SOUTHERN FIRST BANCSHARES INC MANAGEMENT’S DISCUSSION AND Analysis of Financial Condition and Results of Operations. (form 10-Q)

The following discussion reviews our results of operations for the three and six
month periods ended June 30, 2022 as compared to the three and six month periods
ended June 30, 2021 and assesses our financial condition as of June 30, 2022 as
compared to December 31, 2021. You should read the following discussion and
analysis in conjunction with the accompanying consolidated financial statements
and the related notes and the consolidated financial statements and the related
notes for the year ended December 31, 2021 included in our Annual Report on Form
10-K for that period. Results for the three and six month periods ended June 30,
2022 are not necessarily indicative of the results for the year ending December
31, 2022 or any future period.



Unless the context requires otherwise, references to the “Company,” “we,” “us,”
“our,” or similar references mean Southern First Bancshares, Inc. and its
consolidated subsidiary. References to the “Bank” refer to Southern First Bank.

Cautionary Warning Regarding forward-looking statements

This report contains statements which constitute forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934 (the "Exchange Act"). Forward-looking
statements may relate to our financial condition, results of operations, plans,
objectives, or future performance. These statements are based on many
assumptions and estimates and are not guarantees of future performance. Our
actual results may differ materially from those anticipated in any
forward-looking statements, as they will depend on many factors about which we
are unsure, including many factors which are beyond our control. The words
"may," "would," "could," "should," "will," "seek to," "strive," "focus,"
"expect," "anticipate," "predict," "project," "potential," "believe,"
"continue," "assume," "intend," "plan," and "estimate," as well as similar
expressions, are meant to identify such forward-looking statements. Potential
risks and uncertainties that could cause our actual results to differ from those
anticipated in any forward-looking statements include, but are not limited to:



? The continuing impact of COVID-19 and its variants on our business, including

the impact of the actions taken by governmental authorities to try and contain

the virus or address the impact of the virus on the United States economy

(including, without limitation, the Coronavirus Aid, Relief and Economic

Security Act, or the CARES Act), and the resulting effect of these items on our

operations, liquidity and capital position, and on the financial condition of

our borrowers and other customers;

? Restrictions or conditions imposed by our regulators on our operations;

? Increases in competitive pressure in the banking and financial services

industries;

? Changes in access to funding or increased regulatory requirements with regard

   to funding;



 ? Changes in deposit flows;



? Credit losses as a result of declining real estate values, increasing interest

rates, increasing unemployment, changes in payment behavior or other factors;

? Credit losses due to loan concentration;

? Changes in the amount of our loan portfolio collateralized by real estate and

weaknesses in the real estate market;

? Our ability to successfully execute our business strategy;

? Our ability to attract and retain key personnel;

? The success and costs of our expansion into the Charlotte, North Carolina,

Greensboro, North Carolina and Atlanta, Georgia markets and into potential new

   markets;



? Risks with respect to future mergers or acquisitions, including our ability to

successfully expand and integrate the businesses and operations that we acquire

and realize the anticipated benefits of the mergers or acquisitions;




 ? Changes in the interest rate environment which could reduce anticipated or
   actual margins;




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? Changes in political conditions or the legislative or regulatory environment,

including new governmental initiatives affecting the financial services

industry;

? Changes in economic conditions resulting in, among other things, a

deterioration in credit quality;

? Changes occurring in business conditions and inflation;

? Increased cybersecurity risk, including potential business disruptions or

   financial losses;



 ? Changes in technology;



? The adequacy of the level of our allowance for credit losses and the amount of

loan loss provisions required in future periods;

? Examinations by our regulatory authorities, including the possibility that the

regulatory authorities may, among other things, require us to increase our

allowance for credit losses or write-down assets;

? Changes in monetary and tax policies;

? The rate of delinquencies and amounts of loans charged-off;

? The rate of loan growth in recent years and the lack of seasoning of a portion

   of our loan portfolio;



? Our ability to maintain appropriate levels of capital and to comply with our

capital ratio requirements;

? Adverse changes in asset quality and resulting credit risk-related losses and

   expenses;



? Changes in accounting standards, rules and interpretations and the related

impact on our financial statements, including the effects from our adoption of

the current expected credit losses (“CECL”) model on January 1, 2022;

? Risks associated with actual or potential litigation or investigations by

customers, regulatory agencies or others;

? Adverse effects of failures by our vendors to provide agreed upon services in

the manner and at the cost agreed;

? The potential effects of events beyond our control that may have a

destabilizing effect on financial markets and the economy, such as epidemics

and pandemics (including COVID-19), war or terrorist activities, disruptions in

our customers’ supply chains, disruptions in transportation, essential utility

outages or trade disputes and related tariffs; and

? Other risks and uncertainties detailed in Part I, Item 1A, “Risk Factors” of

our Annual Report on Form 10-K for the year ended December 31, 2021, in Part

II, Item 1A, “Risk Factors” of our Quarterly Reports on Form 10-Q, and in our

   other filings with the SEC.




If any of these risks or uncertainties materialize, or if any of the assumptions
underlying such forward-looking statements proves to be incorrect, our results
could differ materially from those expressed in, implied or projected by, such
forward-looking statements. We urge investors to consider all of these factors
carefully in evaluating the forward-looking statements contained in this
Quarterly Report on Form 10-Q. We make these forward-looking statements as of
the date of this document and we do not intend, and assume no obligation, to
update the forward-looking statements or to update the reasons why actual
results could differ from those expressed in, or implied or projected by, the
forward-looking statements, except as required by law.



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OVERVIEW



Our business model continues to be client-focused, utilizing relationship teams
to provide our clients with a specific banker contact and support team
responsible for all of their banking needs. The purpose of this structure is to
provide a consistent and superior level of professional service, and we believe
it provides us with a distinct competitive advantage. We consider exceptional
client service to be a critical part of our culture, which we refer to as
"ClientFIRST."



At June 30, 2022, we had total assets of $3.29 billion, a 12.4% increase from
total assets of $2.93 billion at December 31, 2021. The largest component of our
total assets is loans which were $2.85 billion and $2.49 billion at June 30,
2022 and December 31, 2021, respectively. Our liabilities and shareholders'
equity at June 30, 2022 totaled $3.01 billion and $282.6 million, respectively,
compared to liabilities of $2.65 billion and shareholders' equity of $277.9
million at December 31, 2021. The principal component of our liabilities is
deposits which were $2.87 billion and $2.56 billion at June 30, 2022 and
December 31, 2021, respectively.



Like most community banks, we derive the majority of our income from interest
received on our loans and investments. Our primary source of funds for making
these loans and investments is our deposits, on which we pay interest.
Consequently, one of the key measures of our success is our amount of net
interest income, or the difference between the income on our interest-earning
assets, such as loans and investments, and the expense on our interest-bearing
liabilities, such as deposits and borrowings. Another key measure is the spread
between the yield we earn on these interest-earning assets and the rate we pay
on our interest-bearing liabilities, which is called our net interest spread. In
addition to earning interest on our loans and investments, we earn income
through fees and other charges to our clients.



Our net income to common shareholders was $7.2 million and $10.3 million for the
three months ended June 30, 2022 and 2021, respectively. Diluted earnings per
share ("EPS") was $0.90 for the second quarter of 2022 as compared to $1.29 for
the same period in 2021. The decrease in net income was primarily driven by an
increase in the provision for credit losses and a decrease in mortgage banking
income, as well as an increase in noninterest expense.



Our net income to common shareholders was $15.2 million and $20.7 million for
the six months ended June 30, 2022 and 2021. Diluted EPS was $1.88 for the six
months ended June 30, 2022 as compared to $2.60 for the same period in 2021. The
decrease in net income was primarily driven by an increase in the provision for
credit losses and a decrease in mortgage banking income, as well as an increase
in noninterest expenses.



In addition, during the second quarter of 2022, we relocated our headquarters in
Greenville, South Carolina to a newly constructed, 107,000 square foot building.
As a result of the relocation, we disposed of assets with a book value of
$489,000, including leasehold improvements and furniture and fixtures, and
recorded a net loss on disposal of $394,000.



RESULTS OF OPERATIONS


Net Interest Income and Margin


Our level of net interest income is determined by the level of earning assets
and the management of our net interest margin. Our net interest income was $24.9
million for the second quarter of 2022, a 16.1% increase over net interest
income of $21.4 million for the second quarter of 2021, driven by an increase in
interest income on loans as a result of loan growth during the past 12 months.
In addition, our net interest margin, on a tax-equivalent basis (TE), was 3.35%
for the second quarter of 2022 compared to 3.50% for the same period in 2021.



We have included a number of tables to assist in our description of various
measures of our financial performance. For example, the "Average Balances,
Income and Expenses, Yields and Rates" table reflects the average balance of
each category of our assets and liabilities as well as the yield we earned or
the rate we paid with respect to each category during the three and six month
periods ended June 30, 2022 and 2021. A review of this table shows that our
loans typically provide higher interest yields than do other types of
interest-earning assets, which is why we direct a substantial percentage of our
earning assets into our loan portfolio. Similarly, the "Rate/Volume Analysis"
tables demonstrate the effect of changing interest rates and changing volume of
assets and liabilities on our financial condition during the periods shown. We
also track the sensitivity of our various categories of assets and liabilities
to changes in interest rates, and we have included tables to illustrate our
interest rate sensitivity with respect to interest-earning accounts and
interest-bearing accounts.



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The following tables entitled "Average Balances, Income and Expenses, Yield and
Rates" set forth information related to our average balance sheets, average
yields on assets, and average costs of liabilities. We derived these yields by
dividing income or expense by the average balance of the corresponding assets or
liabilities. We derived average balances from the daily balances throughout the
periods indicated. During the same periods, we had no securities purchased with
agreements to resell. All investments owned have an original maturity of over
one year. Nonaccrual loans are included in the following tables. Loan yields
have been reduced to reflect the negative impact on our earnings of loans on
nonaccrual status. The net of capitalized loan costs and fees are amortized into
interest income on loans.



Average Balances, Income and Expenses, Yields and Rates

For the Three Months Ended June 30,

                                                             2022                                         2021
                             Average       Income/         Yield/         Average       Income/         Yield/
(dollars in thousands)       Balance       Expense        Rate(1)         Balance       Expense        Rate(1)
Interest-earning
assets
Federal funds sold and
interest-bearing
deposits with banks      $    80,909     $     180           0.89 %   $   119,211     $      53           0.18 %
Investment securities,
taxable                       98,527           404           1.64 %        85,306           212           1.00 %
Investment securities,
nontaxable(2)                 10,382            56           2.16 %        11,599            74           2.56 %
Loans(3)                   2,795,274        26,610           3.82 %     2,240,236        22,409           4.01 %
Total interest-earning
assets                     2,985,092        27,250           3.66 %     2,456,352        22,748           3.71 %
Noninterest-earning
assets                       154,659                                      117,836
Total assets             $ 3,139,751                                  $ 2,574,188
Interest-bearing
liabilities
NOW accounts             $   389,563           144           0.15 %   $   298,446            46           0.06 %
Savings & money market     1,267,174         1,200           0.38 %     1,131,391           580           0.21 %
Time deposits                278,101           500           0.72 %       175,612           294           0.67 %
Total interest-bearing
deposits                   1,934,838         1,844           0.38 %     1,605,449           920           0.23 %
FHLB advances and
other borrowings              53,179           105           0.79 %            44             2          18.23 %
Subordinated
debentures                    36,143           405           4.49 %        36,035           379           4.22 %
Total interest-bearing
liabilities                2,024,160         2,354           0.47 %     1,641,528         1,301           0.32 %
Noninterest-bearing
liabilities                  833,943                                      688,576
Shareholders' equity         281,648                                      244,084
Total liabilities and
shareholders' equity     $ 3,139,751                                  $ 2,574,188
Net interest spread                                          3.19 %                                       3.39 %
Net interest income
(tax equivalent) /
margin                                   $  24,896           3.35 %                   $  21,447           3.50 %
Less: tax-equivalent
adjustment(2)                                  (12 )                                         17
Net interest income                      $  24,884                                    $  21,430



(1) Annualized for the three month period.

(2) The tax-equivalent adjustment to net interest income adjusts the yield for

assets earning tax-exempt income to a comparable yield on a taxable basis.

(3) Includes mortgage loans held for sale.




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Our net interest margin (TE) decreased 15 basis points to 3.35% during the
second quarter of 2022, compared to the second quarter of 2021, primarily due to
a reduction in yield on our interest-earning assets combined with higher costs
on our interest-bearing liabilities. Our average interest-earning assets grew by
$528.7 million during the second quarter of 2022, while the average yield on
these assets decreased by five basis points to 3.66% during the same period. In
addition, our average interest-bearing liabilities grew by $382.6 million during
the second quarter of 2022, while the rate on these liabilities increased 15
basis points to 0.47%.



The increase in average interest-earning assets for the second quarter of 2022
related primarily to an increase of $555.0 million in our average loan balances.
The decrease in yield on our interest-earning assets was driven by a 19 basis
point decrease in loan yield as our loan portfolio has repriced at rates lower
than historic rates for the majority of the past 12 months. Following the
Federal Reserve's recent interest rate hikes, our loan yield has begun to
increase, resulting in a five basis point gain from 3.77% in the first quarter
of 2022.


The increase in our average interest-bearing liabilities during the second
quarter of 2022 resulted primarily from a $329.4 million increase in our
interest-bearing deposits and a $53.1 million increase in FHLB advances and
other borrowings, while the 15 basis point increase in rate on our
interest-bearing liabilities resulted primarily from a 15 basis point increase
in deposit rates.




Our net interest spread was 3.19% for the second quarter of 2022 compared to
3.39% for the same period in 2021. The net interest spread is the difference
between the yield we earn on our interest-earning assets and the rate we pay on
our interest-bearing liabilities. The decrease in the yield on our
interest-earning assets and the increase in the rate on our interest-bearing
liabilities resulted in a 20 basis point decrease in our net interest spread for
the 2022 period. We anticipate continued pressure on our net interest spread and
net interest margin in future periods as a significant portion of our loan
portfolio is at fixed rates which do not move with the Federal Reserve's
interest rate increases, while our deposit accounts reprice much more quickly.



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Average Balances, Income and Expenses, Yields and Rates

For the Six Months Ended June 30,

                                                             2022                                         2021
                             Average       Income/         Yield/         Average       Income/         Yield/
(dollars in thousands)       Balance       Expense        Rate(1)         Balance       Expense        Rate(1)
Interest-earning
assets
Federal funds sold and
interest-bearing
deposits with banks      $    84,980     $     239           0.57 %   $   104,449     $      99           0.19 %
Investment securities,
taxable                      105,771           829           1.58 %        85,222           458           1.08 %
Investment securities,
nontaxable(2)                 11,139           121           2.19 %        11,300           147           2.62 %
Loans(3)                   2,685,237        50,541           3.80 %     2,224,987        44,875           4.07 %
Total interest-earning
assets                     2,887,127        51,730           3.61 %     2,425,958        45,579           3.79 %
Noninterest-earning
assets                       153,618                                      109,928
Total assets             $ 3,040,745                                  $ 2,535,886
Interest-bearing
liabilities
NOW accounts             $   397,763           259           0.13 %   $   289,640            93           0.06 %
Savings & money market     1,254,768         1,818           0.29 %     1,108,059           824           0.15 %
Time deposits                218,741           675           0.62 %       194,781         1,087           1.13 %
Total interest-bearing
deposits                   1,871,272         2,752           0.30 %     1,592,480         2,004           0.25 %
FHLB advances and
other borrowings              35,004           118           0.68 %         1,419            78          11.08 %
Subordinated
debentures                    36,130           784           4.38 %        36,022           759           4.25 %
Total interest-bearing
liabilities                1,942,406         3,654           0.38 %     1,629,921         2,841           0.35 %
Noninterest-bearing
liabilities                  818,207                                      668,491
Shareholders' equity         280,132                                      237,474
Total liabilities and
shareholders' equity     $ 3,040,745                                  $ 2,535,886
Net interest spread                                          3.23 %                                       3.44 %
Net interest income
(tax equivalent) /
margin                                   $  48,076           3.36 %                   $  42,738           3.55 %
Less: tax-equivalent
adjustment(2)                                  (28 )                                         35
Net interest income                      $  48,048                                    $  42,703



During the first six months of 2022, our net interest margin (TE) decreased by
19 basis points to 3.36%, compared to 3.55% for the first six months of 2021,
driven by the decrease in yield on our interest-earning assets, combined with
the higher yield on our interest-bearing liabilities. Our average
interest-earning assets grew by $461.2 million from the prior year, with the
average yield decreasing by 18 basis points to 3.61%. In addition, our average
interest-bearing liabilities grew by $312.5 million, while the rate on these
liabilities increased three basis points to 0.38%.



The increase in average interest-earning assets for the first half of 2022
related primarily to a $460.3 million increase in our average loan balances. The
decrease in yield on our interest-earning assets was driven by a 27 basis point
decrease in our loan yield primarily related to the interest rate reductions by
the Federal Reserve which occurred during 2020. Recently, the yield on our loan
portfolio has begun to increase as the Federal Reserve has raised interest rates
by 150 basis points during the first six months of 2022.



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The increase in average interest-bearing liabilities for the first half of 2022
was driven by an increase in interest-bearing deposits of $278.8 million and a
$33.6 million increase in FHLB advances and other borrowings, while the increase
in cost was driven by a five basis point increase on our interest-bearing
deposits.



Our net interest spread was 3.23% for the first half of 2022 compared to 3.44%
for the same period in 2021. The 21 basis point decrease in our net interest
spread was driven by the 18 basis point decrease in yield on our
interest-earning assets.



Rate/Volume Analysis

Net interest income can be analyzed in terms of the impact of changing interest
rates and changing volume. The following tables set forth the effect which the
varying levels of interest-earning assets and interest-bearing liabilities and
the applicable rates have had on changes in net interest income for the periods
presented.




                                                                                                          Three Months Ended
                                                   June 30, 2022 vs. 2021                             June 30, 2021 vs. 2020
                                               Increase (Decrease) Due to                         Increase (Decrease) Due to
                                                        Rate/                                             Rate/
(dollars in thousands)       Volume         Rate       Volume       Total      Volume         Rate       Volume        Total
Interest income
Loans                       $ 5,417         (979 )       (237 )     4,201     $   980       (2,040 )        (85 )     (1,145 )
Investment securities            33          130           16         179         110         (175 )        (50 )       (115 )
Federal funds sold and
interest-bearing deposits
with banks                      (17 )        212          (68 )       127          10           (9 )         (1 )          -
Total interest income         5,433         (637 )       (289 )     4,507       1,100       (2,224 )       (136 )     (1,260 )
Interest expense
Deposits                        195          602          127         924         318       (2,781 )       (244 )     (2,707 )
FHLB advances and other
borrowings                    2,415           (2 )     (2,309 )       104        (175 )      3,501       (3,500 )       (174 )
Subordinated debentures           1           24            -          25           1          (36 )          -          (35 )
Total interest expense        2,611          624       (2,182 )     1,053         144          684       (3,744 )     (2,916 )
Net interest income         $ 2,822       (1,261 )      1,893       3,454     $   956       (2,908 )      3,608        1,656



Net interest income, the largest component of our income, was $24.9 million for
the second quarter of 2022 and $21.4 million for the second quarter of 2021, a
$3.5 million, or 16.2%, increase. The increase during 2022 was driven by a $4.5
million increase in interest income primarily due to higher volume of loans. In
addition, interest expense increased by $1.1 million due to an increase in
volume of FHLB advances and other borrowings at decreased rates.



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                                                                                                           Six Months Ended
                                                  June 30, 2022 vs. 2021                             June 30, 2021 vs. 2020
                                              Increase (Decrease) Due to                         Increase (Decrease) Due to
                                                       Rate/                                             Rate/
(dollars in thousands)      Volume         Rate       Volume       Total      Volume         Rate       Volume        Total
Interest income
Loans                      $ 9,012       (2,786 )       (560 )     5,666     $ 3,557       (5,230 )       (373 )     (2,046 )
Investment securities          120          191           41         352         254         (351 )       (113 )       (210 )
Federal funds sold and
interest-bearing
deposits with banks            (18 )        195          (37 )       140          67          (86 )        (37 )        (56 )
Total interest income        9,114       (2,400 )       (556 )     6,158       3,878       (5,667 )       (523 )     (2,312 )
Interest expense
Deposits                       400          232           45         677       1,016       (7,005 )       (808 )     (6,797 )
FHLB advances and other
borrowings                      70            2           40         112        (327 )      3,096       (3,025 )       (256 )
Subordinated debentures          2           22            -          24           3          (94 )         (1 )        (92 )
Total interest expense         472          256           85         813         692       (4,003 )     (3,834 )     (7,145 )
Net interest income        $ 8,642       (2,656 )       (641 )     5,345     $ 3,186       (1,664 )      3,311        4,833





Net interest income for the first half of 2022 was $48.0 million compared to
$42.7 million for 2021, a $5.3 million, or 12.5%, increase. The increase in net
interest income during 2022 was driven by a $6.2 million increase in interest
income, related primarily to loan growth.



Provision for Credit Losses


The provision for credit losses, which includes a provision for losses on
unfunded commitments, is a charge to earnings to maintain the allowance for
credit losses at a level consistent with management's assessment of expected
losses in the loan portfolio at the balance sheet date. On January 1, 2022, we
adopted the Current Expected Credit Loss (CECL) methodology for estimating
credit losses, which resulted in an increase of $1.5 million in our allowance
for credit losses and an increase of $2.0 million in our reserve for unfunded
commitments. The tax-effected impact of these two items amounted to $2.8 million
and was recorded as an adjustment to our retained earnings as of January 1,
2022. We review the adequacy of the allowance for credit losses on a quarterly
basis. Please see the discussion included in Note 1 - Summary of Significant
Accounting Policies and Note 4 - Loans and Allowance for Credit Losses for a
description of the factors we consider in determining the amount of the
provision we expense each period to maintain this allowance.



We recorded a $1.8 million provision for credit losses in the second quarter of
2022, compared to a $1.9 million reversal of provision expense in the second
quarter of 2021. We recorded a provision expense of $2.9 million and a provision
reversal of $2.2 million for the six months ended June 30, 2022 and June 30,
2021, respectively. The $1.8 million provision in 2022, which included a
$250,000 provision for unfunded commitments, was driven by $184.5 million in
loan growth during the second quarter, combined with a $52.2 million increase in
unfunded commitments. The $2.9 million provision expense for the first half of
2022 included a $330,000 provision for unfunded commitments.



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Noninterest Income

The following table sets forth information related to our noninterest income.


                                                 Three months ended          Six months ended
                                                           June 30,                  June 30,
(dollars in thousands)                            2022         2021          2022        2021
Mortgage banking income                     $    1,184        1,983         2,678       6,616
Service fees on deposit accounts                   209          173           400         358
ATM and debit card income                          563          521         1,092         991
Income from bank owned life insurance              315          331           630         598
Net lender and referral fees on PPP loans            -          268             -         268
Loss on disposal of fixed assets                  (394 )          -        
 (394 )         -
Other income                                       388          346           788         695
Total noninterest income                    $    2,265        3,622         5,194       9,526



Noninterest income decreased $1.4 million, or 37.5%, for the second quarter of
2022 as compared to the same period in 2021. The decrease in total noninterest
income resulted primarily from the following:



? Mortgage banking income decreased by $799,000, or 40.3%, driven by low

inventory in the housing market, lower refinance volumes, and a decrease in

margin on loan sales. We do not expect mortgage origination volume to continue

at levels seen in the prior year which will reduce the amount of mortgage

banking income recorded in future periods in comparison to prior periods.

? Net lender and referral fees on PPP loans were $268,000 during the second

quarter of 2021, while there were no fees received during the current period.

? Loss on disposal of assets of $394,000 was recorded during the second quarter

   of 2022 as we completed construction and relocated our headquarters in
   Greenville, South Carolina.



Noninterest income decreased $4.3 million, or 45.5%, during the first half of
2022 as compared to 2021. The decrease in total noninterest income resulted
primarily from decreases in mortgage banking income and the disposal of fixed
assets from our prior headquarters building.



Noninterest expenses


The following table sets forth information related to our noninterest expenses.




                                                 Three months ended          Six months ended
                                                           June 30,                  June 30,
(dollars in thousands)                            2022         2021         2022         2021
Compensation and benefits                   $    9,915        8,724       19,371       17,834
Occupancy                                        2,219        1,552        3,997        3,190
Real estate owned expenses                           -            1            -          388
Outside service and data processing costs        1,528        1,391       
3,062        2,704
Insurance                                          367          262          628          563
Professional fees                                  693          615        1,292        1,210
Marketing                                          329          208          596          398
Other                                              737          742        1,528        1,370
Total noninterest expense                   $   15,788       13,495       30,474       27,657




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Noninterest expense was $15.8 million for the second quarter of 2022, a $2.3
million, or 17.0%, increase from noninterest expense of $13.5 million for the
second quarter of 2021. The increase in noninterest expense was driven primarily
by the following:


? Compensation and benefits expense increased $1.2 million, or 13.7%, relating

primarily to annual salary increases and compensation and benefits expense

related to the hiring of new team members.

? Occupancy costs increased $667,000, or 43.0%, driven by increased rent expense

and depreciation on our new office in Charlotte, North Carolina, as well as

additional costs associated with the relocation of our headquarters.

? Insurance costs increased $105,000, or 40.1%, during the second quarter of 2022

related to higher FDIC insurance premiums.

? Outside service and data processing costs increased $137,000, or 9.8%, during

the second quarter of 2022 related to increased item processing and electronic

banking costs due to increased transactions.

? Marketing expenses increased $121,000, or 58.2%, due to an increase in

community outreach and sponsorships.





Noninterest expense was $30.5 million for the first half of 2022, a $2.8
million, or 10.2%, increase from noninterest expense of $27.7 million for the
first half of 2021. The increase in noninterest expense was driven primarily by
increases in compensation and benefits, occupancy, outside services and data
processing costs and marketing expenses as discussed above. Partially offsetting
these increases was a decrease in real estate owned expenses during the 2022
period.


Our efficiency ratio was 58.2% for the second quarter of 2022, compared to 53.9%
for the second quarter of 2021 and 57.2% for the first half of 2022 compared to
53.0% for the first half of 2021. The efficiency ratio represents the percentage
of one dollar of expense required to be incurred to earn a full dollar of
revenue and is computed by dividing noninterest expense by the sum of net
interest income and noninterest income. The higher ratio during the second
quarter of 2022, compared to the second quarter of 2021, relates primarily to
the decrease in mortgage banking income.



We incurred income tax expense of $2.3 million and $3.1 million for the three
months ended June 30, 2022 and 2021, respectively, and $4.7 million and $6.1
million for the six months ended June 30, 2022 and 2021, respectively. Our
effective tax rate was 23.5% and 22.7% for the six months ended June 30, 2022
and 2021, respectively. The higher tax rate during the first six months of 2022
relates to the lesser impact of equity compensation transactions during the
period.



Balance Sheet Review



Investment Securities
At June 30, 2022, the $104.1 million in our investment securities portfolio
represented approximately 3.2% of our total assets. Our available for sale
investment portfolio included corporate bonds, US treasuries, US government
agency securities, state and political subdivisions, asset-backed securities and
mortgage-backed securities with a fair value of $99.0 million and an amortized
cost of $111.8 million, resulting in an unrealized loss of $12.8 million. At
December 31, 2021, the $124.3 million in our investment securities portfolio
represented approximately 4.2% of our total assets, including investment
securities with a fair value of $120.3 million and an amortized cost of $121.2
million for an unrealized loss of $937,000.



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Loans

Since loans typically provide higher interest yields than other types of
interest earning assets, a substantial percentage of our earning assets are
invested in our loan portfolio. Average loans, excluding mortgage loans held for
sale, for the six months ended June 30, 2022 and 2021 were $2.67 billion and
$2.21 billion, respectively. Before the allowance for credit losses, total loans
outstanding at June 30, 2022 and December 31, 2021 were $2.85 billion and $2.49
billion, respectively.



The principal component of our loan portfolio is loans secured by real estate
mortgages. As of June 30, 2022, our loan portfolio included $2.43 billion, or
85.3%, of real estate loans, compared to $2.13 billion, or 85.5%, at December
31, 2021. Most of our real estate loans are secured by residential or commercial
property. We obtain a security interest in real estate, in addition to any other
available collateral, in order to increase the likelihood of the ultimate
repayment of the loan. Generally, we limit the loan-to-value ratio on loans to
coincide with the appropriate regulatory guidelines. We attempt to maintain a
relatively diversified loan portfolio to help reduce the risk inherent in
concentration in certain types of collateral and business types. Home equity
lines of credit totaled $161.5 million as of June 30, 2022, of which
approximately 50% were in a first lien position, while the remaining balance was
second liens. At December 31, 2021, our home equity lines of credit totaled
$154.8 million, of which approximately 49% were in first lien positions, while
the remaining balance was in second liens. The average home equity loan had a
balance of approximately $80,000 and a loan to value of 71% as of June 30, 2022,
compared to an average loan balance of $81,000 and a loan to value of
approximately 62% as of December 31, 2021. Further, 0.87% and 1.0% of our total
home equity lines of credit were over 30 days past due as of June 30, 2022 and
December 31, 2021, respectively.



Following is a summary of our loan composition at June 30, 2022 and December 31,
2021. During the first six months of 2022, our loan portfolio increased by
$355.3 million, or 14.3%, with a 13.8% increase in commercial loans while
consumer loans increased by 15.1% during the period. The majority of the
increase was in loans secured by real estate. Our consumer real estate portfolio
grew by $117.7 million and includes high quality 1-4 family consumer real estate
loans. Our average consumer real estate loan currently has a principal balance
of $468,000, a term of 22 years, and an average rate of 3.48% as of June 30,
2022, compared to a principal balance of $454,000, a term of 21 years, and an
average rate of 3.47% as of December 31, 2021.




                                                          June 30, 2022                December 31, 2021
(dollars in thousands)                          Amount       % of Total          Amount       % of Total
Commercial
Owner occupied RE                          $   551,544            19.39 %   $   488,965             19.6 %
Non-owner occupied RE                          741,263            26.05 %  
    666,833             26.8 %
Construction                                    84,612             2.97 %        64,425              2.6 %
Business                                       389,790            13.70 %       333,049             13.4 %
Total commercial loans                       1,767,209            62.11 %  
  1,553,272             62.4 %
Consumer
Real estate                                    812,130            28.54 %       694,401             27.9 %
Home equity                                    161,512             5.68 %       154,839              6.2 %
Construction                                    76,878             2.70 %        59,846              2.4 %
Other                                           27,476             0.97 %        27,519              1.1 %
Total consumer loans                         1,077,996            37.89 %       936,605             37.6 %
Total gross loans, net of deferred fees      2,845,205            100.0 %     2,489,877            100.0 %
Less-allowance for credit losses               (34,192 )                   
    (30,408 )
Total loans, net                           $ 2,811,013                      $ 2,459,469




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  Table of Contents



Nonperforming assets



Nonperforming assets include real estate acquired through foreclosure or deed
taken in lieu of foreclosure and loans on nonaccrual status. Generally, a loan
is placed on nonaccrual status when it becomes 90 days past due as to principal
or interest, or when we believe, after considering economic and business
conditions and collection efforts, that the borrower's financial condition is
such that collection of the contractual principal or interest on the loan is
doubtful. A payment of interest on a loan that is classified as nonaccrual is
recognized as a reduction in principal when received. Our policy with respect to
nonperforming loans requires the borrower to make a minimum of six consecutive
payments in accordance with the loan terms and to show capacity to continue
performing into the future before that loan can be placed back on accrual
status. As of June 30, 2022 and December 31, 2021, we had no loans 90 days
past
due and still accruing.



Following is a summary of our nonperforming assets, including nonaccruing TDRs.




                                             June 30,      December 31,
(dollars in thousands)                           2022              2021
Commercial                                 $      259               270
Consumer                                          383             1,642
Nonaccruing troubled debt restructurings        2,289             2,952
Total nonaccrual loans                          2,931             4,864
Other real estate owned                             -                 -
Total nonperforming assets                 $    2,931             4,864



At June 30, 2022, nonperforming assets were $2.9 million, or 0.09% of total
assets and 0.10% of gross loans. Comparatively, nonperforming assets were $4.9
million, or 0.17% of total assets and 0.20% of gross loans at December 31, 2021.
Nonaccrual loans decreased $1.9 million during the first six months of 2022 due
primarily to $724,000 of loans paid or charged off and $1.1 million of loans
returning to accruing status.



The amount of foregone interest income on nonaccrual loans in the first six
months of 2022 and 2021 was not material. At June 30, 2022 and 2021, the
allowance for credit losses represented 1,166.70% and 619.47% of the total
amount of nonperforming loans, respectively. A significant portion, or
approximately 92%, of nonperforming loans at June 30, 2022, was secured by real
estate. We have evaluated the underlying collateral on these loans and believe
that the collateral on these loans is sufficient to minimize future losses.



As a general practice, most of our commercial loans and a portion of our
consumer loans are originated with relatively short maturities of less than ten
years. As a result, when a loan reaches its maturity we frequently renew the
loan and thus extend its maturity using similar credit standards as those used
when the loan was first originated. Due to these loan practices, we may, at
times, renew loans which are classified as nonaccrual after evaluating the
loan's collateral value and financial strength of its guarantors. Nonaccrual
loans are renewed at terms generally consistent with the ultimate source of
repayment and rarely at reduced rates. In these cases, we will generally seek
additional credit enhancements, such as additional collateral or additional
guarantees to further protect the loan. When a loan is no longer performing in
accordance with its stated terms, we will typically seek performance under
the
guarantee.



In addition, at June 30, 2022, 85.3% of our loans were collateralized by real
estate and 92.2% of our impaired loans were secured by real estate. We utilize
third party appraisers to determine the fair value of collateral dependent
loans. Our current loan and appraisal policies require us to obtain updated
appraisals on an annual basis, either through a new external appraisal or an
appraisal evaluation. Impaired loans are individually reviewed on a quarterly
basis to determine the level of impairment. As of June 30, 2022, we did not have
any impaired real estate loans carried at a value in excess of the appraised
value. We typically charge-off a portion or create a specific reserve for
impaired loans when we do not expect repayment to occur as agreed upon under the
original terms of the loan agreement.



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At June 30, 2022, impaired loans totaled $5.0 million, for which $4.7 million of
these loans had a reserve of approximately $1.0 million allocated in the
allowance. During the first six months of 2022, the average recorded investment
in impaired loans was approximately $7.0 million. Comparatively, impaired loans
totaled $8.2 million at December 31, 2021 for which $2.9 million of these loans
had a reserve of approximately $836,000 allocated in the allowance. During 2021,
the average recorded investment in impaired loans was approximately $12.5
million.



We consider a loan to be a TDR when the debtor experiences financial
difficulties and we provide concessions such that we will not collect all
principal and interest in accordance with the original terms of the loan
agreement. Concessions can relate to the contractual interest rate, maturity
date, or payment structure of the note. As part of our workout plan for
individual loan relationships, we may restructure loan terms to assist borrowers
facing challenges in the current economic environment. As of June 30, 2022, we
determined that we had loans totaling $5.8 million that we considered TDRs
compared to $6.3 million as of December 31, 2021.



Allowance for Credit Losses


On January 1, 2022, we adopted CECL for estimating credit losses, which resulted
in an increase of $1.5 million in our allowance for credit losses and an
increase of $2.0 million in our reserve for unfunded commitments, which is
recorded within other liabilities. The tax-effected impact of those two items
amounted to $2.8 million and was recorded as an adjustment to our retained
earnings as of January 1, 2022. The allowance for loan loss accounting in effect
at December 31, 2021 and all prior periods was based on our estimate of probable
incurred loan losses as of the reporting date.



The allowance for credit losses was $34.2 million, representing 1.20% of
outstanding loans and providing coverage of 1,166.7%, of nonperforming loans at
June 30, 2022 compared to $30.4 million, or 1.22% of outstanding loans and
625.22% of nonperforming loans at December 31, 2021. At June 30, 2021, the
allowance for loan losses was $41.9 million, or 1.86% of outstanding loans and
619.47% of nonperforming loans. The adoption of CECL on January 1, 2022
increased the allowance for credit losses by $1.5 million. In addition, we
recorded a provision for credit losses of $1.5 million during the second quarter
of 2022 driven by the growth in our loan portfolio.



Following is a summary of the activity in the allowance for credit losses.



                                                 Six months ended         Year ended
                                                         June 30,       December 31,
(dollars in thousands)                          2022         2021               2021
Balance, beginning of period                $ 30,408       44,149          

44,149

Adjustment for adoption of CECL                1,500            -          

Provision for (reversal of) credit losses 2,550 (2,200 )

 (12,400 )
Loan charge-offs                                (485 )       (414 )           (2,166 )
Loan recoveries                                  219          377                825
Net loan (charge-offs)                          (266 )        (37 )           (1,341 )
Balance, end of period                      $ 34,192       41,912             30,408



Deposits and Other Interest-Bearing Liabilities


Our primary source of funds for loans and investments is our deposits and
advances from the FHLB. In the past, we have chosen to obtain a portion of our
certificates of deposits from areas outside of our market in order to obtain
longer term deposits than are readily available in our local market. Our
internal guidelines regarding the use of brokered CDs limit our brokered CDs to
20% of total deposits. In addition, we do not obtain time deposits of $100,000
or more through the Internet. These guidelines allow us to take advantage of the
attractive terms that wholesale funding can offer while mitigating the related
inherent risk.



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  Table of Contents


Our retail deposits represented $2.68 billion, or 93.5% of total deposits, while
our wholesale deposits represented $187.5 million, or 6.5%, of total deposits at
June 30, 2022. At December 31, 2021, retail deposits represented $2.56 billion,
or 100%, of our total deposits. Our loan-to-deposit ratio was 99% at June 30,
2022 and 97% at December 31, 2021.



The following is a detail of our deposit accounts:




                                                        June 30,       December 31,
(dollars in thousands)                                      2022               2021
Non-interest bearing                                 $   799,169            768,650
Interest bearing:
NOW accounts                                             364,189            401,788
Money market accounts                                  1,320,329          1,201,099
Savings                                                   41,944             39,696
Time, less than $250,000                                  62,340             68,179
Time and out-of-market deposits, $250,000 and over       282,187           
 84,414
Total deposits                                       $ 2,870,158          2,563,826




During the past 12 months, we continued our focus on increasing core deposits,
which exclude out-of-market deposits and time deposits of $250,000 or more, in
order to provide a relatively stable funding source for our loan portfolio and
other earning assets. Our core deposits were $2.59 billion and $2.48 billion at
June 30, 2022, and December 31, 2021, respectively.



The following table shows the average balance amounts and the average rates paid
on deposits.




                                                                       Six months ended
                                                                               June 30,
                                                        2022                       2021
(dollars in thousands)                     Amount       Rate          Amount       Rate
Noninterest-bearing demand deposits   $   769,844       0.00 %   $   621,934       0.00 %
Interest-bearing demand deposits          397,763       0.13 %       289,640       0.06 %
Money market accounts                   1,214,062       0.30 %     1,077,309       0.22 %
Savings accounts                           40,707       0.05 %        30,750       0.05 %
Time deposits less than $100,000           23,406       0.30 %        32,393       0.52 %
Time deposits greater than $100,000       195,334       0.39 %       161,997       0.91 %
Total deposits                        $ 2,641,116       0.19 %   $ 2,214,023       0.19 %




During the first six months of 2022, our average transaction account balances
increased by $427.1 million, or 19.3%, from the prior year, while our average
time deposit balances increased by $24,000, or 12.5%.



All of our time deposits are certificates of deposits. The maturity distribution
of our time deposits $250,000 or more at June 30, 2022 was as follows:




(dollars in thousands)             June 30, 2022
Three months or less             $       125,510
Over three through six months             69,975
Over six through twelve months            74,329
Over twelve months                        12,373
  Total                          $       282,187



Time deposits that meet or exceed the FDIC insurance limit of $250,000 at June
30, 2022
and December 31, 2021 were $282.2 million and $84.4 million,
respectively.



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  Table of Contents


Liquidity and Capital Resources




Liquidity represents the ability of a company to convert assets into cash or
cash equivalents without significant loss, and the ability to raise additional
funds by increasing liabilities. Liquidity management involves monitoring our
sources and uses of funds in order to meet our day-to-day cash flow requirements
while maximizing profits. Liquidity management is made more complicated because
different balance sheet components are subject to varying degrees of management
control. For example, the timing of maturities of our investment portfolio is
fairly predictable and subject to a high degree of control at the time
investment decisions are made. However, net deposit inflows and outflows are far
less predictable and are not subject to the same degree of control.



At June 30, 2022 and December 31, 2021 our cash and cash equivalents totaled
$182.1 million and $167.2 million, respectively, or 5.5% and 5.7% of total
assets, respectively. Our investment securities at June 30 2022 and December 31,
2021 amounted to $104.1 million and $124.3 million, respectively, or 3.2% and
4.2% of total assets, respectively. Investment securities traditionally provide
a secondary source of liquidity since they can be converted into cash in a
timely manner.



Our ability to maintain and expand our deposit base and borrowing capabilities
serves as our primary source of liquidity. We plan to meet our future cash needs
through the liquidation of temporary investments, the generation of deposits,
loan payoffs, and from additional borrowings. In addition, we will receive cash
upon the maturity and sale of loans and the maturity of investment securities.
We maintain five federal funds purchased lines of credit with correspondent
banks totaling $118.5 million for which there were no borrowings against the
lines of credit at June 30, 2022.



We are also a member of the FHLB, from which applications for borrowings can be
made. The FHLB requires that securities, qualifying mortgage loans, and stock of
the FHLB owned by the Bank be pledged to secure any advances from the FHLB. The
unused borrowing capacity currently available from the FHLB at June 30, 2022 was
$556.6 million, based primarily on the Bank's qualifying mortgages available to
secure any future borrowings. However, we are able to pledge additional
securities to the FHLB in order to increase our available borrowing capacity. In
addition, at June 30, 2022 and December 31, 2021 we had $315.2 million and
$254.5 million, respectively, of letters of credit outstanding with the FHLB to
secure client deposits.


We also have a line of credit with another financial institution for $15.0
million, which was unused at June 30, 2022. The line of credit was renewed on
December 21, 2021 at an interest rate of One Month CME Term SOFR plus 3.5% and a
maturity date of December 20, 2023.



We believe that our existing stable base of core deposits, federal funds
purchased lines of credit with correspondent banks, and borrowings from the FHLB
will enable us to successfully meet our long-term liquidity needs. However, as
short-term liquidity needs arise, we have the ability to sell a portion of our
investment securities portfolio to meet those needs.



Total shareholders' equity was $282.6 million at June 30, 2022 and $277.9
million at December 31, 2021. The $4.7 million increase from December 31, 2021
is primarily related to net income of $15.2 million during the first six months
of 2022 and stock option exercises and equity compensation expenses of $1.7
million, partially offset by a $9.4 million decrease in other comprehensive loss
and the tax-effected impact of $2.8 million of expense related to the adoption
of CECL recorded as an adjustment to retained earnings.



                                       43

  Table of Contents


The following table shows the return on average assets (net income divided by
average total assets), return on average equity (net income divided by average
equity), equity to assets ratio (average equity divided by average assets), and
tangible common equity ratio (total equity less preferred stock divided by total
assets) annualized for the six months ended June 30, 2022 and the year ended
December 31, 2021. Since our inception, we have not paid cash dividends.




                                           June 30, 2022       December 31, 2021
Return on average assets                            1.01 %                  1.75 %
Return on average equity                           10.95 %                 18.64 %
Return on average common equity                    10.95 %                 18.64 %
Average equity to average assets ratio              9.21 %                  9.39 %
Tangible common equity to assets ratio              8.60 %                 
9.50 %




Under the capital adequacy guidelines, regulatory capital is classified into two
tiers. These guidelines require an institution to maintain a certain level of
Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of
common shareholders' equity, excluding the unrealized gain or loss on securities
available for sale, minus certain intangible assets. In determining the amount
of risk-weighted assets, all assets, including certain off-balance sheet assets,
are multiplied by a risk-weight factor of 0% to 100% based on the risks believed
to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital
plus the general reserve for loan losses, subject to certain limitations. We are
also required to maintain capital at a minimum level based on total average
assets, which is known as the Tier 1 leverage ratio.



Regulatory capital rules, which we refer to Basel III, impose minimum capital
requirements for bank holding companies and banks. The Basel III rules apply to
all national and state banks and savings associations regardless of size and
bank holding companies and savings and loan holding companies other than "small
bank holding companies," generally holding companies with consolidated assets of
less than $3 billion (such as the Company). Although we had over $3 billion in
assets at June 30, 2022, under Federal Reserve guidance, the Company will
maintain its status as a "small bank holding company" until March 2023. In order
to avoid restrictions on capital distributions or discretionary bonus payments
to executives, a covered banking organization must maintain a "capital
conservation buffer" on top of our minimum risk-based capital requirements. This
buffer must consist solely of common equity Tier 1, but the buffer applies to
all three measurements (common equity Tier 1, Tier 1 capital and total capital).
The capital conservation buffer consists of an additional amount of CET1 equal
to 2.5% of risk-weighted assets.



To be considered "well-capitalized" for purposes of certain rules and prompt
corrective action requirements, the Bank must maintain a minimum total
risked-based capital ratio of at least 10%, a total Tier 1 capital ratio of at
least 8%, a common equity Tier 1 capital ratio of at least 6.5%, and a leverage
ratio of at least 5%. As of June 30, 2022, our capital ratios exceed these
ratios and we remain "well capitalized."



                                       44

  Table of Contents


The following table summarizes the capital amounts and ratios of the Bank and
the regulatory minimum requirements.




                                                                                                    June 30, 2022
                                                                    For capital            To be well capitalized
                                                              adequacy purposes                      under prompt
                                                               minimum plus the                        corrective
                                                           capital conservation                 action provisions
                                         Actual                          buffer                           minimum
(dollars in
thousands)                 Amount         Ratio           Amount          Ratio            Amount           Ratio

Total Capital (to
risk weighted assets) $ 347,708 13.45 % $ 271,451 10.50 % $ 258,525

           10.00 %

Tier 1 Capital (to
risk weighted assets) 315,369 12.20 % 219,746 8.50 % 206,820

            8.00 %
Common Equity Tier 1
Capital (to risk
weighted assets)          315,369         12.20 %        180,967           7.00 %         168,041            6.50 %
Tier 1 Capital (to
average assets)           315,369         10.01 %        125,964           4.00 %         157,455            5.00 %





                                                                                                December 31, 2021
                                                                    For capital            To be well capitalized
                                                              adequacy purposes                      under prompt
                                                               minimum plus the                        corrective
                                                           capital conservation                 action provisions
                                         Actual                          buffer                           minimum
(dollars in
thousands)                 Amount         Ratio           Amount          Ratio            Amount           Ratio

Total Capital (to
risk weighted assets) $ 331,052 14.36 % $ 242,048 10.50 % $ 230,522

           10.00 %

Tier 1 Capital (to
risk weighted assets) 302,217 13.11 % 195,944 8.50 % 184,418

            8.00 %
Common Equity Tier 1
Capital (to risk
weighted assets)          302,217         13.11 %        161,365           7.00 %         149,839            6.50 %
Tier 1 Capital (to
average assets)           302,217         10.55 %        114,537          
4.00 %         143,172            5.00 %






                                       45

  Table of Contents


The following table summarizes the capital amounts and ratios of the Company and
the minimum regulatory requirements.




                                                                                                      June 30, 2022
                                                                    For capital              To be well capitalized
                                                              adequacy purposes                        under prompt
                                                               minimum plus the                          corrective
                                                           capital conservation                   action provisions
                                         Actual                      buffer (1)                             minimum
(dollars in
thousands)                 Amount         Ratio           Amount          Ratio          Amount               Ratio

Total Capital (to
risk weighted assets) $ 361,119 13.97 % $ 271,451 10.50 %

           N/A                 N/A

Tier 1 Capital (to
risk weighted assets) 305,780 11.83 % 219,746 8.50 %

           N/A                 N/A
Common Equity Tier 1
Capital (to risk
weighted assets)          292,780         11.33 %        180,967           7.00 %           N/A                 N/A
Tier 1 Capital (to
average assets)           305,780          9.71 %        125,980           4.00 %           N/A                 N/A





                                                                                                  December 31, 2021
                                                                    For capital              To be well capitalized
                                                              adequacy purposes                        under prompt
                                                               minimum plus the                          corrective
                                                           capital conservation                   action provisions
                                         Actual                      buffer (1)                             minimum
(dollars in
thousands)                 Amount         Ratio           Amount          Ratio          Amount               Ratio

Total Capital (to
risk weighted assets) $ 343,476 14.90 % $ 242,048 10.50 %

           N/A                 N/A

Tier 1 Capital (to
risk weighted assets) 291,641 12.65 % 195,944 8.50 %

           N/A                 N/A
Common Equity Tier 1
Capital (to risk
weighted assets)          278,641         12.09 %        161,365           7.00 %           N/A                 N/A
Tier 1 Capital (to
average assets)           291,641         10.18 %        114,555           4.00 %           N/A                 N/A



(1) Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the

Company is not subject to the minimum capital adequacy and capital

conservation buffer capital requirements at the holding company level, unless

otherwise advised by the Federal Reserve (such capital requirements are

applicable only at the Bank level). Although the minimum regulatory capital

requirements are not applicable to the Company, we calculate these ratios for

     our own planning and monitoring purposes.




The ability of the Company to pay cash dividends is dependent upon receiving
cash in the form of dividends from the Bank. The dividends that may be paid by
the Bank to the Company are subject to legal limitations and regulatory capital
requirements. Since our inception, we have not paid cash dividends.



                                       46

  Table of Contents


Effect of Inflation and Changing Prices

The effect of relative purchasing power over time due to inflation has not been
taken into account in our consolidated financial statements. Rather, our
financial statements have been prepared on an historical cost basis in
accordance with generally accepted accounting principles.

Unlike most industrial companies, our assets and liabilities are primarily
monetary in nature. Therefore, the effect of changes in interest rates will have
a more significant impact on our performance than will the effect of changing
prices and inflation in general. In addition, interest rates may generally
increase as the rate of inflation increases, although not necessarily in the
same magnitude. As discussed previously, we seek to manage the relationships
between interest sensitive assets and liabilities in order to protect against
wide rate fluctuations, including those resulting from inflation.



Off-Balance Sheet Risk



Commitments to extend credit are agreements to lend money to a client as long as
the client has not violated any material condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses
and may require the payment of a fee. At June 30, 2022, unfunded commitments to
extend credit were $738.6 million, of which $273.8 million were at fixed rates
and $465.0 million were at variable rates. At December 31, 2021, unfunded
commitments to extend credit were $618.7 million, of which approximately $205.4
million were at fixed rates and $413.3 million were at variable rates. A
significant portion of the unfunded commitments related to commercial business
loans and consumer home equity lines of credit. We evaluate each client's credit
worthiness on a case-by-case basis. The amount of collateral obtained, if deemed
necessary by us upon extension of credit, is based on our credit evaluation of
the borrower. The type of collateral varies but may include accounts receivable,
inventory, property, plant and equipment, and commercial and residential real
estate. Following the adoption of CECL on January 1, 2022, we recorded a reserve
for unfunded commitments of $2.0 million, or 0.31% of total unfunded
commitments. As of June 30, 2022, the reserve for unfunded commitments was $2.3
million or 0.32% of total unfunded commitments.



At June 30, 2022 and December 31, 2021, there were commitments under letters of
credit for $12.3 million and $10.2 million, respectively. The credit risk and
collateral involved in issuing letters of credit is essentially the same as that
involved in extending loan facilities to customers. Since most of the letters of
credit are expected to expire without being drawn upon, they do not necessarily
represent future cash requirements.



Except as disclosed in this report, we are not involved in off-balance sheet
contractual relationships, unconsolidated related entities that have off-balance
sheet arrangements or transactions that could result in liquidity needs or other
commitments that significantly impact earnings.



Critical Accounting Estimates

We have adopted various accounting policies that govern the application of
accounting principles generally accepted in the United States and with general
practices within the banking industry in the preparation of our financial
statements.




Certain accounting policies inherently involve a greater reliance on the use of
estimates, assumptions and judgments and, as such, have a greater possibility of
producing results that could be materially different than originally reported,
which could have a material impact on the carrying values of our assets and
liabilities and our results of operations. Of the significant accounting
policies used in the preparation of our consolidated financial statements, we
have identified certain items as critical accounting policies based on the
associated estimates, assumptions, judgments and complexity. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations-Critical Accounting Estimates" in our Annual Report on Form 10-K for
the year ended December 31, 2021, for a description our significant accounting
policies that use critical accounting estimates.



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We have historically identified the determination of the allowance for loan
losses as a significant accounting policy that uses critical accounting
estimates. On January 1, 2022, we adopted the new CECL accounting methodology
that requires entities to estimate and recognize an allowance for lifetime
expected credit losses for loans and other financial assets measured at
amortized cost. In prior periods, our allowance was based on the incurred loss
methodology where we recognized an allowance for loan losses based on probable
incurred losses. We believe that the accounting estimates relating to the
allowance for credit losses is also a "critical accounting policy" as:



? changes in the provision for credit losses can materially affect our financial

results;

? estimates relating to the allowance for credit losses require us to project

future borrower performance, including cash flows, delinquencies and

charge-offs, along with, when applicable, collateral values, based on a

reasonable and supportable forecast period utilizing forward-looking economic

scenarios in order to estimate lifetime probability of default and loss given

default;

? the allowance for credit losses is influenced by factors outside of our control

such as changes in projected economic conditions, real estate markets or

particular industry conditions which may materially impact asset quality and

the adequacy of the allowance for credit losses; and

? considerable judgment is required to determine whether the models used to

generate the allowance for credit losses produce an estimate that is sufficient

   to encompass the current view of lifetime expected credit losses.




Because our estimates of the allowance for credit losses involve judgment and
are influenced by factors outside our control, there is uncertainty inherent in
these estimates. Our estimate of lifetime expected credit losses is inherently
uncertain because it is highly sensitive to changes in economic conditions and
other factors outside of our control. Changes in such estimates could
significantly impact our allowance and provision for credit losses. See Note 1 -
Summary of Significant Accounting Policies in the accompanying notes to the
consolidated financial statements included elsewhere in this report for a
discussion of our Allowance for Credit Losses.



Accounting, Reporting, and Regulatory Matters

See Note 1 - Summary of Significant Accounting Policies in the accompanying
notes to consolidated financial statements included elsewhere in this report for
details of recently issued accounting pronouncements and their expected impact
on our consolidated financial statements.



Other accounting standards that have been issued or proposed by the FASB or
other standards-setting bodies that do not require adoption until a future date
are not expected to have a material impact on the consolidated financial
statements upon adoption.

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