Fair Value		Range		Average
Individually evaluated	Appraisal value	Property specific adjustment	$	2,813	N/A		N/A
Foreclosed assets	Appraisal value	Property specific adjustment		30	N/A		N/A
Servicing rights	Discounted cash flows	Prepayment speed assumptions		2,643	103-137		115
		Discount rate			10.5	%	10.5	%

Disclosure of estimated fair value information about financial instruments, for which it is practicable to estimate that value, is required whether or not recognized in the consolidated balance sheets. In cases in which quoted market prices are not available, estimated fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimate of future cash flows. In that regard, the derived estimated fair value estimates cannot be substantiated by comparison to independent markets and, in many cases could not be realized in immediate settlement of the instruments. Certain

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financial instruments, with an estimated fair value that is not practicable to estimate and all non-financial instruments, are excluded from the disclosure requirements. Accordingly, the aggregate estimated fair value amounts presented do not necessarily represent the underlying value of the Company.

The following disclosures represent financial instruments in which the ending balances, as of September 30, 2023 and December 31, 2022, were not carried at estimated fair value in their entirety on the consolidated balance sheets.

Cash and Cash Equivalents and Accrued Interest

The carrying amounts reported in the consolidated balance sheets approximate those assets and liabilities estimated fair values.

Investment Securities, Held-to-Maturity

The fair values of debt securities held-to-maturity are based on quoted market prices for the same or similar securities, recently executed transactions and pricing models.

Loans

For variable-rate loans that reprice frequently and with no significant change in credit risk, estimated fair values are based on carrying values. The estimated fair values of other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

Bank-Owned Life Insurance

Bank-owned life insurance is carried at the amount due upon surrender of the policy, which is also the estimated fair value. This amount was provided by the insurance companies based on the terms of the underlying insurance contract.

Deposits

The estimated fair values of demand deposits are, by definition, equal to the amount payable on demand at the consolidated balance sheet date. The estimated fair values of fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies current incremental interest rates being offered on certificates of deposit to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit.

Short-Term Borrowings and Long-Term Debt

For variable-rate borrowings that reprice frequently, estimated fair values are based on carrying values. The estimated fair values of fixed-rate borrowings are estimated using discounted cash flow analysis, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance Sheet Credit-Related Commitments

Off-balance sheet credit related commitments are generally of short-term nature. The contract amount of such commitments approximates their estimated fair value since the commitments are comprised primarily of unfunded loan commitments which are generally priced at market at the time of funding.

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The estimated fair values, and related carrying or notional amounts, of the Company’s financial instruments at the dates indicated are as follows:


	September 30, 2023
	Carrying		Estimated Fair Value
(dollars in thousands)	Amount		Level 1		Level 2		Level 3		Total
Financial Assets
Cash and cash equivalents	$	64,724	$	64,724	$	—	$	—	$	64,724
Investment securities held-to-maturity		303,268		—		248,239		—		248,239
Loans, net		2,570,140		—		—		2,451,993		2,451,993
Accrued interest receivable		15,561		15,561		—		—		15,561
Bank-owned life insurance		33,012		—		33,012		—		33,012
Financial Liabilities
Noninterest-bearing deposits	$	717,990	$	—	$	717,990	$	—	$	717,990
Interest-bearing deposits		1,807,259		—		1,807,259		—		1,807,259
Time deposits		346,935		—		—		343,600		343,600
Short-term borrowings		515,470		515,470		—		—		515,470
Long-term debt		58,928		—		55,076		—		55,076
Accrued interest payable		5,358		5,358		—		—		5,358


	December 31, 2022
	Carrying		Estimated Fair Value
(dollars in thousands)	Amount		Level 1		Level 2		Level 3		Total
Financial Assets
Cash and cash equivalents	$	58,242	$	58,242	$	—	$	—	$	58,242
Investment securities held-to-maturity		321,902		—		270,912		—		270,912
Loans, net		2,412,848		—		—		2,311,956		2,311,956
Accrued interest receivable		12,869		12,869		—		—		12,869
Bank-owned life insurance		33,991		—		33,991		—		33,991
Financial Liabilities
Noninterest-bearing deposits	$	860,987	$	—	$	860,987	$	—	$	860,987
Interest-bearing deposits		1,842,138		—		1,842,138		—		1,842,138
Time deposits		212,359		—		—		208,550		208,550
Short-term borrowings		378,080		378,080		—		—		378,080
Long-term debt		58,843		—		56,116		—		56,116
Accrued interest payable		2,426		2,426		—		—		2,426

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

General

The following discussion explains the Company’s financial condition and results of operations as of and for the three and nine months ended September 30, 2023 and 2022. Annualized results for this interim period may not be indicative of results for the full year or future periods. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes presented elsewhere in this report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission on March 13, 2023.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements include, without limitation, statements concerning plans, estimates, calculations, forecasts and projections with respect to the anticipated future performance of Alerus Financial Corporation. These statements are often, but not always, identified by words such as “may”, “might”, “should”, “could”, “predict”, “potential”, “believe”, “expect”, “continue”, “will”, “anticipate”, “seek”, “estimate”, “intend”, “plan”, “projection”, “would”, “annualized”, “target” and “outlook”, or the negative version of those words or other comparable words of a future or forward-looking nature. Examples of forward-looking statements include, among others, statements the Company make regarding the Company’s projected growth, anticipated future financial performance, financial condition, credit quality and management’s long-term performance goals and the future plans and prospects of Alerus Financial Corporation.

Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based only on the Company’s current beliefs, expectations and assumptions regarding the Company’s business, future plans and strategies, projections, anticipated events and trends, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and many of which are outside of the Company’s control. The Company’s actual results and financial condition may differ materially from those indicated in forward-looking statements. Therefore, you should not rely on any of these forward-looking statements. Important factors that could cause the Company’s actual results and financial condition to differ materially from those indicated in forward-looking statements include, among others, the following:

●

interest rate risks, including the effects of recent and potential additional rate increases by the Federal Reserve;

●

the Company’s ability to successfully manage credit risk and maintain an adequate level of allowance for credit losses;

●

new or revised accounting standards, including as a result of the implementation of the new CECL accounting standard;

●

business and economic conditions generally and in the financial services industry, nationally and within the Company’s market areas, including continued rising rates of inflation and possible recession, the effects of recent developments and events in the financial services industry, including the large-scale deposit withdrawals over a short period of time at Silicon Valley Bank, Signature Bank and First Republic Bank that resulted in the failure of those institutions;

●

the Company’s ability to successfully manage liquidity risk, including the Company’s need to access higher cost sources of funds such as fed funds purchased and short-term borrowings;

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●

the concentration of large deposits from certain clients, who have balances above current Federal Deposit Insurance Corporation, or FDIC, insurance limits;

●

fluctuations in the values of securities held in the Company’s securities portfolio, including as a result of changes in interest rates;

●

the overall health of the local and national real estate market;

●

concentrations within the Company’s loan portfolio;

●

the level of nonperforming assets on the Company’s balance sheet;

●

the Company’s ability to implement organic and acquisition growth strategies, including the integration of Metro Phoenix Bank which the Company acquired in 2022;

●

the impact of economic or market conditions on the Company’s fee-based services;

●

the Company’s ability to continue to grow retirement and benefit services business;

●

the Company’s ability to continue to originate a sufficient volume of residential mortgages;

●

the occurrence of fraudulent activity, breaches or failures of the Company’s information security controls or cybersecurity-related incidents, including as a result of sophisticated attacks using artificial intelligence and similar tools;

●

interruptions involving the Company’s information technology and telecommunications systems or third-party servicers;

●

potential losses incurred in connection with mortgage loan repurchases;

●

the composition of the Company’s executive management team and the Company’s ability to attract and retain key personnel;

●

the rapid technological change in the financial services industry;

●

increased competition in the financial services industry from non-banks such as credit unions and Fintech companies, including digital asset service providers;

●

the effectiveness of the Company’s risk management framework;

●

the commencement and outcome of litigation and other legal proceedings and regulatory actions against the Company or to which the Company may become subject;

●

potential impairment to the goodwill the Company recorded in connection with the Company’s past acquisitions; including the acquisition of Metro Phoenix Bank;

●

the extensive regulatory framework that applies to us;

●

the impact of recent and future legislative and regulatory changes, including in response to the recent failures of Silicon Valley Bank, Signature Bank and First Republic Bank;

●

governmental monetary, trade and fiscal policies;

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●

risks related to climate change and the negative impact it may have on the Company’s customers and their businesses;

●

severe weather, natural disasters, widespread disease or pandemics, such as the COVID-19 global pandemic;

●

acts of war or terrorism, including the Israeli-Palestinian conflict and the Russian invasion of Ukraine, or other adverse external events;

●

any material weaknesses in the Company’s internal control over financial reporting;

●

changes to U.S. or state tax laws, regulations and guidance, including the new 1.0% excise tax on stock buybacks to publicly traded companies;

●

talent and labor shortages and employee turnover; the Company’s success at managing the risks involved in the foregoing items; and

●

any other risks described in the “Risk Factors” sections of the reports filed by Alerus Financial Corporation with the Securities and Exchange Commission.

Any forward-looking statement made by the Company in this report is based only on information currently available to the Company and speaks only as of the date on which it is made. The Company undertakes no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future developments or otherwise.

Overview

The Company is a diversified financial services company headquartered in Grand Forks, North Dakota. Through the Company’s subsidiary, Alerus Financial, National Association, or the Bank, the Company provides financial solutions to businesses and consumers through four distinct business lines—banking, retirement and benefit services, wealth management and mortgage. These solutions are delivered through a relationship-oriented primary point of contact along with responsive and client-friendly technology.

The Company’s business model produces strong financial performance and a diversified revenue stream, which has helped the Company establish a brand and culture yielding both a loyal client base and passionate and dedicated employees. The Company generates a majority of overall revenue from noninterest income, which is driven primarily by the Company’s retirement and benefit services, wealth management and mortgage business lines. The remainder of the Company’s revenue consists of net interest income, which the Company derives from offering traditional banking products and services.

Critical Accounting Policies

The Company’s consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States, or GAAP. The preparation of the Company’s consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances. These estimates form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions. The estimates and judgments that management believes have the most effect on the Company’s reported financial position and results of operations are set forth in Note 1 – Significant Accounting Policies of the Notes to the Consolidated Statements, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

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On January 1, 2023, the Company adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which created material changes to the Company’s existing critical accounting policy that existed at December 31, 2022. Effective January 1, 2023, through March 31, 2023, the significant accounting policy which the Company believes to be critical in preparing the Company’s consolidated financial is the determination of the allowance for credit losses.

Management considers the policies related to the allowance for credit losses critical to the financial statement presentation. The allowance for credit losses is established through the provision for credit losses charged to current earnings. The Company’s methodologies for estimating the allowance for credit losses consider available relevant information about the collectability of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts. Refer to Note 1 – Significant Accounting Policies in the accompanying notes to the consolidated financial statements for further discussion on the methodology in establishing the allowance for credit losses.

The JOBS Act permits the Company an extended transition period for complying with new or revised accounting standards affecting public companies. The Company has elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements filed in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as the Company remains an emerging growth company or until the Company affirmatively and irrevocably opts out of the extended transition period under the JOBS Act.

Recent Developments

Shareholder Dividend

On August 24, 2023, the Board of Directors of the Company declared a quarterly cash dividend of $0.19 per common share. This dividend was paid on October 13, 2023, to stockholders of record at the close of business on September 15, 2023.

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Operating Results Overview

The following table summarizes key financial results as of and for the periods indicated:


	Three months ended									Nine months ended
	September 30,			June 30,			September 30,			September 30,			September 30,
(dollars and shares in thousands, except per share data)	2023			2023			2022			2023			2022
Performance Ratios
Return on average total assets		0.95	%		0.96	%		1.02	%		0.93	%		1.13	%
Return on average common equity		10.05	%		10.14	%		10.25	%		9.79	%		11.27	%
Return on average tangible common equity (1)		13.51	%		13.71	%		13.89	%		13.27	%		14.59	%
Noninterest income as a % of revenue		58.21	%		53.69	%		48.82	%		54.51	%		54.08	%
Net interest margin (taxable-equivalent basis)		2.27	%		2.52	%		3.21	%		2.50	%		3.02	%
Efficiency ratio (1)		73.37	%		72.79	%		74.76	%		73.57	%		73.94	%
Average equity to average assets		9.47	%		9.52	%		9.95	%		9.51	%		10.06	%
Net charge-offs/(recoveries) to average loans		(0.09)	%		(0.07)	%		0.07	%		(0.04)	%		0.04	%
Dividend payout ratio		42.22	%		42.22	%		38.30	%		43.08	%		33.33	%
Per Common Share
Earnings per common share - basic	$	0.46		$	0.45		$	0.48		$	1.31		$	1.58
Earnings per common share - diluted	$	0.45		$	0.45		$	0.47		$	1.30		$	1.56
Dividends declared per common share	$	0.19		$	0.19		$	0.18		$	0.56		$	0.52
Book value per common share	$	17.60		$	17.96		$	17.25
Tangible book value per common share (1)	$	14.32		$	14.60		$	13.76
Average common shares outstanding - basic		19,872			20,033			19,987			19,977			18,186
Average common shares outstanding - diluted		20,095			20,241			20,230			20,193			18,431
Other Data
Retirement and benefit services assets under administration/management	$	34,552,569		$	35,052,652		$	30,545,694
Wealth management assets under administration/management	$	3,724,091		$	3,857,710		$	3,435,786
Mortgage originations	$	109,637		$	111,261		$	229,901		$	298,626		$	686,060

(1)	Represents a non-GAAP financial measure. See “Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures.”

Selected Financial Data

The following tables summarize selected financial data as of and for the periods indicated:


	Three months ended						Nine months ended
	September 30,		June 30,		September 30,		September 30,		September 30,
(dollars in thousands)	2023		2023		2022		2023		2022
Selected Average Balance Sheet Data
Loans	$	2,544,836	$	2,482,413	$	2,262,361	$	2,495,122	$	1,958,216
Investment securities		971,913		1,007,792		1,116,458		1,004,436		1,165,414
Assets		3,821,601		3,785,487		3,743,154		3,799,645		3,431,212
Deposits		2,844,758		2,940,216		2,995,071		2,905,675		2,851,425
Fed funds purchased		312,121		360,033		84,149		320,861		55,527
Short-term borrowings		173,913		—		168,750		84,982		60,073
Long-term debt		58,914		58,886		58,843		58,886		58,875
Stockholders’ equity		361,735		360,216		372,274		361,260		345,192

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	September 30,		June 30,		December 31,		September 30,
(dollars in thousands)	2023		2023		2022		2022
Selected Period End Balance Sheet Data
Loans	$	2,606,430	$	2,533,522	$	2,443,994	$	2,318,231
Allowance for credit losses on loans		(36,290)		(35,696)		(31,146)		(30,968)
Investment securities		943,269		985,870		1,039,226		1,055,520
Assets		3,869,138		3,832,978		3,779,637		3,691,253
Deposits		2,872,184		2,852,855		2,915,484		2,961,811
Long-term debt		58,928		58,900		58,843		58,836
Total stockholders’ equity		349,402		357,685		356,872		344,839


	Three months ended						Nine months ended
	September 30,		June 30,		September 30,		September 30,		September 30,
(dollars in thousands)	2023		2023		2022		2023		2022
Selected Income Statement Data
Net interest income	$	20,395	$	22,234	$	28,316	$	66,287	$	72,765
Provision for credit losses		—		—		—		550		—
Noninterest income		28,407		25,778		27,010		79,439		85,706
Noninterest expense		37,260		36,373		42,767		111,503		120,822
Income before income taxes		11,542		11,639		12,559		33,673		37,649
Income tax expense		2,381		2,535		2,940		7,222		8,553
Net income	$	9,161	$	9,104	$	9,619	$	26,451	$	29,096

Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures

In addition to the results presented in accordance with GAAP, the Company routinely supplements its evaluation with an analysis of certain non-GAAP financial measures. These non-GAAP financial measures include the ratio of tangible common equity to tangible assets, tangible book value per common share, return on average tangible common equity, net interest margin (tax-equivalent), and the efficiency ratio, as adjusted. Management uses these non-GAAP financial measures in its analysis of its performance, and believes financial analysts and others frequently use these measures, and other similar measures, to evaluate capital adequacy. Management calculates: (i) tangible common equity as total common stockholders' equity less goodwill and other intangible assets; (ii) tangible book value per common share as tangible common equity divided by shares of common stock outstanding; (iii) tangible assets as total assets, less goodwill and other intangible assets; (iv) return on average tangible common equity as net income adjusted for intangible amortization net of tax, divided by average tangible common equity; and (v) efficiency ratio, as adjusted, as noninterest expense less intangible amortization expense, divided by net interest income plus noninterest income plus a tax-equivalent adjustment.

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The following tables present these non-GAAP financial measures along with the most directly comparable financial measures calculated in accordance with GAAP as of and for the periods indicated:


	September 30,			June 30,			December 31,			September 30,
(dollars and shares in thousands, except per share data)	2023			2023			2022			2022
Tangible common equity to tangible assets
Total common stockholders’ equity	$	349,402		$	357,685		$	356,872		$	344,839
Less: Goodwill		46,783			47,087			47,087			46,060
Less: Other intangible assets		18,482			19,806			22,455			23,779
Tangible common equity (a)		284,137			290,792			287,330			275,000
Total assets		3,869,138			3,832,978			3,779,637			3,691,253
Less: Goodwill		46,783			47,087			47,087			46,060
Less: Other intangible assets		18,482			19,806			22,455			23,779
Tangible assets (b)		3,803,873			3,766,085			3,710,095			3,621,414
Tangible common equity to tangible assets (a)/(b)		7.47	%		7.72	%		7.74	%		7.59	%
Tangible book value per common share
Total common stockholders’ equity	$	349,402		$	357,685		$	356,872		$	344,839
Less: Goodwill		46,783			47,087			47,087			46,060
Less: Other intangible assets		18,482			19,806			22,455			23,779
Tangible common equity (c)		284,137			290,792			287,330			275,000
Total common shares issued and outstanding (d)		19,848			19,915			19,992			19,987
Tangible book value per common share (c)/(d)	$	14.32		$	14.60		$	14.37		$	13.76


	Three months ended									Nine months ended
	September 30,			June 30,			September 30,			September 30,			September 30,
(dollars and shares in thousands, except per share data)	2023			2023			2022			2023			2022
Return on average tangible common equity
Net income	$	9,161		$	9,104		$	9,619		$	26,451		$	29,096
Add: Intangible amortization expense (net of tax)		1,046			1,046			1,046			3,138			2,710
Net income, excluding intangible amortization (e)		10,207			10,150			10,665			29,589			31,806
Average total equity		361,735			360,216			372,274			361,260			345,192
Less: Average goodwill		46,882			47,087			48,141			47,018			37,101
Less: Average other intangible assets (net of tax)		15,109			16,153			19,466			16,149			16,605
Average tangible common equity (f)		299,744			296,976			304,667			298,093			291,486
Return on average tangible common equity (e)/(f)		13.51	%		13.71	%		13.89	%		13.27	%		14.59	%
Efficiency ratio
Noninterest expense	$	37,260		$	36,373		$	42,767		$	111,503		$	120,822
Less: Intangible amortization expense		1,324			1,324			1,324			3,972			3,430
Adjusted noninterest expense (g)		35,936			35,049			41,443			107,531			117,392
Net interest income		20,395			22,234			28,316			66,287			72,765
Noninterest income		28,407			25,778			27,010			79,439			85,706
Tax-equivalent adjustment		180			140			112			444			306
Total tax-equivalent revenue (h)		48,982			48,152			55,438			146,170			158,777
Efficiency ratio (g)/(h)		73.37	%		72.79	%		74.76	%		73.57	%		73.94	%

Discussion and Analysis of Results of Operations

Net Income

Net income for the three months ended September 30, 2023, was $9.2 million, or $0.45 per diluted common share, a $0.5 million, or 4.8%, decrease compared to $9.6 million, or $0.47 per diluted common share, for the three months ended September 30, 2022. Earnings for the third quarter of 2023 compared to the third quarter of 2022

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decreased primarily due to a $7.9 million decrease in net interest income. This negative result was partially offset by a $1.4 million increase in noninterest income and a $5.5 million decrease in noninterest expense.

Net income for the nine months ended September 30, 2023, was $26.5 million, or $1.30 per diluted common share, a $2.6 million, or 9.1%, decrease compared to $29.1 million, or $1.56 per diluted common share, for the nine months ended September 30, 2022. Earnings for the nine months ended September 30, 2023 compared to the nine months ended September 30, 2022 decreased primarily due to a $6.5 million decrease in net interest income, a $550 thousand increase in provision for credit losses, and a $6.3 million decrease in noninterest income. These negative results were partially offset by a $9.3 million decrease in noninterest expense.

Net Interest Income

Net interest income is the difference between interest income and yield-related fees earned on assets and interest expense paid on liabilities. Net interest margin is the difference between the yield on interest earning assets and the cost of interest-bearing liabilities as a percentage of interest earning assets. Net interest margin is presented on a tax-equivalent basis, which means that tax-free interest income has been adjusted to a pre-tax-equivalent income, assuming a federal income tax rate of 21% for the three and nine months ended September 30, 2023 and 2022.

Net interest income for the three months ended September 30, 2023, was $20.4 million, a decrease of $7.9 million, or 28.0%, compared to $28.3 million for the three months ended September 30, 2022. Net interest income for the third quarter of 2023 decreased compared to the third quarter of 2022 primarily due to the increasing cost of interest-bearing liabilities as interest expense increased $17.7 million mainly driven by an increase of 252 basis points in the average rate paid on interest-bearing liabilities. In addition, the average balance of interest-bearing liabilities increased $310.5 million. This was partially offset by a $9.8 million increase in interest income, as interest earning assets increased $73.1 million while the interest earning asset yield increased 101 basis points. The increase in interest earning assets was due to organic growth. The increase in interest-bearing liabilities was due to a decrease in deposits which were replaced with wholesale borrowings and a shift from noninterest-bearing deposits to interest-bearing deposits.

Net interest income for the nine months ended September 30, 2023, was $66.3 million, a decrease of $6.5 million, or 8.9%, compared to $72.8 million for the nine months ended September 30, 2022. Net interest income for the nine months ended September 30, 2023, decreased compared to the nine months ended September 30, 2022, primarily due to a 231 basis point increase in the average rate paid on interest-bearing liabilities in addition to an increase of $446.6 million in the average balance of interest-bearing liabilities. This was partially offset by increases of 121 basis points in the average rate paid on interest earning assets and the average balance of interest earning assets. The average balance of interest earning assets increased $335.1 million. The increase in interest earning assets was due to a combination of organic growth and the acquisition of Metro Phoenix Bank. The increase in interest-bearing liabilities was due to the acquisition of Metro Phoenix Bank and a decrease in noninterest-bearing liabilities.

Net interest margin (on a FTE basis) for the three months ended September 30, 2023, was 2.27%, compared to 3.21% for the same period in 2022.

Net interest margin (on a FTE basis) for the nine months ended September 30, 2023, was 2.50%, compared to 3.02% for the same period in 2022.

As a result of the recent and expected increases in the target federal funds interest rate, the Company anticipates that net interest income and net interest margin (on a FTE basis) will remain under pressure in future periods.

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The following table presents average balance sheet information, interest income, interest expense and the corresponding average yields on assets, average yields earned, and rates paid for the three and nine months ended September 30, 2023 and 2022. The Company derived these yields and rates by dividing income or expense by the average balance of the corresponding assets or liabilities. The Company derived average balances from the daily balances throughout the periods indicated. Average loan balances include loans that have been placed on nonaccrual, while interest previously accrued on these loans is reversed against interest income. In these tables, adjustments are made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis.


	Three months ended September 30,
	2023						2022
			Interest		Average				Interest		Average
	Average		Income/		Yield/		Average		Income/		Yield/
(dollars in thousands)	Balance		Expense		Rate		Balance		Expense		Rate
Interest Earning Assets
Interest-bearing deposits with banks	$	29,450	$	229	3.09	%	$	72,157	$	368	2.02	%
Investment securities ⁽¹⁾		971,913		6,377	2.60	%		1,116,458		6,204	2.20	%
Fed funds sold		—		—	—	%		21,893		131	2.37	%
Loans held for sale		16,518		231	5.55	%		27,032		282	4.14	%
Loans
Commercial:
Commercial and industrial		555,649		9,258	6.61	%		566,987		7,729	5.41	%
Real estate construction		88,450		1,900	8.52	%		70,545		996	5.60	%
Commercial real estate		998,636		13,219	5.25	%		807,505		8,279	4.07	%
Total commercial		1,642,735		24,377	5.89	%		1,445,037		17,004	4.67	%
Consumer
Residential real estate first mortgage		714,874		7,007	3.89	%		624,826		5,580	3.54	%
Residential real estate junior lien		154,939		3,004	7.69	%		140,664		1,918	5.41	%
Other revolving and installment		32,288		497	6.11	%		51,834		651	4.98	%
Total consumer		902,101		10,508	4.62	%		817,324		8,149	3.96	%
Total loans ⁽¹⁾		2,544,836		34,885	5.44	%		2,262,361		25,153	4.41	%
Federal Reserve/FHLB Stock		28,761		495	6.83	%		18,449		249	5.35	%
Total interest earning assets		3,591,478		42,217	4.66	%		3,518,350		32,387	3.65	%
Noninterest earning assets		230,123						224,804
Total assets	$	3,821,601					$	3,743,154
Interest-Bearing Liabilities
Interest-bearing demand deposits	$	751,455	$	2,534	1.34	%	$	659,696	$	211	0.13	%
Money market and savings deposits		1,073,297		8,650	3.20	%		1,180,576		1,202	0.40	%
Time deposits		327,264		3,252	3.94	%		234,459		439	0.74	%
Fed funds purchased		312,121		4,327	5.50	%		84,149		787	3.71	%
Short-term borrowings		173,913		2,201	5.02	%		168,750		729	1.71	%
Long-term debt		58,914		679	4.57	%		58,843		591	3.98	%
Total interest-bearing liabilities		2,696,964		21,643	3.18	%		2,386,473		3,959	0.66	%
Noninterest-Bearing Liabilities and Stockholders' Equity
Noninterest-bearing deposits		692,742						920,340
Other noninterest-bearing liabilities		70,160						64,067
Stockholders’ equity		361,735						372,274
Total liabilities and stockholders’ equity	$	3,821,601					$	3,743,154
Net interest income			$	20,574					$	28,428
Net interest rate spread					1.48	%					2.99	%
Net interest margin on FTE basis ⁽¹⁾					2.27	%					3.21	%

(1)	Taxable equivalent adjustment was calculated utilizing a marginal income tax rate of 21.0 percent.

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	Nine months ended September 30,
	2023						2022
			Interest		Average				Interest		Average
	Average		Income/		Yield/		Average		Income/		Yield/
(dollars in thousands)	Balance		Expense		Rate		Balance		Expense		Rate
Interest Earning Assets
Interest-bearing deposits with banks	$	35,892	$	927	3.45	%	$	68,811	$	442	0.86	%
Investment securities ⁽¹⁾		1,004,436		18,928	2.52	%		1,165,414		18,255	2.09	%
Fed funds sold		—		—	—	%		7,378		131	2.37	%
Loans held for sale		13,822		547	5.29	%		27,864		689	3.31	%
Loans
Commercial:
Commercial and industrial		553,460		27,037	6.53	%		488,771		17,797	4.87	%
Real estate construction		93,098		5,197	7.46	%		52,212		1,839	4.71	%
Commercial real estate		956,018		36,485	5.10	%		670,854		19,378	3.86	%
Total commercial		1,602,576		68,719	5.73	%		1,211,837		39,014	4.30	%
Consumer
Residential real estate first mortgage		700,734		19,942	3.80	%		561,261		14,472	3.45	%
Residential real estate junior lien		153,664		8,565	7.45	%		132,968		4,829	4.86	%
Other revolving and installment		38,148		1,708	5.99	%		52,150		1,791	4.59	%
Total consumer		892,546		30,215	4.53	%		746,379		21,092	3.78	%
Total loans ⁽¹⁾		2,495,122		98,934	5.30	%		1,958,216		60,106	4.10	%
Federal Reserve/FHLB Stock		25,403		1,294	6.81	%		11,877		448	5.04	%
Total interest earning assets		3,574,675		120,630	4.51	%		3,239,560		80,071	3.30	%
Noninterest earning assets		224,970						191,652
Total assets	$	3,799,645					$	3,431,212
Interest-Bearing Liabilities
Interest-bearing demand deposits	$	757,995	$	6,559	1.16	%	$	692,310	$	637	0.12	%
Money market and savings deposits		1,127,630		22,915	2.72	%		1,089,137		1,943	0.24	%
Time deposits		276,797		6,744	3.26	%		224,603		914	0.54	%
Fed funds purchased		320,861		12,556	5.23	%		55,527		1,027	2.47	%
Short-term borrowings		84,982		3,128	4.92	%		60,073		767	1.71	%
Long-term debt		58,886		1,999	4.54	%		58,875		1,712	3.89	%
Total interest-bearing liabilities		2,627,151		53,901	2.74	%		2,180,525		7,000	0.43	%
Noninterest-Bearing Liabilities and Stockholders' Equity
Noninterest-bearing deposits		743,253						845,375
Other noninterest-bearing liabilities		67,981						60,120
Stockholders’ equity		361,260						345,192
Total liabilities and stockholders’ equity	$	3,799,645					$	3,431,212
Net interest income			$	66,729					$	73,071
Net interest rate spread					1.77	%					2.87	%
Net interest margin on FTE basis ⁽¹⁾					2.50	%					3.02	%

(1)	Taxable equivalent adjustment was calculated utilizing a marginal income tax rate of 21.0 percent.

Interest Rates and Operating Interest Differential

Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest earning assets and interest-bearing liabilities, as well as changes in average interest rates. The following table shows the effect that these factors had on the interest earned on interest earning assets and the interest incurred on interest-bearing liabilities. The effect of changes in volume is determined by multiplying the change in

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volume by the previous period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume.


	Three Months Ended September 30, 2023						Nine months ended September 30, 2023
	Compared with						Compared with
	Three Months Ended September 30, 2022						Nine months ended September 30, 2022
	Change due to:				Interest		Change due to:				Interest
(tax-equivalent basis, dollars in thousands)	Volume		Rate		Variance		Volume		Rate		Variance
Interest earning assets
Interest-bearing deposits with banks	$	(217)	$	78	$	(139)	$	(212)	$	697	$	485
Investment securities		(802)		975		173		(2,516)		3,189		673
Loans held for sale		(131)		—		(131)		(131)		—		(131)
Loans held for sale		(110)		59		(51)		(348)		206		(142)
Loans
Commercial:
Commercial and industrial		(155)		1,684		1,529		2,356		6,884		9,240
Real estate construction		253		651		904		1,440		1,918		3,358
Commercial real estate		1,961		2,979		4,940		8,233		8,874		17,107
Total commercial		2,059		5,314		7,373		12,029		17,676		29,705
Consumer
Residential real estate first mortgage		803		624		1,427		3,599		1,871		5,470
Residential real estate junior lien		195		891		1,086		752		2,984		3,736
Other revolving and installment		(245)		91		(154)		(481)		398		(83)
Total consumer		753		1,606		2,359		3,870		5,253		9,123
Total loans		2,812		6,920		9,732		15,899		22,929		38,828
Federal Reserve/FHLB Stock		139		107		246		510		336		846
Total interest income		1,691		8,139		9,830		13,202		27,357		40,559
Interest-bearing liabilities
Interest-bearing demand deposits		30		2,293		2,323		59		5,863		5,922
Money market and savings deposits		(108)		7,556		7,448		69		20,903		20,972
Time deposits		173		2,640		2,813		211		5,619		5,830
Fed funds purchased		2,132		1,408		3,540		4,902		6,627		11,529
Short-term borrowings		22		1,450		1,472		319		2,042		2,361
Long-term debt		1		87		88		—		287		287
Total interest expense		2,250		15,434		17,684		5,560		41,341		46,901
Change in net interest income	$	(559)	$	(7,295)	$	(7,854)	$	7,642	$	(13,984)	$	(6,342)

Provision for Credit Losses

The Company recorded no provision for credit loss expense for the three months ending September 30, 2023 and September 30, 2022.

The Company recorded a provision for credit loss expense of $550 thousand for the nine months ended September 30, 2023, a $550 thousand increase compared to the nine months ended September 30, 2022. The provision for credit loss expense for the nine months ended September 30, 2023 included $460 thousand in provision for credit loss on loans, $44 thousand in provision for credit loss on unfunded commitments and $46 thousand in provision for credit loss on investment securities held-to-maturity. The CECL accounting standard requires the Company to recognize losses over the expected life of the loan as opposed to the losses expected to already have been incurred. The increase in provision for credit losses is primarily a result of a change in forecasting assumptions brought about by the new methodology.

Noninterest Income

The Company’s noninterest income is generated from four primary sources: (1) retirement and benefit services; (2) wealth management; (3) mortgage banking; and (4) other general banking services.

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The following table presents the Company’s noninterest income for the three and nine months ended September 30, 2023 and 2022:


	Three months ended						Nine months ended
	September 30,						September 30,
(dollars in thousands)	2023			2022			2023			2022
Retirement and benefit services	$	18,605		$	16,597		$	49,977		$	50,536
Wealth management		5,271			4,852			15,915			15,726
Mortgage banking		2,510			3,782			7,132			14,751
Service charges on deposit accounts		328			377			940			1,152
Other		1,693			1,402			5,475			3,541
Total noninterest income	$	28,407		$	27,010		$	79,439		$	85,706
Noninterest income as a % of revenue		58.21	%		48.82	%		54.51	%		54.08	%

Total noninterest income for the three months ended September 30, 2023 was $28.4 million, a $1.4 million, or 5.2%, increase compared to $27.0 million for the three months ended September 30, 2022. The increase in noninterest income was primarily driven by an increase of $2.0 million in retirement and benefit services due to the divestiture of the ESOP trustee business and increased assets under administration/management. Assets under administration/management were higher due to an increase in overall plans and participants coupled with improved equity and bond markets.

Total noninterest income for the nine months ended September 30, 2023, was $79.4 million, a $6.3 million, or 7.3%, decrease compared to $85.7 million for the nine months ended September 30, 2022. The decrease in noninterest income was primarily driven by a decrease of $7.6 million in mortgage banking revenue as mortgage originations decreased compared to 2022 as higher interest rates dramatically impacted demand.

The Company anticipates that noninterest income will continue to be significantly adversely affected in future periods as a result of increasing interest rates and inflationary pressure, which have begun to and will continue to adversely affect mortgage originations and mortgage banking revenue.

See “NOTE 15 Segment Reporting” of the consolidated financial statements for additional discussion regarding the Company’s business lines.

Noninterest Expense

The following table presents noninterest expense for the three and nine months ended September 30, 2023 and 2022:


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands)	2023		2022		2023		2022
Compensation	$	19,071	$	21,168	$	57,076	$	61,467
Employee taxes and benefits		4,895		5,079		15,472		17,028
Occupancy and equipment expense		1,883		1,925		5,619		5,713
Business services, software and technology expense		4,774		5,373		15,367		15,082
Intangible amortization expense		1,324		1,324		3,972		3,430
Professional fees and assessments		1,716		3,126		4,397		6,913
Marketing and business development		692		890		2,026		2,304
Supplies and postage		410		588		1,275		1,806
Travel		322		291		876		826
Mortgage and lending expenses		689		409		1,401		1,577
Other		1,484		2,594		4,022		4,676
Total noninterest expense	$	37,260	$	42,767	$	111,503	$	120,822

Total noninterest expense for the three months ended September 30, 2023, was $37.3 million, a $5.5 million, or 12.9%, decrease compared to $42.8 million for the three months ended September 30, 2022. The year over year decrease was primarily due to a $2.1 million decrease in compensation and $1.4 million decrease in professional fees and

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assessments. Compensation decreased primarily due to a decrease in overall headcount and due to lower mortgage related incentive compensation as a result of lower mortgage originations. The decrease in professional fees and assessments was due to merger-related expenses incurred in the third quarter of 2022, in connection with the acquisition of Metro Phoenix Bank.

Total noninterest expense for the nine months ended September 30, 2023, was $111.5 million, a $9.3 million, or 7.7%, decrease compared to $120.8 million for the nine months ended September 30, 2022. The decrease was driven by decreases of $4.4 million in compensation, $1.6 million in employee taxes and benefits, and $2.5 million in professional fees and assessments. The decrease in compensation expense was primarily due to a decrease in overall headcount and due to a lower mortgage related incentive compensation as a result of lower mortgage originations, which was also the primary driver for the decrease in mortgage and lending expenses. The decrease in employee taxes and benefits was primarily due to lower group insurance claims driven by a reduction in headcount along with a decrease in taxes driven by lower compensation expense. The decrease in professional fees and assessments was primarily driven by lower merger and acquisition and recruitment expenses offset by an increase in FDIC assessments.

Income Tax Expense

Income tax expense is an estimate based on the amount the Company expects to owe the respective taxing authorities, plus the impact of deferred tax items. Accrued taxes represent the net estimated amount due, or to be received from, taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account statutory, judicial, and regulatory guidance in the context of the Company’s tax position. If the final resolution of taxes payable differs from the Company’s estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required.

For the three months ended September 30, 2023, the Company recognized income tax expense of $2.4 million on $11.5 million of pre-tax income, resulting in an effective tax rate of 20.6%, compared to income tax expense of $2.9 million on $12.6 million of pre-tax income for the three months ended September 30, 2022, resulting in an effective tax rate of 23.3%.

For the nine months ended September 30, 2023, the Company recognized income tax expense of $7.2 million on $33.7 million of pre-tax income, resulting in an effective tax rate of 21.4%, compared to income tax expense of $8.6 million on $37.6 million of pre-tax income for the nine months ended September 30, 2022, resulting in an effective tax rate of 22.7%.

Financial Condition

Overview

Total assets were $3.9 billion as of September 30, 2023, an increase of $89.5 million, or 2.4%, compared to December 31, 2022. The increase was primarily due to a $162.4 million increase in loans, $6.9 million increase in loans held for sale and $6.5 million increase in cash and cash equivalents, offset by a decrease of $96.0 million in investment securities and a $5.1 million increase in the allowance for credit losses.

Loans

The loan portfolio represents a broad range of borrowers comprised of commercial and industrial, commercial real estate, residential real estate, and other revolving and installment loans. As of September 30, 2023, the portfolio mix was 22.3% commercial and industrial, 39.3% commercial real estate, 33.4% residential real estate and 5.0% in other categories.

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The following table presents the composition of total loans outstanding by portfolio segment as of September 30, 2023 and December 31, 2022:


	September 30, 2023				December 31, 2022
			Percent of				Percent of		Change
(dollars in thousands)	Balance		Portfolio		Balance		Portfolio			Amount	Percent
Commercial
Commercial and industrial	$	582,387	22.3	%	$	583,876	23.9	%	$	(1,489)	(0.3)	%
Real estate construction		97,742	3.8	%		97,810	4.0	%		(68)	(0.1)	%
Commercial real estate		1,025,014	39.3	%		881,670	36.0	%		143,344	16.3	%
Total commercial		1,705,143	65.4	%		1,563,356	63.9	%		141,787	9.1	%
Consumer
Residential real estate first mortgage		717,793	27.5	%		679,551	27.8	%		38,242	5.6	%
Residential real estate junior lien		152,677	5.9	%		150,479	6.2	%		2,198	1.5	%
Other revolving and installment		30,817	1.2	%		50,608	2.1	%		(19,791)	(39.1)	%
Total consumer		901,287	34.6	%		880,638	36.1	%		20,649	2.3	%
Total loans	$	2,606,430	100.0	%	$	2,443,994	100.0	%	$	162,436	6.6	%

Total loans outstanding were $2.6 billion as of September 30, 2023, an increase of $162.4 million, or 6.6%, from December 31, 2022. The increase was primarily driven by a $143.3 million increase in commercial real estate and a $38.2 million increase in residential real estate loans, offset by a $19.8 million decrease in other consumer revolving and installment loans.

Despite headwinds from a higher interest rate environment and competition in the Company’s market areas, the Company anticipates continued loan growth for the commercial and industrial and commercial real estate loan portfolios as a result of recently added production talent.

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The following table presents the maturities and types of interest rates for the loan portfolio as of September 30, 2023:


	September 30, 2023
			After one		After five
	One year		but within		but within		After
(dollars in thousands)	or less		five years		fifteen years		fifteen years		Total
Commercial
Commercial and industrial	$	168,974	$	252,223	$	161,190	$	—	$	582,387
Real estate construction		25,538		63,442		6,567		2,195		97,742
Commercial real estate		67,108		449,764		445,426		62,716		1,025,014
Total commercial		261,620		765,429		613,183		64,911		1,705,143
Consumer
Residential real estate first mortgage		5,829		30,107		45,676		636,181		717,793
Residential real estate junior lien		8,708		22,360		34,557		87,052		152,677
Other revolving and installment		8,734		19,242		2,841		—		30,817
Total consumer		23,271		71,709		83,074		723,233		901,287
Total loans	$	284,891	$	837,138	$	696,257	$	788,144	$	2,606,430
Loans with fixed interest rates:
Commercial
Commercial and industrial	$	14,337	$	217,039	$	59,857	$	—	$	291,233
Real estate construction		5,837		15,930		3,973		—		25,740
Commercial real estate		48,842		330,527		284,539		22,740		686,648
Total commercial		69,016		563,496		348,369		22,740		1,003,621
Consumer
Residential real estate first mortgage		4,269		26,273		38,048		419,213		487,803
Residential real estate junior lien		1,451		6,899		22,487		15,828		46,665
Other revolving and installment		3,231		16,797		2,841		—		22,869
Total consumer		8,951		49,969		63,376		435,041		557,337
Total loans with fixed interest rates	$	77,967	$	613,465	$	411,745	$	457,781	$	1,560,958
Loans with floating interest rates:
Commercial
Commercial and industrial	$	154,637	$	35,184	$	101,333	$	—	$	291,154
Real estate construction		19,701		47,512		2,594		2,195		72,002
Commercial real estate		18,266		119,237		160,887		39,976		338,366
Total commercial		192,604		201,933		264,814		42,171		701,522
Consumer
Residential real estate first mortgage		1,560		3,834		7,628		216,968		229,990
Residential real estate junior lien		7,257		15,461		12,070		71,224		106,012
Other revolving and installment		5,503		2,445		—		—		7,948
Total consumer		14,320		21,740		19,698		288,192		343,950
Total loans with floating interest rates	$	206,924	$	223,673	$	284,512	$	330,363	$	1,045,472

The expected life of the Company’s loan portfolio will differ from contractual maturities because borrowers may have the right to curtail or prepay their loans with or without penalties. Consequently, the table above includes information limited to contractual maturities of the underlying loans.

Asset Quality

The Company’s strategy for credit risk management includes well-defined, centralized credit policies; uniform underwriting criteria; and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The strategy also emphasizes diversification on a geographic, industry, and client level; regular credit examinations; and management reviews of loans experiencing deterioration of credit quality. The Company strives to identify potential problem loans early, take necessary charge-offs promptly, and maintain adequate reserve levels for credit losses inherent in the portfolio. Management performs ongoing, internal reviews of any problem credits and continually assesses the adequacy of the allowance. The Company utilized an internal lending division, Special Credit Services, to develop and implement strategies for the management of individual nonperforming loans.

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Credit Quality Indicators

Loans are assigned a risk rating and grouped into categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The risk ratings are aligned to pass and criticized categories. The criticized categories include special mention, substandard, and doubtful risk ratings. See “NOTE 4 Loans and Allowance for Credit Losses” to the consolidated financial statements for a definition of each of the risk ratings.

The table below presents criticized loans outstanding by loan portfolio segment as of September 30, 2023 and December 31, 2022:


	September 30,			December 31,
(dollars in thousands)	2023			2022
Commercial
Commercial and industrial	$	31,682		$	25,182
Real estate construction		15,131			262
Commercial real estate		6,932			8,400
Total commercial		53,745			33,844
Consumer
Residential real estate first mortgage		107			808
Residential real estate junior lien		1,922			632
Other revolving and installment		—			1
Total consumer		2,029			1,441
Total loans	$	55,774		$	35,285
Criticized loans as a percent of total loans		2.14	%		1.44	%

The following table presents information regarding nonperforming assets as of September 30, 2023 and December 31, 2022:


	September 30,			December 31,
(dollars in thousands)	2023			2022
Nonaccrual loans	$	9,007		$	3,794
Accruing loans 90+ days past due		—			—
Total nonperforming loans		9,007			3,794
OREO and repossessed assets		3			30
Total nonperforming assets		9,010			3,824
Total restructured accruing loans		—			151
Total nonperforming assets and restructured accruing loans	$	9,010		$	3,975
Nonperforming loans to total loans		0.35	%		0.16	%
Nonperforming assets to total assets		0.23	%		0.10	%
Allowance for credit losses on loans to nonperforming loans		403	%		821	%

Interest income lost on nonaccrual loans approximated $287 thousand and $172 thousand for the nine months ended September 30, 2023 and 2022, respectively. There was no interest income included in net interest income related to nonaccrual loans for the nine months ended September 30, 2023 and 2022.

Allowance for Credit Losses on Loans

The allowance for credit losses is a significant estimate in the Company’s Consolidated Balance Sheet, affecting both earnings and capital. Its methodology influences and is influenced by the Company’s overall credit risk management processes. The allowance for credit losses is managed in accordance with GAAP to provide an adequate reserve for expected credit losses that is reflective of management’s best estimate of what is expected to be collected. All estimates of credit losses should be based on a careful consideration of all significant factors affecting the collectability as of the evaluation date. The allowance for credit losses is established through provision for credit loss expense charged to income.

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The Company calculates the allowance for credit losses at each reporting date. The Company recognizes an allowance for the lifetime expected credit losses for the amount the Company does not expect to collect. Subsequent changes in expected credit losses are recognized immediately in earnings. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio, after consideration of risk characteristics of the loans and prevailing and anticipated economic and other conditions. A risk system, consisting of multiple grading categories for each portfolio class, is utilized as an analytical tool to assess risk and appropriate reserves. In addition to the risk system, management further evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, expected loss experience, and other relevant information from internal and external sources which management feels deserve recognition in establishing an appropriate reserve. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change.

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The following table presents, by loan type, the changes in the allowance for credit losses on loans for the periods presented:


	Three months ended						Nine months ended
	September 30,						September 30,
(dollars in thousands)	2023			2022			2023			2022
Balance—beginning of period	$	35,696		$	31,373		$	35,003		$	31,572
Commercial loan charge-offs
Commercial and Industrial		(134)			(672)			(394)			(1,336)
Real estate construction		—			—			—			—
Commercial real estate		—			—			—			—
Total commercial loan charge-offs		(134)			(672)			(394)			(1,336)
Consumer loan charge-offs
Residential real estate first mortgage		(9)			—			(9)			—
Residential real estate junior lien		—			—			(77)			—
Other revolving and installment		(8)			(75)			(36)			(130)
Total consumer loan charge-offs		(17)			(75)			(122)			(130)
Total loan charge-offs		(151)			(747)			(516)			(1,466)
Commercial loan recoveries
Commercial and Industrial		456			105			950			321
Real estate construction		—			76			—			76
Commercial real estate		11			101			34			123
Total commercial recoveries		467			282			984			520
Consumer loan recoveries
Residential real estate first mortgage		254			—			256			—
Residential real estate junior lien		—			7			52			221
Other revolving and installment		24			53			51			121
Total consumer loan recoveries		278			60			359			342
Total loan recoveries		745			342			1,343			862
Net loan charge-offs (recoveries)		(594)			405			(827)			604
Commercial loan provision
Commercial and Industrial		442			(845)			(275)			1,011
Real estate construction		1,063			378			745			473
Commercial real estate		(270)			1,335			408			(229)
Total commercial loan provision		1,235			868			878			1,255
Consumer loan provision
Residential real estate first mortgage		(389)			(584)			(339)			(941)
Residential real estate junior lien		(14)			(109)			140			(151)
Other revolving and installment		(58)			(75)			(188)			65
Total consumer loan provision		(461)			(768)			(387)			(1,027)
Unallocated provision expense		(774)			(100)			(31)			(228)
Total provision for credit losses on loans		—			—			460			—
Balance—end of period	$	36,290		$	30,968		$	36,290		$	30,968
Total loans	$	2,606,430		$	2,318,231		$	2,606,430		$	2,318,231
Average total loans		2,544,836			2,262,361			2,495,122			1,958,216
Allowance for credit losses on loans to total loans		1.39	%		1.34	%		1.39	%		1.34	%
Net charge-offs/(recoveries) to average total loans (annualized)		(0.09)	%		0.07	%		(0.04)	%		0.04	%

Effective January 1, 2023, the Company adopted the new CECL accounting standard. The adoption of the CECL accounting standard resulted in the Company’s allowance for credit losses increasing by approximately $5.9 million relative to the allowance held as of December 31, 2022. The adoption of the CECL accounting standard resulted in an additional allowance of $3.9 million in the allowance for credit losses on loans and $1.9 million in additional allowance for credit losses on unfunded commitments. The allowance for credit losses on loans was $36.3 million as of September 30, 2023, compared to $31.1 million as of December 31, 2022. The $5.1 million increase was the result of a $3.9 million increase from the adoption of the CECL accounting standard as well as a $550 thousand provision for credit losses on loans expense. As of September 30, 2023, the allowance for credit losses on loans represented 1.39% of total loans.

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The following table summarizes the activity in the allowance for credit losses on loans for the periods indicated:


	Three months ended						Nine months ended
	September 30,						September 30,
(dollars in thousands)	2023			2022			2023			2022
Balance—beginning of period	$	35,696		$	31,373		$	35,003		$	31,572
Net charge-offs (recoveries):
Commercial net charge-offs (recoveries)
Commercial and Industrial		(322)			567			(556)			1,015
Real estate construction		—			(76)			—			(76)
Commercial real estate		(11)			(101)			(34)			(123)
Total commercial net charge-offs (recoveries)		(333)			390			(590)			816
Consumer net charge-offs (recoveries)
Residential real estate first mortgage		(245)			—			(247)			—
Residential real estate junior lien		—			(7)			25			(221)
Other revolving and installment		(16)			22			(15)			9
Total consumer net charge-offs (recoveries)		(261)			15			(237)			(212)
Total net charge-offs (recoveries)		(594)			405			(827)			604
Provision for credit losses on loans		—			—			460			—
Balance—end of period	$	36,290		$	30,968		$	36,290		$	30,968

Net charge-offs (recoveries) to average loans
Commercial net charge-offs (recoveries) to average loans
Commercial and Industrial		(0.05)	%		0.10	%		(0.03)	%		0.07	%
Real estate construction		—	%		(0.01)	%		—	%		(0.01)	%
Commercial real estate		—	%		(0.02)	%		—	%		(0.01)	%
Total commercial net charge-offs (recoveries) to average loans		(0.05)	%		0.07	%		(0.03)	%		0.06	%
Consumer net charge-offs (recoveries) to average loans
Residential real estate first mortgage		(0.04)	%		—	%		(0.01)	%		—	%
Residential real estate junior lien		—	%		—	%		—	%		(0.02)	%
Other revolving and installment		—	%		—	%		—	%		—	%
Total consumer net charge-offs (recoveries) to average loans		(0.04)	%		—	%		(0.01)	%		(0.01)	%
Total net charge-offs (recoveries) to average loans		(0.09)	%		0.07	%		(0.04)	%		0.04	%

Allowance for credit losses on loans to total loans		1.39	%		1.34	%		1.39	%		1.34	%
Allowance for credit losses on loans to nonaccrual loans		403	%		816	%		403	%		816	%
Allowance for credit losses on loans to nonperforming loans		403	%		821	%		403	%		821	%

The following table presents the allocation of the allowance for credit losses on loans as of the dates presented:


	September 30, 2023				December 31, 2022
			Percentage				Percentage
	Allocated		of loans to		Allocated		of loans to
(dollars in thousands)	Allowance		total loans		Allowance		total loans
Commercial and industrial	$	8,577	22.3	%	$	9,158	23.9	%
Real estate construction		4,709	3.8	%		1,446	4.0	%
Commercial real estate		12,706	39.3	%		12,688	36.0	%
Residential real estate first mortgage		7,757	27.5	%		5,769	27.8	%
Residential real estate junior lien		1,337	5.9	%		1,289	6.2	%
Other revolving and installment		251	1.2	%		528	2.1	%
Unallocated		953	—	%		268	—	%
Total loans	$	36,290	100.0	%	$	31,146	100.0	%

In the ordinary course of business, the Company enters into commitments to extend credit, including commitments under credit arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. An allowance was established for off-balance sheet credit exposures as part of the adoption of the CECL accounting standard and is measured using similar internal and external assumptions.

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This allowance is located in accrued expenses and other liabilities on the Consolidated Balance Sheets. The reserve for unfunded commitments was $5.2 million as of September 30, 2023.

Investment Securities

The composition of the Company’s investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity for normal operations while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral.

The following table presents the fair value composition of the Company’s investment securities portfolio as of September 30, 2023 and December 31, 2022:


	September 30, 2023				December 31, 2022
			Percent of				Percent of
(dollars in thousands)	Balance		Portfolio		Balance		Portfolio
Available-for-sale
U.S. Treasury and agencies	$	2,665	0.3	%	$	3,520	0.3	%
Mortgage backed securities
Residential agency		521,623	55.3	%		587,679	56.6	%
Commercial		58,685	6.2	%		63,558	6.1	%
Asset backed securities		27	—	%		34	—	%
Corporate bonds		57,001	6.0	%		62,533	6.0	%
Total available-for-sale investment securities		640,001	67.8	%		717,324	69.0	%
Held-to-maturity
Obligations of state and political agencies		130,088	13.8	%		137,787	13.3	%
Mortgage backed securities
Residential agency		173,398	18.4	%		184,115	17.7	%
Total held-to-maturity investment securities		303,486	32.2	%		321,902	31.0	%
Total investment securities	$	943,487	100.0	%	$	1,039,226	100.0	%

The investment securities presented in the following table are reported at fair value and by contractual maturity as of September 30, 2023. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage backed securities and

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collateralized mortgage obligations receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax-equivalent basis.


	Maturity as of September 30, 2023
	One year or less				One to five years				Five to ten years				After ten years
	Fair		Average		Fair		Average		Fair		Average		Fair		Average
(dollars in thousands)	Value		Yield		Value		Yield		Value		Yield		Value		Yield
Available-for-sale
U.S. Treasury and agencies	$	—	—	%	$	390	4.26	%	$	590	5.68	%	$	1,685	5.66	%
Mortgage backed securities
Residential agency		15	3.11	%		3,248	2.22	%		5,416	2.77	%		512,944	1.82	%
Commercial		—	—	%		15,316	2.77	%		9,179	2.88	%		34,190	2.42	%
Asset backed securities		—	—	%		—	—	%		8	5.20	%		19	5.04	%
Corporate bonds		—	—	%		—	—	%		57,001	3.83	%		—	—	%
Total available-for-sale investment securities		15	3.11	%		18,954	2.71	%		72,194	3.66	%		548,838	1.87	%
Held-to-maturity
Obligations of state and political agencies		5,875	0.60	%		45,878	1.38	%		49,427	2.04	%		10,257	2.21	%
Mortgage backed securities
Residential agency		—	—	%		—	—	%		—	—	%		136,802	2.17	%
Total held-to-maturity investment securities		5,875	0.60	%		45,878	1.38	%		49,427	2.04	%		147,059	2.17	%
Total investment securities	$	5,890	0.61	%	$	64,832	1.77	%	$	121,621	2.99	%	$	695,897	1.93	%

Deposits

Deposit inflows and outflows are influenced by prevailing market interest rates, competition, local and economic conditions, and fluctuations in the Company’s customers’ own liquidity needs and may also be influenced by recent developments in the financial services industry, including the large-scale deposit withdrawals over a short period of time at Silicon Valley Bank, Signature Bank, and First Republic Bank that resulted in the failure of those institutions.

Total deposits were $2.9 billion as of September 30, 2023, a decrease of $43.3 million, or 1.5%, from December 31, 2022. Interest-bearing deposits increased $99.7 million while noninterest-bearing deposits decreased $143.0 million. The decrease in total deposits was due to both public unit depositor seasonality and clients using excess liquidity and paying down revolving debt. Noninterest-bearing deposits decreased from 29.5% of total deposits to 25.0% as higher yields on interest-bearing accounts and other investment alternatives, such as U.S. treasuries, attracted funds. Time deposit balances increased as higher short-term CD rates attracted both existing non-maturity deposits as well as new deposits to the Company.

The following table presents the composition of the Company’s deposit portfolio as of September 30, 2023 and December 31, 2022:


	September 30, 2023				December 31, 2022
			Percent of				Percent of		Change
(dollars in thousands)	Balance		Portfolio		Balance		Portfolio		Amount		Percent
Noninterest-bearing demand	$	717,990	25.0	%	$	860,987	29.5	%	$	(142,997)	(16.6)	%
Interest-bearing demand		759,812	26.5	%		706,275	24.2	%		53,537	7.6	%
Money market and savings		1,047,447	36.4	%		1,135,863	39.0	%		(88,416)	(7.8)	%
Time deposits		346,935	12.1	%		212,359	7.3	%		134,576	63.4	%
Total deposits	$	2,872,184	100.0	%	$	2,915,484	100.0	%	$	(43,300)	(1.5)	%

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The following table presents the average balances and rates of the Company’s deposit portfolio for the three months ended September 30, 2023 and 2022:


	Three months ended September 30,
	2023				2022
	Average		Average		Average		Average
(dollars in thousands)	Balance		Rate		Balance		Rate
Noninterest-bearing demand	$	743,253	—	%	$	845,375	—	%
Interest-bearing demand		757,995	1.34	%		692,310	0.13	%
Money market and savings		1,127,630	3.20	%		1,089,137	0.40	%
Time deposits		276,797	3.94	%		224,603	0.74	%
Total deposits	$	2,905,675	1.97	%	$	2,851,425	0.25	%

The following table presents the contractual maturity of time deposits, including certificate of deposit account registry services and IRA deposits of $250 thousand and over, that were outstanding as of September 30, 2023:


	September 30,
(dollars in thousands)	2023
Maturing in:
3 months or less	$	34,094
3 months to 6 months		42,811
6 months to 1 year		17,753
1 year or greater		4,044
Total	$	98,702

The Company’s total uninsured deposits, which are amounts of deposit accounts that exceed the FDIC insurance limit, currently $250,000, were approximately $1.0 billion at September 30, 2023 These amounts were estimated based on the same methodologies used for regulatory reporting purposes.

Borrowings

Borrowings as of September 30, 2023 and December 31, 2022 were as follows:


	September 30, 2023				December 31, 2022
			Percent of				Percent of
(dollars in thousands)	Balance		Portfolio		Balance		Portfolio
Fed funds purchased	$	315,470	54.9	%	$	153,080	35.0	%
FHLB Short-term advances		200,000	34.8	%		225,000	51.6	%
Subordinated notes		50,000	8.7	%		50,000	11.4	%
Junior subordinated debentures		8,928	1.6	%		8,843	2.0	%
Total borrowed funds	$	574,398	100.0	%	$	436,923	100.0	%

Capital Resources

Stockholders' equity is influenced primarily by earnings, dividends, the Company's sales and repurchases of its common stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized gains or losses, net of taxes, on available-for-sale securities.

Stockholders' equity decreased $7.5 million, or 2.1%, to $349.4 million as of September 30, 2023, compared to $356.9 million as of December 31, 2022. Tangible common equity to tangible assets, a non-GAAP financial measure, decreased to 7.47% as of September 30, 2023, from 7.74% as of December 31, 2022. Common equity tier 1 capital to risk weighted assets decreased to 13.01% as of September 30, 2023, from 13.39% as of December 31, 2022.

The Company strives to maintain an adequate capital base to support the Company’s activities in a safe and sound manner while at the same time attempting to maximize stockholder value. Capital adequacy is assessed against the

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risk inherent in the Company’s balance sheet, recognizing that unexpected loss is the common denominator of risk, and that common equity has the greatest capacity to absorb unexpected loss.

The Company is subject to various regulatory capital requirements both at the Company and at the Bank level. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. The Company has consistently maintained regulatory capital ratios at or above the well-capitalized standards.

At September 30, 2023 and December 31, 2022, the Company met all the capital adequacy requirements to which the Company was subject. The table below presents the Company’s and the Bank’s regulatory capital ratios as of September 30, 2023 and December 31, 2022:


	September 30,		December 31,
Capital Ratios	2023		2022
Alerus Financial Corporation Consolidated
Common equity tier 1 capital to risk weighted assets	13.01	%	13.39	%
Tier 1 capital to risk weighted assets	13.30	%	13.69	%
Total capital to risk weighted assets	16.10	%	16.48	%
Tier 1 capital to average assets	11.14	%	11.25	%
Tangible common equity to tangible assets (1)	7.47	%	7.74	%

Alerus Financial, National Association
Common equity tier 1 capital to risk weighted assets	12.68	%	12.76	%
Tier 1 capital to risk weighted assets	12.68	%	12.76	%
Total capital to risk weighted assets	13.86	%	13.83	%
Tier 1 capital to average assets	10.72	%	10.48	%

(1)Represents a non-GAAP financial measure. See “Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures.”

The capital ratios for the Company and the Bank, as of September 30, 2023, as shown in the above table, were at levels above the regulatory minimums to be considered “well capitalized”. See “NOTE 18 Regulatory Matters” to the consolidated financial statements for additional information.

Off-Balance Sheet Arrangements

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of the Company’s customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be required based on management’s assessment of the customer’s creditworthiness. The fair value of these commitments is considered immaterial for disclosure purposes.

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A summary of the contractual amounts of the Company’s exposure to off-balance sheet agreements as of September 30, 2023 and December 31, 2022, was as follows:


	September 30,		December 31,
(dollars in thousands)	2023		2022
Commitments to extend credit	$	786,233	$	806,431
Standby letters of credit		9,734		13,089
Total	$	795,967	$	819,520

Liquidity

Liquidity management is the process by which the Company manages the flow of funds necessary to meet the Company’s financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of the Company’s operations, and capital expenditures. Liquidity is monitored and closely managed by the Company’s asset and liability committee, or the ALCO, a group of senior officers from the finance, enterprise risk management, deposit, investment, treasury, and lending areas. It is the ALCO’s responsibility to ensure the Company has the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for, quickly identified, and management has plans in place to respond. The ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources.

As of September 30, 2023, the Company had on balance sheet liquidity of $623.4 million, compared to $778.9 million as of December 31, 2022. On balance sheet liquidity includes cash and cash equivalents, federal funds sold, unencumbered securities available-for-sale, and over collateralized securities pledging positions available-for-sale.

The Bank is a member of the FHLB, which provides short- and long-term funding to its members through advances collateralized by real estate related assets and other select collateral, most typically in the form of debt securities. Actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As of September 30, 2023, the Company had $315.5 million in federal funds purchased and $200.0 million in short-term borrowings from the FHLB. As of September 30, 2023, the Company had $1.5 billion of collateral pledged to the FHLB and based on this collateral, the Company was eligible to borrow up to an additional $477.1 million from the FHLB. In addition, the Company can borrow up to $107.0 million through the unsecured lines of credit the Company has established with four other correspondent banks.

In addition, because the Bank is “well capitalized,” the Company can accept wholesale deposits up to 20.0% of total assets based on current policy limits, or $773.8 million, as of September 30, 2023. Management believed that the Company had adequate resources to fund all of the Company’s commitments as of September 30, 2023 and December 31, 2022.

The Company’s primary sources of liquidity include liquid assets, as well as unencumbered securities that can be used to collateralize additional funding.

Though remote, the possibility of a funding crisis exists at all financial institutions. The economic impact of the recent rise in inflation and rising interest rates could place increased demand on the Company’s liquidity if the Company experiences significant credit deterioration and as the Company meets borrowers’ needs. Accordingly, management has addressed this issue by formulating a liquidity contingency plan, which has been reviewed and approved by both the Bank’s board of directors and the ALCO. The plan addresses the actions that the Company would take in response to both a short-term and long-term funding crisis.

A short-term funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly short-term funding operations. Such a crisis would likely be temporary in nature and would not involve a change in credit ratings. A long-term funding crisis would most likely be the result of both external and internal factors and would most likely result in drastic credit deterioration. Management believes that both potential

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circumstances have been fully addressed through detailed action plans and the establishment of trigger points for monitoring such events.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates. Interest-rate risk is the risk to earnings and equity value arising from changes in market interest rates and arises in the normal course of business to the extent that there is a divergence between the amount of interest-earning assets and the amount of interest-bearing liabilities that are prepaid/withdrawn, re-price, or mature in specified periods. The Company seeks to achieve consistent growth in net interest income and equity while managing volatility arising from shifts in market interest rates. The ALCO oversees market risk management, monitoring risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. The Bank’s board of directors approves policy limits with respect to interest rate risk.

Interest Rate Risk

Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective interest rate risk management begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk position given business activities, management objectives, market expectations and ALCO policy limits and guidelines.

Interest rate risk can come in a variety of forms, including repricing risk, basis risk, yield curve risk and option risk. Repricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes impact the Company’s assets and liabilities. Basis risk is the risk of adverse consequence resulting from unequal change in the spread between two or more rates for different instruments with the same maturity. Yield curve risk is the risk of adverse consequences resulting from unequal changes in the spread between two or more rates for different maturities for the same or different instruments. Option risk in financial instruments arises from embedded options such as options provided to borrowers to make unscheduled loan prepayments, options provided to debt issuers to exercise call options prior to maturity, and depositor options to make withdrawals and early redemptions.

Management regularly reviews the Company’s exposure to changes in interest rates. Among the factors considered are changes in the mix of interest-earning assets and interest-bearing liabilities, interest rate spreads and repricing periods. The ALCO reviews, on at least a quarterly basis, the interest rate risk position.

The interest-rate risk position is measured and monitored at the Bank using net interest income simulation models and economic value of equity sensitivity analysis that capture both short-term and long-term interest-rate risk exposure.

Modeling the sensitivity of net interest income and the economic value of equity to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. The models used for these measurements rely on estimates of the potential impact that changes in interest rates may have on the value and prepayment speeds on all components of the Company’s loan portfolio, investment portfolio, as well as embedded options and cash flows of other assets and liabilities. The balance sheet composition and size are assumed to remain static in the simulation modeling process. The analysis provides a framework as to what the Company’s overall sensitivity position is as of the Company’s most recent reported position and the impact that potential changes in interest rates may have on net interest income and the economic value of the Company’s equity.

Net interest income simulation involves forecasting net interest income under a variety of interest rate scenarios including instantaneous shocks.

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The estimated impact on the Company’s net interest income as of September 30, 2023 and December 31, 2022, assuming immediate parallel moves in interest rates, is presented in the table below:


	September 30, 2023				December 31, 2022
	Following		Following		Following		Following
	12 months		24 months		12 months		24 months
+400 basis points	−6.3	%	−6.7	%	−25.1	%	−8.2	%
+300 basis points	−4.9	%	−5.5	%	−18.9	%	−6.4	%
+200 basis points	−3.3	%	−3.7	%	−12.7	%	−4.4	%
+100 basis points	−1.4	%	−1.3	%	−6.2	%	−1.8	%
−100 basis points	0.6	%	0.2	%	5.2	%	0.5	%
−200 basis points	0.4	%	−0.9	%	7.9	%	−1.7	%

Management strategies may impact future reporting periods, as actual results may differ from simulated results due to the timing, magnitude, and frequency of interest rate changes, the difference between actual experience, and the characteristics assumed, as well as changes in market conditions. Market-based prepayment speeds are factored into the analysis for loan and securities portfolios. Rate sensitivity for transactional deposit accounts is modeled based on both historical experience and external industry studies.

Management uses an economic value of equity sensitivity analysis to understand the impact of interest rate changes on long-term cash flows, income, and capital. Economic value of equity is based on discounting the cash flows for all balance sheet instruments under different interest rate scenarios. Deposit premiums are based on external industry studies and utilizing historical experience.

The table below presents the change in the economic value of equity as of September 30, 2023 and December 31, 2022, assuming immediate parallel shifts in interest rates:


	September 30,		December 31,
	2023		2022
+400 basis points	−23.1	%	−19.5	%
+300 basis points	−18.5	%	−15.3	%
+200 basis points	−12.3	%	−10.4	%
+100 basis points	−5.5	%	−4.9	%
−100 basis points	4.1	%	4.0	%
−200 basis points	6.5	%	5.0	%

Operational Risk

Operational risk is the risk of loss due to human behavior, inadequate or failed internal systems and controls, and external influences such as market conditions, fraudulent activities, disasters, and security risks. Management continuously strives to strengthen its system of internal controls, enterprise risk management, operating processes and employee awareness to assess the impact on earnings and capital and to improve the oversight of the Company’s operational risk.

Compliance Risk

Compliance risk represents the risk of regulatory sanctions, reputational impact or financial loss resulting from failure to comply with rules and regulations issued by the various banking agencies and standards of good banking practice. Activities which may expose the Company to compliance risk include, but are not limited to, those dealing with the prevention of money laundering, privacy and data protection, community reinvestment initiatives, fair lending challenges resulting from the expansion of the Company’s banking center network, employment and tax matters.

Strategic and/or Reputation Risk

Strategic and/or reputation risk represents the risk of loss due to impairment of reputation, failure to fully develop and execute business plans, failure to assess current and new opportunities in business, markets and products,

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and any other event not identified in the defined risk types mentioned previously. Mitigation of the various risk elements that represent strategic and/or reputation risk is achieved through initiatives to help management better understand and report on various risks, including those related to the development of new products and business initiatives.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company’s management, including the President and Chief Executive Officer, the Chief Financial Officer, and the Chief Accounting Officer have evaluated the effectiveness of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, or the Exchange Act), as of the end of the period covered by this report. Based on such evaluation, the President and Chief Executive Officer, the Chief Financial Officer and the Chief Accounting Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective as of that date to provide reasonable assurance that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its President and Chief Executive Officer, its Chief Financial Officer and its Chief Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II—OTHER INFORMATION

Item 1 – Legal Proceedings

There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business of the Company or its subsidiaries, to which the Company or any of its subsidiaries are a party or to which our property is the subject. The Company does not know of any proceeding contemplated by a governmental authority against the Company or any of its subsidiaries.

Item 1A – Risk Factors

There have been no material changes to the risk factors disclosed in the Company’s Annual Report on Form 10-K filed with the SEC on March 13, 2023.

Item 2 – Unregistered Sales of Equity Securities, Use of Proceeds, and Issuer Purchases of Equity Securities

Unregistered Sales of Equity Securities

None.

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Issuer Repurchases of Equity Securities

The following table presents information related to repurchases of shares of the Company’s common stock for each calendar month in the third quarter of 2023:



				Total Number of	Maximum Number of
	Total Number	Average		Shares Purchased as	Shares that May
	of Shares	Price Paid		Part of Publicly	Yet be Purchased
(dollars in thousands, except per share data)	Purchased (1)	per Share		Announced Plans	Under the Plan (2)
July 1-31, 2023	48,364	$	17.29	46,464	553,490
August 1-31, 2023	861		18.45	861	552,629
September 1-30, 2023	21,103		17.92	21,103	531,526
Total	70,328	$	17.49	68,428	531,526

(1)	Shares repurchased by the Company included shares surrendered by employees to the Company to pay withholding taxes on the vesting of restricted stock awards.

(2)

On February 18, 2021, the Board of Directors of the Company approved a stock repurchase program, or the Program, which authorizes the Company to repurchase up to 770,000 shares of its common stock, subject to certain limitations and conditions. The Program was effective immediately and will continue for a period of 36 months, until February 28, 2024. The Program does not obligate the Company to repurchase any shares of its common stock and there is no assurance that the Company will do so. For the three months ended September 30, 2023, the Company repurchased 68,428 shares of common stock under the Program.

Use of Proceeds from Registered Securities

None.

Item 3 – Defaults Upon Senior Securities

None.

Item 4 – Mine Safety Disclosures

Not Applicable.

Item 5 – Other Information

During the fiscal quarter ended September 30, 2023, none of the Company’s directors or executive officers adopted or terminated any contract, instruction or written plan for the purchase or sale of Company securities that was intended to satisfy the affirmative defense conditions of Rule10b5-1(c) or any non-Rule 10b5-1 trading arrangement.

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Item 6 – Exhibits


Exhibit No.		Description

3.1		Third Amended and Restated Certificate of Incorporation of Alerus Financial Corporation (incorporated herein by reference to Exhibit 3.1 on Form S-1 filed on August 16, 2019).

3.2		Second Amended and Restated Bylaws of Alerus Financial Corporation (incorporated herein by reference to Exhibit 3.2 on Form S-1 filed on August 16, 2019).

31.1		Chief Executive Officer’s Certifications required by Rule 13(a)-14(a) – filed herewith.

31.2		Chief Financial Officer’s Certifications required by Rule 13(a)-14(a) – filed herewith.

32.1		Chief Executive Officer Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.

32.2		Chief Financial Officer Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.

101.INS		iXBRL Instance Document

101.SCH		iXBRL Taxonomy Extension Schema

101.CAL		iXBRL Taxonomy Extension Calculation Linkbase

101.DEF		iXBRL Taxonomy Extension Definition Linkbase

101.LAB		iXBRL Taxonomy Extension Label Linkbase

101.PRE		iXBRL Taxonomy Extension Presentation Linkbase

104		Cover Page Interactive Data File (formatted Inline XBRL and contained in Exhibits 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.


	ALERUS FINANCIAL CORPORATION

Date: November 2, 2023	By:	/s/ Katie A. Lorenson
		Name: Katie A. Lorenson
		Title: President and Chief Executive Officer (Principal Executive Officer)

Date: November 2, 2023	By:	/s/ Alan A. Villalon
		Name: Alan A. Villalon
		Title: Executive Vice President and Chief Financial Officer (Principal Financial Officer)