SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2022
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 001-38280
Stellar Bancorp, Inc.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction
of incorporation or organization)
9 Greenway Plaza, Suite 110
Houston, Texas 77046
(Address of principal executive offices, including zip code)
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
|Title of each class||Trading Symbol(s)||Name of each exchange on which registered|
|Common stock, par value $0.01 per share||STEL||The Nasdaq Stock Market LLC|
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.:
|Large Accelerated Filer||£||Accelerated Filer|
|Non-accelerated Filer||£||Smaller Reporting Company||£|
|Emerging growth company||£|
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. £
Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. Yes S No £
If securities are registered pursuant to Section 12(b) of the Act, indicated by check mark whether the financial statements of the registrant included in the filing reflect a correction of an error in previously issued financial statements. £
Indicate by check mark whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant's executive officers during the relevant recover period pursuant to §240.1D-1(b). £
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No S
The aggregate market value of the shares of common stock held by non-affiliates based on the closing price per share of the registrant’s common stock as reported on the NASDAQ Stock Market LLC on June 30, 2022 was approximately $483.7 million.
As of March 10, 2023, there were 52,974,885 shares of the registrant's common stock, $0.01 par value, outstanding.
Documents Incorporated by Reference:
Portions of the Proxy Statement relating to the 2023 Annual Meeting of Shareholders of Stellar Bancorp, Inc., which will be filed within 120 days after December 31, 2022, are incorporated by reference into Part III, Items 10-14 of this Annual Report on Form 10-K.
STELLAR BANCORP, INC.
2022 ANNUAL REPORT ON FORM 10-K
Except where the context otherwise requires or where otherwise indicated in this Annual Report on Form 10-K the term “Stellar” refers to Stellar Bancorp, Inc., the terms “we,” “us,” “our,” “Company” and “our business” refer to Stellar Bancorp, Inc. and our wholly owned banking subsidiary, Stellar Bank, a Texas banking association, and the terms “Stellar Bank” or the “Bank” refer to Stellar Bank.
ITEM 1. BUSINESS
The disclosures set forth in this item are qualified by Item 1A. “Risk Factors,” and; the section captioned “Cautionary Notice Regarding Forward-Looking Statements” in the forepart of this report, Item 7. “Cautionary Notice Regarding Forward-Looking Statements” and other cautionary statements set forth elsewhere in this Annual Report on Form 10-K.
Merger of Equals
On October 1, 2022, Allegiance Bancshares, Inc. (“Allegiance”) and CBTX, Inc. (“CBTX”) merged (the “Merger”) with CBTX as the surviving corporation that was renamed Stellar Bancorp, Inc. and the ticker symbol changed to “STEL.” At the effective time of the Merger, each outstanding share of Allegiance common stock, par value of $1.00 per share, was converted into the right to receive 1.4184 shares of common stock of the Company.
Immediately following the Merger, CommunityBank of Texas, N.A. (“CommunityBank”), a national banking association and a wholly-owned subsidiary of CBTX, merged with and into Allegiance Bank, a wholly-owned subsidiary of Allegiance (the “Bank Merger”), with Allegiance Bank as the surviving bank. In connection with the operational conversion during the first quarter of 2023, Allegiance Bank changed its name to Stellar Bank on February 18, 2023. After the merger, Stellar became one of the largest banks based in Houston.
The Merger constituted a business combination and was accounted for as a reverse merger using the acquisition method of accounting. As a result, Allegiance was the accounting acquirer and CBTX was the legal acquirer and the accounting acquiree. Accordingly, the historical financial statements of Allegiance became the historical financial statements of the combined company. In addition, the assets and liabilities of CBTX have been recorded at their estimated fair values and added to those of Allegiance as of October 1, 2022. The determination of fair value required management to make estimates about discount rates, expected future cash flows, market conditions and other future events that are subjective and subject to change.
The Company’s results of operations for the year ended December 31, 2022 reflect Allegiance results for the first nine months of 2022, while the results for the fourth quarter of 2022, after the Merger on October 1, 2022, set forth the results of operations for Stellar. The Company’s historical operating results as of and for the years ended December 31, 2021 and 2020, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. The Company has substantially completed its valuations of CBTX’s assets and liabilities but may refine those valuations for up to a year from the date of the Merger. The Merger had a significant impact on all aspects of the Company’s financial statements, and financial results for periods after the Merger are not comparable to financial results for periods prior to the Merger. The number of shares issued and outstanding, earnings per share, additional paid-in capital, dividends paid per share and all references to share quantities of the Company have been retrospectively adjusted to reflect the equivalent number of shares issued to holders of Allegiance common stock in the Merger. See Note 2 – Acquisitions in the accompanying notes to the consolidated financial statements for the impact of the Merger.
The Company is a Texas corporation and registered bank holding company headquartered in Houston, Texas. We refer to the Houston-The Woodlands-Sugar Land metropolitan statistical area (“MSA”), as the Houston region (“Houston region”) and the Beaumont-Port Arthur MSA, as the Beaumont region (“Beaumont region”). As of December 31, 2022, we operated 60 full-service banking centers, with 43 banking centers in the Houston region, 16 banking centers in the Beaumont region and one banking center in Dallas, Texas, which we collectively refer to as our markets. In February 2023, we consolidated five of the Houston banking centers in connection with the change of the bank’s name to Stellar Bank.
Through its wholly-owned subsidiary, Stellar Bank, the Company provides a diversified range of commercial banking services primarily to small- to medium-sized businesses, professionals and individual customers within our markets. We believe the size, growth and increasing economic diversity of our market, when combined with our community banking strategy, provides us with excellent opportunities for long-term, sustainable growth. Our community banking strategy, which is described in more detail below, is designed to foster strong customer relationships while benefitting from a platform and scale that is competitive with larger regional
and national banks. We believe this strategy presents a significant market advantage for serving small- to medium-sized business customers and further enables us to attract talented bankers.
As of December 31, 2022, we had total assets of $10.9 billion, total gross loans of $7.75 billion, total deposits of $9.27 billion and total shareholders’ equity of $1.38 billion.
The Company’s objective is to grow and strengthen its banking franchise through its community banking strategy and strategic acquisitions. The Company is a leading provider of customized commercial banking services to small- and medium-sized business in our markets by providing superior customer service and by leveraging the strength and capabilities of local management.
Community banking strategy. Our community banking strategy leverages local delivery of the stellar customer service associated with community banking combined with the products, efficiencies and scale associated with larger banks. By empowering our personnel to make certain business decisions at a local level in order to respond quickly to customers’ needs, we are able to establish and foster strong relationships with customers through superior service. We operate full-service banking centers and employ bankers with strong underwriting credentials who are authorized to make loan and underwriting decisions up to prescribed limits at the banking center level. We support banking center operations with a centralized credit approval process for larger credit relationships, loan operations, information technology, core data processing, accounting, finance, treasury and treasury management support, deposit operations and executive and board oversight. We emphasize lending to and banking with small- to medium-sized businesses, with which we believe we can establish stronger relationships through excellent service and provide lending that can be priced on terms that are more attractive to the Company than would be achieved by lending to larger businesses. We believe this approach produces a competitive advantage by delivering an extraordinary customer experience and fostering a culture dedicated to achieving superior external and internal service levels.
We will leverage our community banking strategy to organically grow our banking franchise through:
•increasing the productivity of existing bankers, as measured by loans, deposits and fee income per banker, while enhancing profitability by leveraging our existing operating platform;
•focusing on local decision-making, allowing us to provide customers with timely decisions on loan requests, which we believe allows us to effectively compete with larger financial institutions;
•preserving a culture of risk management;
•identifying and hiring additional seasoned bankers who will thrive within a locally-focused community banking model; and
•broadening our financial services offerings and technology adoption to better serve our customer base's evolving needs while increasing operational efficiency.
Strategic acquisitions. We intend to continue to expand our presence through organic growth and a disciplined acquisition strategy. We generally focus on like-minded community banks with similar strategies to our own when evaluating acquisition opportunities and will also consider strategic non-bank acquisition opportunities that complement our growth strategy. We believe that our management’s experience in assessing, executing and integrating target institutions will allow us to capitalize on acquisition opportunities.
Competitive Strengths. We believe that we are well positioned to execute our community banking strategy as a result of the following competitive strengths:
•Experienced, growth-focused senior management team. Our senior management team has a demonstrated track record of managing profitable organic growth, improving operating efficiencies, maintaining a strong risk management culture, implementing a community and service-focused approach to banking and successfully executing and integrating acquisitions.
•Scalable banking and operational platform designed to foster and accommodate significant growth. We believe in the value of scale in banking and our operating platform and strategy is designed for growth. We have made extensive investments in the technology and systems necessary to build a scalable corporate infrastructure with the capacity to support continued growth. Our recently completed Merger better positions us to effectively invest in technology and be more future-focused than smaller banks. We believe that our scalable operating platform will effectively support growth, resulting in greater efficiency and enhanced profitability.
•Community-focused, full service customer relationships. We believe that our community banking strategy facilitates strong relationships with our customers. We are focused on delivering a wide variety of high-quality, relationship-driven commercial and community-oriented banking products and services tailored to meet the needs of small- to medium-sized businesses, professionals and individuals in our markets. We actively solicit the deposit business of our consumer and commercial loan customers and seek to deepen these relationships with additional products and services.
•Local decision making authority. Recent acquisitions of many local financial institutions in our markets by larger, more regionally focused competitors have led to a reduced number of locally-based competitors, and we believe this has created an underserved base of small- to medium-sized businesses, professionals and individuals that are interested in banking with a company headquartered in, and with decision-making authority based in our markets. We seek to develop comprehensive, long-term banking relationships with customers and offer an array of products and services to support our loan and deposit activities. Our products and services are tailored to address the needs of our targeted customers and we believe positions us well to compete effectively and build strong customer relationships.
•Focus on seasoned bankers. We believe our management team’s long-standing presence and experience in our markets gives us valuable insight into the local market and the ability to successfully develop and recruit talented bankers. Our team of seasoned bankers has been the driver of our organic growth. Our officer compensation structure, which includes equity grants and various incentive programs, attracts talented bankers and motivates them to increase the size of their loan and deposit portfolios and generate fee income while maintaining strong credit quality.
•Disciplined underwriting and credit administration. Our management, bankers and credit administration team emphasize a strong culture of risk management that is supported by comprehensive policies and procedures for credit underwriting, funding and administration that enable us to maintain sound asset quality. The Company’s underwriting methodology emphasizes analysis of global cash flow coverage, loan to collateral value and obtaining personal guaranties in all but a nominal number of cases. Our tiered underwriting structure includes progressive levels of individual loan authority, concurrence authority and senior level loan committee approval. We intend to continue to emphasize and adhere to these procedures and controls, which we believe have helped to minimize our level of loan charge-offs.
•Quality loan portfolio. The Company’s focus on loans to small- to medium-sized businesses results in a more diffused portfolio of relatively smaller loan relationships, thus which we believe reduces the risk relative to a dependence on significantly larger lending relationships. We define core loans as total loans excluding Paycheck Protection Program loans. As of December 31, 2022, our average funded core loan size was approximately $452 thousand.
Community Banking Services
We offer a wide range of commercial and retail lending services, including commercial loans, loans to small businesses guaranteed by the Small Business Administration (the “SBA”), mortgage loans, home equity loans, personal loans and automobile loans, among others, specifically designed for small- to medium-sized businesses and companies, professionals and individuals generally located within Texas and primarily in our markets. We also offer factoring services through American Prudential Capital, Inc., a wholly-owned subsidiary of the Bank. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition—Loan Portfolio” for a more detailed discussion of the Company’s lending activities.
Deposits are our principal source of funds for use in lending and other general banking purposes. We offer a variety of deposit products and services with the goal of attracting a wide variety of customers, with an emphasis on small- to medium-sized businesses. The types of deposit accounts that the Company offers are typical of most commercial banks and consist of checking accounts, commercial accounts, money market accounts, savings accounts and other time deposits of various types and terms. We actively pursue business checking accounts by offering our business customers competitive rates and convenient services such as telephone, mobile and online banking. Our deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”) to the fullest extent permitted by law. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition—Deposits” for a more detailed discussion of the Company’s deposit products.
Other Banking Services
We offer basic banking products and services, which we believe are attractively priced, easily understood, convenient and readily accessible to our customers. In addition to banking during normal business hours, we offer extended drive-through hours, ATMs, mobile banking and banking by telephone, mail and Internet. Customers can conveniently access their accounts by phone, through a mobile application for smartphones and tablets, as well as through Internet banking that allows customers to obtain account balances, make deposits, transfer funds, pay bills online and receive electronic delivery of statements. We also provide safe deposit boxes, debit cards, cash management and wire transfer services, night depository, direct deposits, cashier’s checks and letters of credit. We have established relationships with correspondent banks and other independent financial institutions to provide other services requested by customers, including loan participations sold when the requested loan amount exceeds the lending limits in our lending policies.
We compete in the highly competitive commercial banking industry through the Bank and firmly believe that the Bank’s presence in the community and philosophy of personalized service enhances our ability to attract and retain customers. The Bank faces strong direct competition for deposit funds, lending opportunities, talented bankers, acquisition candidates and other financial-related services.
We compete primarily with other commercial banks, savings banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based nonbank lenders and certain other nonfinancial entities, including retail stores that may maintain their own credit programs and certain governmental organizations, all of which are actively engaged in providing various types of loans and other financial services that may offer more favorable financing than we are able to offer. Although some of our competitors are situated locally, others have statewide or nationwide presence. We believe that we are able to compete with other financial institutions because of our experienced banking professionals, the range and quality of products that we offer, our responsive decision-making with respect to loans and our emphasis on customer service, thereby establishing strong customer relationships and building customer loyalty that distinguishes us from our competitors.
We rely heavily on the continued business our bankers generate and the efforts of our officers and directors to solicit and refer potential customers, and we expect this reliance to continue for the foreseeable future. We believe that our recent market share gains in our geographic areas of operation are a reflection of our ability to effectively compete with the larger banks in our markets most of which are based out of state.
Human Capital Overview
We focus on attracting, developing and engaging high caliber talent focused on serving and fulfilling the needs of each of our identified constituencies. We have developed and created a unique culture where we empower people to thrive each day and believe in the power of local, and pursue a shared vision of success.
As a testament to our culture and our commitment to excellence, for the thirteenth consecutive year, the Bank was named a Top Workplace in Houston by the Houston Chronicle and this year we ranked number three in the large company category with 500 plus employees.
As of December 31, 2022, we employed approximately 1,025 full-time equivalent employees. None of our employees were represented by a collective bargaining unit or are party to a collective bargaining agreement. We believe our commitment to employee development and engagement decreases turnover and benefits our operating strategies.
We are committed to implementing diverse, equitable and inclusive policies and practices across the organization. Our corporate values speak directly to the spirit of inclusion as well as the importance of embracing diversity and equitable practices to ensure we are representative of the communities we serve. We are committed to building togetherness and a culture where integrity, personal responsibility, extraordinary communication and servant leadership are the center of all that we do.
We continuously focus our efforts on recruiting, employing and advancing talented individuals, and our efforts include among many considerations, race and gender diversity. We monitor our workforce demographics on a routine basis and take pride in the diverse talent we employ and retain.
As of December 31, 2022, the race and gender diversity of our workforce was as follows:
|Number of Employees (Headcount)|
|Percentage of Women|
(1) Of the 1,014 employee headcount, 19 did not disclose their race, therefore, the percentage of non-white employees in the table is based on 995 employees.
Learning and Development
We have a very robust learning and development program that provides numerous offerings to help employees achieve their career goals. The program offers management excellence courses, leadership development programs and communication and technology courses (to name a few) as part of our commitment to help engage and retain talent. Our investment in the growth and development of our employees serves as part of our short and long-term succession strategy to ensure we are developing the appropriate leadership and management pipelines for continuity purposes. Our strategy also includes developing individuals for key and critical roles to ensure the Bank is prepared to meet its growth goals.
Additionally, our employees receive continuing education courses that are relevant to the banking industry and their job function. All of these resources provide employees with the skills and knowledge necessary for them to fulfill their career aspirations as well as agile talent that is ready to move up and/or across the organization when ready and needed.
As part of our commitment to employee development, as well as to advance our diversity, equity and inclusion strategy, we entered into a partnership with Texas Southern University, a historically black university located in the Houston metropolitan area, to debut an endowed bankers program, which started in the Fall of 2021, to train the next diverse generation of bankers in an industry that has historically lacked diversity. The goal is to educate and prepare bankers to provide banking and financial education services to underrepresented communities that have traditionally lacked access to such services. Participants enroll in courses that range from financial technology and commercial bank management to lending activities and accreditation analysis and are taught by banking executives with extensive experience in the industry.
Compensation and Benefits
We provide a competitive compensation and benefits program to help attract, retain and meet the needs of our employees. In addition to providing competitive salaries, we offer performance-based incentive compensation in the form of an annual bonus and stock awards program to officers and a 401(k) Plan with an employer matching contribution. Additionally, we offer healthcare and insurance benefits, health savings and flexible spending accounts, paid time-off, family leave and an employee assistance program.
The Company’s website address is www.stellar.bank. We make available free of charge on or through our investor relations website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), as soon as reasonably practicable after such materials are electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). Information contained on our website is not incorporated by reference into this Annual Report on Form 10-K and is not part of this or any other report that we file with or furnish to the SEC.
Regulation and Supervision
The U.S. banking industry is highly regulated under federal and state law. These laws and regulations affect the operations and performance of the Company and its subsidiaries.
Statutes, regulations and policies limit the activities in which we may engage and how we conduct certain permitted activities. Further, the bank regulatory system imposes reporting and information collection obligations. We incur significant costs related to compliance with these laws and regulations. Banking statutes, regulations and policies are continually under review by federal and state legislatures and regulatory agencies, and a change in them, including changes in how they are interpreted or implemented, could have a material adverse effect on our business.
The material statutory and regulatory requirements that are applicable to us and our subsidiaries are summarized below. The description below is not intended to summarize all laws and regulations applicable to us and our subsidiaries, and is based upon the statutes, regulations, policies, interpretive letters and other written guidance that are in effect as of the date of this Annual Report on Form 10-K.
Bank Holding Company and Bank Regulation
The Company is a legal entity separate and distinct from the Bank and its other subsidiaries. As a bank holding company, the Company is regulated under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and it and its subsidiaries are subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (‘Federal Reserve”). As a bank holding company of a Texas state chartered bank, the Company is also subject to supervision, regulation, examination and enforcement by the Texas Department of Banking (“TDB”) and the FDIC.
The Bank is a Texas-chartered banking association, the deposits of which are insured by the FDIC’s Deposit Insurance Fund. up to applicable legal limits. The Bank is not a member of the Federal Reserve System; therefore, the Bank is subject to ongoing and comprehensive supervision, regulation, examination and enforcement by the TDB and the FDIC.
Broad Supervision, Examination and Enforcement Powers
The primary objectives of the U.S. bank regulatory system are to protect depositors by ensuring the financial safety and soundness of banking organizations, facilitate the conduct of sound monetary policy and promote fairness and transparency for financial products and services. To that end, the banking regulators have broad regulatory, examination and enforcement authority and regularly examine the operations of banking organizations.
The regulators have various remedies available if they determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of a banking organization’s operations are unsatisfactory. The regulators may also take action if they determine that the banking organization or its management is violating or has violated any law or regulation or has engaged in unsafe or unsound banking practices. The regulators have the power to, among other things:
•require affirmative actions to correct any violation or practice;
•issue administrative orders that can be judicially enforced;
•direct increases in capital;
•direct the sale of subsidiaries or other assets;
•limit dividends and distributions;
•assess civil monetary penalties;
•remove officers and directors; and
•terminate deposit insurance.
The Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) mandates certain requirements on the financial services industry, including, among many other things: (1) enhanced resolution authority with respect to troubled or failing banks and their holding companies, (2) increased regulatory examination fees, (3) the creation of the Consumer Financial Protection Board (the “CFPB”), and (4) numerous other provisions designed to improve supervision and oversight of, and strengthen safety and soundness within, the financial services sector.
Under the Durbin Amendment to the Dodd-Frank Act, the Federal Reserve adopted rules establishing standards for assessing whether the interchange fees that may be charged with respect to certain electronic debit transactions are “reasonable and proportional” to the costs incurred by issuers for processing such transactions. Interchange fees, or “swipe” fees, are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. Federal Reserve rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction is the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. An upward adjustment of no more than 1 cent to an issuer's debit card interchange fee is allowed if the card issuer develops and implements
policies and procedures reasonably designed to achieve certain fraud-prevention standards. The Federal Reserve also has rules governing routing and exclusivity that require issuers to offer two unaffiliated networks for routing transactions on each debit or prepaid product.
The Volcker Rule
The Volcker Rule under the Dodd-Frank Act restricts banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain hedge funds and private equity funds. Since neither the Company nor the Bank engages in the types of trading or investing covered by the Volcker Rule, the Volcker Rule does not currently have any effect on our operations.
Source of Strength
Under Federal Reserve policy and federal regulations, bank holding companies are required to act as a source of financial and managerial strength to their subsidiary banks. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when the Company may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
Notice and Approval Requirements Related to Control
Federal and state banking laws impose notice, application, approval or non-objection and ongoing regulatory requirements on any shareholder or other person that controls or seeks to acquire direct or indirect “control” of an FDIC-insured depository institution. These laws include the BHC Act, the Change in Bank Control Act and the Texas Banking Act. Among other things, these laws require regulatory filings by a shareholder or other person that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution. The determination whether a person “controls” a depository institution or its holding company is based on all of the facts and circumstances surrounding the investment. As a general matter, a person is deemed to control a depository institution or other company if the person owns or controls 25% or more of any class of voting stock. Subject to rebuttal, a person may be presumed to control a depository institution or other company if the person owns or controls 10% or more of any class of voting stock and other regulatory criteria are met. Ownership by affiliated persons, or persons acting in concert, is typically aggregated for these purposes.
In January 2020, the Federal Reserve approved a final rule that clarifies the framework for when a company controls a bank holding company or bank under the BHC Act. In particular, the final rule sets forth tiered presumptions of control in the Federal Reserve’s regulations. Under the BHC Act, a company controls a bank holding company if it controls 25 percent or more of any class of voting securities of the bank holding company. A company that controls less than 5 percent of any class of voting securities of a bank holding company is presumed not to control the bank holding company. In instances in which a company owns at least 5 percent but less than 25 percent, the Federal Reserve considers the full fact and circumstances of the relationship between the company and the bank holding company to determine whether the company controls the bank holding company. As part of its determination as to control, the Federal Reserve considers, among other things, level of ownership of voting and non-voting securities, board representation, business relationships, senior management interlocks, contractual limits on major operational or policy decisions, proxies on issues, threats to dispose of securities and management agreements. The rule also provides several additional examples of presumptions of control and noncontrol, along with various ancillary provisions such as definitions of terms used in the presumptions. The changes in the final rule became effective September 30, 2020.
Permissible Activities and Investments
Banking laws generally restrict our ability to engage in, or acquire more than 5% of the voting shares of a company engaged in, activities other than those determined by the Federal Reserve to be so closely related to banking as to be a proper incident thereto. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “GLB Act”) expanded the scope of permissible activities for a bank holding company that qualifies as a financial holding company. Under the regulations implementing the GLB Act, a financial holding company may engage in additional activities that are financial in nature or incidental or complementary to a financial activity. Those activities include, among other activities, certain insurance and securities activities. Qualifications for becoming a financial holding company include, among other things, meeting certain specified capital standards and achieving certain management ratings in examinations. Under the Dodd-Frank Act, bank holding companies and their subsidiaries must be well-capitalized and well-managed in order for the bank holding company and its nonbank affiliates to engage in the expanded financial activities permissible only for a financial holding company. The Company has not elected to pursue financial holding company status.
In addition, as a general matter, we must receive prior regulatory approval before establishing or acquiring a depository institution or, in certain cases, a non-bank entity.
The Texas Constitution, as amended in 1986, provides that a Texas-chartered bank has the same rights and privileges that are or may be granted to national banks domiciled in Texas. To the extent that the Texas laws and regulations may have allowed state-chartered banks to engage in a broader range of activities than national banks, the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), has operated to limit this authority. The FDICIA provides that no state bank or subsidiary thereof may engage as a principal in any activity not permitted for national banks, unless the institution complies with applicable capital requirements and the FDIC determines that the activity poses no significant risk to the Deposit Insurance Fund of the FDIC. In general, statutory restrictions on the activities of banks are aimed at protecting the safety and soundness of depository institutions.
Texas law provides that a Texas-chartered bank can establish a branch anywhere in Texas provided that the branch is approved in advance by the TDB. The branch must also be approved by the FDIC. The regulators consider a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers. The Dodd-Frank Act permits insured state banks to engage in de novo interstate branching if the laws of the state where the new branch is to be established would permit the establishment of the branch if it were chartered by such state.
Regulatory Capital Requirements and Capital Adequacy
The bank regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital relative to the amount and types of assets they hold. The final supervisory determination on an institution’s capital adequacy is based on the regulator’s assessment of numerous factors. As a bank holding company and a state-chartered non-member bank, the Company and the Bank are subject to both risk-based and leverage regulatory capital requirements.
The Company and the Bank are required to comply with applicable capital adequacy standards adopted by the Federal Reserve and the FDIC (the “Basel III Capital Rules”). The Basel III Capital Rules, among other things, require the Company to maintain an additional capital conservation buffer, composed entirely of Common Equity Tier 1 (“CET1”), of 2.50%, effectively resulting in minimum ratios of (1) CET1 to risk-weighted assets of 7.00%, (2) Tier 1 capital to risk-weighted assets of 8.50%, (3) total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of 10.50% and (4) Tier 1 capital to average quarterly assets as reported on consolidated financial statements (known as the “leverage ratio”) of 4.00%. As of December 31, 2022, the Company’s ratio of CET1 to risk-weighted assets was 10.04%, Tier 1 capital to risk-weighted assets was 10.15%, total capital to risk-weighted assets was 12.39% and Tier 1 capital to average tangible quarterly assets was 8.55%.
Banking institutions that fail to meet the effective minimum ratios once the capital conservation buffer is taken into account, as detailed above, will be subject to constraints on capital distributions, including dividends and share repurchases, and certain discretionary executive compensation. The severity of the constraints depends on the amount of the shortfall and the institution’s “eligible retained income” (that is, four quarter trailing net income, net of distributions and tax effects not reflected in net income).
The Basel III Capital Rules also changed the capital categories for insured depository institutions for purposes of prompt corrective action as discussed below under “Prompt Corrective Action”. Under the Basel III Capital Rules, to be well capitalized, an insured depository institution is required to maintain a minimum common equity Tier 1 capital ratio of at least 6.5%, a tier 1 risk-based capital ratio of at least 8.0%, a total risk-based capital ratio of at least 10.0%, and a leverage capital ratio of at least 5.0%. In addition, the Basel III Capital Rules established more conservative standards for including an instrument in regulatory capital and impose certain deductions from and adjustments to the measure of common equity Tier 1 capital.
Under the Basel III Capital Rules, banking organizations were provided a one-time option in their initial regulatory financial report filed after January 1, 2015, to remove certain components of accumulated other comprehensive income from the computation of common equity regulatory capital. For banking organizations with less than $15 billion in total assets, existing trust preferred securities and cumulative perpetual preferred stock continue to be included in regulatory capital while other instruments are disallowed. The Basel III Capital Rules also provide additional constraints on the inclusion of minority interests, mortgage servicing assets, deferred tax assets and certain investments in the capital of unconsolidated financial institutions in Tier 1 capital, as well as providing stricter risk weighting rules to these assets.
The Basel III Capital Rules also provide stricter rules related to the risk weighting of past due and certain commercial real estate loans, as well as on some equity investment exposures, and replace the existing credit rating approach for determining the risk weighting of securitization exposures with an alternative approach.
The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.
In February 2019, the federal bank regulatory agencies issued a final rule (the “2019 CECL Rule”) that revised certain capital regulations to account for changes to credit loss accounting under U.S. GAAP. The 2019 CECL Rule included a transition option that allows banking organizations to phase in, over a three-year period, the day-one adverse effects of adopting a ASC 310-20 the accounting standard related to the measurement of current expected credit losses on their regulatory capital ratios. We did not elect to adopt the transition option. On January 1, 2020, the Company adopted ASC 310-20 and all loans accounted for under ASC 310-20 were included in the allowance for credit losses methodology, with no offset provided for any remaining fair value marks. In addition, all loans previously accounted for under ASC 310-30 had their credit marks reclassified to be included in the allowance for credit losses.
Prompt Corrective Action
Under the Federal Deposit Insurance Act (the “FDIA”), the federal bank regulatory agencies must take prompt corrective action against undercapitalized U.S. depository institutions. U.S. depository institutions are assigned one of five capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized,” and are subjected to different regulation corresponding to the capital category within which the institution falls. A depository institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a common equity Tier 1 capital ratio of 6.5% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a leverage ratio of 5.0% or greater and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific level for any capital measure. A depository institution is deemed to be “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 4.5% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, a leverage ratio of 4.0% or greater, and does not meet the criteria for a “well capitalized” bank. A depository institution is “under-capitalized” if it has a total risk-based capital ratio of less than 8.0%, a common equity Tier 1 capital ratio less than 4.5%, a Tier 1 risk-based capital ratio of less than 6.0% or a leverage ratio of less than 4.0%. Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category. A banking institution that is undercapitalized is required to submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary’s compliance with the capital restoration plan up to a certain specified amount.
Failure to meet capital guidelines could subject the institution to a variety of enforcement remedies by federal bank regulatory agencies, including termination of deposit insurance upon notice and hearing, restrictions on certain business activities and appointment of the FDIC as conservator or receiver. As of December 31, 2022, the Bank met the requirements to be “well capitalized” under the prompt corrective action regulations.
The prompt corrective action regulations do not apply to bank holding companies. However, the Federal Reserve is authorized to take appropriate action at the bank holding company level, based upon the undercapitalized status of the bank holding
company’s depository institution subsidiaries.
Regulatory Limits on Dividends, Distributions and Repurchases
As a bank holding company, we are subject to certain restrictions on paying dividends under applicable federal and Texas laws and regulations. The Federal Reserve has issued a policy statement that provides that a bank holding company should not pay dividends unless (1) its net income over the last four quarters (net of dividends paid) has been sufficient to fully fund the dividends, (2) the prospective rate of earnings retention appears to be consistent with the capital needs, asset quality and overall financial condition of the bank holding company and its subsidiaries and (3) the bank holding company will continue to meet minimum required capital adequacy ratios. Accordingly, a bank holding company should not pay cash dividends that exceed its net income or that can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. The Dodd-Frank Act and Basel III capital requirements impose additional restrictions on the ability of banking institutions to pay dividends.
Substantially all of our income, and a principal source of our liquidity, are dividends from the Bank. The ability of the Bank to pay dividends to us is restricted by federal and state laws, regulations and policies.
Capital adequacy requirements serve to limit the amount of dividends that may be paid by the Bank. Under the FDIA, an insured depository institution such as the Bank is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized.” The FDIC may further restrict the payment of dividends by requiring the Bank to maintain a higher level of capital than would otherwise be required in order to be adequately capitalized for regulatory purposes. Payment of dividends by the Bank also may be restricted at any time at the discretion of the appropriate regulator if it deems the payment to constitute an unsafe and unsound banking practice. As noted above, the capital conservation buffer created under the Basel III Capital Rules could also have the effect of limiting the payment of capital distributions from the Bank.
In July 2019, the federal bank regulators adopted final rules that, among other things, eliminated the standalone prior approval requirement in the capital rules for any repurchase of common stock. In certain circumstances, the Company’s repurchases of its common stock may be subject to a prior approval or notice requirement under other regulations, policies or supervisory expectations of the Federal Reserve. Any redemption or repurchase of preferred stock or subordinated debt remains subject to the prior approval of the Federal Reserve.
Pursuant to regulations of the Federal Reserve, all banking organizations are required to maintain average daily reserves at mandated ratios against their transaction accounts. In addition, reserves must be maintained on certain non-personal time deposits. These reserves must be maintained in the form of vault cash or in an account at a Federal Reserve Bank.
Limits on Transactions with Affiliates and Insiders
Insured depository institutions are subject to restrictions on their ability to conduct transactions with affiliates and other related parties. Section 23A of the Federal Reserve Act imposes quantitative limits, qualitative requirements, and collateral requirements on certain transactions by an insured depository institution with, or for the benefit of, its affiliates. Transactions covered by Section 23A include loans, extensions of credit, investment in securities issued by an affiliate and acquisitions of assets from an affiliate. Section 23B of the Federal Reserve Act requires that most types of transactions by an insured depository institution with, or for the benefit of, an affiliate be on terms, substantially the same or at least as favorable to the insured depository institution as if the transaction were conducted with an unaffiliated third party.
The Dodd-Frank Act generally enhances the restrictions on transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and a clarification regarding the amount of time for which collateral requirements regarding covered credit transactions must be satisfied. The ability of the Federal Reserve to grant exemptions from these restrictions is also narrowed by the Dodd-Frank Act, including by requiring coordination with other bank regulators.
The Federal Reserve’s Regulation O imposes restrictions and procedural requirements in connection with the extension of credit by an insured depository institution to directors, executive officers, principal shareholders and their related interests.
The FDIA restricts the use of brokered deposits by certain depository institutions. Under the applicable regulations, a “well capitalized insured depository institution” may solicit and accept, renew or roll over any brokered deposit without restriction. An “adequately capitalized insured depository institution” may not accept, renew or roll over any brokered deposit unless it has applied for and been granted a waiver of this prohibition by the FDIC. An “undercapitalized insured depository institution” may not accept, renew or roll over any brokered deposit. The FDIC may, on a case-by-case basis and upon application by an adequately capitalized insured depository institution, waive the restriction on brokered deposits upon a finding that the acceptance of brokered deposits does not constitute an unsafe or unsound practice with respect to such institution.
In addition, the FDIA prohibits an insured depository institution from offering interest rates on any deposits significantly higher than the prevailing rate in the bank’s normal market area or nationally (depending upon where the deposits are solicited), unless it is well capitalized or is adequately capitalized and receives a waiver from the FDIC.
On December 15, 2020, the FDIC issued a final rule on brokered deposits. The rule aims to clarify and modernize the FDIC’s existing regulatory framework for brokered deposits. Notable aspects of the rule include (1) the establishment of bright-line standards for determining whether an entity meets the statutory definition of “deposit broker”, (2) the identification of a number of business relationships (“designated exceptions”) to which the “primary purpose” exception is automatically applicable, (3) the establishment of a “transparent” application process for entities that seek a “primary purpose” exception, but do not qualify as a “designated exception” and (4) the clarification that third parties that have an exclusive deposit-placement arrangement with only one insured depository institution are not considered a “deposit broker.”
Concentrated Commercial Real Estate Lending Guidance
The federal banking agencies, including the FDIC, have promulgated guidance governing financial institutions with concentrations in commercial real estate lending. The guidance provides that a bank has a concentration in commercial real estate lending if (1) total reported loans for construction, land development, and other land represent 100% or more of total capital or (2) total reported loans secured by multifamily and non-farm non-residential properties and loans for construction, land development and other land represent 300% or more of total capital and the bank’s commercial real estate loan portfolio has increased 50% or more during the prior 36 months. Owner-occupied commercial real estate loans are excluded from this second category. If a concentration is present, management must employ heightened risk management practices that address the following key elements: board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing and maintenance of increased capital levels as needed to support the level of commercial real estate lending.
Examination and Examination Fees
The FDIC periodically examines and evaluates state non-member banks. Based on such an evaluation, the Bank, among other things, may be required to revalue its assets and establish specific reserves to compensate for the difference between the Bank’s assessment and that of the FDIC. The TDB also conducts examinations of state banks but may accept the results of a federal examination in lieu of conducting an independent examination. In addition, the FDIC and TDB may elect to conduct a joint examination. The TDB charges fees to recover the costs of examining Texas chartered banks, as well as filing fees for certain applications and other filings. The Dodd-Frank Act provides various agencies with the authority to assess additional supervision fees.
Deposit Insurance and Deposit Insurance Assessments
The FDIC is an independent federal agency that insures the deposits of federally insured depository institutions up to applicable limits. The FDIC also has certain regulatory, examination and enforcement powers with respect to FDIC-insured institutions. The deposits of the Bank are insured by the FDIC up to applicable limits. As a general matter, the maximum deposit insurance amount is $250 thousand per depositor. FDIC-insured depository institutions are required to pay deposit insurance assessments to the FDIC. The amount of a particular institution’s deposit insurance assessment for institutions with less than $10 billion in assets is based on that institution’s risk classification under an FDIC risk-based assessment system. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. Institutions assigned to higher risk categories (that is, institutions that pose a higher risk of loss to the Deposit Insurance Fund) pay assessments at higher rates than institutions that pose a lower risk. The FDIC has the ability to make discretionary adjustments to the total score based upon significant risk factors that are not adequately captured in the calculations. For larger institutions, such as Stellar Bank, the FDIC uses a performance score and a loss-severity score that are used to calculate an initial assessment rate. In calculating these scores, the FDIC uses a bank’s capital level and supervisory ratings and certain financial measures to assess an institution’s ability to withstand asset-related stress and funding-related stress. The FDIC has the ability to make discretionary adjustments to the total score based upon significant risk factors that are not adequately captured in the calculations.
Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. In addition, the FDIC is authorized to conduct examinations of and require reporting by FDIC-insured institutions.
On June 22, 2020, the FDIC issued a final rule that mitigates the deposit insurance assessment effects of participating in the Paycheck Protection Program (“PPP”), the Paycheck Protection Program Liquidity Facility (“PPPLF”) and the Money Market Mutual Fund Liquidity Facility (“MMLF”). Pursuant to the final rule, the FDIC will generally remove the effect of PPP lending in calculating an institutions deposit insurance assessment. The final rule also provides an offset to an institution’s total assessment amount for the increase in its assessment base attributable to participation in the PPP and MMLF.
The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution (including the claims of the FDIC as subrogee of insured depositors) and certain claims for administrative expenses of the FDIC as a receiver will have priority over other general unsecured claims against the institution. If the Company invests in or acquires an insured depository institution that fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including the Company, with respect to any extensions of credit they have made to such insured depository institution.
Anti-Money Laundering and OFAC
Under federal law, financial institutions must maintain anti-money laundering programs that include established internal policies, procedures and controls, a designated compliance officer, an ongoing employee training program and testing of the program by an independent audit function. Financial institutions are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and customer identification in their dealings with non-U.S. financial institutions and non-U.S. customers. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions, and law enforcement authorities have been granted increased access to financial information maintained by financial institutions. Bank regulators routinely examine institutions for compliance with these obligations and they must consider an institution’s compliance with such obligations in connection with the regulatory review of applications, including applications for mergers and acquisitions. The regulatory authorities have imposed cease and desist orders and civil money penalty sanctions against institutions found to be violating these obligations.
The U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”) is responsible for helping to ensure that U.S. entities do not engage in transactions with certain prohibited parties, as defined by various Executive Orders and Acts of Congress. OFAC publishes lists of persons, organizations and countries suspected of aiding, harboring or engaging in terrorist acts, known as Specially Designated Nationals and Blocked Persons. If the Company or the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, the Company or the Bank must freeze or block such account or transaction, file a suspicious activity report and notify the appropriate authorities.
On January 1, 2021, Congress passed the National Defense Authorization Act for Fiscal Year 2021 (“NDAA”), which enacted the most significant overhaul of the Bank Secrecy Act (“BSA”), and related anti-money laundering laws since the Patriot Act. The Anti-Money Laundering Act of 2020 (“AMLA”), which amends the BSA, was included in the NDAA. Among other things, it codifies a risk-based approach to anti-money laundering compliance for financial institutions; requires the U.S. Department of the Treasury to promulgate priorities for anti-money laundering and countering the financing of terrorism; requires the development of standards for testing technology and internal processes for BSA compliance; expands enforcement- and investigation-related authority, including increasing available sanctions for certain BSA violations; and expands BSA whistleblower incentives and protections. Notable amendments include (1) significant changes to the collection of beneficial ownership information and the establishment of a beneficial ownership registry, which requires corporate entities (generally, any corporation, LLC, or other similar entity with 20 or fewer employees and annual gross income of $5 million or less) to report beneficial ownership information to FinCEN (which will be maintained by Financial Crimes Enforcement Network (“FinCEN”), and made available upon request to financial institutions), (2) enhanced whistleblower provisions, which provide that one or more whistleblowers who voluntarily provide original information leading to the successful enforcement of violations of the AML laws in any judicial or administrative action brought by the Secretary of the Treasury or the Attorney General resulting in monetary sanctions exceeding $1 million (including disgorgement and interest but excluding forfeiture, restitution, or compensation to victims) will receive not more than 30 percent of the monetary sanctions collected and will receive increased protections, (3) increased penalties for violations of the BSA, (4) improvements to existing information sharing provisions that permit financial institutions to share information relating to SARs with foreign branches, subsidiaries, and affiliates (except those located in China, Russia, or certain other jurisdictions) for the purpose of combating illicit finance risks and (5) expanded duties and powers of FinCEN. Many of the statutory provisions in the AMLA will require additional rulemakings, reports and other measures, and the impact of the AMLA will depend on, among other things, rulemaking and implementation guidance. In June 2021, the Financial Crimes Enforcement Network, a bureau of the U.S. Department of the Treasury, issued the priorities for anti-money laundering and countering the financing of terrorism policy required under the AMLA. The priorities include corruption, cybercrime, terrorist financing, fraud, transnational crime, drug trafficking, human trafficking and proliferation financing.
Consumer Laws and Regulations
Banking organizations are subject to numerous laws and regulations intended to protect consumers. These laws include, among others:
•Truth in Lending Act;
•Truth in Savings Act;
•Electronic Funds Transfer Act;
•Expedited Funds Availability Act;
•Equal Credit Opportunity Act;
•Fair and Accurate Credit Transactions Act;
•Fair Housing Act;
•Fair Credit Reporting Act;
•Fair Debt Collection Act;
•Home Mortgage Disclosure Act;
•Right to Financial Privacy Act;
•Real Estate Settlement Procedures Act;
•laws regarding unfair and deceptive acts and practices; and
Many states and local jurisdictions have consumer protection laws analogous to, and in addition to, those listed above. These federal, state and local laws regulate the manner in which financial institutions deal with customers when taking deposits, making loans or conducting other types of transactions. Failure to comply with these laws and regulations could give rise to regulatory sanctions, customer rescission rights, action by state and local attorneys general and civil or criminal liability.
Consumer Financial Protection Bureau. We are subject to a number of federal and state consumer protection laws that extensively govern our relationship with our customers. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Home Mortgage Disclosure Act, the Fair Housing Act, the Real Estate Settlement Procedures Act, the Fair Debt Collection Practices Act, the Service Members Civil Relief Act and these laws’ respective state-law counterparts, as well as state usury laws and laws regarding unfair and deceptive acts and practices. These and other federal laws, among other things, require disclosures of the cost of credit and terms of deposit accounts, provide substantive consumer rights, prohibit discrimination in credit transactions, regulate the use of credit report information, provide financial privacy protections, prohibit unfair, deceptive and abusive practices, restrict our ability to raise interest rates and subject us to substantial regulatory oversight. Violations of applicable consumer protection laws can result in significant potential liability from litigation brought by customers, including actual damages, restitution and attorneys’ fees. Federal bank regulators, state attorneys general and state and local consumer protection agencies may also seek to enforce consumer protection requirements and obtain these and other remedies, including regulatory sanctions, customer rescission rights, action by the state and local attorneys general in each jurisdiction in which we operate and civil money penalties. Failure to comply with consumer protection requirements may also result in our failure to obtain any required bank regulatory approval for merger or acquisition transactions we may wish to pursue or our prohibition from engaging in such transactions even if approval is not required.
The CFPB is a federal agency responsible for implementing, examining and enforcing compliance with federal consumer protection laws. The CFPB has broad rulemaking authority for a wide range of consumer financial laws that apply to all banks, including, among other things, laws relating to fair lending and the authority to prohibit “unfair, deceptive or abusive” acts and practices. Abusive acts or practices are defined as those that materially interfere with a consumer’s ability to understand a term or condition of a consumer financial product or service or take unreasonable advantage of a consumer’s (1) lack of financial savvy, (2) inability to protect himself in the selection or use of consumer financial products or services, or (3) reasonable reliance on a covered entity to act in the consumer’s interests. The CFPB can issue cease-and-desist orders against banks and other entities that violate consumer financial laws. The CFPB may also institute a civil action against an entity in violation of federal consumer financial law in order to impose a civil penalty or injunction. The CFPB has examination and enforcement authority over all banks with more than $10 billion in assets, as well as their affiliates. Banking regulators take into account compliance with consumer protection laws when considering approval of a proposed transaction.
Mortgage loan origination. The Dodd-Frank Act authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower’s ability to repay a residential mortgage loan. Under the Dodd-Frank Act, financial institutions may not make a residential mortgage loan unless they make a “reasonable and good faith determination” that the consumer has a “reasonable ability” to repay the loan. The Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure, but provides a full or partial safe harbor from such defenses for loans that are “qualified mortgages.” The CFPB has promulgated rules to, among other things, specify the types of income and assets that may be considered in the ability to repay determination, the permissible sources for verification and the required methods of calculating the loan’s monthly payments. The rules extend the requirement that creditors verify and document a borrower’s income and assets to include all information that creditors rely on in determining repayment ability. The rules also provide further examples of third party documents that may be relied on for such verification, such as government records and check cashing or funds transfer service receipts. The rules also define “qualified mortgages,” imposing both underwriting standards—for example, a borrower’s debt to income ratio may not exceed 43%—and limits on the terms of their loans. Points and fees are subject to a relatively stringent cap, and the terms include a wide array of payments that may be made in the course of closing a loan. Certain loans, including interest only loans and negative amortization loans, cannot be qualified mortgages.
The Community Reinvestment Act
The Community Reinvestment Act (the “CRA”) and related regulations are intended to encourage banks to help meet the credit needs of their service areas, including low- and moderate-income neighborhoods, consistent with safe and sound operations. The bank regulators examine and assign each bank a public CRA rating. The CRA requires bank regulators to take into account the bank’s record in meeting the needs of its service area when considering an application by a bank to establish or relocate a branch or to conduct certain mergers or acquisitions. The Federal Reserve is required to consider the CRA records of a bank holding company’s controlled banks when considering an application by the bank holding company to acquire a banking organization or to merge with another bank holding company. When we or the Bank applies for regulatory approval to engage in certain transactions, the regulators will consider the CRA record of target institutions and our depository institution subsidiaries. An unsatisfactory CRA record could substantially delay approval or result in denial of an application. The regulatory agency’s assessment of the institution’s record is made available to the public. The Bank received an overall CRA rating of “satisfactory” on its most recent CRA examination.
In December 2019, the FDIC and the Office of the Comptroller of the Currency (“OCC”) jointly proposed rules that would significantly change existing CRA regulations. The proposed rules are intended to increase bank activity in low- and moderate-income communities where there is significant need for credit, more responsible lending, greater access to banking services and improvements to critical infrastructure. The proposals change four key areas: (1) clarifying what activities qualify for CRA credit, (2) updating where activities count for CRA credit, (3) providing a more transparent and objective method for measuring CRA performance and (4) revising CRA-related data collection, record keeping and reporting. However, the Federal Reserve Board did not join the proposed rulemaking. In June 2020, the OCC issued its final CRA rule, effective October 1, 2020, while the FDIC did not finalize any revisions to its CRA rule. In September 2020, the Federal Reserve issued an Advance Notice of Proposed Rulemaking (“ANPR”) that invited public comment on an approach to modernize the regulations that implement the CRA by strengthening, clarifying, and tailoring them to reflect the current banking landscape and better meet the core purpose of the CRA. The ANPR sought feedback on ways to evaluate how banks meet the needs of low- and moderate-income communities and address inequities in credit access. In December 2021, the OCC issued a final rule to rescind its June 2020 final rule in favor of working with other agencies to put forward a joint rule. We will continue to evaluate the impact of any changes to the regulations implementing the CRA and their impact to our financial condition, results of operations, and/or liquidity, which cannot be predicted at this time.
In May 2022, the Federal Reserve, the FDIC and the OCC issued a joint proposal that would, among other things (1) expand access to credit, investment and basic banking services in low- and moderate-income communities, (2) adapt to changes in the banking industry, including internet and mobile banking, (3) provide greater clarity, consistency and transparency in the application of the regulations and (4) tailor performance standards to account for differences in bank size, business model, and local conditions. We will continue to evaluate the impact of any changes to the regulations implementing the CRA and their impact to our financial condition, results of operations, and/or liquidity, which cannot be predicted at this time.
Incentive Compensation Guidance
The Federal Reserve reviews, as part of its regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews are tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
In July 2010, the federal banking agencies issued guidance on incentive compensation policies that applies to all banking organizations supervised by the agencies, including the Company and the Bank. Pursuant to the guidance, to be consistent with safety and soundness principles, a banking organization’s incentive compensation arrangements should: (1) provide employees with incentives that appropriately balance risk and reward, (2) be compatible with effective controls and risk management and (3) be supported by strong corporate governance including active and effective oversight by the banking organization’s board of directors. Monitoring methods and processes used by a banking organization should be commensurate with the size and complexity of the organization and its use of incentive compensation.
Section 956 of the Dodd-Frank Act requires the federal bank regulatory agencies and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities that encourage inappropriate risk-taking by providing an executive officer, employee, director or principal shareholder with excessive compensation, fees or benefits or that could lead to material financial loss to the entity. The federal bank regulatory agencies issued such proposed rules in April 2011 and issued a revised proposed rule in June 2016 implementing the requirements and prohibitions set forth in Section 956. The revised proposed rule would apply to all banks, among other institutions, with at least $1 billion in average total consolidated assets, for which it would go beyond the existing guidance to (1) prohibit certain types and features of incentive-based compensation arrangements for senior executive officers, (2) require incentive-based compensation arrangements to adhere to certain basic principles to avoid a presumption of encouraging inappropriate risk, (3) require appropriate board or committee oversight, (4) establish minimum recordkeeping and (5) mandate disclosures to the appropriate federal banking agency.
Federal bank regulatory agencies have adopted guidelines for establishing information security standards and cybersecurity programs for implementing safeguards. These guidelines, along with related regulatory materials, increasingly focus on risk management and processes related to information technology and the use of third parties in the provision of financial services. State regulators have also been increasingly active in implementing privacy and cybersecurity standards and regulations. Many states have recently implemented or modified their data breach notification and data privacy requirements, which could apply to us depending on the location of our customers. Many states, including Texas, have also recently implemented or modified their data breach notification, information security and data privacy requirements. We expect this trend of state-level activity in those areas to continue, and are continually monitoring developments in the states in which our customers are located.
In February 2018, the SEC published interpretive guidance to assist public companies in preparing disclosures about cybersecurity risks and incidents. These SEC guidelines, and any other regulatory guidance, are in addition to notification and disclosure requirements under state and federal banking law and regulations.
The federal banking regulators regularly issue new guidance and standards, and update existing guidance and standards, regarding cybersecurity intended to enhance cyber risk management among financial institutions. Financial institutions are expected to
comply with such guidance and standards and to accordingly develop appropriate security controls and risk management processes. If
we fail to observe such regulatory guidance or standards, we could be subject to various regulatory sanctions, including financial
In November 2021, the federal banking agencies adopted a final rule related to computer-security incident reporting. With compliance required by May 1, 2022, the final rule requires banking organizations to notify their primary banking regulator within 36 hours of determining that a “computer-security incident” has materially disrupted or degraded, or is reasonably likely to materially disrupt or degrade, the banking organization’s ability to carry out banking operations or deliver banking products and services to a material portion of its customer base, its businesses and operations that would result in material loss, or its operations that would impact the stability of the United States.
Changes in Laws, Regulations or Policies
Federal, state and local legislators and regulators regularly introduce measures or take actions that would modify the regulatory requirements applicable to banks, their holding companies and other financial institutions. Changes in laws, regulations or regulatory policies could adversely affect the operating environment for us in substantial and unpredictable ways, increase or decrease our cost of doing business, impose new restrictions on the way in which the Company conducts its operations or modify significant operational constraints that might impact the Company’s profitability. Whether new legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, would have on the Company and its subsidiaries’ business, financial condition or results of operations cannot be predicted. A change in laws, regulations or regulatory policies may have a material adverse effect on the Company’s business and results of operations.
Effect on Economic Environment
The policies of regulatory authorities, including the monetary policy of the Federal Reserve, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements with respect to deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits. Federal Reserve monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The Company cannot predict the nature of future monetary policies and the effect of such policies on its business and earnings.
ITEM 1A. RISK FACTORS
Summary of Risk Factors
The Company’s business is subject to a number of risks, including risks that may prevent it from achieving its business objectives or may adversely affect its business, reputation, financial condition, results of operations, revenue and future prospects. These risks are discussed more fully in the section following this summary and include, but are not limited to, the following:
Risks Related to the Merger of CBTX and Allegiance
•cost savings, revenue synergies and other anticipated benefits of the Merger may not be fully realized or may take longer to realize than expected;
•reputational risk and the reaction of our customers, suppliers and employees or other business partners to the Merger;
•ability to effectively manage our expanded operations following the Merger; and
•substantial costs related to the Merger may be incurred.
Risks Related to Business and Operations
External and Market Related Risks
•challenging market conditions and economic trends;
•inflationary pressures and rising prices;
•concentration of our business in our markets and largely dependent upon the growth and welfare of those markets;
•impact of sustained volatility in oil prices and instability in the energy industry;
•strong competition to attract and retain customers;
•adverse impact of geopolitical events, war, natural disasters, pandemics and other catastrophes;
•climate change and related legislative and regulatory initiatives;
•ability to retain bankers and recruit additional successful bankers;
•operations may be adversely affected by labor shortages, turnover and labor cost increases; and
•the ability of our executive officers and other key individuals to continue the implementation of our long-term business strategy.
Growth Strategy Risks
•risks of pursuing additional acquisitions;
•risk that local teams may not follow internal policies or are negligent in their decision-making for business decisions that are made at the banking center level; and
•goodwill and other intangibles recorded in connection with a business acquisition may become impaired.
Credit and Lending Risks
•a significant percentage of our loan portfolio is comprised of real estate loans, including commercial real estate and construction, land development and other land loan portfolios, which expose us to credit risks that may be greater than the risks related to other types of loans;
•a large portion of our loan portfolio is comprised of commercial and industrial loans secured by receivables, inventory, equipment or other commercial collateral;
•we focus our business development and marketing strategy primarily on lending to small- to medium-sized businesses who may have fewer resources to weather adverse business developments;
•our allowance for credit losses may not be sufficient to cover actual losses; and
•failure to originate SBA loans in compliance with SBA guidelines could result in losses on the guaranteed portion of our SBA loans.
•lack of liquidity could impair our ability to fund operations;
•loss of government banking deposits lost within a short period of time could negatively impact liquidity and earnings; and
•additional capital and funding may not be available when needed or at all.
Interest Rate Risks
•the impact of fluctuations in interest rates; and
•potential losses related to our securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.
Risks Related to Cybersecurity, Third-Parties and Technology
•we are dependent on information technology and telecommunications provided by third-parties;
•fraudulent activity, breaches of information security and cybersecurity attacks could have an adverse effect on our business; and
•continuing need for technological change, challenges resources to effectively implement new technology or operational challenges when implementing new technology.
Risks Related to Legal, Reputational and Compliance Matters
•failure to comply with laws regarding the privacy, information security and protection of personal information;
•employee errors and customer or employee fraud;
•the accuracy and completeness of information provided by the Company’s borrowers and counterparties;
•potential environmental liabilities in connection to our properties or real estate we foreclose on;
•potential claims and litigation pertaining to intellectual properties;
•regulatory requirements as total assets exceed $10 billion; and
•failure to maintain the Company’s reputation.
Risks Related to the Regulation of the Company’s Industry
•the Company operates in a highly regulated industry;
•failure to comply with any supervisory actions;
•new activities and expansion plans may require regulatory approval;
•noncompliance and enforcement action under the BSA and other anti-money laundering statutes and regulations;
•failure to comply with economic and trade sanctions or anti-corruption laws;
•risks associated with failure to comply with numerous federal and state lending laws designed to protect consumers;
•increases in FDIC deposit insurance premiums;
•Federal Reserve may require the Company to commit capital resources to support the Bank;
•the potential effects of the soundness, creditworthiness and liquidity of other financial institutions;
•monetary policies and regulations of the Federal Reserve may adversely affect the Company's business; and
•risks of loans to and deposits from related parties.
Risks Related to the Company’s Common Stock
•fluctuations in the market price of the Company’s common stock;
•priority of the holders of the Company’s debt obligations over its common stock with respect to payment;
•additional dilution of the percentage ownership of the Company’s shareholders from future sales and issuances of its capital stock or rights to purchase common stock;
•potential future issuance of shares of preferred stock;
•dependence upon the Bank for cash flow and restrictions on the Bank’s ability to make cash distributions;
•anti-takeover effect of certain provisions of the Company’s corporate organizational documents and provisions of federal and state law; and
•bylaws could limit a shareholder’s ability to obtain a favorable forum for disputes with the Company.
An investment in the Company's common stock is subject to risks inherent to our business. Before you decide to invest in our common stock, you should carefully consider the risks and uncertainties described below, together with all the other information in this Annual Report on Form 10-K including “Part II.—Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the related notes in “Part II.—Item 8.—Financial Statements and Supplementary Data.” If any of the following risks occur, the Company’s business, reputation, financial condition, results of operations, revenue and future prospects could be seriously harmed. As a result, the trading price of the Company’s common stock could decline, and shareholders could lose all or part of their investment. Some statements in this Annual Report on Form 10-K, including statements in the following risk factors section, constitute forward‑looking statements. Please refer to “Cautionary Note Regarding Forward‑Looking Statements” and “Part II.—Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K.
Risks Related to the Merger of CBTX and Allegiance
We may fail to realize all of the anticipated benefits of the Merger, or those benefits may take longer to realize than expected.
A significant portion of the anticipated benefit of the Merger is attributable to anticipated cost savings from the integration of the two companies and elimination of duplicated costs and business functions. The Merger will require integration of the companies’ banking, sales and marketing, operating, finance and administrative functions. We may not be able to successfully integrate the companies, or we may not be able to do so in a timely, efficient and cost-effective manner. Our inability to complete the integration of the two companies in a timely and orderly manner could increase costs and lower profits. Factors affecting the successful integration of the two companies include, but are not limited to, our inability to manage or control integration costs; merging or linking different accounting and financial reporting systems and systems of internal controls; merging computer, technology and other information networks and systems; assimilating personnel, human resources and other administrative departments and potentially contrasting corporate cultures; failure to retain existing key personnel and recruit qualified new employees at new locations; disrupting our relationship with, or loss of, key customers; incurring or guaranteeing additional indebtedness; and delays or cost-overruns in the integration process.
Any of these integration-related issues could divert management’s attention and resources from our day-to-day operations, cause significant disruption to our businesses, and lead to substantial additional costs. The success of the Merger will depend on, among other things, the ability of the Company to operate its businesses in a manner that facilitates growth and realizes cost savings following the Merger. Our inability to realize the anticipated benefits of the Merger or to successfully integrate the two companies as well as other transaction-related issues could have a material adverse effect on our businesses, financial condition, and results of operations.
Reputational risk and the reaction of our customers, suppliers and employees or other business partners to the Merger.
Uncertainties about the effects of the Merger could cause customers and others who work with us to seek to change their existing business relationships with us and these uncertainties may impair our ability to attract, retain and motivate key personnel. Employee retention may be particularly challenging during the integration of the two companies, as employees may experience uncertainty about their roles with the Company. It is not unusual for competitors to use mergers as an opportunity to target the merging parties’ customers and to hire certain of their employees.
The Company’s future results will suffer if we do not effectively manage our expanded operations following the Merger.
As a result of the Merger, the size of our business increased significantly. The future success of the Company depends, in part, upon the ability to manage this expanded business, which will pose substantial challenges for management, including challenges related to the management and monitoring of new operations and associated increased costs and complexity. Additionally, the Company will be subject to increased regulatory requirements due to its increased asset size, and the ultimate effect of compliance with those expectations is not yet known.
We expect to continue to incur substantial costs related to the Merger.
We have incurred substantial costs in connection with the Merger and subsequent integration of the processes, policies, procedures, operations, and technologies and systems, including purchasing, accounting and finance, payroll, compliance, treasury management, branch operations, vendor management, risk management, lines of business, pricing and benefits. While we have
attempted to accurately forecast these costs, factors that are beyond our control or that we have failed to accurately estimate could result in us incurring future charges in excess of our current estimates. These charges could be material and could materially adversely affect our future earnings.
Risks Related to Business and Operations
External and Market Related Risks
Challenging market conditions and economic trends have adversely affected the banking industry.
We operate in the challenging and uncertain financial services industry. The success of our business and operations is sensitive to general business and economic conditions in the U.S., our industry and our markets. If the U.S. economy weakens, enters a recession or there is a lack of growth in population, income levels, deposits and business investment in our local markets, our growth and profitability from our lending, deposit and asset management services could be constrained or negatively impacted. Financial institutions continue to be affected by volatility in the real estate market in some parts of the country and uncertain regulatory and interest rate conditions.
Uncertain market and economic conditions can make our ability to assess the creditworthiness of customers and estimate the losses in our loan portfolio more complex. Another national economic recession or continued deterioration of conditions in our market could drive losses beyond that which is provided for in our allowance for credit losses and result in the following consequences, any of which could have a material adverse effect on our business: (1) loan delinquencies may rise, (2) nonperforming assets and foreclosures may increase, (3) demand for our products and services may decline and (4) collateral securing our loans, especially real estate, may decline in value, which could reduce customers’ borrowing power and repayment ability.
The future effects of economic activity could negatively affect the collateral values associated with our existing loans, our ability to liquidate the real estate collateral securing our residential and commercial real estate loans, our ability to maintain loan origination volume and to obtain additional financing, the future demand for or profitability of our lending and services and the financial condition and credit risk of our customers. Further, in the event of delinquencies, regulatory changes and policies designed to protect borrowers may slow or prevent us from making our business decisions or may result in a delay in our taking certain remediation actions, such as foreclosure. In addition, we have unfunded commitments to extend credit to customers. During challenging economic environments, our customers are more dependent on our credit commitment, and increased borrowings under these commitments could adversely impact our liquidity.
Inflationary pressures and rising prices may affect our results of operations and financial condition.
Inflation rose in 2022 at levels not seen for over 40 years, and inflationary pressures are currently expected to continue in 2023. Inflation could lead to increased costs to our customers, making it more difficult for them to repay their loans or other obligations increasing our credit risk. In general, the impact of inflation on the banking industry differs significantly from that of other industries in which a large portion of total resources are invested in fixed assets such as property, plant and equipment. Assets and liabilities of financial institutions are primarily all monetary in nature, and therefore are principally impacted by interest rates rather than changing prices. While the general level of inflation underlies most interest rates, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy. Sustained high inflation could result in market volatility and higher interest rates.
Sustained higher interest rates by the Federal Reserve may be needed to tame persistent inflationary price pressures, which could depress asset prices and weaken economic activity. A deterioration in economic conditions in the United States and our markets could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for our products and services, all of which, in turn, would adversely affect our business, financial condition and results of operations.
The Company’s business is concentrated in and largely dependent upon the growth and welfare of its markets.
We conduct our operations almost exclusively in the Houston and Beaumont regions, a majority of the loans in our loan portfolio were made to borrowers who live and/or conduct business in these regions and a majority of our secured loans were secured by collateral located in these regions. The Company’s success depends, to a significant extent, upon the economic activity and conditions in its markets. Adverse economic conditions that impact the Company’s markets could reduce its growth rate, the ability of customers to repay their loans, the value of collateral underlying loans, the Company’s ability to attract deposits and generally impact
its business, financial condition, results of operations and future prospects. Due to the Company’s geographic concentration, it may be less able than other larger regional or national financial institutions to diversify the Company’s credit risks.
We may be adversely impacted by sustained volatility in oil prices and instability in the energy industry.
The economic conditions in our markets are dependent on the energy sector generally and oil and gas specifically. Actions by the Organization of Petroleum Exporting Countries (“OPEC”) or OPEC plus Russia (“OPEC Plus”), including various Russian sanctions, have impacted global crude oil production levels and led to significant volatility in global oil supplies and oil prices. General uncertainty in the oil and gas market has led to unpredictable borrowing needs, construction and purchases of real estate related to energy and a number of other potential impacts that are difficult to isolate or quantify. As of December 31, 2022, the Company’s loan portfolio included $397.5 million, or 5.1%, of total loans directly or indirectly related to the oil and gas industry. Oil and gas loans are loans with revenue related to well-head, oil in the ground or extracting oil or gas, including any activity, product or service related to the oil and gas industry, such as exploration and production, drilling, equipment, services, midstream companies, service companies and commercial real estate companies with significant reliance on oil and gas companies. These loans directly or indirectly related to the oil and gas industry carry an overall allowance of 1.3% at December 31, 2022, have various types of collateral and are usually personally guaranteed by the owners of the borrower.
We face strong competition to attract and retain customers from other companies that offer banking services.
We conduct our operations almost exclusively in the Houston and Beaumont regions. Many of our competitors offer the same, or a wider variety of, banking services within this market area. These competitors include banks with nationwide operations, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including savings banks, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based non-bank lenders, financial technology (“fintech”) competitors and certain other non-financial entities, such as retail stores that may maintain their own credit programs and certain governmental organizations that may offer more favorable financing or deposit terms than the Company can. In addition, a number of out-of-state financial intermediaries have opened production offices, or otherwise solicit deposits, in our market area. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. In particular, the activity of fintech companies has grown significantly over recent years and is expected to continue to grow. Some fintech companies are not subject to the same regulations as we are, which may allow them to be more competitive. Increased competition from fintech companies and the growth of digital banking may also lead to pricing pressures as competitors offer more low-fee and no-fee products. In addition, as customer preferences and expectations continue to evolve, technology has lowered barriers to entry and made it possible for banks to expand their geographic reach by providing services over the internet and for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Increased competition in our market may result in reduced loans and deposits, as well as reduced net interest margin, fee income and profitability. Ultimately, the Company may not be able to compete successfully against current and future competitors. If we are unable to attract and retain banking customers, we may be unable to continue to grow our loan and deposit portfolios, and our business, financial condition and results of operations could be adversely affected.
The Company could be adversely impacted by geopolitical events, war, natural disasters, pandemics and other catastrophes.
Acts of terrorism, cyber-terrorism, political unrest, war (including the Russian invasion of Ukraine and its consequences), civil disturbance, armed regional and international hostilities and international responses to these hostilities, natural disasters, global health risks or pandemics or the threat of or perceived potential for these events could have a negative impact on us. In addition, malfunctions of the electronic grid and other infrastructure breakdowns (such as the grid failures in Texas in February 2021 resulting from unusually cold weather for the region) could adversely affect economic conditions in our markets. Our business continuity and
disaster recovery plans may not be successful upon the occurrence of one of these scenarios, and a significant catastrophic event could materially adversely affect our operating results.
The COVID-19 pandemic created extensive disruptions to the global economy and to the lives of individuals throughout the world and although the extreme disruptions have abated, the level of continued impact remains uncertain and cannot be predicted. The Company may be subject to continued risks, including but not limited to: (1) the risk of operational failures due to changes in the Company’s normal business practices including temporarily closing branches and offices, working remotely, and the loss of key employees and management due to illness, (2) credit losses resulting from financial stress experienced by the Company’s borrowers as a result of the pandemic, (3) collateral for loans, such as real estate, may decline in value, which could cause credit losses to increase and (4) cybersecurity and information security risks as the result of an increase in the number of employees working remotely. The future impact of the COVID-19 pandemic is uncertain but could materially affect the Company’s future financial and operational results.
Climate change, and related legislative and regulatory initiatives, have the potential to disrupt our business and adversely impact the operations and creditworthiness of our customers.
Climate change may lead to more frequent and more extreme weather events, such as prolonged droughts or flooding, hurricanes, wildfires and extreme seasonal weather, which could disrupt operations at one or more of our locations and our ability to provide financial products and services to our customers. Such events could also have a negative effect on the financial status and creditworthiness of our customers, which may decrease revenues and business activities from those customers and increase the credit risk associated with loans and other credit exposures to such customers. In addition, weather disasters, shifts in local climates and other disruptions related to climate change may adversely affect the value of real properties securing our loans, which could diminish the value of our loan portfolio. Such events may also cause reductions in regional and local economic activity that may have an adverse effect on our customers, which could limit our ability to raise and invest capital in these areas and communities, each of which could have a material adverse effect on our financial condition and results of operations.
Political and social attention to the issue of climate change has increased. The federal and state legislatures and regulatory agencies have proposed legislative and regulatory initiatives seeking to mitigate the effects of climate change. These agreements and measures may result in the imposition of taxes and fees, the required purchase of emission credits, and the implementation of significant operational changes. In addition, the federal banking agencies may address climate-related issues in their agendas in various ways, including by increasing supervisory expectations with respect to banks’ risk management practices, accounting for the effects of climate change in stress testing scenarios and systemic risk assessments, revising expectations for credit portfolio concentrations based on climate-related factors, and encouraging investment by banks in climate-related initiatives and lending to communities disproportionately impacted by the effects of climate change. We may incur compliance, operating, maintenance and remediation costs.
Our ability to retain bankers and recruit additional successful bankers is critical to the success of our business strategy and any failure to do so could impair our customer relationships and adversely affect our business and results of operations.
Our ability to retain and grow our loans, deposits and fee income depends upon the business generation capabilities, reputation and the relationship management skills of our bankers. If we were to lose the services of highly productive bankers, including successful bankers employed by an acquired bank, to a competitor or otherwise, the Company may not be able to retain valuable relationships and some of our customers could choose to use the services of a competitor instead of our services.
Our success and growth strategy also depends on our continued ability to attract and retain experienced loan officers and support staff, as well as other management personnel, including our ability to replace our current loan officers, staff and personnel as they age-out of the workforce. The Company may face difficulties in recruiting and retaining bankers and other personnel of our desired caliber, including as a result of staffing shortages and competition from other financial institutions. Competition for loan officers and other personnel is strong and the Company may not be successful in attracting or retaining the personnel it requires. In particular, many of our competitors are significantly larger with greater financial resources, and may be able to offer more attractive compensation packages and broader career opportunities. Furthermore, our current and potential new personnel may prefer and seek jobs where they can work fully remote. Additionally, the Company may incur significant expenses and expend significant time and resources on training, integration and business development before it is able to determine whether a new loan officer will be profitable or effective. If we are unable to attract and retain successful loan officers and other personnel, or if our loan officers and other personnel fail to meet our expectations in terms of customer relationships and profitability, we may be unable to execute our business strategy and our business, financial condition, results of operations and growth prospects may be negatively affected.
Our results of operations may be adversely affected by labor shortages, turnover and labor cost increases.
Labor costs are a material component of operating our business. A number of factors may adversely affect the labor force available to us or increase labor costs, a shift towards remote work, wage inflation, higher unemployment subsidies, other government regulations and general macroeconomic factors. A sustained labor shortage or increased turnover rates within our employee base could lead to increased costs, such as increased overtime to meet demand and increased wage rates and employee benefits costs to attract and retain employees, and could negatively affect our ability to efficiently operate our business. If we are unable to hire and retain employees capable of performing at a high-level, or if mitigation measures we may take to respond to a decrease in labor availability, such as overtime and third-party outsourcing, have negative effects, our business could be adversely affected. An overall labor shortage, increased turnover or labor inflation could have a material adverse impact on our business, financial condition or operating results.
We are dependent on our executive officers and other key individuals to continue the implementation of our long-term business strategy and the loss of one or more of these key individuals could curtail our growth and adversely affect our business, financial condition, results of operations and prospects.
Our continued success depends in large part upon the skills, experience and continued service of our executive management team and Board of Directors. Our goals, strategies and continued growth are closely tied to the strengths and banking philosophy of our executive management team. Successful implementation of our business strategy is also dependent in part on the continued service of our banking center presidents. The community involvement and diverse and extensive local business relationships and experience in our markets of our officers are important to our success. The loss of services of any of these key personnel in the future could have a negative impact on our business because of their skills, years of industry experience and it may be difficult to find qualified replacement personnel who are experienced in the specialized aspects of our business or who have ties to the communities within our market area. Currently, it is generally our policy to utilize employment agreements only in connection with merger or acquisition activities and not to have long-term employment agreements with our officers. While the Company does not anticipate any changes in our executive management team, the unexpected loss of any of these members of management could have a material adverse effect on the Company and our ability to implement our business strategy.
Growth Strategy Risks
Our strategic growth plan, which includes pursuing acquisitions, could expose the Company to financial, execution and operational risks.
The Company’s growth strategy focuses on organic growth, supplemented by strategic acquisitions. The Company may not be able to generate sufficient new loans and deposits within acceptable risk and expense tolerances, obtain the personnel or funding necessary for additional growth or find suitable acquisition candidates. Various factors, such as economic conditions and competition, may impede or prohibit the growth of the Company’s operations, the opening of new branches and the consummation of additional acquisitions. Further, the Company may be unable to attract and retain experienced bankers, which could adversely affect its growth. The success of the Company’s growth strategy also depends on its ability to effectively manage growth, which is dependent upon a number of factors, including the Company’s ability to adapt its existing credit, operational, technology and governance infrastructure to accommodate expanded operations. If the Company fails to implement one or more aspects of its growth strategy, the Company may be unable to maintain its historical earnings trends, which could adversely affect its business, financial condition and results of operations.
The Company intends to continue to pursue a strategy that includes future acquisitions. An acquisition strategy involves significant risks, including the following: (1) discovering proper candidates for acquisition, (2) incurring time and expense associated with identifying and evaluating potential acquisitions and negotiating potential transactions, resulting in management’s attention being diverted from the operation of our existing business, (3) using inaccurate estimates and judgments to evaluate credit, operations, management, compliance and market risks with respect to the target institution or assets, (4) conducting adequate due diligence and managing known and unknown risks and uncertainties, including compliance and legal matters, (5) obtaining necessary regulatory approvals, (6) integrating the operations and personnel of the combined businesses, thereby creating an adverse short-term effect on results of operations, (7) attracting and retaining qualified management and key personnel, including bankers, (8) maintaining asset quality, (9) attracting and retaining customers, (10) attracting funding to support additional growth within acceptable risk tolerances and (11) maintaining adequate regulatory capital.
The market for acquisition targets is highly competitive, which may adversely affect our ability to find acquisition candidates that fit our strategy and standards. To the extent that we are unable to find suitable acquisition targets, an important component of our growth strategy may not be realized. Acquisitions of financial institutions involve operational risks and uncertainties, such as unknown
or contingent liabilities with no available manner of recourse, exposure to unexpected problems such as asset quality, the retention of key employees and customers and other issues that could negatively affect our business. Acquisitions of financial institutions are also subject to regulatory approvals that can result in delays, which in some cases could be for a lengthy period of time or may not be received. The Company may not be able to complete future acquisitions or, if completed, the Company may not be able to successfully integrate the operations, technology platforms, management, products and services of the entities that it acquires or effectively eliminate redundancies. The integration process may also require significant time and attention from our management that would otherwise be directed toward servicing existing business and developing new business. Further, acquisitions typically involve the payment of a premium over book and market values and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future acquisition, and the goodwill that the Company currently maintains or may recognize in connection with future transactions may be subject to impairment in future periods.
Certain business decisions are made at the bank center level, and our business, financial condition, results of operations and prospects could be negatively affected if our local teams do not follow our internal policies or are negligent in their decision-making.
We attract and retain our management talent by empowering them to make certain business decisions on a local level. Lending authorities are assigned to bankers based on their level of experience. Additionally, all loan relationships in excess of internal specified maximums are reviewed by a senior level loan committee, comprised of senior management of the Bank. Our local bankers may not follow our internal procedures or otherwise act in our best interests with respect to our decision-making. A failure of our employees to follow our internal policies, or actions taken by our employees that are negligent, could have a material adverse effect on our business, financial condition, results of operations and prospects.
If the goodwill that we have recorded in connection with business acquisitions becomes impaired, it could require charges to earnings.
Goodwill represents the amount by which the cost of an acquisition exceeded the fair value of net assets we acquired in connection with the purchase of another financial institution. The Company reviews goodwill for impairment at least annually, or more frequently if a triggering event occurs which indicates that the carrying value of the asset might be impaired. The Company determines impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments are reflected in our results of operations in the periods in which they become known. Factors that could cause an impairment charge include adverse changes to macroeconomic conditions, declines in the profitability of the reporting unit or declines in the tangible book value of the reporting unit. While we have not recorded any impairment charges, our future evaluations of goodwill may result in findings of impairment and related write-downs, which may have a material adverse effect on our financial condition and results of operations. As of December 31, 2022, our goodwill totaled $497.3 million, compared to $223.6 million as of December 31, 2021.
Credit and Lending Risks
As a significant percentage of our loan portfolio is comprised of real estate loans, including commercial real estate and construction, land development and other land loan portfolios, which expose us to credit risks that may be greater than the risks related to other types of loans.
As of December 31, 2022, $6.24 billion, or 80.4%, of our total loans was comprised of loans with real estate as a primary or secondary component of collateral. The real estate collateral provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value over the term of the loan, limiting our ability to realize the full value of the collateral anticipated at the time of the originating loan. A weakening of the real estate market in our primary market area could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of our business. In addition, the volatility of the real estate market may result in a lower valuation at the time collateral is put on the market for sale. Collateral may have to be sold for less than the outstanding balance of the loan, which could result in losses on such loans. Such declines and losses in real estate values may cause the Company to experience increases in provisions for loan losses and charge-offs, which could adversely affect our profitability.
As of December 31, 2022, $3.93 billion, or 50.7%, of our total loans were comprised of commercial real estate loans (including owner-occupied commercial real estate loans) and $1.04 billion, or 13.4%, of our total loans were comprised of construction, land development and other land loans. Commercial real estate loans generally involve relatively large balances to single borrowers or related groups of borrowers. Repayment of these loans is typically dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service. The availability of such income for repayment may be adversely affected by changes in the economy or local market conditions. These loans expose a lender to greater credit risk than loans secured by other types of collateral because the collateral securing these loans is typically more difficult to liquidate due to the fluctuation of real estate values. Unexpected deterioration in the credit quality of our commercial real estate loan portfolio could require us to increase our allowance for credit losses, which would reduce our profitability.
Real estate construction, land development and other similar land loans involve risks attributable to the fact that loan funds are secured by a project under construction, and the project is of uncertain value prior to our completion. These risks include: (1) the viability of the contractor, (2) the value of the project being subject to successful completion, (3) the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within our estimates and (4) concentration of such loans with a single contractor and our affiliates.
Real estate construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan and also presents risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If we are forced to foreclose on a project prior to completion, we may be unable to recover the entire unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time.
A large portion of our loan portfolio is comprised of commercial and industrial loans secured by receivables, inventory, equipment or other commercial collateral.
As of December 31, 2022, $1.46 billion, or 18.8%, of our total loans were comprised of commercial and industrial loans that are typically based on the borrowers’ ability to repay the loans from the cash flow of their businesses. These loans may involve greater risk because the availability of funds to repay each loan depends substantially on the success of the borrower’s business itself and these loans are typically larger in amount, which creates the potential for larger losses on a single loan basis. Commercial and industrial loans are collateralized by general business assets including, among other things, accounts receivable, inventory and equipment and are generally backed by a personal guaranty of the borrower or principal. This collateral may decline in value more rapidly than the Company anticipates, exposing it to increased credit risk. In addition, a portion of our customer base, including customers in the energy and real estate business, may be in industries which are particularly sensitive to commodity prices or market fluctuations, such as energy and real estate prices. Accordingly, negative changes in commodity prices and real estate values and liquidity could impair the value of the collateral securing these loans. Significant adverse changes in the economy or local market conditions in which our commercial lending customers operate could cause rapid declines in loan collectability and the values associated with general business assets resulting in inadequate collateral coverage that may expose the Company to credit losses.
The small- to medium-sized businesses that the Company lends to may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan.
We focus our business development and marketing strategy primarily on small- to medium-sized businesses, which we categorize as commercial borrowing relationships of generally less than $10.0 million of exposure. Small- to medium-sized businesses frequently have a smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small- or medium-sized business often depends on the management skills, talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have a material adverse impact on the business and its ability to repay our loan. If general economic conditions negatively impact our markets and small- to medium-sized businesses are adversely affected, or our borrowers are otherwise affected by adverse business developments, our business, financial condition and results of operations may be negatively affected.
If our allowance for credit losses is not sufficient to cover actual loan losses, our earnings may be affected.
The allowance for credit losses is a valuation allowance for current expected credit losses. We establish our allowance for credit losses and maintain it at a level management considers adequate to absorb expected loan losses in our loan portfolio. The allowance for credit losses represents our estimate of probable losses in the portfolio at each balance sheet date and is based upon relevant information available to us, such as past loan loss experience, the nature and volume of the portfolio, information about
specific borrower situations and estimated collateral values, economic conditions and other factors. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited back to the allowance. Our allowance for credit losses consists of a general component based upon expected losses in the portfolio and a specific component based on individual loans that are individually evaluated. In determining the collectability of certain loans, management also considers the fair value of any underlying collateral. The amount ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond our control, and any such differences may be material.
As of December 31, 2022, our allowance for credit losses on loans was $93.2 million, which represented 1.20% of our total loans and 206.85% of our total nonperforming loans. As of December 31, 2021, our allowance for credit losses on loans was $47.9 million, which represented 1.14% of our total loans and 198.7% of our total nonperforming loans as of the same date. Additional loan losses may occur in the future and may occur at a rate greater than the Company has previously experienced. We may be required to take additional provisions for loan losses in the future to further supplement the allowance for credit losses, either due to results of the allowance for credit losses model or as required by our banking regulators. In addition, federal and state bank regulatory agencies periodically review our allowance for credit losses and the value attributed to nonaccrual loans or to real estate acquired through foreclosure. Such regulatory agencies may require the Company to recognize future charge-offs. Their conclusions about the quality of a particular borrower or our entire loan portfolio may be different than ours. Additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans, accounting rule changes and other factors, both within and outside of our management’s control. These additions may require increased provision expense.
Our SBA lending program is dependent upon the federal government and our status as a participant in the SBA’s Preferred Lenders Program and a failure to originate SBA loans in compliance with SBA guidelines could result in losses on the guaranteed portion of our SBA loans.
We participate in the SBA Preferred Lenders Program. As an SBA Preferred Lender, we enable our clients to obtain SBA loans without being subject to the potentially lengthy SBA approval process necessary for lenders who are not SBA Preferred Lenders. The SBA periodically reviews the lending operations of participating lenders to assess, among other things, whether the lender exhibits prudent risk management. When weaknesses are identified, the SBA may request corrective actions or impose enforcement actions, including revocation of the lender’s Preferred Lender status. If we lose our status as an SBA Preferred Lender, we may lose some or all of our customers to lenders who are SBA Preferred Lenders, which could adversely affect our business, financial condition and results of operations.
The laws, regulations and standard operating procedures that are applicable to SBA loan products may change in the future. We cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, including our organization, changes in the laws, regulations and procedures applicable to SBA loans could adversely affect our ability to operate profitably. In addition, the aggregate amount of all SBA 7(a) and 504 loan guarantees by the SBA must be approved each fiscal year by the federal government. We cannot predict the amount of SBA 7(a) loan guarantees in any given fiscal year. If the federal government were to reduce the amount of SBA loan guarantees, such reduction could adversely impact our SBA lending program.
The Company is subject to liquidity risk.
Liquidity risk is the potential that the Company will be unable to meet its obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Company requires sufficient liquidity to meet customer loan requests, customer deposit maturities and withdrawals, payments on debt obligations as they come due and other cash commitments under both normal operating conditions and unpredictable circumstances, including events causing industry or general financial market stress. The Company relies on its ability to generate deposits and effectively manage the repayment and maturity schedules of loans and securities to ensure that it has adequate liquidity to fund operations. An inability to raise funds through deposits, borrowings, loan repayments, sales of the Company’s securities, sales of loans and other sources could have a negative impact liquidity.
The Company’s most important source of funds is deposits, which have historically been stable sources of funds. However, deposits are subject to fluctuations in availability or price due to factors that may be outside of the Company’s control, including increasing competitive pressure from other financial services firms for consumer or corporate customer deposits, changes in interest
rates, returns on other investment classes and systemic risk of the financial system, the actions of regulatory agencies, the reputation of the Company among others. As a result, there could be significant outflows of deposits within short periods of time or significant changes in pricing necessary to maintain current customer deposits or attract additional deposits, increasing funding costs and reducing net interest income and net income. A significant outflow of deposits could force us to sell securities held in our securities portfolio and could result in us recognizing significant losses.
The Company has unfunded commitments to extend credit, which are formal agreements to lend funds to customers as long as there are no violations of any conditions established in the contracts. Unfunded credit commitments are not reflected on the Company’s consolidated balance sheet and are generally not drawn upon. Borrowing needs of customers may exceed the Company’s expectations, especially during a challenging economic environment where clients are more dependent on credit commitments. Increased borrowings under these commitments could adversely impact liquidity.
The Company’s access to funding sources, such as through its line of credit, capital markets offerings, borrowing from the Federal Reserve Bank of Dallas and the Federal Home Loan Bank of Dallas, or from other third-parties, in amounts adequate to finance or capitalize its activities, or on terms that are acceptable, could be impaired by factors that affect the Company directly or the financial services industry or economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry.
If our deposits from governments and municipalities were to significantly decline within a short period of time, this could negatively impact our liquidity and earnings.
As of December 31, 2022, we held $1.23 billion of deposits from municipalities throughout Texas. These deposits may be more volatile than other deposits. If a significant amount of these deposits were withdrawn within a short period of time, it could have a negative impact on our short-term liquidity and have an adverse impact on our earnings.
We may need to raise additional capital in the future, and such capital may not be available when needed or at all.
We may need to raise additional capital, in the form of additional debt or equity, in the future to have sufficient capital resources and liquidity to meet our commitments and fund our business needs and future growth, particularly if the quality of our assets or earnings were to deteriorate significantly. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial condition. Economic conditions and a loss of confidence in financial institutions may increase our cost of funding and limit access to certain customary sources of capital or make such capital only available on unfavorable terms, including interbank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve. We may not be able to obtain capital on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of our bank or counterparties participating in the capital markets or other disruption in capital markets, may adversely affect our capital costs and our ability to raise capital and, in turn, our liquidity. Further, if we need to raise capital in the future, we may have to do so when many other financial institutions are also seeking to raise capital and would then have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our business, financial condition and results of operations.
Interest Rate Risks
The Company is subject to interest rate risk.
Changes in interest rates could have an adverse impact on the Company’s net interest income, business, financial condition and results of operations. Many factors outside the Company’s control impact interest rates, including governmental monetary policies, inflation, deflation, recession, changes in unemployment, the money supply, international disorder, instability in domestic and foreign financial markets and other macroeconomic conditions. Beginning early in 2022, in response to growing signs of inflation, the Federal Reserve increased interest rates rapidly. Further, the Federal Reserve has increased the benchmark rapidly and has announced an intention to take further actions to mitigate inflationary pressures. A majority of banking assets and liabilities are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, the Company’s earnings and cash flows are significantly dependent on its net interest income and are subject to “gaps” in the interest rate sensitivities of assets and liabilities that may negatively impact earnings. Changes in interest rates can increase or decrease our net interest income, because different types of assets and liabilities may react differently, and at different times, to market interest rate changes. When interest-bearing liabilities mature or reprice more quickly, or to a greater degree than interest-earning assets in a period, an increase in interest rates could reduce
net interest income. Similarly, when interest-earning assets mature or reprice more quickly, or to a greater degree than interest-bearing liabilities, falling interest rates could reduce net interest income. Interest rate increases often result in larger payment requirements for borrowers, including our floating-rate borrowers, which increase the potential for default and delayed payment, and reduces demand for collateral securing the loan. Further, loans in nonaccrual status require continued funding costs, but result in decreased interest income. Interest rate increases may also reduce the demand for loans, decrease loan repayment rates and increase competition for deposits, which could cause an increase in nonperforming assets and charge offs, which could adversely affect our business. Declining interest rates can increase loan prepayments and long‑term fixed rate credits, which could adversely impact earnings and net interest margin if rates increase. If short‑term interest rates remain at low levels for a prolonged period and longer‑term interest rates fall, the Company could experience net interest margin compression as interest‑earning assets would continue to reprice downward while interest-bearing liability rates could fail to decline in tandem. Accordingly, changes in the level of market interest rates affect our net yield on interest-earning assets, loan origination volume and our overall results of operations. Changes in interest rates can also impact the value of loans, securities and other assets.
We could recognize losses on securities held in our securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.
The Company invests in available for sale securities with the primary objectives of providing a source of liquidity, providing an appropriate return on funds invested, managing interest rate risk, meeting pledging requirements and meeting regulatory capital requirements. As of December 31, 2022, the fair value of our securities portfolio was $1.81 billion, which represented 16.6% of total assets. Factors beyond our control, including interest rate increases, can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. In order to satisfy liquidity needs, we may be forced to sell securities which would then require us to realize losses. For example, fixed-rate securities are generally subject to decreases in market value when interest rates rise. Additional factors include, but are not limited to, rating agency downgrades of the securities, defaults by the issuer or individual borrowers with respect to the underlying securities and continued instability in the credit markets. Any of the foregoing factors could cause impairment in future periods and result in realized losses. The process for determining impairment usually requires difficult, subjective judgments about the future financial performance of the issuer and any collateral underlying the security in order to assess the probability of receiving all contractual principal and interest payments on the security. Our unrealized losses for our securities portfolio may increase in future periods and we may recognize losses within our securities portfolio.
Risks Related to Cybersecurity, Third-Parties and Technology
The Company depends on information technology and telecommunications including third-party service providers.
The Company’s business depends on the successful and uninterrupted functioning of its information technology and telecommunications systems including with third-party servicers and financial intermediaries. The Company relies on third-parties for certain services, including, but not limited to, core systems processing, website hosting, internet services, monitoring its network and other processing services. The failure of these systems, an information security or cybersecurity breach involving any of the Company’s third-party service providers, or the termination or change in terms of a third-party software license or service agreement on which any of these systems is based, could adversely impact the Company’s business, financial condition and results of operations. In addition, the Company’s regulators have issued guidance outlining the expectations for third-party service provider oversight and monitoring by financial institutions. Any failure on the Company’s part to adequately oversee the actions of its third-party service providers could result in regulatory actions against the Bank.
We could be adversely impacted by fraudulent activity, breaches of our information security and cybersecurity attacks.
As a financial institution, we are susceptible to fraudulent activity, information security breaches and cybersecurity-related incidents that may be committed against us, our clients or third-parties with whom we interact and that may result in financial losses or increased costs to us or our clients, disclosure or misuse of confidential information belonging to us or personal or confidential information belonging to our clients or misappropriation of assets and litigation. The occurrence of any of these could also damage our reputation. Our industry has seen increases in electronic fraudulent activity, hacking, security breaches, sophisticated social engineering and cyber-attacks.
Our business is highly dependent on the security and efficacy of our infrastructure, computer and data management systems, as well as those of third-parties with whom we interact or on whom we rely. Our business relies on the secure processing, transmission, storage and retrieval of confidential, proprietary and other information in our computer and data management systems and networks and in the computer and data management systems and networks of third-parties. In addition, to access our network, products and services, our customers and other third-parties may use personal mobile devices or computing devices that are outside of
our network environment and are subject to their own cybersecurity risks. All of these factors increase our risks related to cyber-threats and electronic disruptions.
While we invest in systems and processes that are designed to detect and prevent security breaches and cyber-attacks and we conduct periodic tests of our security systems and processes, we may not succeed in anticipating or adequately protecting against or preventing all security breaches and cyber-attacks from occurring. Even the most advanced internal control environment may be vulnerable to compromise. Targeted social engineering attacks are becoming more sophisticated and are extremely difficult to prevent. Additionally, the existence of cyber-attacks or security breaches at third-parties with access to our data, such as vendors, may not be disclosed to us in a timely manner. As cyber-threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities or incidents.
As is the case with non-electronic fraudulent activity, cyber-attacks or other information or security breaches, whether directed at us or third-parties, may result in a material loss or have material consequences. Furthermore, the public perception that a cyber-attack on our systems has been successful, whether or not this perception is correct, may damage our reputation with customers and third-parties with whom we do business. A successful penetration or circumvention of system security could cause negative consequences, including loss of customers and business opportunities, disruption to our operations and business, misappropriation or destruction of our confidential information and/or that of our customers, or damage to our customers’ and/or third-parties’ computers or systems, and could expose us to additional regulatory scrutiny and result in a violation of applicable privacy laws and other laws, litigation exposure, regulatory fines, penalties or intervention, loss of confidence in our security measures, reputational damage, reimbursement or other compensatory costs, additional compliance costs.
During 2018, CommunityBank experienced a security incident involving the possible unauthorized access of certain personal information in the possession of CommunityBank. The Company takes the privacy of personal information seriously and took steps to address the incident promptly after it was discovered, including initiating an internal investigation into the incident and working with an independent forensic investigation firm to assist in the investigation of and response to the incident. The Company may be subject to similar cyber-attacks or incidents in the future that could lead to litigation, cause reputational harm or cause customers to lose confidence in the Company’s ability to safeguard their information.
We have a continuing need for technological change, and we may not have the resources to effectively implement new technology, or we may experience operational challenges when implementing new technology.
The financial services industry is changing rapidly, and to remain competitive, we continue to enhance and improve the functionality and features of our products, services and technologies. In addition to better serving our customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, at least in part, upon our ability to respond to future technological changes and the ability to address the needs of our customers. We address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our products and service offerings. We may experience operational challenges as we implement these new technology enhancements or products, which could result in our not fully realizing the anticipated benefits from such new technology or require us to incur significant costs to remedy any such challenges in a timely manner. In addition, complications during a conversion of our core technology platform or implementation or upgrade of any software could negatively impact the experiences or satisfaction of our customers, which could cause those customers to terminate their relationship with us or reduce the amount of business that they do with us, either of which could adversely affect our business, financial condition or results of operations.
Third-parties upon which we rely for our technology needs may not be able to develop on a cost-effective basis systems that will enable us to keep pace with such developments. As a result, our competitors may be able to offer additional or superior products compared to those that we will be able to provide, which would put us at a competitive disadvantage. We may lose customers seeking new technology-driven products and services to the extent we are unable to provide such products and services.
Risks Related to Legal, Reputational and Compliance Matters
The Company is subject to laws regarding the privacy, information security and protection of personal information.
Our business requires the collection and retention of large volumes of customer data, including personally identifiable information in various information systems that we maintain and in those maintained by third-parties with whom we contract to provide data services. We also maintain important internal company data such as personally identifiable information about our
employees and information relating to our operations. We are subject to complex and evolving laws and regulations governing the privacy and protection of personal information of individuals (including customers, employees, suppliers and other third-parties). Various state and federal banking regulators and states have also enacted data security breach notification requirements with varying levels of individual, consumer, regulatory or law enforcement notification in certain circumstances in the event of a security breach. Ensuring that our collection, use, transfer and storage of personal information complies with all applicable laws and regulations can increase our costs.
Furthermore, we may not be able to ensure that all of our clients, suppliers, counterparties and other third parties have appropriate controls in place to protect the confidentiality of the information that they exchange with us, particularly where such information is transmitted by electronic means. If personal, confidential or proprietary information of customers or others were to be mishandled or misused (in situations where, for example, such information was erroneously provided to parties who are not permitted to have the information, or where such information was intercepted or otherwise compromised by third parties), we could be exposed to litigation or regulatory sanctions under personal information laws and regulations. Concerns regarding the effectiveness of our measures to safeguard personal information, or even the perception that such measures are inadequate, could cause us to lose customers or potential customers for our products and services and thereby reduce our revenues. Accordingly, any failure or perceived failure to comply with applicable privacy or data protection laws and regulations may subject us to inquiries, examinations and investigations that could result in requirements to modify or cease certain operations or practices or in significant liabilities, fines or penalties, and could damage our reputation and otherwise adversely affect our operations and financial condition.
The Company could be adversely impacted by employee errors and customer or employee fraud.
As a financial institution, employee errors and employee or customer misconduct could cause financial losses or regulatory sanctions and seriously harm the Company’s reputation. Misconduct by employees could include hiding unauthorized activities, improper or unauthorized activities on behalf of customers or improper use of confidential information, each of which can be damaging to the Company. It is not always possible to prevent employee errors and misconduct and the precautions taken to prevent and detect this activity may not be effective in all cases. Employee errors could also subject the Company to financial claims for negligence.
The Company maintains a system of internal controls to mitigate operational risks, including data processing system failures and errors and customer or employee fraud, as well as insurance coverage designed to protect it from material losses associated with these risks, including losses resulting from any associated business interruption. If these internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could adversely impact the Company’s business, financial condition and results of operations.
The Company depends on the accuracy and completeness of information provided by its borrowers and counterparties.
In deciding whether to approve loans or to enter into other transactions with borrowers and counterparties, the Company relies on information furnished by, or on behalf of, borrowers and counterparties, including financial statements, credit reports, audit reports, other financial information and representations as to accuracy and completeness of that information. Any intentional or negligent misrepresentation, if undetected prior to loan funding, may significantly lower the value of the loan, and the Company may be subject to regulatory action. The Company generally bears the risk of loss associated with these misrepresentations. The Company’s controls and processes may not detect misrepresented information. Any such misrepresented information could adversely impact the Company’s business, financial condition and results of operations.
The Company may be subject to environmental liabilities in connection with the real properties we own and the foreclosure on real estate assets securing our loan portfolio.
In the course of our business, we may acquire real estate in connection with our growth efforts, or we may foreclose on and take title to real estate or otherwise be deemed to be in control of property that serves as collateral on loans we make. As a result, we could be subject to environmental liabilities with respect to those properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property.
The cost of removal or abatement may substantially exceed the value of the affected properties or the loans secured by those properties; we may not have adequate remedies against the prior owners or other responsible parties; and we may not be able to resell the affected properties either before or after completion of any such removal or abatement procedures. Furthermore, the value of the property as collateral will generally be substantially reduced, or we may elect not to foreclose on the property and, as a result, we may
suffer a loss upon collection of the loan. Any significant environmental liabilities could have a material adverse effect on our business, financial condition and results of operations.
The Company is subject to claims and litigation pertaining to intellectual property in addition to other litigation in the ordinary course of business.
Banking and other financial services companies, such as the Company, rely on technology companies to provide information technology products and services necessary to support their day‑to‑day operations. Technology companies frequently enter litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company also uses trademarks and logos for marketing purposes, and third-parties may allege that the Company’s marketing, processes or systems may infringe their intellectual property rights. Competitors of the Company’s vendors, or other individuals or companies, may from time to time claim to hold intellectual property sold to the Company. Such claims may increase in the future as the financial services sector becomes more reliant on information technology vendors. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or actual litigants, the Company may have to engage in protracted litigation that can be expensive, time‑consuming, and disruptive to operations and distracting to management.
In addition to litigation relating to intellectual property, the Company is regularly involved in litigation matters in the ordinary course of business. While the Company believes that these litigation matters should not have a material adverse impact on its business, financial condition, results of operations or future prospects, it may be unable to successfully defend or resolve any current or future litigation matters.
We are subject to heightened regulatory requirements as our total assets exceed $10 billion.
Our total assets were approximately $10.9 billion as of December 31, 2022. The Dodd-Frank Act and its implementing regulations impose various additional requirements on banks and bank holding companies with $10 billion or more in total assets, including a more frequent and enhanced regulatory examination regime. In addition, banks with $10 billion or more in total assets (including our bank) are primarily examined by the CFPB with respect to various federal consumer financial protection laws and regulations, with the Federal Reserve maintaining supervision over some consumer related regulations. In light of evolving priorities among government and agency leaders, there is some uncertainty as to how the CFPB examination and regulatory authority might impact our business in the near and medium terms.
Negative public opinion regarding the Company or its failure to maintain the Company’s or the Bank’s reputation in the communities served could adversely impact business.
As a community bank, the Company’s reputation within the communities served is critical to its success. The Company believes it has set itself apart from competitors by building strong personal and professional relationships with its customers and by being an active member of the communities it serves. The Company strives to enhance its reputation by recruiting, hiring and retaining employees who share the Company’s core values of being an integral part of the communities it serves and delivering superior service to customers. Negative public opinion could result from the Company’s actual or alleged conduct in any number of activities, including (1) lending practices, (2) expansion strategy, (3) product and service offerings, (4) corporate governance, (5) regulatory compliance, (6) mergers and acquisitions, (7) disclosure, (8) sharing or inadequate protection of customer information, (9) successful or attempted cyber-attacks against the Company, its customers or its third-party partners or vendors and (10) failure to discharge any publicly announced commitments to employees or environmental, social and governance initiatives or to respond adequately to social and sustainability concerns from the viewpoint of its stakeholders from actions taken by government regulators and community organizations in response to the Company’s conduct. If the Company’s reputation is negatively affected by the actions of its employees or otherwise, the Company may be less successful in attracting new talent and customers or may lose existing customers. Further, negative public opinion can expose the Company to litigation and regulatory action and could delay and impede efforts to implement its expansion strategy.
Risks Related to Regulation of the Company’s Industry
The Company operates in a highly regulated environment.
As a bank holding company, we are subject to extensive examination, supervision and comprehensive regulation by various federal and state agencies that govern almost all aspects of our operations. These laws and regulations are not intended to protect our shareholders. Rather, these laws and regulations are intended to protect customers, depositors, the FDIC's Deposit Insurance Fund and the overall financial stability of the U.S. These laws and regulations, among other matters, prescribe minimum capital requirements,
impose limitations on the business activities in which the Company can engage, limit the dividend or distributions that the Bank can pay to the Company, restrict the ability of institutions to guarantee our debt and impose certain specific accounting requirements on the Company that may be more restrictive and may result in greater or earlier charges to earnings or reductions in our capital than GAAP would require. Compliance with these laws and regulations is difficult and costly, and changes to these laws and regulations often impose additional compliance costs. Our failure to comply with these laws and regulations, even if the failure follows good faith efforts to comply or reflects a difference in interpretation, could subject the Company to restrictions on our business activities, fines and other penalties, any of which could adversely affect our results of operations, capital base and the price of our securities. Further, any new laws, rules or regulations could make compliance more difficult or expensive.
State and federal banking agencies periodically conduct examinations of our business, including compliance with laws and regulations, and our failure to comply with any supervisory actions to which the Company is or becomes subject as a result of such examinations may adversely affect the Company.
Texas and federal banking agencies, including the TDB and the Federal Reserve, periodically conduct examinations of our business, including compliance with laws and regulations. If, as a result of an examination, a Texas or federal banking agency were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that the Company, the Bank or their respective management were in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our and/or the Bank’s capital, to restrict our growth, to assess civil monetary penalties against the Company, the Bank or their respective officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate the Bank’s deposit insurance. If we become subject to such regulatory actions, our business, financial condition, results of operations, cash flows and reputation may be negatively impacted.
Many of the Company’s new activities and expansion plans may require regulatory approvals, and failure to obtain them may restrict our growth.
We intend to continue to grow our business through strategic acquisitions of financial institutions coupled with organic growth. Generally, we must receive state and federal regulatory approval before we can acquire an FDIC-insured depository institution or related business. In determining whether to approve a proposed acquisition, federal banking regulators will consider, among other factors, the effect of the acquisition on competition, our financial condition, liquidity, our future prospects and the impact of the proposal on U.S. financial stability. The regulators also review current and projected capital ratios and levels, the competence, experience and integrity of management and our record of compliance with laws and regulations, the convenience and needs of the communities to be served including the acquiring institution’s record of compliance under the CRA and the effectiveness of the acquiring institution in combating money laundering activities. Such regulatory approvals may not be granted on terms that are acceptable to the Company, or at all, or may be granted only after lengthy delay. We may also be required to sell or, in the alternative, commit to retain branches as a condition to receiving regulatory approval, which may not be acceptable to us or, if acceptable to us, may reduce the benefit of any acquisition.
We also plan to continue de novo branching as a part of our organic growth strategy. De novo branching and any acquisitions carry with them numerous risks, including the inability to obtain all required regulatory approvals. The failure to obtain these regulatory approvals for potential future strategic acquisitions and de novo branches may impact our business plans and restrict our growth.
The Company faces a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.
The federal Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the U.S. Department of the Treasury (“U.S. Treasury”) to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements, and engages in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice (the “Department of Justice”), Drug Enforcement Administration and Internal Revenue Service.
We provide banking services to customers located outside the United States, primarily in Guatemala. These banking services are primarily deposit accounts, including checking, money market and short term certificates of deposit. As of December 31, 2022, our deposits from foreign nationals, primarily residents of Guatemala, accounted for approximately 1.2% of our total deposits.
In order to comply with regulations, guidelines and examination procedures in this area, we have dedicated significant resources to our anti-money laundering program. If our policies, procedures and systems are deemed deficient, we could be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plans, including acquisitions and de novo branching. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
Failure to comply with economic and trade sanctions or with applicable anti‑corruption laws could have a material adverse impact our business, financial condition and results of operations.
The Office of Foreign Assets Control administers and enforces economic and trade sanctions against targeted foreign countries and regimes, under authority of various laws, including designated foreign countries, nationals and others. We are responsible for, among other things, blocking accounts of and transactions with such persons and countries, prohibiting unlicensed trade and financial transactions with them and reporting blocked transactions after their occurrence. In addition, we are subject to the Foreign Corrupt Practices Act (“FCPA”), which prohibits offering, promising, giving, or authorizing others to give anything of value, either directly or indirectly, to a non‑U.S. government official in order to influence official action or otherwise gain an unfair business advantage. We are also subject to applicable anti‑corruption laws in the jurisdictions in which we may operate. Failure to comply with economic and trade sanctions or with applicable anti‑corruption laws, including the FCPA, could have serious legal and reputational consequences for us.
The Company is subject to numerous federal and state lending laws designed to protect consumers, including the Community Reinvestment Act and fair lending laws, and failure to comply with these laws could lead to material sanctions and penalties.
The CRA, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. The Consumer Financial Protection Bureau, the Department of Justice and other federal and state agencies are responsible for enforcing these laws and regulations. A successful challenge to an institution’s performance under the CRA or fair lending laws and regulations could result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on mergers and acquisitions activity and restrictions on expansion activity. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation.
Increases in FDIC deposit insurance premiums could adversely affect our earnings.
On September 15, 2020, in response to the decline in the reserve ratio due to deposit growth resulting mainly from the COVID-19 pandemic, the FDIC adopted a restoration plan to restore the Deposit Insurance Fund reserve ratio to at least 1.35% within eight years, as required by the Federal Deposit Insurance Act. At least semi-annually, the FDIC updates its loss and income projections for the fund and, if needed, increases or decreases assessment rates. If any required increase is insufficient for the Deposit Insurance Fund to meet its funding requirements, further special assessments or increases in deposit insurance premiums may be required. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional financial institution failures that affect the Deposit Insurance Fund, we may be required to pay FDIC premiums higher than current levels. Future additional assessments, increases or required prepayments in FDIC insurance premiums may materially adversely affect our business, financial condition and results of operations. In addition, we are no longer eligible to utilize credits to reduce our FDIC insurance premiums as a result of our exceeding $10 billion in assets. These increased premiums would have an adverse effect on our net income and results of operations.
The Federal Reserve may require the Company to commit capital resources to support the Bank.
A bank holding company is required to act as a source of financial and managerial strength to its subsidiary banks and to commit resources to support its subsidiary banks. The Federal Reserve may require a bank holding company to make capital injections into a troubled subsidiary bank and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. Under these requirements, in the future, the Company could be required to provide financial assistance to the Bank if it experiences financial distress.
A capital injection may be required at times when our resources are limited and we may be required to borrow the funds to make the required capital injection. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of any note obligations. Thus, any borrowing that must be done by the holding company in order to make the required capital injection becomes more difficult and expensive and will adversely impact the holding company’s business, financial condition and results of operations.
We may be materially and adversely affected by the soundness, creditworthiness and liquidity of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional customers. Many of these transactions expose us to credit risk in the event of a default by a counterparty or customer. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on our business, financial condition and results of operations.
The Company could be adversely impacted by monetary policies and regulations of the Federal Reserve.
In addition to being affected by general economic conditions, our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the U.S. money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, adjustments of both the discount rate and the federal funds rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits. The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Although we cannot determine the effects of such policies on us at this time, such policies could have a material adverse effect on our business, financial condition and results of operations.
The Company has made loans to and accepted deposits from related parties.
From time to time, the Bank has made loans to and accepted deposits from certain of the Company’s directors and officers and the directors and officers of the Bank in compliance with applicable regulations and the Company’s written policies. The Company’s business relationships with related parties are highly regulated. In particular, the Company’s ability to do business with related parties is limited with respect to, among other things, extensions of credit described in the Federal Reserve’s Regulation O and covered transactions described in sections 23A and 23B of the Federal Reserve Act and the Federal Reserve’s Regulation W. If the Company fails to comply with any of these regulations, it could be subject to enforcement and other legal actions by the Federal Reserve.
Risks Related to the Company’s Common Stock
The market price of Company’s common stock may be volatile and fluctuate significantly, which could cause the value of an investment in the Company's common stock to decline.
The market price of the Company’s common stock could fluctuate substantially due to a variety of factors, many of which are beyond our control, including, but not limited to:
•general economic conditions and overall market fluctuations;
•actual or anticipated fluctuations in our quarterly or annual financial results;
•operating and stock price performance of other companies that investors deem comparable to ours;
•the perception that investment in Texas is unattractive or less attractive during periods of low or unstable oil prices;
•publication of research reports about the Company, its competitors, or the financial services industry generally, or changes in, or failure to meet, securities analysts’ estimates of the Company’s financial and operating performance, or lack of research reports by industry analysts or ceasing of coverage;
•other news, announcements or disclosures (whether by the Company or others) related to the Company, its competitors, its primary markets or the financial services industry or the trading volume of the Company’s common stock;
•changes in dividends and capital returns;
•changes in governmental trade, monetary policies and fiscal policies, including the interest rate policies of the Federal Reserve;
•changes in economic, competitive, regulatory conditions and technical factors , or other developments affecting participants in our industry, and publicity regarding our business or any of our significant customers or competitors;
•significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Company or the Company’s competitors; and
•additional or anticipated sales of the Company’s common stock or other securities by the Company or existing shareholders.
Additionally, the realization of any of the risks described in this “Risk Factors” section could have a material adverse effect on the market price of the Company’s common stock and cause the value of an investment in the Company’s common stock to decline. Furthermore, the stock market has experienced substantial fluctuations, which in many cases have been unrelated to the operating performance and prospects of particular companies. These types of broad market fluctuations may adversely affect investor confidence and could affect the trading price of the Company’s common stock over the short, medium or long term, regardless of our actual performance.
The holders of the Company’s debt obligations have priority over its common stock with respect to payment in the event of liquidation, dissolution or winding up and with respect to the payment of interest.
In the event of any liquidation, dissolution or winding up of the Company, its common stock would rank below all claims of debt holders against the Company. The Company’s debt obligations are senior to its shares of common stock. As a result, the Company must make payments on its debt obligations before any dividends can be paid on its common stock. In the event of bankruptcy, dissolution or liquidation, the holders of the Company’s debt obligations must be satisfied before any distributions can be made to the holders of the Company’s common stock. To the extent that the Company issues additional debt obligations, they will be of equal rank with, or senior to, the Company’s existing debt obligations and senior to shares of the Company’s common stock.
Future sales and issuances of the Company’s common stock or rights to purchase common stock could result in additional dilution of the percentage ownership of its shareholders.
The Company may issue additional securities in the future and from time to time, including as consideration in future acquisitions or under compensation or incentive plans. Future sales and issuances of the Company’s common stock or rights to purchase its common stock could result in substantial dilution to the Company’s existing shareholders. New investors in such subsequent transactions could gain rights, preferences and privileges senior to those of holders of the Company’s common stock. The Company may grant registration rights covering shares of its common stock or other securities in connection with acquisitions and investments.
The Company may issue shares of preferred stock in the future, which could make it difficult for another company to acquire it or could otherwise adversely affect the rights of the holders of the Company’s common stock, which could depress the price of the Company’s common stock.
The Company’s second amended and restated certificate of formation authorizes it to issue up to 10,000,000 shares of one or more series of preferred stock. The Company’s Board of Directors, in its sole discretion, has the authority to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series, the designation of such series and the dividend rate for each series, without any further vote or action by the Company’s shareholders. The Company’s preferred stock may be issued with voting, liquidation, dividend and other rights superior to the rights of the Company’s common stock. The potential issuance of preferred stock may delay or prevent a change in control of the Company, discouraging bids for the Company’s common stock at a premium over the market price, and materially adversely affect the market price and the voting and other rights of the holders of the Company’s common stock.
The Company is dependent upon the Bank for cash flow, and the Bank's ability to make cash distributions is restricted, which could impact the Company's ability to satisfy its obligations.
There can be no assurance of whether or when we may pay dividends on our common stock in the future. Our ability to pay dividends is dependent on the Bank’s ability to pay dividends to it, which is limited by applicable laws and banking regulations. These statutes and regulations require, among other things, that the Bank maintain certain levels of capital in order to pay a dividend. Further, federal and state banking authorities have the ability to restrict the Bank’s payment of dividends through supervisory action. Payments of future dividends, if any, will be declared and paid at the discretion of our Board of Directors after taking into account our business, operating results and financial condition, current and anticipated cash needs, plan for expansion and any legal or contractual limitations on our ability to pay dividends. In addition, the Company’s existing credit agreement restricts our ability to pay dividends.
The Company’s corporate governance documents and certain corporate and banking provisions of Texas law applicable to it could have an anti-takeover effect and may delay, make more difficult or prevent an attempted acquisition and other actions.
The Company’s second amended and restated certificate of formation and bylaws contain certain provisions that may have an anti-takeover effect and may delay, discourage or prevent an attempted acquisition or change of control. These provisions include: (1) staggered terms for directors, who may be removed from office only for cause, (2) a provision establishing certain advance notice procedures for nomination of candidates for election as directors and for shareholder proposals and (3) a provision that any special meeting of the Company’s shareholders may be called only by a majority of the Board of Directors, the Chairman of the Board of Directors or a holder or group of holders of at least 50% of the Company’s shares entitled to vote at the meeting.
The Company’s second amended and restated certificate of formation does not provide for cumulative voting for directors and authorizes the Board of Directors to issue shares of preferred stock without shareholder approval and upon such terms as the Board of Directors may determine. The issuance of the Company’s preferred stock, while providing desirable flexibility in connection with possible acquisitions, financings and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of discouraging a third-party from acquiring, a controlling interest. In addition, certain provisions of Texas law, including a provision that restricts certain business combinations between a Texas corporation and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control.
In addition, banking laws impose notice, approval and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution. These laws include the Bank Holding Company Act and the Change in Bank Control Act. These laws could delay or prevent an acquisition.
The Company’s bylaws include an exclusive forum provision, which could limit a shareholder’s ability to obtain a favorable judicial forum for disputes with the Company or its directors, officers or other employees.
The Company’s bylaws provide that unless the Company consents in writing to the selection of an alternative forum for the following purposes, any state or federal court located in Harris County in the State of Texas (the county in which Houston, Texas is located) shall be the sole and exclusive forum for (1) any actual or purported derivative action or proceeding brought on behalf of the Company, (2) any action asserting a claim of breach of a fiduciary duty owed by any current or former director, officer, or other employee or agent of the Company to the Company or the Company’s shareholders or creditors, including a claim alleging the aiding and abetting of such a breach of fiduciary duty, (3) any action asserting a claim against the Company or any current or former director, officer, or other employee or agent of the Company arising pursuant to any provision of the TBOC, the certificate of formation, or the bylaws of the Company (as any of the foregoing may be amended from time to time), or (4) any action asserting a claim against the Company or any current or former director, officer, or other employee or agent of the Company as governed by the internal affairs doctrine, including any action to interpret, apply, enforce or determine the validity of any provision of the TBOC, the certificate of formation, or the bylaws of the Company (as any of the foregoing may be amended from time to time).
Section 27 of the Exchange Act creates exclusive federal jurisdiction over all suits brought to enforce any duty or liability created by the Exchange Act or the rules and regulations thereunder, and the exclusive forum provision with respect to state courts of the Company’s bylaws will not apply to suits brought to enforce a duty or liability created by the Exchange Act or any other claim for which the federal courts have exclusive jurisdiction. Section 22 of the Securities Act creates concurrent jurisdiction for federal and state courts over all suits brought to enforce any duty or liability created by the Securities Act or the rules and regulations thereunder. Accordingly, there is uncertainty as to whether a court would enforce such an exclusive forum provision as written in connection with claims arising under the Securities Act, and the Company’s shareholders will not be deemed to have waived the Company’s compliance with the federal securities laws and the rules and regulations thereunder. Any person or entity purchasing or otherwise acquiring any interest in any security of the Company shall be deemed to have notice of and consented to the exclusive forum provision of the Company’s bylaws, as amended pursuant to the merger agreement.
The exclusive forum provision in the Company’s bylaws, as amended pursuant to the merger agreement, may limit the Company’s shareholders’ ability to obtain a favorable judicial forum for disputes with us. In addition, shareholders who do bring a claim in a Harris County court could face additional litigation costs in pursuing any such claim, particularly if they do not reside in or near Harris County, Texas. Furthermore, if a court were to find the exclusive forum provision contained in the Company’s bylaws, as amended pursuant to the merger agreement, to be inapplicable or unenforceable in an action, the Company may incur additional costs associated with resolving such action in other jurisdictions, which could adversely affect its business, operating results and financial condition.
ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 2. PROPERTIES
The Company’s principal executive office is located at 9 Greenway Plaza, Suite 110, Houston, Texas 77046. As of December 31, 2022, we had 60 full-service banking centers, with 43 banking centers located in the Houston region, 16 banking centers in the Beaumont region and one banking center in Dallas, Texas. We lease 22 of these banking centers, as well as our executive office, and own the remaining 38 banking centers. On February 18, 2023, we consolidated five of the Houston region banking centers upon conversion of the Allegiance Bank and CommunityBank banking centers to Stellar Bank banking centers.
For the leased locations, the Company either leases the location entirely, owns the building and has a ground lease, or owns the drive through and leases the branch. The Company believes that lease terms for the 22 banking centers that it leases are generally consistent with prevailing market terms. The expiration dates of the leases range from 2023 to 2045, without consideration of any renewal periods available.
We believe that our facilities are in good condition and adequate to meet our operating needs for the present and immediately foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are subject to claims and litigation arising in the ordinary course of business. In the opinion of management, we are not party to any legal proceedings the resolution of which we believe would have a material adverse effect on our business, prospects, financial condition, liquidity, results of operation, cash flows or capital levels. However, one or more unfavorable outcomes in any claim or litigation against us could have a material adverse effect for the period in which such claim or litigation is resolved. In addition, regardless of their merits or their ultimate outcomes, such matters are costly, divert management’s attention and may materially adversely affect our reputation, even if resolved in our favor. We intend to defend ourselves vigorously against any future claims or litigation.
ITEM 4. MINE SAFETY DISCLOSURES
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Common Stock Market Prices
The Company’s common stock is listed on the NASDAQ Global Market under the symbol “STEL.” Prior to the Merger, the Company’s stock was listed on the NASDAQ Global Market under the symbol “CBTX.” Quotations of the sales volume and the closing sales prices of the common stock of the Company are listed daily in the NASDAQ Global Market’s listings. As of March 10, 2023, there were 52,974,885 shares outstanding and 1,285 shareholders of record of the Company’s common stock. The closing price per share of common stock on December 31, 2022, the last trading day of the year, was $29.46.
During 2022, the Company paid three quarterly cash dividends of $0.10 per share and one quarterly dividend of $0.13 per share on its common stock during 2022. Stellar declared a quarterly dividend of $0.13 per share to be paid in the first quarter of 2023. See Note 21 — Subsequent Events. The dividends paid per share of the Company have been retrospectively adjusted to reflect the effect of the Merger. Payments of future dividends, if any, will be at the discretion of the Company’s Board of Directors after taking into account various factors, including its business, operating results and financial condition, current and anticipated cash needs, plans for expansion and any legal or contractual limitations on Stellar’s ability to pay dividends.
As a bank holding company, the Company’s ability to pay dividends is affected by the regulations promulgated by and the policies and enforcement powers of the Federal Reserve. In addition, because the Company is a holding company, it is dependent upon the payment of dividends by the Bank to the Company as its principal source of funds to pay dividends in the future, if any, and to make other payments. The Bank is also subject to various legal, regulatory and other restrictions on its ability to pay dividends and make other distributions and payments to the Company. See Item 1. “Business—Regulation and Supervision—Regulatory Limits on Dividends, Distributions and Repurchases.”
In connection with the F&M Bancshares, Inc. acquisition, Allegiance assumed junior subordinated debentures that allow it to defer interest payments thereunder for a period of time. To the extent the Company elects to defer any interest payments under the junior subordinated debentures, the Company will be prohibited by the terms of the junior subordinated debentures from making dividend payments on its common stock until it retires the arrearages on the junior subordinated debentures. In addition, the Company’s existing credit agreement restricts its ability to pay dividends under certain conditions.
Recent Sales of Unregistered Securities
Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information as of December 31, 2022, regarding the equity compensation plans under which the Company’s equity securities are authorized for issuance:
|Plan Category||Number of securities|
to be issued upon
warrants and rights
exercise price of
warrants and rights
|Number of securities |
for future issuance
reflected in column (a))
Equity compensation plans approved by security holders
|942,879 ||$||26.16 ||1,424,973 |
Equity compensation plans not approved by security holders
|— ||— ||— |
|Total||942,879 || ||1,424,973 |
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
In 2022, the Company’s Board of Directors authorized a share repurchase program, or the 2022 Repurchase Program, under which the Company may repurchase up to $40.0 million of the Company’s common stock starting September 22, 2022 through September 30, 2023.
Repurchases under the Company’s share repurchase program may be made from time to time at the Company’s discretion in open market transactions, through block trades, in privately negotiated transactions, and pursuant to any trading plan that may be adopted by the Company’s management in accordance with Rule 10b5-1 of the Exchange Act or otherwise. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. The repurchase program does not obligate the Company to acquire a specific dollar amount or number of shares and may be modified, suspended or discontinued at any time.
The following table provides information with respect to purchases made by or on behalf of the Company or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) of the Company’s common stock during the
fourth quarter of 2022.
Number of Shares Purchased(1)
|Average Price Paid Per Share||Shares Purchased as Part of Publicly Announced Plan|
Number of Shares That May Yet be Purchased Under the Plan(2)
|October 1, 2022 to October 31, 2022||90,247 ||$||29.33 ||— ||1,218,027 |
|November 1, 2022 to November 30, 2022||— ||$||— ||— ||1,183,082 |
|December 1, 2022 to December 31, 2022||— ||$||— ||— ||1,357,773 |
|Total||90,247 ||$||29.33 |
(1) Shares employees elected to have withheld to satisfy their tax liabilities related to options exercised or restricted stock vested or to pay the exercise price of the options as allowed under the Company’s stock compensation plans. When this settlement method is elected by the employee, the Company repurchases the shares withheld upon vesting of the award stock.
(2) Computed based on the closing share price of the Company’s common stock as of the end of each period shown.
The performance graph compares the cumulative total shareholder return on CBTX’s common stock for the period beginning at the close of trading on December 31, 2017 to the close of trading on September 30, 2022 and Stellar’s common stock for the period beginning October 1, 2022 to the close of trading on December 31, 2022, with the cumulative total return of the NASDAQ Composite Index and the NASDAQ Bank Index for the same period. Dividend reinvestment has been assumed. The Performance Graph assumes $100 invested on December 31, 2017 in the Company’ common stock, in the NASDAQ Composite Index and in the NASDAQ Bank Index. The historical stock price performance for Stellar’s common stock shown on the graph below is not necessarily indicative of future stock performance.
(1) Prior to the Merger, the shares were traded under the symbol “CBTX.”
* $100 invested on December 31, 2017 in Stellar’s common stock or an index, including reinvestment of dividends. Fiscal year ending December 31.
|Stellar Bancorp, Inc.||100.00 ||99.75 ||107.01 ||89.53 ||103.66 ||107.19 |
|NASDAQ Composite||100.00 ||97.16 ||132.81 ||192.47 ||235.15 ||158.65 |
|NASDAQ Bank||100.00 ||75.78 ||89.41 ||81.19 ||114.69 ||96.14 |
ITEM 6. [RESERVED]
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Notice Regarding Forward-Looking Statements
This Annual Report on Form 10-K contains forward‑looking statements. These forward‑looking statements reflect the Company’s current views with respect to, among other things, future events and the Company’s financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and “outlook,” or the negative version of those words or other comparable words or phrases of a future or forward‑looking nature. These forward‑looking statements are not historical facts, and are based on current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond the Company’s control. Accordingly, the Company cautions that any such forward‑looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. Although the Company believes that the expectations reflected in these forward‑looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward‑looking statements.
There are or will be important factors that could cause the Company’s actual results to differ materially from those indicated in these forward‑looking statements, including, but not limited to, the risks described in “Part I.—Item 1A.—Risk Factors” and the following:
•the effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board;
◦inflation, interest rate, securities market and monetary fluctuations;
◦local, regional, national and international economic conditions and the impact they may have on the Company and our customers and the Company’s assessment of that impact;
◦sustained instability of the oil and gas industry in general and within Texas;
◦liquidity risks associated with the Company’s business, including lack of access to liquidity;
◦the composition of the Company’s loan portfolio and the concentration of loans in commercial real estate and commercial real estate construction;
◦the geographic concentration of the Company’s markets;
◦the accuracy and sufficiency of the assumptions and estimates the Company makes in establishing reserves for potential loan losses and other estimates;
◦the amount of nonperforming and classified assets that the Company holds and the time and effort necessary to resolve nonperforming assets;
◦deterioration of asset quality;
◦changes in the value of collateral securing the Company’s loans;
◦the risk that the expected cost savings and any revenue synergies from the Merger may not be fully realized or may take longer than anticipated to be realized;
◦the ability to retain personnel after the completion of the Merger;
◦natural disasters and adverse weather on the Company’s market area, acts of terrorism, pandemics, an outbreak of hostilities, such as the conflict in Ukraine, or other international or domestic calamities and other matters beyond the Company’s control;
◦the potential impact of climate change;
◦the impact of pandemics, epidemics or any other health-related crisis;
◦the Company’s ability to maintain important deposit customer relationships and its reputation;
◦the Company’s ability to maintain effective internal control over financial reporting;
◦the cost and effects of cyber incidents or other failures, interruptions or security breaches of the Company's systems or those of the Company's customers or third-party providers;
◦the failure of certain third- or fourth-party vendors to perform;
◦the institution and outcome of litigation and other legal proceedings against the Company or to which it may become subject;
◦the costs, effects and results of regulatory examinations, investigations, or reviews or the ability to obtain required regulatory approvals or meet conditions associated with the same;
◦changes in the laws, rules, regulations, interpretations or policies relating to financial institution, accounting, tax, trade, monetary and fiscal matters;
◦the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters; and
◦other risks, uncertainties, and factors that are discussed from time to time in the Company’s reports and documents filed with the SEC.
The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with Item 15.—Exhibits and Financial Statement Schedules and the consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis includes forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that the Company believes are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth in “Part I.—Item 1A.—Risk Factors” and elsewhere in this Annual Report on Form 10-K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis.
The Company disclaims any obligation and does not intend to update or revise any forward-looking statements contained in this Annual Report on Form 10-K, which speak only as of the date hereof, whether as a result of new information, future events or otherwise, except as required by federal securities laws. As forward-looking statements involve significant risks and uncertainties, caution should be exercised against placing undue reliance on such statements.
We generate most of our income from interest income on loans, interest income from investments in securities and service charges on customer accounts. We incur interest expense on deposits and other borrowed funds and noninterest expenses such as salaries and employee benefits and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings that are used to fund those assets. Net interest income is our largest source of revenue. To evaluate net interest income, we measure and monitor (1) yields on our loans and other interest-earning assets, (2) the interest expenses of our deposits and other funding sources, (3) our net interest spread and (4) our net interest margin. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Net interest margin is calculated as net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and shareholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources.
Our net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas and specifically in our markets, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target market and throughout the state of Texas.
Our net interest income is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and borrowed funds, referred to as a “rate change.” Fluctuations in market interest rates are driven by many factors,
including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets.
Completion of Merger of Equals
On October 1, 2022, Allegiance and CBTX merged with CBTX as the surviving corporation that was renamed Stellar Bancorp, Inc. At the effective time of the Merger, each outstanding share of Allegiance common stock, par value of $1.00 per share, was converted into the right to receive 1.4184 shares of common stock of the Company.
Immediately following the Merger, CommunityBank merged with and into Allegiance Bank with Allegiance Bank as the surviving bank. In connection with the operational conversion during the first quarter of 2023, Allegiance Bank changed its name to Stellar Bank on February 18, 2023. After the merger, Stellar became one of the largest banks based in Houston.
The Merger constituted a business combination and was accounted for as a reverse merger using the acquisition method of accounting. As a result, Allegiance was the accounting acquirer and CBTX was the legal acquirer and the accounting acquiree. Accordingly, the historical financial statements of Allegiance became the historical financial statements of the combined company. In addition, the assets and liabilities of CBTX have been recorded at their estimated fair values and added to those of Allegiance as of October 1, 2022. The determination of fair value required management to make estimates about discount rates, expected future cash flows, market conditions and other future events that are subjective and subject to change.
The Company’s results of operations for the year ended December 31, 2022 reflect Allegiance results for the first nine months of 2022, while the results for the fourth quarter of 2022, after the Merger on October 1, 2022, set forth the results of operations for Stellar. The Company’s historical operating results as of and for the years ended December 31, 2021 and 2020, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. The Company has substantially completed its valuations of CBTX’s assets and liabilities but may refine those valuations for up to a year from the date of the Merger. The Merger had a significant impact on all aspects of the Company’s financial statements, and financial results for periods after the Merger are not comparable to financial results for periods prior to the Merger. The number of shares issued and outstanding, earnings per share, additional paid-in capital, dividends paid and all references to share quantities of the Company have been retrospectively adjusted to reflect the equivalent number of shares issued to holders of Allegiance common stock in the Merger. See Note 2 – Acquisitions in the accompanying notes to the consolidated financial statements for the impact of the Merger.
Critical Accounting Policies
Certain of our accounting estimates are important to the portrayal of our financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Management believes that determining the allowance for credit losses is its most critical accounting estimate. Our accounting policies are discussed in detail in Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies in the accompanying notes to the consolidated financial statements.
Allowance for Credit Losses
The allowance for credit losses is a valuation account which represents management’s best estimate of lifetime expected losses based on reasonable and supportable forecasts, historical loss experience, and other qualitative considerations. The Company bases its estimates of credit losses on three primary components: (1) estimates of expected losses that exist in various segments of performing loans over the remaining life of the loan portfolio using a reasonable and supportable economic forecast, (2) specifically identified losses in individually analyzed credits which are collateral-dependent, which generally include loans internally graded as impaired and purchased credit deteriorated (“PCD”) loans and (3) qualitative factors related to economic conditions, portfolio concentrations, regulatory policy updates, and other relevant factors that address estimates of expected losses not fully addressed based upon management’s judgment of portfolio conditions. One of the most significant judgments used in determining the allowance for credit losses is the reasonable and supportable economic forecast. Estimating the timing and amounts of future losses is subject to significant management judgment as these projected cash flows rely upon the estimates discussed above and factors that are reflective of current or future expected conditions. Volatility in certain credit metrics and differences between expected and actual outcomes are to be expected. Customers may not repay their loans according to the original terms, and the collateral securing the payment of those loans may be insufficient to pay any remaining loan balance.
The allowance for credit losses includes the allowance for credit losses on loans, which is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on loans, and the allowance for credit losses on unfunded commitments reported in other liabilities. The amount of the allowance for credit losses is affected by the following: (1) charge-offs of loans that decrease the allowance, (2) subsequent recoveries on loans previously charged off that increase the allowance and (3) provisions for (or reversal of) credit losses charged to income that increase or decrease the allowance. Management considers the policies related to the allowance for credit losses as the most critical to the financial statement presentation. The total allowance for credit losses includes activity related to allowances calculated in accordance with Accounting Standards Codification (“ASC”) 326 – Measurement of Credit Losses on Financial Instruments.
In addition, various regulatory agencies, as an integral part of the examination process, periodically review the allowance for credit losses. Such agencies may require the Bank to recognize adjustments to the allowance based on their judgments of the information available to them at the time of their examination.
The allowance for credit losses could be affected by significant downturns in circumstances relating to loan quality and economic conditions and as such may not be sufficient to cover expected losses in the loan portfolio which could necessitate additional provisions or a reduction in the allowance for credit losses if our assumption prove to be incorrect. Unanticipated changes and events could have a significant impact on the financial performance of borrowers and their ability to perform as agreed. We may experience significant credit losses if borrowers experience financial difficulties, which could have a material adverse effect on our operating results.
Fair value of loans acquired in a business combination
On October 1, 2022, the Company recorded $273.6 million of goodwill, based on the fair value of acquired assets and liabilities of CBTX. The fair value often involved third-party estimates utilizing input assumptions by management which may be complex or uncertain. The fair value of acquired loans is based on a discounted cash flow methodology that considers factors such as type of loan and related collateral, and requires management’s judgement on estimates about discount rates, expected future cash flows, market conditions and other future events.
For purchased financial loans with credit deterioration, PCD loans, an estimate of expected credit losses was made for loans with similar risk characteristics and was added to the purchase price to establish the initial amortized cost basis of the PCD loans. Any difference between the unpaid principal balance and the amortized cost basis is considered to relate to noncredit factors and results in a discount or premium. Discounts and premiums are recognized through interest income on a level-yield method over the life of the loans. For acquired loans not deemed PCD at acquisition, the differences between the initial fair value and the unpaid principal balance are recognized as interest income on a level-yield basis over the lives of the related loans.
Management relied on economic forecasts, internal valuations, or other relevant factors which were available at the time of the Merger in the determination of the assumptions used to calculate the fair value of the acquired loans. The estimates about discount rates, expected future cash flows, market conditions and other future events are subjective and may differ from estimates.
The estimate of fair values on acquired loans contributed to the recorded goodwill from the Merger. In future income statement periods, interest income on loans will include the amortization and accretion of any premiums and discounts resulting from the fair value of acquired loans. Additionally, the provision for credit losses on acquired individually analyzed PCD loans may be impacted due to changes in the assumptions used to calculated expected cash flows.
Merger and goodwill
The acquisition method of accounting requires that assets acquired and liabilities assumed in business combinations are recorded at their fair values. This often involves estimates based on third-party or internal valuations based on discounted cash flow analyses or other valuation techniques, which are inherently subjective. Business combinations also typically result in goodwill, which is subject to ongoing periodic impairment tests based on the fair values of the reporting units to which the goodwill relates. The amortization of intangible assets with definite useful lives is based upon the estimated economic benefits to be received, which is also subjective. Provisional estimates of fair values may be adjusted for a period of up to one year from the acquisition date if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. Adjustments recorded during this period are recognized in the current reporting period.
Management uses various valuation methodologies to estimate the fair value of these assets and liabilities, and often involves a significant degree of judgment, particularly when liquid markets do not exist for the particular item being valued. Examples of such
items include loans, deposits, identifiable intangible assets and certain other assets and liabilities. Management uses significant estimates and assumptions to value such items, including projected cash flows, repayment rates, default rates and losses assuming default, discount rates, and realizable collateral values. The allowance for credit losses on PCD loans is recognized within business combination accounting. The allowance for credit losses for non-purchased credit deteriorated (“non-PCD”) assets is recognized as provision expense in the same reporting period as the business combination. The valuation of other identifiable intangible assets, including core deposit intangibles and other intangibles, requires assumptions such as projected attrition rates, expected revenue and costs, discount rates and other forward-looking factors. The purchase date valuations and any subsequent adjustments also determine the amount of goodwill recognized in connection with the business combination. Our estimates of the fair value of assets acquired and liabilities assumed are based upon assumptions that we believe to be reasonable, and whenever necessary, include assistance from independent third-party appraisal and valuation firms.
Goodwill represents the excess of the consideration paid over the fair value of the net assets acquired in a business
combination. The Company assesses goodwill for impairment at the reporting unit level on an annual basis, or more often if an
event occurs or circumstances change which indicate there may be impairment. The impairment test compares the estimated fair
value of each reporting unit with its net book value. The fair value of the reporting unit is estimated using valuation techniques that market participants would use in an acquisition of the whole reporting unit, such as estimated discounted cash flows, the quoted market price of our common stock adjusted for a control premium, and observable average price-to forward-earnings and price-to-tangible book multiples of observed transactions. If the unit’s fair value is less than its carrying value, an estimate of the implied fair value of the goodwill is compared to the goodwill’s carrying value and any impairment recognized.
The Company performed its annual qualitative assessment to determine if it was more likely than not that a reporting unit’s
fair value was less than its carrying value as of September 30, 2022. Based on this assessment, it was determined the
reporting units’ fair value exceeded their carrying value. See Note 3 – Goodwill and Other Intangible Assets to the consolidated financial statements for additional information on the Company’s goodwill balances and Note 2 – Acquisitions to the consolidated financial statements for goodwill and intangibles recorded in the periods presented.
Recently Issued Accounting Pronouncements
We have evaluated new accounting pronouncements that have recently been issued and have determined that there are no new accounting pronouncements that should be described in this section that will impact the Company’s operations, financial condition or liquidity in future periods. Refer to Note 1 – Nature of Operations and Summary of Significant Accounting and Reporting Policies in the accompanying notes to the consolidated financial statements.
Results of Operations
This section provides a comparative discussion of the Company’s results of operations for the two-year period ended December 31, 2022, unless otherwise specified. See “Item 7 – Management Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2021 for a discussion of 2021 versus 2020 results.
The Company’s results of operations for the year ended December 31, 2022 reflect Allegiance’s activity for the first nine months of 2022 while the results for the fourth quarter of 2022, after the Merger on October 1, 2022, set forth the results of operations for Stellar. Accordingly, the Company’s historical operating results as of and for the years ended December 31, 2021 and 2020, as presented and discussed in this Annual Report on Form 10-K, do not include the historical results of CBTX. The Company has substantially completed its valuations of CBTX’s assets and liabilities. The Company’s taxes are provisional along with the review of certain contracts assumed in the Merger. The Merger had a significant impact on all aspects of the Company’s financial statements, and as a result, financial results after the Merger are not comparable to financial results prior to the Merger. The number of shares issued and outstanding, earnings per share, additional paid-in capital, dividends paid per share and all references to share quantities of the Company have been retrospectively adjusted to reflect the equivalent number of shares issued to holders of Allegiance common stock in the Merger. See Note 2 – Acquisitions in the accompanying notes to the consolidated financial statements for the impact of the Merger.
Net income was $51.4 million, or $1.47 per diluted common share, for the year ended December 31, 2022 compared with $81.6 million, or $2.82 per diluted common share, for the year ended December 31, 2021, a decrease of $30.1 million, or 36.9%. The decrease in net income was primarily due to a $56.5 million increase in noninterest expense and a $53.0 million increase in provision for credit losses, partially offset by a $60.4 million increase in net interest income, an $11.8 million increase in noninterest income and a $7.2 million decrease in the provision for income taxes. The increased provision for credit losses from the prior year was primarily due to the initial provision for credit losses recorded on acquired non-PCD loans of $28.2 million. Acquisition and merger-related
expenses totaled $24.1 million for the year ended December 31, 2022 compared to $2.0 million for the year ended December 31, 2021. See further analysis of the material fluctuations in the related discussions that follow.
Returns on average equity were 5.69% and 10.38%, returns on average assets were 0.64% and 1.24% and efficiency ratios were 64.23% and 58.86% for the years ended December 31, 2022 and 2021, respectively. The efficiency ratio is calculated by dividing total noninterest expense by the sum of net interest income plus noninterest income, excluding gains and losses on the sale of loans, securities and assets. Additionally, taxes and provision for credit losses are not part of the efficiency ratio calculation.
Net Interest Income
Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is our largest source of revenue, representing 93.4% of total revenue during 2022. Tax equivalent net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.
The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the effective federal funds rate, which is the cost of immediately available overnight funds, and the U.S. prime interest rate. During 2022, the effective federal funds rate increased 425 basis points to end the year at 4.50%. There were no changes to the effective federal funds rate during 2021. During 2020, the effective federal funds rate decreased 150 basis points to end the period at 0.25%. Similarly, during 2022, the U.S. prime rate increased 425 basis points to end the period at 7.50%. There were no changes to the U.S. prime rate during 2021. During 2020, the U.S. prime rate decreased 150 basis points to end the year at 3.25%.
Net interest income before the provision for credit losses for the year ended December 31, 2022 was $289.0 million compared with $228.6 million for the year ended December 31, 2021, an increase of $60.4 million, or 26.4% primarily due to the increase in average interest-earning assets and liabilities as a result of the Merger.
Interest income was $323.0 million for the year ended December 31, 2022, an increase of $69.8 million, or 27.6%, compared with $253.2 million for the year ended December 31, 2021 primarily due to the Merger as average interest-earning asset balances increased along with increased interest rates and an increase in higher-yielding loans during the year. Average interest-earning assets increased $1.48 billion, or 25.0%, for the year ended December 31, 2022 compared with the year ended December 31, 2021 primarily due to the Merger.
Interest expense was $34.0 million for the year ended December 31, 2022, an increase of $9.4 million, or 38.2%, compared with $24.6 million for the year ended December 31, 2021. This increase was primarily due to higher funding costs on interest-bearing deposits due to higher interest rates and an increase in average interest-bearing liabilities. The cost of average interest-bearing liabilities increased to 81 basis points for the year ended December 31, 2022 compared to 66 basis points for the same period in 2021. Average interest-bearing liabilities increased $439.5 million for the year ended December 31, 2022 compared to the year ended December 31, 2021 primarily due to the Merger.
Tax equivalent net interest margin, defined as net interest income adjusted for tax-free income divided by average interest-earning assets, for the year ended December 31, 2022 was 3.94%, an increase of 4 basis points compared to 3.90% for the year ended December 31, 2021. The increase in the net interest margin on a tax equivalent basis was primarily due to the Merger and an increase in the average yield on interest-earning assets partially offset by increased funding costs. The average yield on interest-earning assets of 4.36% and the average rate paid on interest-bearing liabilities of 0.81% for the year ended December 31, 2022 increased by 9 basis points and 15 basis points, respectively, over the same period in 2021. Tax equivalent adjustments to net interest margin are the result of increased or decreased income from tax-free securities by an amount equal to the taxes that would have been paid if the income were fully taxable based on a 21% federal tax rate for the years ended December 31, 2022 and 2021, thus making tax-exempt yields relatively more comparable to taxable asset yields.
The following table presents, for the periods indicated, the total dollar amount of average balances, interest income from average interest-earning assets and the annualized resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed in both dollars and rates. Any nonaccruing loans have been included in the table as loans carrying a zero yield.
|For the Years Ended December 31, |
|(Dollars in thousands) |
|Assets|| || |
|Interest-Earning Assets:|| || || || || || || || || |
|Loans||$||5,171,944 ||$||280,375 ||5.42%||$||4,422,467 ||$||230,713 ||5.22%||$||4,383,375 ||$||225,959 ||5.15%|
|Securities||1,779,425 ||37,861 ||2.13%||1,050,376 ||21,798 ||2.08%||588,318 ||15,538 ||2.64%|
Deposits in other financial institutions
|462,075 ||4,758 ||1.03%||458,190 ||673 ||0.15%||36,945 ||265 ||0.72%|
|Total interest-earning assets||7,413,444 ||$||322,994 ||4.36%||5,931,033 ||$||253,184 ||4.27%||5,008,638 ||$||241,762 ||4.83%|
Allowance for credit losses on loans
|Noninterest-earning assets||634,073 ||680,191 ||675,701 |
|Total assets||$||7,988,273 ||$||6,559,711 ||$||5,637,659 |
Liabilities and Shareholders' Equity
| || || || || || || || || |
|Interest-Bearing Liabilities:|| || || || || || || || || |
|Interest-bearing demand deposits||$||1,140,575 ||$||9,278 ||0.81%||$||574,079 ||$||1,409 ||0.25%||$||385,482 ||$||2,045 ||0.53%|
Money market and savings deposits
|1,841,348 ||9,861 ||0.54%||1,571,532 ||3,956 ||0.25%||1,316,188 ||7,326 ||0.56%|
Certificates and other time deposits
|1,034,491 ||7,825 ||0.76%||1,349,216 ||11,628 ||0.86%||1,268,080 ||21,675 ||1.71%|
|Borrowed funds||61,773 ||1,216 ||1.97%||144,354 ||1,878 ||1.30%||197,525 ||2,183 ||1.11%|
|Subordinated debt||109,111 ||5,856 ||5.37%||108,588 ||5,749 ||5.29%||108,064 ||5,850 ||5.41%|
Total interest-bearing liabilities
|4,187,298 ||$||34,036 ||0.81%||3,747,769 ||$||24,620 ||0.66%||3,275,339 ||$||39,079 ||1.19%|
| || || || || || || || || |
Noninterest-bearing demand deposits
|2,833,865 ||1,983,934 ||1,593,354 || || |
|Other liabilities||62,581 ||41,972 ||37,278 || || |
|Total liabilities||7,083,744 ||5,773,675 ||4,905,971 || || |
|Shareholders' equity||904,529 ||786,036 ||731,688 || || |
Total liabilities and shareholders' equity
|$||7,988,273 ||$||6,559,711 ||$||5,637,659 || || |
|Net interest rate spread|| ||3.55%||3.61%||3.64%|
Net interest income and margin(1)
| ||$||288,958 ||3.90%||$||228,564 ||3.85%||$||202,683 ||4.05%|
Net interest income and margin (tax equivalent)(2)
| ||$||292,152 ||3.94%||$||231,315 ||3.90%||$||204,416 ||4.08%|
(1)The net interest margin is equal to net interest income divided by average interest-earning assets.
(2)The tax-equivalent adjustment has been computed using a federal income tax rate of 21% for the years ended December 31, 2022, 2021 and 2020 and other applicable effective tax rates.
The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to rate.
|For the Years Ended December 31, |
|2022 vs. 2021||2021 vs. 2020|
Due to Change in
|Total ||Increase |
Due to Change in
|Volume ||Rate ||Volume ||Rate |
|(In thousands) |
|Loans||$||39,262 ||$||10,400 ||$||49,662 ||$||2,640 ||$||2,114 ||$||4,754 |
|Securities||15,214 ||849 ||16,063 ||12,203 ||(5,943)||6,260 |
Deposits in other financial institutions
|20 ||4,065 ||4,085 ||3,022 ||(2,614)||408 |
Total increase (decrease) in interest income
|54,496 ||15,314 ||69,810 ||17,865 ||(6,443)||11,422 |
Interest-bearing demand deposits
|1,442 ||6,427 ||7,869 ||1,001 ||(1,637)||(636)|
|Money market and savings deposits||647 ||5,258 ||5,905 ||1,421 ||(4,791)||(3,370)|
|Certificates and other time deposits||(2,731)||(1,072)||(3,803)||1,387 ||(11,434)||(10,047)|
|Borrowed funds||(1,075)||413 ||(662)||(588)||283 ||(305)|
|Subordinated debt||23 ||84 ||107 ||28 ||(129)||(101)|
|Total (decrease) increase in interest expense||(1,694)||11,110 ||9,416 ||3,249 ||(17,708)||(14,459)|
Increase in net interest income
|$||56,190 ||$||4,204 ||$||60,394 ||$||14,616 ||$||11,265 ||$||25,881 |
Provision for Credit Losses
Our allowance for credit losses is established through charges to income in the form of the provision in order to bring our allowance for credit losses for various types of financial instruments including loans, securities and unfunded commitments to a level deemed appropriate by management. We recorded a $50.7 million provision for credit losses for the year ended December 31, 2022 compared to a $2.3 million release of provision for credit losses for the year ended December 31, 2021. The provision for credit losses for the year ended December 31, 2022 included an initial provision for credit losses recorded on acquired non-PCD loans of $28.2 million along with a provision for acquired unfunded commitments of $5.0 million as a result of the Merger. The remaining increase in the provision during 2022 compared to the prior year primarily reflects the increase in loans during the year, among other factors.
Our primary sources of noninterest income are debit card and ATM card income, service charges on deposit accounts, income earned on bank owned life insurance and nonsufficient funds fees. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method.
Noninterest income totaled $20.4 million for the year ended December 31, 2022 compared to $8.6 million for the year ended December 31, 2021, an increase of $11.8 million, or 137.7%. Noninterest income increased in 2022 primarily due to increased scale as a result of the Merger along with nonrecurring gains on sales of securities, loans and assets held for sale totaling $4.1 million.
The following table presents, for the periods indicated, the major categories of noninterest income:
|For the Years Ended|
|For the Years Ended|
|(In thousands) |
|Nonsufficient funds fees||$||834 ||$||464 ||$||370 ||$||464 ||$||404 ||$||60 |
|Service charges on deposit accounts||2,856 ||1,671 ||1,185 ||1,671 ||1,530 ||141 |
|Gain (loss) on sale of assets||4,050 ||(272)||4,322 ||(272)||287 ||(559)|
|Bank owned life insurance income||1,125 ||554 ||571 ||554 ||582 ||(28)|
|Debit card and ATM card income||4,465 ||2,996 ||1,469 ||2,996 ||2,205 ||791 |
|7,024 ||3,149 ||3,875 ||3,149 ||3,148 ||1 |
|Total noninterest income||$||20,354 ||$||8,562 ||$||11,792 ||$||8,562 ||$||8,156 ||$||406 |
(1)Other includes wire transfer and letter of credit fees, among other items.
Noninterest expense was $196.1 million for the year ended December 31, 2022 compared to $139.6 million for the year ended December 31, 2021, an increase of $56.5 million, or 40.5%. The increase in noninterest expense was primarily due to increased salaries and benefits, amortization of core deposit intangibles and acquisition and merger-related expenses associated with the Merger.
The following table presents, for the periods indicated, the major categories of noninterest expense:
|For the Years Ended|
|For the Years Ended|
|(In thousands) |
Salaries and employee benefits(1)
|$||107,554 ||$||90,177 ||$||17,377 ||$||90,177 ||$||80,152 ||$||10,025 |
|Net occupancy and equipment||10,335 ||9,144 ||1,191 ||9,144 ||7,969 ||1,175 |
|Depreciation||4,951 ||4,254 ||697 ||4,254 ||3,716 ||538 |
|Data processing and software amortization||11,337 ||8,862 |