1ST SOURCE CORPORATION The purpose of this analysis is to provide the reader with information relevant to understanding and assessing our results of operations for each of the past three years and financial condition for each of the past two years. In order to fully appreciate this analysis you are encouraged to review the consolidated financial statements and statistical data presented in this document.
FORWARD-LOOKING STATEMENTS
This report, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements. Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. Words such as "believe," "contemplate," "seek," "estimate," "plan," "project," "anticipate," "possible," "assume," "expect," "intend," "targeted," "continue," "remain," "will," "should," "indicate," "would," "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance, nor should they be relied upon as representing management's views as of any subsequent date. All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation, and do not undertake, to update, revise, or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made. We have expressed our expectations, beliefs, and projections in good faith and we believe they have a reasonable basis. However, we make no assurances that our expectations, beliefs, or projections will be achieved or accomplished. The results or outcomes indicated by our forward-looking statements may not be realized due to a variety of factors, including, without limitation, the following:
•Local, regional, national, and international economic conditions and the impact they may have on us and our clients and our assessment of that impact.
•Changes in the level of nonperforming assets and charge-offs.
•Changes in estimates of future cash reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.
•The effects of and changes in trade and monetary and fiscal policies and laws,
including the interest rate policies of the
•Inflation, interest rate, securities market, and monetary fluctuations.
•Political instability.
•Acts of war or terrorism.
•The spread of infectious diseases or pandemics.
•Substantial changes in the cost of fuel.
•The timely development and acceptance of new products and services and perceived overall value of these products and services by others.
•Changes in consumer spending, borrowings, and savings habits.
•Changes in the financial performance and/or condition of our borrowers.
•Technological changes.
•The impact of climate change.
•Acquisitions and integration of acquired businesses.
•The ability to increase market share and control expenses.
•The ability to expand effectively into new markets that we target.
•Changes in the competitive environment among bank holding companies.
•The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, insurance, and climate change) with which we and our subsidiaries must comply.
•The effect of changes in accounting policies and practices and auditing
requirements, as may be adopted by the regulatory agencies, as well as the
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•Changes in our organization, compensation, and benefit plans.
•The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquires and the results of regulatory examinations or reviews.
•Greater than expected costs or difficulties related to the integration of new products and lines of business.
•Our success at managing the risks described in Item 1A. Risk Factors.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our consolidated financial statements are prepared in accordance withU.S. generally accepted accounting principles (GAAP) and follow general practices within the industries in which we operate. Application of these principles requires management to make estimates or judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates or judgments reflect management's view of the most appropriate manner in which to record and report our overall financial performance. Because these estimates or judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. As such, changes in these estimates, judgments, and/or assumptions may have a significant impact on our financial statements. All accounting policies are important, and all policies described in Part II, Item 8, Financial Statements and Supplementary Data - Note 1 of the Notes to Consolidated Financial Statements (Note 1), should be reviewed for a greater understanding of how our financial performance is recorded and reported. We have identified the following two policies as being critical because they require management to make particularly difficult, subjective, and/or complex estimates or judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the determination of the allowance for loan and lease losses and fair value measurements. Management believes it has used the best information available to make the estimations or judgments necessary to value the related assets and liabilities. Actual performance that differs from estimates or judgments and future changes in the key variables could change future valuations and impact net income. Management has reviewed the application of these policies with theAudit, Finance and Risk Committee of the Board of Directors. Following is a discussion of the areas we view as our most critical accounting policies. Allowance for Credit Losses - The allowance for credit losses represents management's estimate of expected credit losses over the expected contractual life of our existing loan and lease portfolio and the establishment of an allowance that is sufficient to absorb those losses. As ofDecember 31, 2020 , we adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended, which replaced the incurred loss methodology with an expected loss methodology that is referred to as current expected credit losses (CECL). The accounting standard was implemented at a time when we were experiencing conditions without historical precedent. Determining the appropriateness of the allowance is complex and requires judgement by management about the effect of matters that are inherently uncertain. In determining an appropriate allowance, management makes numerous judgments, assumptions, and estimates which are inherently subjective, as they require material estimates that may be susceptible to significant change. These estimates are derived based on continuous review of the loan and lease portfolio, assessments of client performance, movement through delinquency stages, probability of default, losses given default, collateral values, and disposition, as well as expected cash flows, economic forecasts, and qualitative factors, such as changes in current economic conditions. As stated in Note 1, we segment our loan and lease portfolios based on similar risk characteristics for collective evaluation using a non-discounted cash flow approach to estimate expected losses. We use a cohort cumulative loss methodology for select loan and lease segments. The cohort methodology has a steady state assumption. For other segments, we use a PD/LGD (probability of default/loss given default) model which aligns well with our internal risk rating system. When we observe limitations in the data or models, we use model overlays to make adjustments to model outputs to capture a particular risk or compensate for a known limitation, or in the case of the cohort model, changes in the steady state assumptions. Actual losses may differ from estimated amounts due to model inefficiencies or management's inability to adequately determine appropriate model adjustment factors. The accounting standard further requires management to use forecasts about future economic conditions to determine the expected credit losses over the remaining life of the asset. Forecast adjustments are fundamentally difficult to establish and the current environment presents challenges with persistent inflation, markedly higher interest rates, and heightened geopolitical uncertainty. We endeavor to apply a forecast adjustment that is directionally consistent, reasonable, supportable, and reflective of current expectations and conditions. We use a two-year reasonable and supportable period across all loan and lease segments to forecast economic conditions. We believe the two-year time horizon aligns with available industry guidance and various forecasting sources. Following this two-year forecasting period, we use a two-year reversion period to revert forecast rates to historical loss rates. 18 -------------------------------------------------------------------------------- Table of Contents In assessing the factors used to derive an appropriate allowance, management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. We have been diligent in our efforts to gain a thorough understanding of the CECL accounting standard, and have reviewed our portfolios, loan segmentations, methodologies and models and believe we have made appropriate and prudent decisions. Nonetheless, if management's underlying assumptions prove to be inaccurate, the allowance for loan and lease losses would have to be adjusted. Our accounting policies related to the allowance for credit losses is disclosed in Note 1 under the heading "Allowance for Credit Losses." Fair Value Measurements - We use fair value measurements to record certain financial instruments and to determine fair value disclosures. Available-for-sale securities, trading account securities, mortgage loans held for sale, and interest rate swap agreements are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial assets on a nonrecurring basis. These nonrecurring fair value adjustments typically involve write-downs of, or specific reserves against, individual assets. GAAP establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used in the measurement are observable or unobservable. Observable inputs reflect market-driven or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market data. For financial instruments that trade actively and have quoted market prices or observable market data, there is minimal subjectivity involved in measuring fair value. When observable market prices and data are not fully available, management judgment is necessary to estimate fair value. In addition, changes in the market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. Therefore, when market data is not available, we use valuation techniques that require more management judgment to estimate the appropriate fair value measurement. Fair value is discussed further in Note 1 under the heading "Fair Value Measurements" and in Note 21, "Fair Value Measurements." EARNINGS SUMMARY Net income available to common shareholders in 2022 was$120.51 million , up from$118.53 million in 2021 and up from$81.44 million in 2020. Diluted net income per common share was$4.84 in 2022,$4.70 in 2021, and$3.17 in 2020. Return on average total assets was 1.49% in 2022 compared to 1.53% in 2021, and 1.14% in 2020. Return on average common shareholders' equity was 13.81% in 2022 versus 13.07% in 2021, and 9.41% in 2020. Net income in 2022, as compared to 2021, was positively impacted by a$26.83 million or 11.34% increase in net interest income and a$1.45 million or 0.78% decrease in noninterest expense which was offset by a$17.55 million or 407.81% increase in the provision for credit losses and a$8.83 million or 8.82% decrease in noninterest income. Net income in 2021, as compared to 2020, was positively impacted by a$10.82 million or 4.79% increase in net interest income, a$40.30 million or 111.95% decrease in the provision for credit losses, and a$1.22 million or 0.65% decrease in noninterest expense which was offset by a$3.80 million or 3.65% decrease in noninterest income and a$11.45 million or 46.01% increase in income tax expense. Dividends paid on common stock in 2022 amounted to$1.26 per share, compared to$1.21 per share in 2021, and$1.13 per share in 2020. The level of earnings reinvested and dividend payouts are determined by the Board of Directors based on various considerations, including liquidity needs, capital requirements, and management's assessment of future growth opportunities and the level of capital necessary to support them. Net Interest Income - Our primary source of earnings is net interest income, the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities while deposits and borrowings represent the major portion of interest-bearing liabilities. For purposes of the following discussion, comparison of net interest income is done on a tax-equivalent basis, which provides a common basis for comparing yields on earning assets exempt from federal income taxes to those which are fully taxable. Net interest margin (the ratio of net interest income to average earning assets) is significantly affected by movements in interest rates and changes in the mix of earning assets and the liabilities that fund those assets. Net interest margin on a fully taxable- equivalent basis was 3.45% in 2022, compared to 3.23% in 2021 and 3.39% in 2020. Net interest income was$263.47 million for 2022, compared to$236.64 million for 2021 and$225.82 million for 2020. Tax-equivalent net interest income totaled$264.10 million for 2022, up$27.00 million from the$237.10 million reported in 2021. Tax-equivalent net interest income for 2021 was up$10.73 million from the$226.36 million reported for 2020. 19 -------------------------------------------------------------------------------- Table of Contents During 2022, average earning assets increased$322.53 million or 4.39% while average interest-bearing liabilities increased$217.47 million or 4.55% over the comparable period in 2021. The yield on average earning assets increased 36 basis points to 3.84% for 2022 from 3.48% for 2021 primarily due to higher rates on loans and leases and investment securities. Total cost of average interest-bearing liabilities increased 23 basis points to 0.61% during 2022 from 0.38% in 2021 as a result of the higher interest rate environment. The result to the fully taxable-equivalent net interest margin was an increase of 22 basis points. The largest contributor to the increase in the yield on average earning assets in 2022 was the 42 basis point improvement in the loan and lease portfolio yield primarily due to market conditions as a result of sevenFederal Reserve interest rate increases during the year. Average loans and leases increased$128.88 million or 2.37% in 2022 from 2021 while the yield increased to 4.74%. The yield on net loans and leases was positively impacted by three basis points in 2022 due to the recognition of$2.70 million of fees on PPP loans which have been forgiven by the SBA or paid down by customers. PPP forgiveness and customer payments totaled$74.88 million for the full year of 2022 with less than$1 million remaining. Strong growth primarily within our specialty finance group portfolios drove total average loans and leases higher during the year. During 2022, the tax-equivalent yield on investment securities available-for-sale increased 21 basis points to 1.50% while the average balance grew$401.97 million or 27.85% with the largest increases inU.S. treasury and federal agency securities and mortgage-backed securities. Average mortgages held for sale decreased$11.85 million or 69.59% during 2022 while the yield increased 156 basis points. Average other investments, which include federal funds sold, time deposits with other banks,Federal Reserve Bank excess balances,Federal Reserve Bank andFederal Home Loan Bank (FHLB) stock and commercial paper decreased$196.48 million or 44.61% during 2022 while the yield increased 75 basis points. The average balance decrease in other investments was primarily a result of lower balances held at theFederal Reserve Bank . Average interest-bearing deposits increased$213.14 million or 4.78% during 2022 while the effective rate paid on those deposits increased 26 basis points. The increased average balance was primarily due to increases in business, consumer and public fund deposits. The increase in the average cost of interest-bearing deposits was primarily the result of higher rates and a shift in the deposit mix. The deposit mix changed as the year progressed with clients moving their funds from non-maturity accounts to certificates of deposit due to the rising interest rate environment. Additionally, brokered deposits grew during the fourth quarter. Average noninterest-bearing demand deposits increased$155.71 million or 8.27% during 2022 due primarily to uncertain economic conditions and business customers maintaining a cautious stance with their funds and spending. Average short-term borrowings increased$28.24 million or 15.12% during 2022 while the effective rate paid increased 63 basis points. The increase in short-term borrowings was primarily the result of higher borrowings with the FHLB as part of liquidity management to support loan growth. Average long-term debt and mandatorily redeemable securities balances decreased$23.91 million or 30.32% during 2022 as the effective rate decreased 301 basis points primarily due to lower rates on mandatorily redeemable securities from a reduction in book value per share during 2022. Mandatorily redeemable shares are issued under the terms of one of our executive incentive compensation plans and are settled based on book value per share with changes from the previous reporting date recorded as interest expense. 20 -------------------------------------------------------------------------------- Table of Contents The following table provides an analysis of net interest income and illustrates interest income earned and interest expense charged for each major component of interest earning assets and the interest bearing liabilities. Yields/rates are computed on a tax-equivalent basis, using a 21% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding. 2022 2021 2020 Interest Interest Interest
(Dollars in thousands) Average Balance Income/Expense Yield/Rate Average Balance Income/Expense Yield/Rate Average Balance Income/Expense Yield/Rate ASSETS Investment securities available-for-sale: Taxable$ 1,805,041 $ 26,294 1.46 %$ 1,410,797 $ 17,767 1.26 %$ 1,009,794 $ 18,080 1.79 % Tax-exempt(1) 40,310 1,311 3.25 % 32,583 741 2.27 % 48,266 1,105 2.29 % Mortgages held for sale 5,178 217 4.19 % 17,026 448 2.63 % 20,628 600 2.91 % Loans and leases, net of unearned discount(1) 5,566,701 264,043 4.74 % 5,437,817 234,902 4.32 % 5,463,436 242,505 4.44 % Other investments 243,938 2,579 1.06 % 440,416 1,373 0.31 % 142,122 1,284 0.90 % Total earning assets(1) 7,661,168 294,444 3.84 % 7,338,639 255,231 3.48 % 6,684,246 263,574 3.94 % Cash and due from banks 75,836 77,275 71,626 Allowance for loan and lease losses (133,028) (139,141) (130,776) Other assets 469,135 454,374 494,913 Total assets$ 8,073,111 $ 7,731,147 $ 7,120,009 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits$ 4,673,494 $ 25,231 0.54 %$ 4,460,359 $ 12,276 0.28 %$ 4,205,904 $ 30,459 0.72 % Short-term borrowings: Securities sold under agreements to repurchase 166,254 85 0.05 % 180,610 112 0.06 % 173,398 317 0.18 % Other short-term borrowings 48,716 1,412 2.90 % 6,119 3 0.05 % 27,767 200 0.72 % Subordinated notes 58,764 3,550 6.04 % 58,764 3,267 5.56 % 58,764 3,367 5.73 % Long-term debt and mandatorily redeemable securities 54,940 69 0.13 % 78,845 2,476 3.14 % 80,715 2,868 3.55 % Total interest-bearing liabilities 5,002,168 30,347 0.61 % 4,784,697 18,134 0.38 % 4,546,548 37,211 0.82 % Noninterest-bearing deposits 2,037,882 1,882,168 1,530,698 Other liabilities 103,740 112,291 145,807 Shareholders' equity 872,721 906,951 865,278 Noncontrolling interests 56,600 45,040 31,678 Total liabilities and equity$ 8,073,111 $ 7,731,147 $ 7,120,009 Less: Fully tax-equivalent adjustments (628) (459) (543) Net interest income/margin (GAAP-derived)(1)$ 263,469 3.44 %$ 236,638 3.22 %$ 225,820 3.38 % Fully tax-equivalent adjustments 628 459 543 Net interest income/margin - FTE(1)$ 264,097 3.45 %$ 237,097 3.23 %$ 226,363 3.39 %
(1) See "Reconciliation of Non-GAAP Financial Measures" for more information on this performance measure/ratio.
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Reconciliation of Non-GAAP Financial Measures - Our accounting and reporting
policies conform to GAAP in the United States and prevailing practices in the
banking industry. However, certain non-GAAP performance measures are used by
management to evaluate and measure the Company's performance. These include
taxable-equivalent net interest income (including its individual components) and
net interest margin (including its individual components). Management believes
that these measures provide users of the Company's financial information a more
meaningful view of the performance of the interest-earning assets and
interest-bearing liabilities.
Management reviews yields on certain asset categories and the net interest
margin of the Company and its banking subsidiaries on a fully taxable-equivalent
("FTE") basis. In this non-GAAP presentation, net interest income is adjusted to
reflect tax-exempt interest income on an equivalent before-tax basis. This
measure ensures comparability of net interest income arising from both taxable
and tax-exempt sources. The following table shows the reconciliation of non-GAAP
financial measures for the most recent three years ended December 31 .
(Dollars in thousands) 2022 2021 2020
Calculation of Net Interest Margin
(A) Interest income (GAAP) $ 293,816 $ 254,772 $ 263,031
Fully tax-equivalent adjustments:
(B) - Loans and leases 366 319 333
(C) - Tax-exempt investment securities 262 140 210
(D) Interest income - FTE (A+B+C) 294,444 255,231 263,574
(E) Interest expense (GAAP) 30,347 18,134 37,211
(F) Net interest income (GAAP) (A-E) 263,469 236,638 225,820
(G) Net interest income - FTE (D-E) 264,097 237,097 226,363
(H) Total earning assets $ 7,661,168 $ 7,338,639 $ 6,684,246
Net interest margin (GAAP-derived) (F/H) 3.44 % 3.22 % 3.38 %
Net interest margin - FTE (G/H) 3.45 % 3.23 % 3.39 %
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The change in interest due to both rate and volume illustrated in the following
table has been allocated to volume and rate changes in proportion to the
relationship of the absolute dollar amounts of the change in each. The following
table shows changes in tax-equivalent interest earned and interest paid,
resulting from changes in volume and changes in rates.
Increase (Decrease) due to
(Dollars in thousands) Volume Rate Net
2022 compared to 2021
Interest earned on:
Investment securities available-for-sale:
Taxable $ 5,463 $ 3,064 $ 8,527
Tax-exempt 203 367 570
Mortgages held for sale (412) 181 (231)
Loans and leases, net of unearned discount 5,674 23,467 29,141
Other investments (843) 2,049 1,206
Total earning assets $ 10,085 $ 29,128 $ 39,213
Interest paid on:
Interest-bearing deposits $ 613 $ 12,342 $ 12,955
Short-term borrowings:
Securities sold under agreements to repurchase (8) (19) (27)
Other short-term borrowings 151 1,258 1,409
Subordinated notes - 283 283
Long-term debt and mandatorily redeemable securities (578) (1,829) (2,407)
Total interest-bearing liabilities $ 178 $ 12,035 $ 12,213
Net interest income - FTE $ 9,907 $ 17,093 $ 27,000
2021 compared to 2020
Interest earned on:
Investment securities available-for-sale:
Taxable $ 5,961 $ (6,274) $ (313)
Tax-exempt (357) (7) (364)
Mortgages held for sale (98) (54) (152)
Loans and leases, net of unearned discount (1,133) (6,470) (7,603)
Other investments 1,350 (1,261) 89
Total earning assets $ 5,723 $ (14,066) $ (8,343)
Interest paid on:
Interest-bearing deposits $ 1,741 $ (19,924) $ (18,183)
Short-term borrowings:
Securities sold under agreements to repurchase 13 (218) (205)
Other short-term borrowings (90) (107) (197)
Subordinated notes - (100) (100)
Long-term debt and mandatorily redeemable securities (65) (327) (392)
Total interest-bearing liabilities $ 1,599 $ (20,676) $ (19,077)
Net interest income - FTE $ 4,124 $ 6,610 $ 10,734
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Noninterest Income - Noninterest income decreased$8.83 million or 8.82% in 2022 from 2021 following a$3.80 million or 3.65% decrease in 2021 from 2020. The following table shows noninterest income for the most recent three years endedDecember 31 . (Dollars in thousands) 2022 2021 2020 Noninterest income: Trust and wealth advisory$ 23,107 $ 23,782 $ 21,114 Service charges on deposit accounts 12,146 10,589 9,485 Debit card 18,052 18,125 14,983 Mortgage banking 4,122 11,822 15,674 Insurance commissions 6,703 7,247 7,025 Equipment rental 12,274 16,647 23,380 (Losses) gains on investment securities available-for-sale (184) (680) 279 Other 15,042 12,560 11,949 Total noninterest income$ 91,262 $ 100,092 $ 103,889 Trust and wealth advisory fees (which include investment management fees, estate administration fees, mutual fund fees, annuity fees, and fiduciary fees) decreased$0.68 million or 2.84% in 2022 from 2021 compared to a$2.67 million or 12.64% increase in 2021 over 2020. Trust and wealth advisory fees are largely based on the number and size of client relationships and the market value of assets under management. The market value of trust assets under management atDecember 31, 2022 and 2021 was$4.84 billion and$5.33 billion , respectively. The negative performance of the stock and bond markets in 2022 resulted in a decline in the market value of trust assets under management compared to 2021. AtDecember 31, 2022 , these trust assets were comprised of$3.21 billion of personal and agency trusts and estate administration assets,$1.03 billion of employee benefit plan assets,$0.49 million of individual retirement accounts, and$0.11 million of custody assets. Service charges on deposit accounts increased by$1.56 million or 14.70% in 2022 from 2021 compared to an increase of$1.10 million or 11.64% in 2021 from 2020. The growth in service charges on deposit accounts in 2022 was primarily due to increased consumer and business nonsufficient fund transactions. The increase in service charges on deposit accounts in 2021 was primarily due to a higher customer ATM fees from an increased volume of transactions and a change in the fees charged, as well as increased business deposit account fees offset by a decrease in consumer nonsufficient fund transactions. Economic recovery in 2021 led to a corresponding improvement in consumer and business activity. Debit card income was relatively flat from 2022 to 2021 compared to an increase of$3.14 million or 20.97% in 2021 from 2020. The decline in 2022 to 2021 was mainly the result of decreased discretionary spending and a focus on core expenses by consumers. Debit card transactions in 2021 were helped significantly by the reopened economy driving increased consumer activity. Mortgage banking income dropped$7.70 million or 65.13% in 2022 over 2021, compared to a$3.85 million or 24.58% decrease in 2021 from 2020. We had$0.81 million of MSR impairment recoveries in 2021 and$0.81 million of MSR impairment charges in 2020. During 2022, 2021 and 2020, we determined that no permanent write-down was necessary for previously recorded impairment on MSRs. During 2022, mortgage banking income decreased primarily due to reduced mortgage origination volumes resulting in lower income on loans sold in the secondary market. Demand for mortgages has continued to decline with steep increases in interest rates, limited inventory, and fewer housing starts all of which impacted market activity. During 2021, mortgage banking income decreased primarily due to reduced margins on a lower volume of loan sales. Insurance commissions declined$0.54 million or 7.51% in 2022 compared to 2021 and improved$0.22 million or 3.16% in 2021 compared to 2020. The decrease in 2022 was primarily due to a reduced book of business and fewer contingent commissions received. The increase in 2021 was primarily due to higher contingent commissions received due to achieving sales goals set forth by various carrier incentive programs. Equipment rental income generated from operating leases decreased by$4.37 million or 26.27% during 2022 from 2021 compared to a reduction of$6.73 million or 28.80% during 2021 from 2020. The average equipment rental portfolio decreased 21.27% in 2022 over 2021 and decreased 29.16% in 2021 over 2020 as a result of reduced leasing volume primarily in the construction equipment and the auto and light truck portfolios due to changing customer preferences and competitive pricing pressures for new business. In 2022 and 2021, the decline in rental income was offset by a similar decline in depreciation on equipment owned under operating leases. 24 -------------------------------------------------------------------------------- Table of Contents Losses on the sale of investment securities available-for-sale were$0.18 million and$0.68 million in 2022 and 2021, respectively. There were gains of$0.28 million on the sale of investment securities available-for-sale for the year ended 2020. Losses and gains on the sale of investment securities available-for-sale were primarily from the sale of Federal agency securities in 2022 and corporate securities in 2021 and 2020, with the goal of managing portfolio risk and liquidity. Other income improved$2.48 million or 19.76% in 2022 from 2021 compared to an increase of$0.61 million or 5.11% in 2021 from 2020. The increase in 2022 was mainly a result of partnership investment gains on sale of renewable energy tax equity investments of$2.24 million and higher bank owned life insurance policy claims offset by a write down of$0.37 million on small business capital investments and reduced customer swap fees of$0.33 million . The increase in 2021 was mainly a result of higher brokerage fees and commissions and increased partnership investment gains offset by reduced customer swap fees and lower bank owned life insurance policy claims. Noninterest Expense - Noninterest expense decreased$1.45 million or 0.78% in 2022 from 2021 following a$1.22 million or 0.65% decrease in 2021 from 2020. The following table shows noninterest expense for the most recent three years endedDecember 31 . (Dollars in thousands) 2022 2021 2020 Noninterest expense: Salaries and employee benefits$ 105,110 $ 105,808 $ 101,556 Net occupancy 10,728 10,524 10,276 Furniture and equipment 5,448 5,977 6,541 Data Processing 22,375 19,877 19,147 Depreciation - leased equipment 10,023 13,694 20,203 Professional fees 7,280 8,676 6,317 FDIC and other insurance 3,625 2,677 2,606 Business development and marketing 5,823 8,013 4,157 Other 14,287 10,902 16,564 Total noninterest expense$ 184,699 $ 186,148 $ 187,367
Total salaries and employee benefits were relatively flat in 2022 from 2021,
following a
Employee salaries grew$0.62 million or 0.73% in 2022 from 2021 compared to an increase of$2.93 million or 3.54% in 2021 from 2020. The increase in 2022 was mainly a result of higher base salaries due to normal merit increases offset by a decrease in incentive compensation and commission compensation primarily in our residential mortgage area. The growth in 2021 was mainly a result of higher base salaries due to normal merit increases and a rise in incentive compensation including a one-time special reward to COVID-19 vaccinated employees announced at the end of 2021 offset by a decrease in commission compensation primarily in our residential mortgage area. Employee benefits decreased$1.32 million or 6.58% in 2022 from 2021, compared to a$1.32 million or 7.05% increase in 2021 from 2020. During 2022, group insurance costs were lower due to decreased claims experienced compared to levels in 2021. In 2021, company contributions to employee retirement accounts increased due to higher salaries during 2021 and a rise in group insurance costs as healthcare access and usage increased from levels in 2020. Occupancy expense rose$0.20 million or 1.94% in 2022 from 2021, compared to an increase of$0.25 million or 2.41% in 2021 from 2020. The elevated expense in 2022 was primarily the result of higher snow removal costs due to inclement weather conditions. The increased expense in 2021 was primarily the result of higher premises repairs and cleaning offset by lower real estate taxes and reduced lease expenses. Furniture and equipment expense, including depreciation, declined by$0.53 million or 8.85% in 2022 from 2021 compared to a decrease of$0.56 million or 8.62% in 2021 from 2020. The lower expense in 2022 was primarily due to a reduction in equipment rental and depreciation expenses. The lower expense in 2021 was primarily due to a reduction in furniture and equipment depreciation and lower corporate aircraft maintenance. Data processing expense rose by$2.50 million or 12.57% in 2022 from 2021, following a$0.73 million or 3.81% increase in 2021 from 2020. The increase in 2022 was due to a rise in software maintenance costs and higher computer processing charges related to a variety of technology projects. The increase in 2021 was a result of increases in software maintenance costs and point of sale computer operating expenses. Depreciation on equipment owned under operating leases declined$3.67 million or 26.81% in 2022 from 2021, following a$6.51 million or 32.22% decrease in 2021 from 2020. In 2022 and 2021, depreciation on equipment owned under operating leases correlated with the change in equipment rental income. 25 -------------------------------------------------------------------------------- Table of Contents Professional fees decreased$1.40 million or 16.09% in 2022 from 2021, compared to a$2.36 million or 37.34% increase in 2021 from 2020. The lower expense in 2022 can primarily be attributed to a decline in legal fees offset by increased utilization of consulting services for technology projects and compliance services. The higher expense in 2021 compared to 2020 was primarily due to a rise in legal fees and increased utilization of consulting services for technology projects.FDIC and other insurance expense grew$0.95 million or 35.41% in 2022 from 2021 and increased$0.07 million or 2.72% in 2021 from 2020. The increase in 2022 was mainly the result of higher assessments forFDIC premiums from a larger asset base and a one-time$0.38 million recovery of an incurred but not reported insurance reserve in 2021. The increase in 2021 was mainly the result of$0.55 million inFDIC insurance premium credits received during 2020 which were not present in 2021 offset by a one-time$0.38 million recovery of an incurred but not reported insurance reserve. Business development and marketing expenses declined$2.19 million or 27.33% in 2022 from 2021 and rose$3.86 million or 92.76% in 2021 from 2020. The decreased expense in 2022 was mainly the result of a one-time charitable contribution of$3.00 million made during 2021 offset by increased business development expense and marketing promotions. The higher expense in 2021 was mainly the result of a charitable contribution of$3.00 million made during 2021 to support COVID-19 initiatives and increased business development expense as a result of more business entertainment and travel opportunities tied to fewer COVID-19 restrictions. Other expenses increased by$3.39 million or 31.05% in 2022 as compared to 2021 and decreased$5.66 million or 34.18% in 2021 as compared to 2020. The higher expense in 2022 was primarily the result of an increase in the provision for unfunded loan commitments, a rise in the provision for interest rate swaps with customers, and higher employee training expenses. The reduction in 2021 was primarily the result of lower general collection and repossession expenses, fewer valuation adjustments on repossessed assets, a lower provision for interest rate swaps with customers, a decrease in the provision for unfunded loan commitments, and a reduction in postage and shipping expenses offset by reduced gains on the sale of operating lease equipment and higher employee training expenses due to fewer COVID-19 travel restrictions. Income Taxes - 1st Source recognized income tax expense in 2022 of$36.26 million , compared to$36.33 million in 2021, and$24.88 million in 2020. The effective tax rate in 2022 was 23.12% compared to 23.45% in 2021, and 23.40% in 2020.
For a detailed analysis of 1st Source's income taxes see Part II, Item 8, Financial Statements and Supplementary Data - Note 17 of the Notes to Consolidated Financial Statements.
FINANCIAL CONDITION
Loan and Lease Portfolio - The following table shows 1st Source's loan and lease
distribution at the end of each of the last two years as of
(Dollars in thousands) 2022 2021 Commercial and agricultural$ 812,031 $ 918,712 Solar 381,163 348,302 Auto and light truck 808,117 603,775 Medium and heavy duty truck 313,862 259,740 Aircraft 1,077,722 898,401 Construction equipment 938,503 754,273 Commercial real estate 943,745 929,341
Residential real estate and home equity 584,737 500,590 Consumer
151,282 133,080
Total loans and leases $ 6,011,162 $ 5,346,214 At
Loans and leases, net of unearned discount, atDecember 31, 2022 , were$6.01 billion and were 72.08% of total assets, compared to$5.35 billion and 66.03% of total assets atDecember 31, 2021 . Average loans and leases, net of unearned discount, increased$128.88 million or 2.37% and decreased$25.62 million or 0.47% in 2022 and 2021, respectively. PPP loans, net of unearned discount, atDecember 31, 2022 and 2021 were$0.90 million and$73.08 million , respectively, and were located in the Commercial and agricultural lending portfolio. 26 -------------------------------------------------------------------------------- Table of Contents Commercial and agricultural lending, excluding those loans secured by real estate but including PPP loans, decreased$106.68 million or 11.61% in 2022 over 2021. Commercial and agricultural lending outstandings were$812.03 million and$918.71 million atDecember 31, 2022 andDecember 31, 2021 , respectively. Similar to 2021, the decrease during 2022 was largely due to PPP loan forgiveness and customer pay downs which amounted to$74.88 million during 2022. Additionally, one-time reclassifications of loan outstandings from this portfolio into the commercial real estate portfolio of$32.66 million contributed to the balance reduction. Excluding PPP loans, commercial and agricultural outstandings were$811.13 million and$845.63 million as ofDecember 31, 2022 and 2021, respectively. Solar loans and leases increased$32.86 million or 9.43% in 2022 over 2021. Solar loan and lease outstandings were$381.16 million and$348.30 million atDecember 31, 2022 and 2021, respectively. The increase during 2022 was due to continued positive momentum in this business line. We expect that momentum to continue into 2023.
Auto and light truck loans increased
Medium and heavy duty truck loans and leases increased$54.12 million or 20.84% in 2022. Medium and heavy duty truck financing atDecember 31, 2022 and 2021 had outstandings of$313.86 million and$259.74 million , respectively. The increase atDecember 31, 2022 fromDecember 31, 2021 can be mainly attributed to expanded relationships with existing clients while fleet availability continues to be constrained. Aircraft financing at year-end 2022 increased$179.32 million or 19.96% from year-end 2021. Aircraft financing atDecember 31, 2022 and 2021 had outstandings of$1.08 billion and$898.40 million , respectively. The increase during 2022 was due to higher domestic outstandings of$75.17 million and foreign outstandings of$104.15 million . Our 2022 balances increased as demand was bolstered by ongoing health safety concerns sparked by COVID-19 and increasingly less convenient commercial travel. Those concerns as well as customers hoping to take advantage of bonus depreciation, which will begin phasing down during 2023, increased demand for private turbine aircraft especially amongst private business and high net worth market segments. Our foreign outstandings increased 53.88% year over year. Our foreign loan and lease outstandings, all denominated inU.S. dollars were$297.46 million and$193.31 million as ofDecember 31, 2022 and 2021, respectively. Loan and lease outstandings to borrowers inBrazil andMexico were$129.98 million and$136.68 million as ofDecember 31, 2022 , respectively, compared to$65.24 million and$117.90 million as ofDecember 31, 2021 , respectively. Outstanding balances to other borrowers in other countries were insignificant. Construction equipment financing increased$184.23 million or 24.42% in 2022 compared to 2021. Construction equipment financing atDecember 31, 2022 had outstandings of$938.50 million , compared to outstandings of$754.27 million atDecember 31, 2021 . The growth in this category was primarily due to significant new client relationships and continued growth with existing clients. Commercial loans secured by real estate, of which approximately 57% is owner occupied, increased$14.40 million or 1.55% in 2022 over 2021. Commercial loans secured by real estate outstanding atDecember 31, 2022 were$943.75 million and$929.34 million atDecember 31, 2021 . The increase in 2022 was the result of one-time reclassifications from the commercial and agricultural portfolio of$32.66 million as well as by continued modest growth of owner occupied borrowings within certain business sectors of our markets. Our non-owner occupied real estate portfolio again declined slightly as projects took advantage of low market rates and refinanced via the secondary markets. In addition, some of our newer projects have seen continued delays due to labor and material shortages. Residential real estate and home equity loans were$584.74 million atDecember 31, 2022 and$500.59 million atDecember 31, 2021 . Residential real estate and home equity loans increased$84.15 million or 16.81% in 2022 from 2021. Residential mortgage and home equity outstandings grew in 2022 as new adjustable-rate mortgage loans were retained rather than being sold into the secondary market along with high demand for home equity lines of credit. The trends from 2021 shifted in 2022 as clients did not want to refinance their first mortgages to pull equity from their homes. In addition, a slow housing market and low builder confidence tended to slow home purchases. Consumer loans increased$18.20 million or 13.68% in 2022 over 2021. Consumer loans outstanding atDecember 31, 2022 , were$151.28 million and$133.08 million atDecember 31, 2021 . Volumes increased as consumer spending improved as restrictions associated with the COVID-19 pandemic were relaxed. In addition, an increase in new and used car prices resulted in an increase in average loan size. 27 -------------------------------------------------------------------------------- Table of Contents The following table shows the contractual maturities of loans and leases outstanding as ofDecember 31, 2022 as well as classification according to the sensitivity to changes in interest rates. (Dollars in thousands) 0-1 Year 1-5 Years 5-15 Years Over 15 Years Total Commercial and agricultural Fixed rate$ 85,965 $ 193,834 $ 12,217 $ -$ 292,016 Variable rate 325,353 172,675 21,983 4 520,015 Total commercial and agricultural 411,318 366,509 34,200 4 812,031 Solar Fixed rate 57,841 42,481 30,304 - 130,626 Variable rate 70,956 121,096 58,485 - 250,537 Total solar 128,797 163,577 88,789 - 381,163 Auto and light truck Fixed rate 144,292 259,020 4,959 - 408,271 Variable rate 148,006 251,066 772 2 399,846 Total auto and light truck 292,298 510,086 5,731 2 808,117 Medium and heavy duty truck Fixed rate 92,317 209,572 10,747 - 312,636 Variable rate 883 343 - - 1,226 Total medium and heavy duty truck 93,200 209,915 10,747 - 313,862 Aircraft Fixed rate 112,874 612,932 33,222 - 759,028 Variable rate 66,490 154,453 97,751 - 318,694 Total aircraft 179,364 767,385 130,973 - 1,077,722 Construction equipment Fixed rate 253,899 625,379 14,888 - 894,166 Variable rate 8,506 24,679 11,152 - 44,337 Total construction equipment 262,405 650,058 26,040 - 938,503 Commercial real estate Fixed rate 90,585 398,476 78,656 186 567,903 Variable rate 39,042 192,324 117,986 26,490 375,842 Total commercial real estate 129,627 590,800 196,642 26,676 943,745 Residential real estate and home equity Fixed rate 48,859 152,851 166,168 18,408 386,286 Variable rate 27,185 88,978 79,961 2,327 198,451 Total residential real estate and home equity 76,044 241,829 246,129 20,735 584,737 Consumer Fixed rate 61,233 73,252 157 - 134,642 Variable rate 13,811 2,805 24 - 16,640 Total consumer 75,044 76,057 181 - 151,282 Total loans and leases Fixed rate 947,865 2,567,797 351,318 18,594 3,885,574 Variable rate 700,232 1,008,419 388,114 28,823 2,125,588 Total loans and leases$ 1,648,097 $
3,576,216
During 2022, approximately 38% of the Bank's residential mortgage originations were sold into the secondary market. Mortgage loans held for sale were$3.91 million atDecember 31, 2022 and were$13.28 million atDecember 31, 2021 .1st Source Bank sells residential mortgage loans to Fannie Mae as well as FHA-insured andVA -guaranteed loans inGinnie Mae mortgage-backed securities. Additionally, we have sold loans on a service released basis to various other financial institutions in the past. The agreements under which we sell these mortgage loans contain various representations and warranties regarding the acceptability of loans for purchase. On occasion, we may be asked to indemnify the loan purchaser for credit losses on loans that were later deemed ineligible for purchase or we may be asked to repurchase a loan. Both circumstances are collectively referred to as "repurchases." Within the industry, repurchase demands have decreased during recent years. We believe the loans we have underwritten and sold to these entities have met or exceeded applicable transaction parameters. 28 -------------------------------------------------------------------------------- Table of Contents Our liability for repurchases, included in Accrued Expenses and Other Liabilities on the Statements of Financial Condition, was$0.17 million and$0.22 million as ofDecember 31, 2022 and 2021, respectively. Our (recovery) expense for repurchase losses, included in Loan and Lease Collection and Repossession expense on the Statements of Income, was$(0.05) million in 2022 compared to$(0.09) million in 2021 and$0.03 million in 2020. The mortgage repurchase liability represents our best estimate of the loss that we may incur. The estimate is based on specific loan repurchase requests and a historical loss ratio with respect to origination dollar volume. Because the level of mortgage loan repurchase losses is dependent on economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment.
CREDIT EXPERIENCE
Allowance for Credit Losses - As ofDecember 31, 2020 , we adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended, which replaced the incurred loss methodology with an expected loss methodology that is referred to as current expected credit losses (CECL) methodology. The allowance for credit losses considers the historical loss experience, current conditions, and reasonable and supportable forecasts. To estimate expected loan and lease losses under CECL, we use a broader range of data than under previousU.S. GAAP. We are able to access loan data over a long-time horizon, generally back to the fourth quarter of 2007, thus capturing most of the economic business cycle which includes the Great Recession and the subsequent long slow recovery which supports full lifetime losses. The CECL methodology requires our loan portfolio to be segregated into pools based on similar risk characteristics. We evaluate each portfolio, establishing numerous segments. We then review risk characteristics for each segment, noting that some pools were either too small for meaningful analysis or contained risk characteristics similar to other pools. Thus, some pools were consolidated. Loans and leases within each pool are collectively evaluated using either the cohort cumulative loss rate methodology or the probability of default (PD)/loss given default (LGD) methodology with transition matrix PD/historical average LGD. Our management evaluates the allowance quarterly, reviewing all loans and leases over a fixed-dollar amount ($250,000 ) where the internal credit quality grade is at or below a predetermined classification, actual and anticipated loss experience, current economic events in specific industries, and other pertinent factors including general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates and adjustments to historical loss rates to capture differences that may exist between the current and historical conditions, including consideration of environmental factors, principally economic risk which is generally reflected in forecast adjustments, specific industry risk and concentration risk, all of which may be susceptible to significant and unforeseen changes. We review the status of the loan and lease portfolio to identify borrowers that might develop financial problems in order to aid borrowers in the handling of their accounts and to mitigate losses. Our allowance for loan and lease losses is provided for by direct charges to the provision for credit losses. Losses on loans and leases are charged against the allowance and likewise, recoveries during the period for prior losses are credited to the allowance. Because business processes and credit risks associated with unfunded credit commitments are essentially the same as for loans, we utilize similar processes to estimate our liability for unfunded credit commitments. Our allowance for unfunded credit commitments is included in Accrued Expenses and Other Liabilities on the Consolidated Statements of Financial Position and is provided by direct charges to the provision for unfunded credit commitments located in Other Noninterest Expense on the Consolidated Statements of Income. See Part II, Item 8, Financial Statements and Supplementary Data - Note 1 of the Notes to Consolidated Financial Statements for additional information on management's evaluation of the allowance for credit losses. We perform a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency in order to review portfolio trends, including specific industry risks and economic conditions, which may have an impact on the allowance and allowance ratios applied to various portfolios. We adjust the calculated historical-based ratio as a result of our analysis of environmental factors, principally specific industry risk, collateral risk and concentration risk, in addition to global economic and political issues. We also have a forecast adjustment that includes key economic factors affecting our portfolios such as growth in gross domestic product, unemployment rates, housing market trends, commodity prices, and inflation. Forecasts are difficult to establish and the current environment presents complexity with near 40-year high inflation, markedly higher interest rates, and heightened uncertainty from the protracted war inUkraine . Residual economic impacts from the pandemic remain an intermittent, but recurrent, headwind for global trade particularly inChina and neighboring countries where spiking COVID-19 cases led to lockdown measures and travel restrictions. Economic growth prospects entering the new year are discouraging, with widespread calls for recession in theU.S. GDP forecasts continue to trend downward as persistent inflation, continued hawkishness of theFederal Reserve , and the ongoing war inUkraine heavily weigh on the outlook. Current political turmoil inBrazil , growing tensions betweenChina and theU.S. , and longstanding turmoil in theMiddle East , also cause increased uncertainty. Collateral values are significant to underwriting our specialty finance portfolios and volatility or declining values pose a threat. Concentration risk is impacted primarily by geographic concentration in northernIndiana and southwesternMichigan in our business banking and commercial real estate portfolios and by collateral concentration in our specialty finance portfolios. 29 -------------------------------------------------------------------------------- Table of Contents The outlook for world economies is weak, with decades-high inflation, geopolitical uncertainty, lingering pandemic activity and a consequent slowdown inChina impacting the outlook. Current concerns include corruption scandals and political unrest in Latin American countries, the competitive and complex nature ofU.S. -China relations, the geopolitical tensions withRussia , and persistent threats of terrorist attacks. InBrazil andMexico where we have a presence with our aircraft lending, we remain concerned with significant inflation, high interest rates and their resultant economic impact, political unrest most prominently evident inBrazil , and the likelihood of economic weakness in future periods that would parallel an expected slowdown in theU.S. We include a factor in our qualitative adjustments for global risk, as we are increasingly aware of the threat that global concerns may affect our customers. While we are unable to determine with any precision the impact of global economic and political issues on1st Source Bank's loan and lease portfolios, we feel the risks are real and significant. We believe there is a risk of negative consequences for our borrowers that would affect their ability to repay their financial obligations. Therefore, we continued to include a factor for global risk in our analysis for 2023.
The following discussion focuses on relevant economic conditions and various
circumstances impacting the
Commercial and agricultural - There are several industries represented in the commercial and agricultural portfolio. Loan outstandings have fluctuated in recent years as two rounds of Paycheck Protection Program loans entered and exited the portfolio with loan forgiveness. Our customers have benefited from the monetary and fiscal stimulus, which provided a lifeline during a period of unprecedented market undercurrents. The outlook for the portfolio is guarded. Small business confidence remains below the long term average as fewer business owners expect the economy to improve in the next six months. Wholesalers and manufacturers have generally performed well and most were able to navigate the supply chain difficulties while passing along rising costs to their consumers. The recreational vehicle industry, which is centered in our footprint, is slowing from record high shipment levels with supply and demand dynamics reversing in recent months. Our business customers engaged in manufacturing for, and supplying the industry, performed very well during the recent years. There has been broad consolidation within the industry over the last two decades and industry suppliers and manufacturers are generally stronger and better capitalized than past cycles to navigate a downturn. The outlook in our agricultural portfolio remains cautiously optimistic as commodity prices remain high, although an expiring Farm Bill is cause for uncertainty. Input prices are expected to remain elevated and along with higher borrowing costs and cash rents, will likely result in thin, but still profitable margins on our agricultural business clients next year. Our customers experienced favorable growing and harvesting conditions during the year which resulted in strong crop yields. In the commercial and agricultural portfolio, we have experienced generally stable credit quality trends with low delinquencies and minimal charge-offs. As of the end of 2022, we reviewed the historical loss ratios and assessed the environmental factors and concentration issues affecting these portfolios and believe the qualitative adjustments we made to our allowance ratios are appropriate and adequate. Solar - Our entry into solar financing over six years ago continues to gain momentum in terms of the performance of existing projects financed, loan growth opportunities and overall credit quality. Financing is provided to qualified borrowers throughout the continentalUnited States with an emphasis on the region east of theRocky Mountains . Risks include construction and developer related risks and delays, site issues, climate and weather risks, regulatory problems and permitting issues, as well as risks related to utility companies and their ability and willingness to facilitate the solar customer tying into the grid, among others. To date, we have not incurred any losses in this portfolio and qualitative adjustments were lowered in the portfolio with the current year-end analysis given continued favorable credit performance. 30 -------------------------------------------------------------------------------- Table of Contents Auto and light truck - The primary auto rental segment of the auto and light truck portfolio experienced a strong year with sizable loan growth as demand for rental vehicles was high and revenue per unit reached a record for the industry. Semiconductor shortages restrained new vehicle production and manufacturers dramatically reduced fleet sales in response. With limited new vehicle availability, used prices skyrocketed and forced operators to forego typical fleet cycles and hold existing inventory for longer periods. The significant increase in vehicle values generally benefited our customers however, elevated valuations increase risk with new fundings which we have attempted to mitigate by maintaining appropriate terms and limiting funding on used units. Wholesale used vehicle prices have declined in nine of the last twelve months and are 15% off the prior year peak, although used values remain well above the historical trendline. Loan growth is strong with operators holding vehicles longer thereby extending fleet cycles. The auto leasing segment also performed well in 2022 and the portfolio exhibits stable credit quality and low delinquency. Leasing customers lease to auto rental companies as well as other commercial entities. We have some concern that increasing vehicle prices and higher borrowing costs could lead to leasing companies stretching for yield by lowering credit quality standards on sub-lessees. We remain diligent in setting our terms and residual value appropriately and monitoring fleet mix given the recent volatility in vehicle prices. The portfolio reported a net recovery position for the year in both the auto rental and specialty vehicle portfolios which include the bus, step van, and funeral car segments. The bus segment experienced losses in the prior two years due to the pandemic and collateral values for motor coaches decreasing substantially during that time. Values are showing signs of stabilization, particularly in late-model motor coaches. There remains concern with repossessing bus units should credit quality deteriorate as outlets for repossessed inventory are not well established and markets are limited. Long-term, there remains uncertainty as some bus portfolio customers may struggle to adapt to the new environment and may experience further losses. We reviewed the annual historical incurred losses and the life of the loan calculated historical loss ratios as of year-end and removed the majority of qualitative factors in the bus segment as we believe historical loss rates are sufficient to cover remaining risk in the portfolio as we recognized charge-offs during 2022 and 2021 and our expectation is that future losses will be lower than recent experience. We believe we appropriately recognized the losses in our portfolio and that peak charge-offs occurred in 2021. Special attention balances decreased from$26.26 million at the end of 2021 to$14.56 million at the end of 2022. Credit quality in the auto rental and leasing portions of the portfolio remain stable and we modestly reduced qualitative factors in those segments. Medium and heavy duty truck - Credit quality remains stable in the medium and heavy duty truck portfolio. The industry continues to struggle with driver shortages. However, the highly limited inventory of Class 8 tractors experienced in 2021 due to a semiconductor chip shortage appears to have largely been rectified - inventory levels are rebounding and auction valuations are softening. Loan growth opportunities were improved during 2022 as more equipment became available. We believe our reserve ratios for this portfolio are appropriate. Aircraft - Our domestic and foreign aircraft segments both experienced strong loan growth during the year as high asset valuations and demand for private aircraft increased lending opportunities. The portfolio has been a relatively stable performer of late, but was among the sectors affected most by the sluggish economy following the Great Recession. Our portfolio loss history has been volatile, characterized by lengthy periods of minimal losses or modest recoveries followed by short intervals of higher losses. Aircraft collateral values, particularly those in our niche, have strengthened considerably in this economic cycle. Long, often multi-year, delays for new aircraft have in some instances driven used valuations beyond the price of new aircraft given their immediate availability. In this portfolio we have$297 million of foreign exposure, primarily inMexico andBrazil .Brazil's economy continues to struggle to sustain growth and is further hampered by increased inflation fears and political uncertainties. The Mexican economy has fared better of late as its manufacturing rebounded with recovering automotive production. Growth continues to be threatened by drug trafficking and related violence with widespread poverty and income inequality remaining significant concerns. Qualitative adjustments are assigned toBrazil andMexico's economic risk as the bulk of foreign aircraft outstandings are domiciled in those markets. Our historical loss ratios reflect our high and volatile loss histories. We adjusted the historical ratios for current conditions, principally, a small increase in collateral concentration risk as we are currently lending into an abnormally strong used aircraft market with increased downside valuation risk on new fundings. Additionally, we increased the qualitative forecast factor adjustment for cohort based pools which is commensurate to the impact of the forecast adjustment in the PD/LGD (probability of default/loss given default) model analysis. We believe the ratios as adjusted are appropriate. 31 -------------------------------------------------------------------------------- Table of Contents Construction equipment - Our construction equipment portfolio historically has been characterized by stable credit quality; however, there have been credit quality concerns in recent periods with a steady undercurrent of unanticipated downgrades to special attention during the last two years. The portfolio recognized the largest singular charge-off in both 2021 and 2022. The construction industry benefited from growth in private residential construction over the last several years, but higher interest rates and a rapidly slowing housing market have weakened the outlook for site developers. Certain sectors are experiencing stress and we continue to monitor for credit weaknesses. Construction equipment remains vulnerable due to volatility and regulation in the oil and gas sector. The general nature of bidding on construction projects can also have unknown costs or delays. Increased energy costs have been harmful to portfolio clients which often operate under long-term contracts that may lack adequate cost escalators. Diesel prices remain elevated and will be a hardship for clients in the construction industry and have impacted margins. Historically, we have experienced less volatility in this portfolio than the broader industry as losses have been mitigated by appropriate underwriting and a global market for used construction equipment. Continued infrastructure spending is expected to have a positive impact for many contractors within the segment and for the industry's used equipment markets. We modified our qualitative factors as of 2021 year-end to recognize the increased volume of accounts moving into special attention, and qualitative factors were largely maintained with the 2022 portfolio review given continued special attention activity. Commercial real estate - Similar to the commercial portfolio, our commercial real estate loans are concentrated in our local market with local customers. Approximately 57% of the Bank's exposure in this portfolio is from owner occupied facilities where we are the primary relationship bank for our customers. We reviewed our qualitative adjustments as of year-end, and made some modifications as we are concerned about higher interest and capitalization rates within the segment and the potential negative impact on real estate valuations. We believe our ratios as adjusted are appropriate and adequate as ofDecember 31, 2022 . Residential real estate and home equity - Our residential real estate and home equity portfolio consists of loans to individuals in the communities we serve. Generally, residential mortgage loans are originated using standards that result in salable mortgages. Home equity loans are also advanced in compliance with regulatory guidelines and the Bank's credit policy. Losses in these portfolios have been immaterial since 2013, but we did experience losses during the housing crises and recognized one loss of$0.23 million during 2022 which is related to a commercial special attention account. We reviewed our qualitative adjustments at the end of 2022 which are primarily for reasonable and supportable forecasts, and believe they are appropriate and adequate. Consumer - Our consumer loan portfolio consists of loans to individuals in the communities we serve. This portfolio consists primarily of loans secured by autos with advances in compliance with the Bank's underwriting standards. Losses are stable during good economic times and tend to increase when there is deterioration in local economic factors and employment rates. We reviewed our qualitative adjustments at the end of the 2022 which are primarily for reasonable and supportable forecasts, and believe they are appropriate. The allowance for loan and lease losses atDecember 31, 2022 , totaled$139.27 million and was 2.32% of loans and leases, compared to$127.49 million or 2.38% of loans and leases atDecember 31, 2021 and$140.65 million or 2.56% of loans and leases atDecember 31, 2020 . It is our opinion that the allowance for loan and lease losses was appropriate to absorb current expected credit losses inherent in the loan and lease portfolio as ofDecember 31, 2022 . Charge-offs for loan and lease losses were$3.41 million for 2022, compared to$12.52 million for 2021 and$13.97 million for 2020. In order to accommodate net charge offs and strong loan and lease growth, we added$13.25 million to the provision for credit losses for 2022, compared to a recovery of provision of$(4.30) million for 2021 and a provision of$36.00 million for 2020. 32 -------------------------------------------------------------------------------- Table of Contents The following table summarizes our loan and lease loss experience for each of the last three years endedDecember 31 . (Dollars in thousands) 2022 2021 2020 Amounts of loans and leases outstanding at end of period $
6,011,162
$
127,492
- - 2,584
Adjusted balance of allowance for loan and lease losses at beginning of period
127,492 140,654 113,838
Charge-offs:
Commercial and agricultural 625 2,930 903 Solar - - - Auto and light truck 118 7,797 7,107 Medium and heavy duty truck - - 15 Aircraft - - 855 Construction equipment 1,114 856 4,090 Commercial real estate 538 - 37 Residential real estate and home equity 284 228 74 Consumer 730 712 893 Total charge-offs 3,409 12,523 13,974 Recoveries: Commercial and agricultural 56 812 663 Solar - - - Auto and light truck 417 1,316 499 Medium and heavy duty truck - - 18 Aircraft 785 687 1,800 Construction equipment 17 473 1,415 Commercial real estate 45 19 58 Residential real estate and home equity 160 16 33 Consumer 460 341 303 Total recoveries 1,940 3,664 4,789 Net charge-offs (recoveries) 1,469 8,859 9,185 Provision (recovery of provision) for loan and lease losses 13,245 (4,303) 36,001 Balance at end of period $
139,268
0.03 % 0.16 % 0.17 %
2.32 % 2.38 % 2.56 %
Coverage ratio of allowance for loan and lease losses to nonperforming loans and leases
526.06 % 327.28 % 232.47 %
The following table shows net charge-offs (recoveries) as a percentage of average loans and leases by portfolio type:
2022 2021 2020
Commercial and agricultural 0.07 % 0.19 % 0.02 %
Solar - - -
Auto and light truck (0.04) 1.11 1.18
Medium and heavy duty truck - - -
Aircraft (0.08) (0.08) (0.12)
Construction equipment 0.13 0.05 0.37
Commercial real estate 0.05 - -
Residential real estate and home equity 0.02 0.04 0.01
Consumer 0.19 0.28 0.43
Total net charge-offs (recoveries) to average portfolio loans
and leases 0.03 % 0.16 % 0.17 %
33-------------------------------------------------------------------------------- Table of Contents The allowance for loan and lease losses has been allocated according to the amount deemed necessary to provide for the estimated current expected credit losses. The following table shows the amount of such components of the allowance for loan and lease losses atDecember 31 and the ratio of such loan and lease categories to total outstanding loan and lease balances. 2022 2021 Percentage of Loans Percentage of Loans and Leases in Each and Leases in Each
Allowance Category to Total Allowance Category to Total (Dollars in thousands)
Amount Loans and Leases Amount Loans and Leases
Commercial and agricultural$ 14,635 13.51 %$ 15,409 17.18 % Solar 7,217 6.34 6,585 6.51 Auto and light truck 18,634 13.44 19,624 11.30 Medium and heavy duty truck 7,566 5.22 6,015 4.87 Aircraft 41,093 17.93 33,628 16.80 Construction equipment 24,039 15.61 19,673 14.11 Commercial real estate 17,431 15.70 19,691 17.38 Residential real estate and home equity 6,478 9.73 5,084 9.36 Consumer 2,175 2.52 1,783 2.49 Total$ 139,268 100.00 %$ 127,492 100.00 % Nonperforming Assets - Nonperforming assets include loans past due over 90 days, nonaccrual loans and leases, other real estate, repossessions and other nonperforming assets we own. Our policy is to discontinue the accrual of interest on loans and leases where principal or interest is past due and remains unpaid for 90 days or more, or when an individual analysis of a borrower's credit worthiness indicates a credit should be placed on nonperforming status, except for residential real estate and home equity loans, which are placed on nonaccrual at the time the loan is placed in foreclosure and consumer loans that are both well secured and in the process of collection. Nonperforming assets amounted to$26.93 million atDecember 31, 2022 , compared to$41.33 million atDecember 31, 2021 , and$64.53 million atDecember 31, 2020 . During 2022, interest income on nonaccrual loans and leases would have increased by approximately$2.68 million compared to$2.62 million in 2021 if these loans and leases had earned interest at their full contractual rate. Nonperforming assets atDecember 31, 2022 decreased fromDecember 31, 2021 , mainly due to declines in nonaccrual loans and leases in the bus segment of the auto and light truck portfolio along with modestly lower nonaccrual loans in construction equipment. Repossessions consisted mainly of units in the bus and step van segments of the auto and light truck portfolio. Other real estate consists of one residential real estate property. 34
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Nonperforming assets at December 31 (Dollars in thousands) 2022 2021 Loans past due over 90 days$ 54 $ 249 Nonaccrual loans and leases: Commercial and agricultural 864 2,053 Solar - - Auto and light truck 14,153 24,170 Medium and heavy duty truck 15 273 Aircraft 571 649 Construction equipment 5,469 7,090 Commercial real estate 3,229 2,996 Residential real estate and home equity 1,785 1,225 Consumer 334 250 Total nonaccrual loans and leases 26,420 38,706 Total nonperforming loans and leases 26,474 38,955 Other real estate 104 - Repossessions: Commercial and agricultural - - Auto and light truck 311 75 Medium and heavy duty truck - - Aircraft - - Construction equipment - 757 Consumer 16 29 Total repossessions 327 861 Operating leases 22 1,518 Total nonperforming assets$ 26,927 $ 41,334
Nonperforming loans and leases to loans and leases, net of unearned discount
0.44 % 0.73 %
Nonperforming assets to loans and leases and operating leases, net of unearned discount
0.45 % 0.77 %
Potential Problem Loans - Potential problem loans consist of loans that are
performing but for which management has concerns about the ability of a borrower
to continue to comply with repayment terms because of the borrowers' potential
operating or financial difficulties. Management monitors these loans closely and
reviews their performance on a regular basis. As of December 31, 2022 and 2021,
we had $7.83 million and $1.23 million , respectively, in loans of this type
which are not included in either of the non-accrual or 90 days past due loan
categories. At December 31, 2022 , potential problem loans consisted of one
credit relationship in the commercial and agricultural portfolio. Weakness in
the borrower's operating performance have caused us to heighten attention given
to this credit.
INVESTMENT PORTFOLIO
The amortized cost of securities available-for-sale at year-end 2022 increased
4.96% from 2021, following a 59.90% increase from year-end 2020 to year-end
2021. The amortized cost of securities available-for-sale at December 31, 2022
was $1.97 billion or 23.61% of total assets, compared to $1.88 billion or 23.17%
of total assets at December 31, 2021 .
The following table shows the amortized cost of investment securities
available-for-sale as of
(Dollars in thousands) 2022
2021
95,700
Mortgage-backed securities - Federal agencies 730,672 663,441 Corporate debt securities 16,486 22,510 Foreign government securities 600 600
Total investment securities available-for-sale
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Yields on tax-exempt obligations are calculated on a fully tax-equivalent basis
assuming a 21% tax rate. The following table shows the maturities of securities
available-for-sale at December 31, 2022 , at the amortized costs and weighted
average yields of such securities.
(Dollars in thousands) Amount Yield
U.S. Treasury and Federal agencies securities Under 1 year$ 40,202 1.79 % 1 - 5 years 1,050,541 0.95 5 - 10 years - - Over 10 years - - Total U.S. Treasury and Federal agencies securities 1,090,743
0.98
U.S. States and political subdivisions securities Under 1 year 15,121 2.79 1 - 5 years 52,541 1.65 5 - 10 years 21,835 1.30 Over 10 years 41,173 5.92
Total
3.07 Corporate debt securities Under 1 year 8,002 2.98 1 - 5 years 8,484 2.32 5 - 10 years - - Over 10 years - - Total Corporate debt securities 16,486 2.64 Foreign government securities Under 1 year - - 1 - 5 years 600 2.12 5 - 10 years - - Over 10 years - - Total Foreign government securities 600
2.12
Mortgage-backed securities - Federal agencies 730,672
1.85
Total investment securities available-for-sale$ 1,969,171
1.45 %
AtDecember 31, 2022 , the residential mortgage-backed securities we held consisted of GNMA,FNMA and FHLMC pass-through certificates (Government Sponsored Enterprise, GSEs). The type of loans underlying the securities were all conforming loans at the time of issuance. The underlying GSEs backing these mortgage-backed securities are rated Aaa or AA+ from the rating agencies. AtDecember 31, 2022 , the vintage (years originated) of the underlying loans comprising our securities are: 14% in the year 2022; 45% in the year 2021; 28% in the years 2019 and 2020; 7% in the years 2017 and 2018; 2% in the years 2015 and 2016; 4% in the years 2014 prior.
DEPOSITS
The following table shows the average daily amounts of deposits and rates paid
on such deposits.
2022 2021 2020(Dollars in thousands) Amount Rate Amount Rate Amount Rate Noninterest bearing demand$ 2,037,882 - %$ 1,882,168 - %$ 1,530,698 - % Interest bearing demand 2,554,945 0.69 2,278,498 0.13 1,827,673 0.24 Savings 1,283,143 0.08 1,172,411 0.07 926,585 0.11 Time 835,406 0.79 1,009,450 0.84 1,451,646 1.73 Total deposits$ 6,711,376 $ 6,342,527 $ 5,736,602 36
-------------------------------------------------------------------------------- Table of Contents The following table shows the estimated scheduled maturities of the portion of time deposits inU.S. offices in excess of theFDIC insurance limit and time deposits that are otherwise uninsured. (Dollars in thousands) Under 3 Months$ 138,892 4 - 6 Months 70,383 7 - 12 Months 181,961 Over 12 Months 217,415 Total$ 608,651 See Part II, Item 8, Financial Statements and Supplementary Data - Note 10 of the Notes to Consolidated Financial Statements for additional information on deposits. SHORT-TERM BORROWINGS The following table shows the distribution of our short-term borrowings and the weighted average interest rates thereon at the end of each of the last two years. Also provided are the maximum amount of borrowings and the average amount of borrowings, as well as weighted average interest rates for the last two years. Federal Funds Purchased and Other Securities Repurchase Federal Home Loan Short-Term (Dollars in thousands) Agreements Commercial Paper Bank Advances Borrowings Total Borrowings 2022 Balance at December 31, 2022$ 141,432 $ 3,096 $ 70,000 $ 1,001 $ 215,529 Maximum amount outstanding at any month-end 193,798 4,072 250,000 1,746 449,616 Average amount outstanding 169,600 3,838 40,123 1,409 214,970 Weighted average interest rate during the year 0.12 % 0.04 % 3.22 % - % 0.70 % Weighted average interest rate for outstanding amounts at December 31, 2022 0.05 % 0.03 % 4.16 % - % 1.39 %
2021
Balance at December 31, 2021$ 194,727 $ 3,967 $ -$ 1,333 $ 200,027 Maximum amount outstanding at any month-end 210,275 5,141 - 3,007 218,423 Average amount outstanding 180,610 4,316 - 1,802 186,728 Weighted average interest rate during the year 0.06 % 0.08 % - % - % 0.06 % Weighted average interest rate for outstanding amounts at December 31, 2021 0.04 % 0.04 % N/A - % 0.04 %
LIQUIDITY AND CAPITAL RESOURCES
Core Deposits - Our major source of investable funds is provided by stable core deposits consisting of all interest bearing and noninterest bearing deposits, excluding brokered certificates of deposit, listing services certificates of deposit and certain certificates of deposit over$250,000 based on establishedFDIC insured deposits. In 2022, average core deposits equaled 79.60% of average total assets, compared to 78.04% in 2021 and 73.64% in 2020. The effective rate of core deposits in 2022 was 0.32%, compared to 0.12% in 2021 and 0.39% in 2020. Average noninterest bearing core deposits increased 8.27% in 2022 compared to an increase of 22.96% in 2021. These represented 31.71% of total core deposits in 2022, compared to 31.20% in 2021, and 29.20% in 2020. Purchased Funds - We use purchased funds to supplement core deposits, which include certain certificates of deposit over$250,000 , brokered certificates of deposit, listing services certificates of deposit, over-night borrowings, securities sold under agreements to repurchase, commercial paper, and other short-term borrowings. Purchased funds are raised from customers seeking short-term investments and are used to manage the Bank's interest rate sensitivity. During 2022, our reliance on purchased funds decreased to 6.19% of average total assets from 6.41% in 2021. 37 -------------------------------------------------------------------------------- Table of Contents Shareholders' Equity - Average shareholders' equity equated to 10.81% of average total assets in 2022, compared to 11.73% in 2021. Shareholders' equity was 10.36% of total assets at year-end 2022, compared to 11.32% at year-end 2021. We include unrealized gains (losses) on available-for-sale securities, net of income taxes, in accumulated other comprehensive income (loss) which is a component of shareholders' equity. While regulatory capital adequacy ratios exclude unrealized gains (losses), it does impact our equity as reported in the audited financial statements. The unrealized losses on available-for-sale securities, net of income taxes, were$147.69 million and$9.86 million atDecember 31, 2022 and 2021, respectively. The unrealized losses occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase. Additionally, we do not intend to sell these investments and it is more likely than not that we will not be required to sell these investments before recovery of the amortized cost basis, which may be the maturity dates of the securities. Other Liquidity - Under Indiana law governing the collateralization of public fund deposits, theIndiana Board of Depositories determines which financial institutions are required to pledge collateral based on the strength of their financial ratings. We have been informed that no collateral is required for our public fund deposits. However, theBoard of Depositories could alter this requirement in the future and adversely impact our liquidity. Our potential liquidity exposure if we must pledge collateral is approximately$1.15 billion . Liquidity Risk Management - The Bank's liquidity is monitored and closely managed by the Asset/Liability Management Committee (ALCO), whose members are comprised of the Bank's senior management. Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates.
Liquidity management is the process by which the Bank ensures that adequate liquid funds are available to meet short-term and long-term financial commitments on a timely basis. Financial institutions must maintain liquidity to meet day-to-day requirements of depositors and borrowers, take advantage of market opportunities and provide a cushion against unforeseen needs.
Liquidity of the Bank is derived primarily from core deposits, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability-funded liquidity is deposit growth and retention of the core deposit base. The principal source of asset-funded liquidity is available-for-sale investment securities, cash and due from banks, overnight investments, securities purchased under agreements to resell, and loans and interest bearing deposits with other banks maturing within one year. Additionally, liquidity is provided by repurchase agreements, and the ability to borrow from theFederal Reserve Bank (FRB) and theFederal Home Loan Bank (FHLB). The Bank's liquidity strategy is guided by internal policies and the Interagency Policy Statement on Funding and Liquidity Risk Management. Internal guidelines consist of:
(i)Available Liquidity (sum of short term borrowing capacity) greater than
(ii)Liquidity Ratio (total of net cash, short term investments and unpledged marketable assets divided by the sum of net deposits and short term liabilities) greater than 15%; (iii)Dependency Ratio (net potentially volatile liabilities minus short term investments divided by total earning assets minus short term investments) less than 15%; and
(iv)Loans to Deposits Ratio less than 100%
At
The Bank also maintains a contingency funding plan that assesses the liquidity needs under various scenarios of market conditions, asset growth and credit rating downgrades. The plan includes liquidity stress testing which measures various sources and uses of funds under the different scenarios. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. We have borrowing sources available to supplement deposits and meet our funding needs.1st Source Bank has established relationships with several banks to provide short term borrowings in the form of federal funds purchased. AtDecember 31, 2022 , we had no borrowings in the federal funds market. We could borrow$245.00 million in additional funds for a short time from these banks on a collective basis. As ofDecember 31, 2022 , we had$91.31 million outstanding in FHLB advances and could borrow an additional$464.70 million contingent on the FHLB activity-based stock ownership requirement. We also had no outstandings with the FRB and could borrow$444.99 million as ofDecember 31, 2022 . 38 -------------------------------------------------------------------------------- Table of Contents Interest Rate Risk Management - ALCO monitors and manages the relationship of earning assets to interest bearing liabilities and the responsiveness of asset yields, interest expense, and interest margins to changes in market interest rates. In the normal course of business, we face ongoing interest rate risks and uncertainties. We may utilize interest rate swaps to partially manage the primary market exposures associated with the interest rate risk related to underlying assets, liabilities, and anticipated transactions. A hypothetical change in net interest income was modeled by calculating an immediate 200 basis point (2.00%) and 100 basis point (1.00%) increase and a 100 basis point (1.00%) decrease in interest rates across all maturities. The following table shows the aggregate hypothetical impact to pre-tax net interest income. Percentage Change in Net Interest Income December 31, 2022 December 31, 2021 Basis Point Interest Rate Change 12 Months 24 Months 12 Months 24 Months Up 200 (2.32)% 2.99% 0.34% 7.00% Up 100 (1.15)% 1.52% (0.51)% 2.86% Down 100 (2.39)% (5.10)% (3.22)% (8.00)% The earnings simulation model excludes the earnings dynamics related to how fee income and noninterest expense may be affected by changes in interest rates. Actual results may differ materially from those projected. The use of this methodology to quantify the market risk of the balance sheet should not be construed as an endorsement of its accuracy or the accuracy of the related assumptions. AtDecember 31, 2022 and 2021, the impact of these hypothetical fluctuations in interest rates on our derivative holdings was not significant, and, as such, separate disclosure is not presented. We manage the interest rate risk related to mortgage loan commitments by entering into contracts for future delivery of loans with outside parties. See Part II, Item 8, Financial Statements and Supplementary Data - Note 18 of the Notes to Consolidated Financial Statements. Commitments and Contractual Obligations - In the ordinary course of operations, we enter into certain contractual obligations. Such obligations include customer deposits, the funding of operations through debt issuances as well as operating leases for the rent of premises and equipment. Additionally, we routinely enter into contracts for services that may require payment to be provided in the future and may contain penalty clauses for early termination of the contract. Further discussion of commitments and contractual obligations is included in Part II, Item 8, Financial Statements and Supplementary Data - Notes 10, 11, 12 and 18 of the Notes to Consolidated Financial Statements. We also enter into derivative contracts under which we are required to either receive cash from, or pay cash to, counterparties depending on changes in interest rates. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of the contracts changes daily as market interest rates change. Further discussion of derivative contracts is included in Part II, Item 8, Financial Statements and Supplementary Data - Note 19 of the Notes to Consolidated Financial Statements.
OFF-BALANCE SHEET ARRANGEMENTS
Assets under management and assets under custody are held in fiduciary or
custodial capacity for our clients. In accordance with
We are also party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of our clients. These
financial instruments include commitments to extend credit and standby letters
of credit. Further discussion of these commitments is included in Part II, Item
8, Financial Statements and Supplementary Data - Note 18 of the Notes to
Consolidated Financial Statements.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
For information regarding Quantitative and Qualitative Disclosures about Market
Risk, see Part II, Item 7, Management's Discussion and Analysis of Financial
Condition and Results of Operations, Interest Rate Risk Management.
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