10-Q
 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q


(Mark One)
 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2016
 
OR
 
 o 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  001-33572

Bank of Marin Bancorp
(Exact name of Registrant as specified in its charter)
 
California  
 
20-8859754
(State or other jurisdiction of incorporation)  
 
(IRS Employer Identification No.)
 
 
 
504 Redwood Blvd., Suite 100, Novato, CA 
 
94947
(Address of principal executive office)
 
(Zip Code)
 
Registrant’s telephone number, including area code:  (415) 763-4520
 
Indicate by check mark whether the registrant (1) has filed all reports 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 x                    No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).
Yes x                   No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
         
 Large accelerated filer   o
 Accelerated filer   x
 Non-accelerated filer   o
 Smaller reporting company   o
 
Indicate by check mark if the registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act.
Yes   o     No  x
 
As of April 30, 2016, there were 6,116,515 shares of common stock outstanding.


TABLE OF CONTENTS
 
 
 
 
PART I
 
 
 
ITEM 1.
 
 
 
 
 
 
 
 
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
PART II
 
 
 
ITEM 1.
 
 
 
ITEM 1A.
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
ITEM 5.
 
 
 
ITEM 6.
 
 
 




Page-2


PART I       FINANCIAL INFORMATION
 
ITEM 1.  Financial Statements
 
BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CONDITION 
at March 31, 2016 and December 31, 2015
(in thousands, except share data; unaudited)
March 31, 2016

 
December 31, 2015

Assets
 

 
 
Cash and due from banks
$
39,770

 
$
26,343

Investment securities
 

 
 
Held-to-maturity, at amortized cost
63,246

 
69,637

Available-for-sale, at fair value
336,234

 
417,787

Total investment securities
399,480

 
487,424

Loans, net of allowance for loan losses of $15,028 and $14,999 at March 31, 2016 and December 31, 2015, respectively
1,426,811

 
1,436,229

Bank premises and equipment, net
8,909

 
9,305

Goodwill
6,436

 
6,436

Core deposit intangible
2,980

 
3,113

Interest receivable and other assets
59,216

 
62,284

Total assets
$
1,943,602

 
$
2,031,134

 
 
 
 
Liabilities and Stockholders' Equity
 

 
 

Liabilities
 

 
 

Deposits
 

 
 

Non-interest-bearing
$
758,869

 
$
770,087

Interest-bearing
 

 
 
Transaction accounts
102,829

 
114,277

Savings accounts
145,874

 
141,316

Money market accounts
514,274

 
541,089

Time accounts
159,500

 
161,457

Total deposits
1,681,346

 
1,728,226

   Federal Home Loan Bank ("FHLB") and other borrowings
19,350

 
67,000

 Subordinated debentures
5,445

 
5,395

   Interest payable and other liabilities
15,815

 
16,040

Total liabilities
1,721,956

 
1,816,661

 
 
 
 
Stockholders' Equity
 

 
 

Preferred stock, no par value
Authorized - 5,000,000 shares, none issued
—

 
—

Common stock, no par value
Authorized - 15,000,000 shares;
Issued and outstanding - 6,116,473 and 6,068,543 at
    March 31, 2016 and December 31, 2015, respectively
86,133

 
84,727

Retained earnings
133,681

 
129,553

Accumulated other comprehensive income, net
1,832

 
193

Total stockholders' equity
221,646

 
214,473

Total liabilities and stockholders' equity
$
1,943,602

 
$
2,031,134


The accompanying notes are an integral part of these consolidated financial statements (unaudited).

Page-3


BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
Three months ended
(in thousands, except per share amounts; unaudited)
March 31, 2016
 
March 31, 2015
Interest income
 
 
 
Interest and fees on loans
$
17,141

 
$
15,379

Interest on investment securities


 


Securities of U.S. government agencies
1,352

 
1,035

Obligations of state and political subdivisions
586

 
540

Corporate debt securities and other
105

 
205

Interest on Federal funds sold and short-term investments
11

 
21

Total interest income
19,195

 
17,180

Interest expense
 

 
 

Interest on interest-bearing transaction accounts
27

 
30

Interest on savings accounts
14

 
12

Interest on money market accounts
111

 
127

Interest on time accounts
196

 
231

Interest on FHLB and other borrowings
100

 
78

Interest on subordinated debentures
109

 
104

Total interest expense
557

 
582

Net interest income
18,638

 
16,598

Provision for loan losses
—

 
—

Net interest income after provision for loan losses
18,638

 
16,598

Non-interest income
 

 
 

Service charges on deposit accounts
456

 
525

Wealth Management and Trust Services
566

 
638

Debit card interchange fees
338

 
347

Merchant interchange fees
113

 
130

Earnings on bank-owned life insurance
201

 
203

Dividends on FHLB stock
169

 
148

Gains on investment securities, net
110

 
8

Other income
210

 
190

Total non-interest income
2,163

 
2,189

Non-interest expense
 

 
 

Salaries and related benefits
6,748

 
6,790

Occupancy and equipment
1,281

 
1,342

Depreciation and amortization
453

 
421

Federal Deposit Insurance Corporation insurance
261

 
236

Data processing
856

 
786

Professional services
498

 
564

Directors' expense
189

 
191

Information technology
193

 
152

Reversal of losses on off-balance sheet commitments
—

 
(201
)
Other expense
1,531

 
1,567

Total non-interest expense
12,010

 
11,848

Income before provision for income taxes
8,791

 
6,939

Provision for income taxes
3,145

 
2,482

Net income
$
5,646

 
$
4,457

Net income per common share:
 

 
 

Basic
$
0.93

 
$
0.75

Diluted
$
0.93

 
$
0.74

Weighted average shares used to compute net income per common share:


 
 

Basic
6,048

 
5,921

Diluted
6,090

 
6,048

Dividends declared per common share
$
0.25

 
$
0.22

Comprehensive income:
 
 
 
Net income
$
5,646

 
$
4,457

Other comprehensive income


 


Change in net unrealized gain on available-for-sale securities
2,923

 
1,317

Reclassification adjustment for gains on available-for-sale securities
    included in net income
(110
)
 
(8
)
             Net change in unrealized gain on available-for-sale securities, before tax
2,813

 
1,309

Deferred tax expense
1,174

 
554

Other comprehensive income, net of tax
1,639

 
755

Comprehensive income
$
7,285

 
$
5,212

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

Page-4


BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
for the year ended December 31, 2015 and the three months ended March 31, 2016
(in thousands, except share data; unaudited)
 
Common Stock
 
Retained
Earnings

 
Accumulated Other
Comprehensive Income (Loss),
Net of Taxes

 
 Total

Shares

 
Amount

 
 
 
Balance at December 31, 2014
 
5,939,482

 
$
82,436

 
$
116,502

 
$
1,088

 
$
200,026

Net income
 
—

 
—

 
18,441

 
—

 
18,441

Other comprehensive loss
 
—

 
—

 
—

 
(895
)
 
(895
)
Stock options exercised
 
37,071

 
1,139

 
—

 
—

 
1,139

Excess tax benefit - stock-based compensation
 
—

 
212

 
—

 
—

 
212

Stock issued under employee stock purchase plan
 
339

 
17

 
—

 
—

 
17

Restricted stock granted
 
15,970

 
—

 
—

 
—

 
—

Restricted stock forfeited / cancelled
 
(450
)
 
—

 
—

 
—

 
—

Stock-based compensation - stock options
 
—

 
252

 
—

 
—

 
252

Stock-based compensation - restricted stock
 
—

 
384

 
—

 
—

 
384

Cash dividends paid on common stock
 
—

 
—

 
(5,390
)
 
—

 
(5,390
)
Stock purchased by directors under director stock plan
 
245

 
12

 
—

 
—

 
12

Stock issued in payment of director fees
 
5,295

 
275

 
—

 
—

 
275

Stock issued from exercise of warrants
 
70,591

 
—

 
—

 
—

 
—

Balance at December 31, 2015
 
6,068,543

 
$
84,727

 
$
129,553

 
$
193

 
$
214,473

Net income
 
—

 
—

 
5,646

 
—

 
5,646

Other comprehensive income
 
—

 
—

 
—

 
1,639

 
1,639

Stock options exercised
 
28,075

 
956

 
—

 
—

 
956

Excess tax benefit - stock-based compensation
 
—

 
79

 
—

 
—

 
79

Stock issued under employee stock purchase plan
 
125

 
6

 
—

 
—

 
6

Restricted stock granted
 
16,910

 
—

 
—

 
—

 
—

Stock-based compensation - stock options
 
—

 
81

 
—

 
—

 
81

Stock-based compensation - restricted stock
 
—

 
133

 
—

 
—

 
133

Cash dividends paid on common stock
 
—

 
—

 
(1,518
)
 
—

 
(1,518
)
Stock purchased by directors under director stock plan
 
260

 
14

 
—

 
—

 
14

Stock issued in payment of director fees
 
2,560

 
137

 
—

 
—

 
137

Balance at March 31, 2016
 
6,116,473

 
$
86,133

 
$
133,681

 
$
1,832

 
$
221,646


The accompanying notes are an integral part of these consolidated financial statements (unaudited).

Page-5


BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the three months ended March 31, 2016 and 2015
(in thousands; unaudited)
March 31, 2016

 
March 31, 2015

Cash Flows from Operating Activities:
 
 
 
Net income
$
5,646

 
$
4,457

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Reversal of losses on off-balance sheet commitments
—

 
(201
)
Compensation expense - common stock for director fees
71

 
74

Stock-based compensation expense
214

 
92

Excess tax benefits from exercised or vesting of stock based-awards
(79
)
 
(16
)
Amortization of core deposit intangible
133

 
155

Amortization of investment security premiums, net of accretion of discounts
742

 
570

Accretion of discount on acquired loans
(428
)
 
(490
)
Accretion of discount on subordinated debentures
50

 
53

Net amortization of deferred loan origination costs/fees
75

 
(164
)
Write-down of other real estate owned
—

 
40

Gain on sale of investment securities
(110
)
 
(8
)
Depreciation and amortization
453

 
421

Earnings on bank-owned life insurance policies
(201
)
 
(203
)
Net change in operating assets and liabilities:
 

 
 

Interest receivable
724

 
456

Interest payable
10

 
(5
)
Deferred rent and other rent-related expenses
(51
)
 
(11
)
Other assets
1,348

 
674

Other liabilities
(999
)
 
(8
)
Total adjustments
1,952

 
1,429

Net cash provided by operating activities
7,598

 
5,886

Cash Flows from Investing Activities:
 

 
 

Purchase of held-to-maturity securities
—

 
(2,375
)
Purchase of available-for-sale securities
(3,636
)
 
(11,493
)
Proceeds from sale of available-for-sale securities
54,985

 
1,559

Proceeds from paydowns/maturity of held-to-maturity securities
6,237

 
11,043

Proceeds from paydowns/maturity of available-for-sale securities
32,548

 
7,133

Loans originated and principal collected, net
10,821

 
18,149

Purchase of premises and equipment
(57
)
 
(414
)
Cash paid for low income housing tax credit investment
(76
)
 
(218
)
Net cash provided by investing activities
100,822

 
23,384

Cash Flows from Financing Activities:
 

 
 

Net (decrease) increase in deposits
(46,880
)
 
33,501

Proceeds from stock options exercised
956

 
312

Proceeds from stock issued under employee and director stock purchase plans
20

 
5

Repayment of borrowings
(47,650
)
 
—

Cash dividends paid on common stock
(1,518
)
 
(1,307
)
Excess tax benefits from exercised or vesting of stock based-awards
79

 
16

Net cash (used in) provided by financing activities
(94,993
)
 
32,527

Net increase in cash and cash equivalents
13,427

 
61,797

Cash and cash equivalents at beginning of period
26,343

 
103,773

Cash and cash equivalents at end of period
$
39,770

 
$
165,570

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
498

 
$
534

Cash paid for income taxes
$
505

 
$
30

Supplemental disclosure of non-cash investing and financing activities:
 

 
 

Change in unrealized gain on available-for-sale securities
$
2,813

 
$
1,309

Subscription in low income housing tax credit investment
$
—

 
$
1,023

Stock issued in payment of director fees
$
137

 
$
138


The accompanying notes are an integral part of these consolidated financial statements (unaudited).

Page-6


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 
Note 1:  Basis of Presentation
 
The consolidated financial statements include the accounts of Bank of Marin Bancorp (“Bancorp”), a bank holding company, and its wholly-owned bank subsidiary, Bank of Marin (the “Bank”), a California state-chartered commercial bank. References to “we,” “our,” “us” mean the holding company and the Bank that are consolidated for financial reporting purposes. The accompanying unaudited consolidated interim financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles ("GAAP") have been condensed or omitted pursuant to those rules and regulations. Although we believe that the disclosures are adequate and the information presented is not misleading, we suggest that these interim financial statements be read in conjunction with the annual financial statements and the notes thereto included in our 2015 Annual Report on Form 10-K.  In the opinion of Management, the unaudited consolidated financial statements reflect all adjustments which are necessary for a fair presentation of the consolidated financial position, the results of operations, changes in comprehensive income, changes in stockholders’ equity, and cash flows for the periods presented. All material intercompany transactions have been eliminated. The results of these interim periods may not be indicative of the results for the full year or for any other period. We have evaluated subsequent events through the date of filing with the SEC and have determined that there are no subsequent events that require additional recognition or disclosure.

On November 29, 2013, we completed the merger of NorCal Community Bancorp ("NorCal"), parent company of Bank of Alameda, to enhance our market presence (the “NorCal Acquisition”). On the date of acquisition, Bancorp assumed ownership of NorCal Community Bancorp Trusts I and II, respectively (the "Trusts"), which were formed for the sole purpose of issuing trust preferred securities. Bancorp is not considered the primary beneficiary of the Trusts (variable interest entities), therefore the Trusts are not consolidated in our consolidated financial statements, but rather the subordinated debentures are shown as a liability on our consolidated statements of condition (See Note 6, Borrowings). Bancorp's investment in the common stock of the Trusts is accounted for under the equity method and is included in interest receivable and other assets on the consolidated statements of condition.
 
The following table shows: 1) weighted average basic shares, 2) potentially dilutive weighted average common shares related to stock options, unvested restricted stock awards and stock warrant, and 3) weighted average diluted shares. Basic earnings per share (“EPS”) are calculated by dividing net income by the weighted average number of common shares outstanding during each period, excluding unvested restricted stock awards. Diluted EPS are calculated using the weighted average number of potentially dilutive common shares, which is based on average market prices during the three months of the reporting period, under the treasury stock method. The number of potentially dilutive common shares included in year-to-date diluted EPS is a year-to-date weighted average of potentially dilutive common shares included in each quarterly diluted EPS computation. We have two forms of our outstanding common stock: common stock and unvested restricted stock awards. Holders of unvested restricted stock awards receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings. Therefore, under the two-class method, the difference in EPS is not significant for these participating securities.
 
Three months ended
(in thousands, except per share data)
March 31, 2016

March 31, 2015

Weighted average basic shares outstanding
6,048

5,921

Potentially dilutive common shares related to:
 
 
Stock options
35

47

Unvested restricted stock awards
7

6

Warrant
—

74

Weighted average diluted shares outstanding
6,090

6,048

Net income
$
5,646

$
4,457

Basic EPS
$
0.93

$
0.75

Diluted EPS
$
0.93

$
0.74

Weighted average anti-dilutive shares not included in the calculation of diluted EPS
48

24


Page-7


Note 2: Recently Issued Accounting Standards

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). The ASU is a converged standard involving FASB and International Financial Reporting Standards that provides a single comprehensive revenue recognition model for all contracts with customers across transactions and industries. The core principal of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount and at a time that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date which institutes a one-year deferral of the effective date of this amendment to annual reporting periods beginning after December 15, 2017. Early application is permitted only as of annual periods beginning after December 15, 2016, including interim reporting periods within that reporting period. In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net). This ASU clarifies the implementation guidance on principal versus agent considerations and on the use of indicators that assist an entity in determining whether it controls a specified good or service before it is transferred to the customer. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. This most recent ASU provides guidance in determining performance obligations in a contract with a customer and clarifies whether a promise to grant a license provides a right to access or the right to use intellectual property. We are currently evaluating the provisions of these updates and will be monitoring developments and additional guidance to determine the potential impact the new standards will have on our financial condition and results of operations.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this ASU make improvements to GAAP related to financial instruments that include the following as applicable to us.
•
Equity investments, except for those accounted for under the equity method of accounting or those that result in consolidation of the investee, are required to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.
•
Simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment - if impairment exists, this requires measuring the investment at fair value.
•
Eliminates the requirement for public companies to disclose the method(s) and significant assumptions used to estimate the fair value that is currently required to be disclosed for financial instruments measured at amortized cost on the balance sheet.
•
Public companies will be required to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes.
•
Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements.
•
The reporting entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity's other deferred tax assets.

ASU 2016-01 is effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. This ASU will impact our financial statement disclosures, however, we do not expect this ASU to have a material impact on our financial condition or results of operations.

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This ASU was issued to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities, including leases classified as operating leases under previous GAAP, on the balance sheet and requiring additional disclosures of key information about leasing arrangements. This ASU applies to leasing arrangements exceeding a twelve month term. ASU 2016-02 is effective for annual periods, including interim periods within those annual periods beginning after December 15, 2018 and requires a modified retrospective method upon adoption. Early application of the amendments is permitted. We are currently evaluating the provisions of this ASU and will be monitoring developments and additional guidance to determine the timing of our adoption and the potential outcome the amendments will have on our financial condition and results of operations.

Page-8



In March 2016, the FASB issued ASU No. 2016-05, Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships. A contract novation refers to replacing one of the parties to a derivative instrument with a new party. This ASU clarifies that a change in counterparty in a derivative instrument does not, in and of itself, require dedesignation of that hedging relationship and therefore discontinue the application of hedge accounting. ASU 2016-05 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted in any interim or annual period. We do not expect this ASU to have a material impact on our financial condition or results of operations.

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This ASU identifies areas for simplification involving several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, forfeiture accounting, and classifications on the statement of cash flows. ASU 2016-09 is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted in any interim or annual period. We are currently evaluating the the provisions of this ASU and will be monitoring developments and additional guidance to determine the potential outcome the amendments will have on our financial condition and results of operations.

Note 3:  Fair Value of Assets and Liabilities
 
Fair Value Hierarchy and Fair Value Measurement
 
We group our assets and liabilities that are measured at fair value into three levels within the fair value hierarchy, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
 
Level 1: Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities.
 
Level 2: Valuations are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuations for which all significant assumptions are observable or can be corroborated by observable market data.
 
Level 3: Valuations are based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Values are determined using pricing models and discounted cash flow models and may include significant Management judgment and estimation.

Transfers between levels of the fair value hierarchy are recognized through our monthly and/or quarterly valuation process in the reporting period during which the event or circumstances that caused the transfer occurred. 


Page-9


The following table summarizes our assets and liabilities that were required to be recorded at fair value on a recurring basis.
(in thousands)  
Description of Financial Instruments
Carrying Value

 
Quoted Prices in Active Markets for Identical Assets (Level 1)

 
Significant Other Observable Inputs (Level 2)

 
Significant Unobservable Inputs (Level 3)

At March 31, 2016:
 

 
 
 
 

 
 

Securities available-for-sale:
 
 
 
 
 
 
 
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government-sponsored agencies
$
180,306

 
$
—

 
$
179,633

 
$
673

Debentures of government-sponsored agencies
$
87,623

 
$
—

 
$
87,623

 
$
—

Privately-issued collateralized mortgage obligations
$
3,971

 
$
—

 
$
3,971

 
$
—

Obligations of state and political subdivisions
$
59,373

 
$
—

 
$
59,373

 
$
—

Corporate bonds
$
4,961

 
$
—

 
4,961

 
$
—

Derivative financial liabilities (interest rate contracts)
$
2,531

 
$
—

 
$
2,531

 
$
—

At December 31, 2015:
 

 
 
 
 

 
 

Securities available-for-sale:
 

 
 
 
 

 
 

Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government-sponsored agencies
$
190,093

 
$
—

 
$
188,381

 
$
1,712

Debentures of government-sponsored agencies
$
160,892

 
$
—

 
$
160,892

 
$
—

Privately-issued collateralized mortgage obligations
$
4,150

 
$
—

 
$
4,150

 
$
—

Obligations of state and political subdivisions
$
57,673

 
$
—

 
$
57,673

 
$
—

Corporate bonds
$
4,979

 
$
—

 
$
4,979

 
$
—

Derivative financial assets (interest rate contracts)
$
3

 
$
—

 
$
3

 
$
—

Derivative financial liabilities (interest rate contracts)
$
1,658

 
$
—

 
$
1,658

 
$
—

 
Securities available-for-sale are recorded at fair value on a recurring basis. When available, quoted market prices (Level 1) are used to determine the fair value of securities available-for-sale. If quoted market prices are not available, we obtain pricing information from a reputable third-party service provider, who may utilize valuation techniques that use current market-based or independently sourced parameters, such as bid/ask prices, dealer-quoted prices, interest rates, benchmark yield curves, prepayment speeds, probability of default, loss severity and credit spreads (Level 2).   Level 2 securities include obligations of state and political subdivisions, U.S. agencies or government sponsored agencies' debt securities, mortgage-backed securities, government agency-issued and privately-issued collateralized mortgage obligations. As of March 31, 2016 and December 31, 2015, there were no securities that were considered Level 1 securities. As of March 31, 2016, we had one available-for-sale security that was considered a Level 3 security. The security is a U.S. government agency obligation collateralized by a small number of business equipment loans guaranteed by the Small Business Administration ("SBA") program. This security is not actively traded and is owned only by a few investors. The significant unobservable data that is reflected in the fair value measurement include dealer quotes, projected prepayment speeds/average life and credit information, among other things. The decrease in fair value during the first three months of 2016 was due to the payoff of one of the larger loans in the pool collateralizing the security. The unrealized gain on this SBA-guaranteed security decreased by $4 thousand in the same period as part of other comprehensive income.

Securities held-to-maturity may be written down to fair value (determined using the same techniques discussed above for securities available-for-sale) as a result of an other-than-temporary impairment, if any.
 
On a recurring basis, derivative financial instruments are recorded at fair value, which is based on the income approach using observable Level 2 market inputs, reflecting market expectations of future interest rates as of the measurement date.  Standard valuation techniques are used to calculate the present value of the future expected cash flows assuming an orderly transaction.  Valuation adjustments may be made to reflect both our own credit risk and the counterparties’ credit risk in determining the fair value of the derivatives. Level 2 inputs for the valuations are limited to observable market prices for London Interbank Offered Rate ("LIBOR") and Overnight Index Swap ("OIS") rates (for the very short term), quoted prices for LIBOR futures contracts, observable market prices for LIBOR and OIS swap rates, and one-month and three-month LIBOR basis spreads at commonly quoted intervals.  Mid-market pricing of the inputs is used

Page-10


as a practical expedient in the fair value measurements.  We project spot rates at reset days specified by each swap contract to determine future cash flows, then discount to present value using either LIBOR or OIS curves depending on whether the swap positions are fully collateralized as of the measurement date.  When the value of any collateral placed with counterparties is less than the interest rate derivative liability, a credit valuation adjustment ("CVA") is applied to reflect the credit risk we pose to counterparties.  We have used the spread between the Standard & Poor's BBB rated U.S. Bank Composite rate and LIBOR for the closest maturity term corresponding to the duration of the swaps to derive the CVA. A similar credit risk adjustment, correlated to the credit standing of the counterparty, is made when collateral posted by the counterparty does not fully cover their liability to Bank of Marin. For further discussion on our methodology in valuing our derivative financial instruments, refer to Note 9.

Certain financial assets may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from the application of the lower of cost or fair value accounting or write-downs of individual assets, such as impaired loans and other real estate owned ("OREO").
 
The following table presents the carrying value of assets and liabilities measured at fair value on a non-recurring basis and that were held in the consolidated statements of condition at each respective period end, by level within the fair value hierarchy as of March 31, 2016 and December 31, 2015.
(in thousands)
Carrying Value1

 
Quoted Prices in Active Markets for Identical Assets
(Level 1)

 
Significant Other Observable Inputs
(Level 2)

 
Significant Unobservable Inputs 
(Level 3)

At March 31, 2016:
 
 
 

 
 

 
 

Other real estate
$
421

 
$
—

 
$
—

 
$
421

At December 31, 2015:
 

 
 

 
 

 
 

Other real estate
$
421

 
$
—

 
$
—

 
$
421


When a loan is identified as impaired, it is reported at the lower of cost or fair value, measured based on the loan's observable market price (Level 1) or the current net realizable value of the underlying collateral securing the loan, if the loan is collateral dependent (Level 3).  Net realizable value of the underlying collateral is the fair value of the collateral less estimated selling costs and any prior liens. Appraisals, recent comparable sales, offers and listing prices are factored in when valuing the collateral. We review and verify the qualifications and licenses of the certified general appraisers used for appraising commercial properties or certified residential appraisers for residential properties. Real estate appraisals may utilize a combination of approaches including replacement cost, sales comparison and the income approach. Comparable sales and income data are analyzed by the appraisers and adjusted to reflect differences between them and the subject property such as property type, leasing status and physical condition. When appraisals are received, Management reviews the underlying assumptions and methodology utilized, as well as the overall resulting value in conjunction with independent data sources such as recent market data and industry-wide statistics. We generally use a 6% discount for selling costs which is applied to all properties, regardless of size. Appraised values may be adjusted to reflect changes in market conditions that have occurred subsequent to the appraisal date, or for revised estimates regarding the timing or cost of the property sale. These adjustments are based on qualitative judgments made by Management on a case-by-case basis and are generally unobservable valuation inputs as they are specific to the underlying collateral. There have been no significant changes in the valuation techniques during the three months ended March 31, 2016.

OREO represents collateral acquired through foreclosure and is initially recorded at fair value as established by a current appraisal, adjusted for disposition costs. Subsequently, OREO is measured at lower of cost or fair value. OREO values are reviewed on an ongoing basis and any subsequent decline in fair value is recorded as a foreclosed asset expense in the current period. The value of OREO is determined based on independent appraisals, similar to the process used for impaired loans, discussed above, and is classified as Level 3. All OREO was acquired from Bank of Alameda as part of the Acquisition. There was no change in the estimated fair value of the OREO during the first three months ended March 31, 2016.

 Disclosures about Fair Value of Financial Instruments
 
The table below is a summary of fair value estimates for financial instruments as of March 31, 2016 and December 31, 2015, excluding financial instruments recorded at fair value on a recurring basis (summarized in the first table in this note). The carrying amounts in the following table are recorded in the consolidated statements of condition under the indicated captions. We have excluded non-financial assets and non-financial liabilities defined by the Codification

Page-11


(ASC 820-10-15-1A), such as Bank premises and equipment, deferred taxes and other liabilities.  In addition, we have not disclosed the fair value of financial instruments specifically excluded from disclosure requirements of the Financial Instruments Topic of the Codification (ASC 825-10-50-8), such as Bank-owned life insurance policies. 
 
March 31, 2016
 
December 31, 2015
(in thousands)
Carrying Amounts

Fair Value

Fair Value Hierarchy
 
Carrying Amounts

Fair Value

Fair Value Hierarchy
Financial assets
 
 
 
 
 
 
 
Cash and cash equivalents
$
39,770

$
39,770

Level 1
 
$
26,343

$
26,343

Level 1
Investment securities held-to-maturity
63,246

64,848

Level 2
 
69,637

71,054

Level 2
Loans, net
1,426,811

1,460,637

Level 3
 
1,436,229

1,470,380

Level 3
Interest receivable
5,919

5,919

Level 2
 
6,643

6,643

Level 2
Financial liabilities
 

 

 
 
 

 

 
Deposits
1,681,346

1,681,787

Level 2
 
1,728,226

1,728,717

Level 2
Federal Home Loan Bank and other borrowings
19,350

19,682

Level 2
 
67,000

67,279

Level 2
Subordinated debentures
5,445

4,969

Level 3
 
5,395

5,132

Level 3
Interest payable
197

197

Level 2
 
187

187

Level 2

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument not recorded at fair value but required for disclosure purposes:
 
Cash and Cash Equivalents - The carrying amounts of cash and cash equivalents approximate their fair value because of the short-term nature of these instruments.
 
Held-to-maturity Securities - Held-to-maturity securities, which generally consist of obligations of state and political subdivisions and corporate bonds, are recorded at their amortized cost. The fair value for disclosure purposes is determined using methodologies similar to those described above for available-for-sale securities using Level 2 inputs. If Level 2 inputs are not available, we may utilize pricing models that incorporate unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities (Level 3).  As of March 31, 2016 and December 31, 2015, we did not hold any held-to-maturity securities whose fair value was measured using significant unobservable inputs.
 
Loans - The fair value of loans with variable interest rates approximates their current carrying value, because their rates are regularly adjusted to current market rates. The fair value of fixed rate loans or variable loans at negotiated interest rate floors or ceilings with remaining maturities in excess of one year is estimated by discounting the future cash flows using current market rates at which similar loans would be made to borrowers with similar creditworthiness and similar remaining maturities. The allowance for loan losses (“ALLL”) is considered to be a reasonable estimate of the portion of loan discount attributable to credit risks.
 
Interest Receivable and Payable - The interest receivable and payable balances approximate their fair value due to the short-term nature of their settlement dates.

Deposits - The fair value of deposits without stated maturity, such as transaction accounts, savings accounts and money market accounts, is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using current rates offered for deposits of similar remaining maturities.
 
Federal Home Loan Bank Borrowings - The fair value is estimated by discounting the future cash flows using current rates offered by the Federal Home Loan Bank of San Francisco ("FHLB") for similar credit advances corresponding to the remaining term of our fixed-rate credit advances.

Subordinated Debentures - As part of the NorCal Acquisition, we assumed two subordinated debentures. See Note 6 for further information. The fair values of the subordinated debentures were estimated by discounting the future cash flows (interest payment at a rate of three-month LIBOR plus 3.05% and 1.40%) to their present values using current market rates at which similar bonds would be issued with similar credit ratings as ours and similar remaining maturities. Each interest payment was discounted at the spot rate for the corresponding term, determined based on the yields and terms of comparable trust preferred securities, plus a liquidity premium. In July 2010, the Dodd-Frank

Page-12


Act was signed into law and limits the ability of certain bank holding companies to treat trust preferred security debt issuances as Tier 1 capital. This law effectively closed the trust-preferred securities markets for new issuances and led to the absence of observable or comparable transactions in the market place. Due to the use of unobservable inputs of trust preferred securities, we consider the fair value to be a Level 3 measurement.

Commitments - The value of unrecognized financial instruments is estimated based on the fee income associated with the commitments which, in the absence of credit exposure, is considered to approximate their settlement value. The fair value of commitment fees was not material at March 31, 2016 and December 31, 2015, respectively.

Note 4:  Investment Securities
 
Our investment securities portfolio consists of obligations of state and political subdivisions, corporate bonds, U.S. government agency securities, including mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”) issued or guaranteed by Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage Corporation ("FHLMC"), or Government National Mortgage Association ("GNMA"), debentures issued by government-sponsored agencies such as FNMA, Federal Farm Credit Bureau, FHLB and FHLMC, as well as privately issued CMOs, as reflected in the table below:
 
March 31, 2016
 
December 31, 2015
 
Amortized
Fair
Gross Unrealized
 
Amortized
Fair
Gross Unrealized
(in thousands)
Cost
Value
Gains
(Losses)
 
Cost
Value
Gains
(Losses)
Held-to-maturity:
 
 
 
 
 
 
 
 
 
Obligations of state and
  political subdivisions
$
40,254

$
41,580

$
1,338

$
(12
)

$
42,919

$
44,146

$
1,246

$
(19
)
Corporate bonds
11,544

11,560

19

(3
)

15,072

15,098

42

(16
)
MBS pass-through securities issued by FHLMC and FNMA
11,448

11,708

267

(7
)

11,646

11,810

171

(7
)
Total held-to-maturity
63,246
64,848
1,624
(22
)

69,637

71,054

1,459

(42
)
Available-for-sale:
 
 
 
 
 
 
 
 
 
Securities of U.S. government or government-sponsored agencies:
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
128,434

129,983

1,613

(64
)

138,222

138,462

694

(454
)
CMOs issued by FNMA
17,190

17,290

147

(47
)

18,266

18,219

97

(144
)
CMOs issued by FHLMC
23,287

23,471

196

(12
)

22,889

22,932

82

(39
)
CMOs issued by GNMA
9,394

9,562

172

(4
)

10,326

10,480

169

(15
)
Debentures of government- sponsored agencies
87,592

87,623

93

(62
)

161,690

160,892

28

(826
)
Privately issued CMOs
3,785

3,971

187

(1
)

3,960

4,150

190

—

Obligations of state and
political subdivisions
58,412

59,373

964

(3
)

57,110

57,673

580

(17
)
Corporate bonds
4,950

4,961

25

(14
)

4,947

4,979

43

(11
)
Total available-for-sale
333,044
336,234
3,397
(207
)

417,410

417,787

1,883

(1,506
)
Total investment securities
$
396,290

$
401,082

$
5,021

$
(229
)

$
487,047

$
488,841

$
3,342

$
(1,548
)


Page-13


The amortized cost and fair value of investment debt securities by contractual maturity at March 31, 2016 are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.
 
March 31, 2016
 
December 31, 2015
 
Held-to-Maturity
 
Available-for-Sale
 
Held-to-Maturity
 
Available-for-Sale
(in thousands)
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
Within one year
$
16,713

 
$
16,805

 
$
8,798

 
$
8,825

 
$
18,853

 
$
18,920

 
$
12,135

 
$
12,176

After one year but within five years
28,225

 
28,929

 
114,762

 
115,006

 
31,677

 
32,360

 
188,007

 
187,326

After five years through ten years
7,974

 
8,394

 
64,092

 
64,720

 
8,580

 
8,969

 
64,899

 
64,999

After ten years
10,334

 
10,720

 
145,392

 
147,683

 
10,527

 
10,805

 
152,369

 
153,286

Total
$
63,246

 
$
64,848

 
$
333,044

 
$
336,234

 
$
69,637

 
$
71,054

 
$
417,410

 
$
417,787

 
Sales of investment securities and gross realized gains and losses are shown in the following table.
 
Three months ended
(in thousands)
March 31, 2016
 
March 31, 2015
Available-for-sale:
 
 
 
  Sales proceeds
$
54,985

 
$
1,559

  Gross realized gains
$
110

 
$
8


Investment securities carried at $84.8 million and $87.9 million at March 31, 2016 and December 31, 2015, respectively, were pledged to the State of California: $84.0 million and $87.1 million to secure public deposits in compliance with the Local Agency Security Program at March 31, 2016 and December 31, 2015, respectively, and $836 thousand and $840 thousand to provide collateral for trust deposits at March 31, 2016 and December 31, 2015, respectively. In addition, investment securities carried at $1.1 million were pledged to collateralize a Wealth Management and Trust Services (“WMTS”) checking account at both March 31, 2016 and December 31, 2015.

Other-Than-Temporarily Impaired Debt Securities
 
We have evaluated the credit of our investment securities and their issuers and/or insurers. Based on our evaluation, Management has determined that no investment security in our investment portfolio is other-than-temporarily impaired as of March 31, 2016. We do not have the intent and it is more likely than not that we will not have to sell securities temporarily impaired at March 31, 2016 before recovery of the cost basis.
 

Page-14


Twenty-three and fifty-four investment securities were in unrealized loss positions at March 31, 2016 and December 31, 2015, respectively. Those securities are summarized and classified according to the duration of the loss period in the tables below:
March 31, 2016
< 12 continuous months
 
≥ 12 continuous months
 
Total securities
 in a loss position
(in thousands)
Fair value
Unrealized loss
 
Fair value
Unrealized loss
 
Fair value
Unrealized loss
Held-to-maturity:
 
 
 
 
 
 
 
 
Obligations of state and political subdivisions
$
1,057

$
(12
)
 
$
—

$
—

 
$
1,057

$
(12
)
Corporate bonds
3,530

(3
)
 
—

—

 
3,530

(3
)
MBS pass-through securities issued by FHLMC and FNMA
—

—

 
2,320

(7
)
 
2,320

(7
)
Total held-to-maturity
4,587

(15
)
 
2,320

(7
)
 
6,907

(22
)
Available-for-sale:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
21,435

(64
)
 
—

—

 
21,435

(64
)
CMOs issued by FNMA
6,515

(16
)
 
2,986

(31
)
 
9,501

(47
)
CMOs issued by FHLMC
1,938

(12
)
 
—

—

 
1,938

(12
)
CMOs issued by GNMA
—

—

 
2,219

(4
)
 
2,219

(4
)
Debentures of government- sponsored agencies
9,967

(30
)
 
9,968

(32
)
 
19,935

(62
)
Privately issued CMOs
212

(1
)
 
—

—

 
212

(1
)
Obligations of state & political subdivisions
2,487

(3
)
 
—

—

 
2,487

(3
)
Corporate bonds
2,982

(14
)
 
—

—

 
2,982

(14
)
Total available-for-sale
45,536

(140
)
 
15,173

(67
)
 
60,709

(207
)
Total temporarily impaired securities
$
50,123

$
(155
)
 
$
17,493

$
(74
)
 
$
67,616

$
(229
)
December 31, 2015
< 12 continuous months
 
≥ 12 continuous months
 
Total securities
 in a loss position
(in thousands)
Fair value
Unrealized loss
 
Fair value
Unrealized loss
 
Fair value
Unrealized loss
Held-to-maturity:
 
 
 
 
 
 
 
 
Obligations of state and political subdivisions
$
8,297

$
(19
)
 
$
—

$
—

 
$
8,297

$
(19
)
Corporate bonds
3,523

(15
)
 
1,999

(1
)
 
5,522

(16
)
MBS pass-through securities issued by FHLMC and FNMA
2,332

(7
)
 
—

—

 
2,332

(7
)
Total held-to-maturity
14,152

(41
)
 
1,999

(1
)
 
16,151

(42
)
Available-for-sale:




 




 




MBS pass-through securities issued by FHLMC and FNMA
68,809

(454
)
 
—

—

 
68,809

(454
)
CMOs issued by FNMA
9,277

(80
)
 
3,158

(64
)
 
12,435

(144
)
CMOs issued by FHLMC
—

—

 
1,989

(39
)
 
1,989

(39
)
CMOs issued by GNMA
164

—

 
2,374

(15
)
 
2,538

(15
)
Debentures of government- sponsored agencies
136,064

(713
)
 
9,887

(113
)
 
145,951

(826
)
Obligations of state & political subdivisions
4,557

(15
)
 
579

(2
)
 
5,136

(17
)
Corporate bonds
2,986

(11
)
 
—

—

 
2,986

(11
)
Total available-for-sale
221,857

(1,273
)
 
17,987

(233
)
 
239,844

(1,506
)
Total temporarily impaired securities
$
236,009

$
(1,314
)
 
$
19,986

$
(234
)
 
$
255,995

$
(1,548
)


Page-15


As of March 31, 2016, there were four investment positions that had been in a continuous loss position for twelve months or more. These securities consisted of a government-sponsored agency debenture, an MBS and CMOs issued by government or government-sponsored agencies. We have evaluated each of the bonds and believe that the decline in fair value is primarily driven by factors other than credit. It is probable that we will be able to collect all amounts due according to the contractual terms and no other-than-temporary impairment exists on these securities. We determine that the strength of GNMA through the U.S. Federal Government guarantee is sufficient to protect us from credit losses. The government-sponsored agency debenture, the MBS and CMOs issued by FNMA are supported by the U.S. Federal Government to protect us from credit losses. Based upon our assessment of the credit fundamentals, we concluded that these securities were not other-than-temporarily impaired at March 31, 2016.

Nineteen investment securities in our portfolio were in a temporary loss position for less than twelve months as of March 31, 2016. They consisted of U.S. agency CMO and MBS pass-through securities, obligations of U.S. state and political subdivisions, one privately issued CMO and corporate bonds. The government-sponsored agency debenture, MBS and CMOs issued by FNMA and FHLMC are supported by the U.S. Federal Government to protect us from credit losses. Other temporarily impaired securities are deemed creditworthy after internal analysis of the issuer's latest financial information and credit enhancement. Additionally, all are rated as investment grade by at least one major rating agency. As a result of this impairment analysis, we have concluded that these securities were not other-than-temporarily impaired at March 31, 2016.

Non-Marketable Securities

As a member of the FHLB, we are required to maintain a minimum investment in the FHLB capital stock determined by the Board of Directors of the FHLB. The minimum investment requirements can increase in the event we increase our total asset size or borrowings with the FHLB. Shares cannot be purchased or sold except between the FHLB and its members at the $100 per share par value. We held $8.4 million of FHLB stock recorded at cost in other assets on the consolidated statements of condition at both March 31, 2016 and December 31, 2015. The carrying amounts of these investments are reasonable estimates of fair value because the securities are restricted to member banks and they do not have a readily determinable market value. Management does not believe that the FHLB stock is other-than-temporarily-impaired, as we expect to be able to redeem this stock at cost. On April 28, 2016, FHLB announced a cash dividend for the first quarter of 2016 at an annualized dividend rate of 8.90% to be distributed in mid May 2016. Cash dividends paid on FHLB capital stock are recorded as non-interest income.

As a member bank of Visa U.S.A., we hold 16,939 shares of Visa Inc. Class B common stock with a carrying value of zero, which is equal to our cost basis. These shares are restricted from resale until their conversion into Class A (voting) shares upon the termination of Visa Inc.'s covered litigation escrow account. As a result of the restriction, these shares are not considered available-for-sale and are not carried at fair value. When converting this Class B common stock to Class A common stock under the current conversion rate of 1.6483 and the closing stock price of Class A shares, the value of our shares of Class B common stock would have been $2.1 million at March 31, 2016 and $2.2 million at December 31, 2015. The conversion rate is subject to further reduction upon the final settlement of the covered litigation against Visa Inc. and its member banks. See Note 8 herein.

We invest in low income housing tax credit funds as a limited partner, which totaled $2.6 million and $2.7 million recorded in other assets as of March 31, 2016 and December 31, 2015, respectively. In the first quarter of 2016, we recognized $82 thousand of low income housing tax credits and other tax benefits, net of $63 thousand of amortization expense of low income housing tax credit investment, as a component of income tax expense. As of March 31, 2016, our unfunded commitments for these low income housing tax credit funds totaled $1.7 million. We did not recognize any impairment losses on these low income housing tax credit investments during the first quarter of 2016 or 2015.


Page-16


Note 5:  Loans and Allowance for Loan Losses

Credit Quality of Loans
 
Outstanding loans by class and payment aging as of March 31, 2016 and December 31, 2015 were as follows:
Loan Aging Analysis by Loan Class
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential 1

Installment and other consumer

Total

March 31, 2016
 

 

 

 

 

 

 

 

 30-59 days past due
$
—

$
177

$
1,789

$
—

$
255

$
—

$
216

$
2,437

 60-89 days past due
—

—

—

—

—

—

1

1

90 days or more past due
21

—

—

—

99

—

—

120

Total past due
21

177

1,789

—

354

—

217

2,558

Current
213,047

238,155

705,551

74,528

110,539

73,896

23,565

1,439,281

Total loans 3
$
213,068

$
238,332

$
707,340

$
74,528

$
110,893

$
73,896

$
23,782

$
1,441,839

Non-accrual 2
$
21

$
—

$
1,789

$
—

$
791

$
—

$
65

$
2,666

December 31, 2015
 

 

 

 

 

 

 

 

 30-59 days past due
$
36

$
—

$
1,096

$
1

$
—

$
—

$
249

$
1,382

 60-89 days past due
—

—

—

—

633

—

89

722

90 days or more past due
21

—

—

—

99

—

—

120

Total past due
57

—

1,096

1

732

—

338

2,224

Current
219,395

242,309

714,783

65,494

111,568

73,154

22,301

1,449,004

Total loans 3
$
219,452

$
242,309

$
715,879

$
65,495

$
112,300

$
73,154

$
22,639

$
1,451,228

Non-accrual 2
$
21

$
—

$
1,903

$
1

$
171

$
—

$
83

$
2,179

1 Our residential loan portfolio does not include sub-prime loans, nor is it our practice to underwrite loans commonly referred to as "Alt-A mortgages", the characteristics of which are loans lacking full documentation, borrowers having low FICO scores or higher loan-to-value ratios.

2 Amounts include $1 thousand of Purchased Credit Impaired ("PCI") loans that had stopped accreting interest at December 31, 2015. Amounts exclude accreting PCI loans of $2.8 million and $3.7 million at March 31, 2016 and December 31, 2015, respectively, as we have a reasonable expectation about future cash flows to be collected and we continue to recognize accretable yield on these loans in interest income. These accreting PCI loans are included in current loans.

3 Amounts include net deferred loan costs of $693 thousand and $768 thousand at March 31, 2016 and December 31, 2015, respectively. Amounts are also net of unaccreted purchase discounts on non-PCI loans of $2.8 million and $3.2 million at March 31, 2016 and December 31, 2015, respectively.

Our commercial loans are generally made to established small and mid-sized businesses to provide financing for their growth and working capital needs, equipment purchases and/or acquisitions.  Management examines historical, current, and projected cash flows to determine the ability of the borrower to repay obligations as agreed. Commercial loans are made based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral and/or guarantor support. The cash flows of borrowers, however, may not occur as expected, and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed, such as accounts receivable and/or inventory, and typically include a personal guarantee. We target stable businesses with guarantors that have proven to be resilient in periods of economic stress.  Typically, the guarantors provide an additional source of repayment for most of our credit extensions.
 
Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans discussed above. We underwrite these loans to be repaid from cash flow and to be supported by real property collateral. Underwriting standards for commercial real estate loans include, but are not limited to, debt coverage and loan-to-value ratios. Furthermore, substantially all of our loans are guaranteed by the owners of the properties.  Commercial real estate loans may be adversely affected by conditions in the real estate markets or in the general economy. In the event of a vacancy, guarantors are expected to carry the loans until a replacement tenant can be found.  The owner's substantial equity investment provides a strong economic incentive to continue to support the commercial real estate projects. As such, we have generally experienced a relatively low level of loss and delinquencies in this portfolio.

Construction loans are generally made to developers and builders to finance construction, renovation and occasionally land acquisitions. These loans are underwritten after evaluation of the borrower's financial strength, reputation, prior track record, and independent appraisals. The construction industry can be affected by significant events, including: the inherent volatility of real estate markets and vulnerability to delays due to weather, change orders, inability to obtain construction permits, labor or material shortages, and price changes. Estimates of construction costs and value

Page-17


associated with the completed project may be inaccurate. Repayment of construction loans is largely dependent on the ultimate success of the project.
 
Consumer loans primarily consist of home equity lines of credit, other residential (tenancy-in-common, or “TIC”) loans, and installment and other consumer loans. We originate consumer loans utilizing credit score information, debt-to-income ratio and loan-to-value ratio analysis. Diversification, coupled with relatively small loan amounts that are spread across many individual borrowers, mitigates risk. Additionally, trend reports are reviewed by Management on a regular basis. Our residential loan portfolio includes TIC units almost entirely in San Francisco. These loans tend to have more equity in their properties than conventional residential mortgages, which mitigates risk. Installment and other consumer loans include mostly loans for floating homes and mobile homes along with a small number of installment loans.
 
We use a risk rating system to evaluate asset quality, and to identify and monitor credit risk in individual loans, and ultimately in the portfolio. Definitions of loans that are risk graded “Special Mention” or worse are consistent with those used by the Federal Deposit Insurance Corporation ("FDIC").  Our internally assigned grades are as follows:
 
Pass: Loans to borrowers of acceptable or better credit quality. Borrowers in this category demonstrate fundamentally sound financial positions, repayment capacity, credit history and management expertise.  Loans in this category must have an identifiable and stable source of repayment and meet the Bank’s policy regarding debt service coverage ratios.  These borrowers are capable of sustaining normal economic, market or operational setbacks without significant financial consequences.  Negative external industry factors are generally not present.  The loan may be secured, unsecured or supported by non-real estate collateral for which the value is more difficult to determine and/or marketability is more uncertain. This category also includes “Watch” loans, where the primary source of repayment has been delayed. “Watch” is intended to be a transitional grade, with either an upgrade or downgrade within a reasonable period.
 
Special Mention: Potential weaknesses that deserve close attention. If left uncorrected, those potential weaknesses may result in deterioration of the payment prospects for the asset. Special Mention assets do not present sufficient risk to warrant adverse classification.
 
Substandard: Inadequately protected by either the current sound worth and paying capacity of the obligor or the collateral pledged, if any. A Substandard asset has a well-defined weakness or weaknesses that jeopardize(s) the liquidation of the debt. Substandard assets are characterized by the distinct possibility that we will sustain some loss if such weaknesses or deficiencies are not corrected. Well-defined weaknesses include adverse trends or developments in the borrower’s financial condition, managerial weaknesses and/or significant collateral deficiencies.
 
Doubtful: Critical weaknesses that make collection or liquidation in full improbable. There may be specific pending events that work to strengthen the asset; however, the amount or timing of the loss may not be determinable. Pending events generally occur within one year of the asset being classified as Doubtful. Examples include: merger, acquisition, or liquidation; capital injection; guarantee; perfecting liens on additional collateral; and refinancing. Such loans are placed on non-accrual status and usually are collateral-dependent.

We regularly review our credits for accuracy of risk grades whenever new information is received. Borrowers are required to submit financial information at regular intervals:
•
Generally, commercial borrowers with lines of credit are required to submit financial information with reporting intervals ranging from monthly to annually depending on credit size, risk and complexity.
•
Investor commercial real estate borrowers are generally required to submit rent rolls or property income statements at least annually.
•
Construction loans are monitored monthly, and reviewed on an ongoing basis.
•
Home equity and other consumer loans are reviewed based on delinquency.
•
Loans graded “Watch” or more severe, regardless of loan type, are reviewed no less than quarterly.


Page-18


The following table represents an analysis of loans by internally assigned grades, including the PCI loans, at March 31, 2016 and December 31, 2015:
Credit Risk Profile by Internally Assigned Grade
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Purchased credit-impaired

Total

March 31, 2016
 
 
 
 
 
 
 
 
 
Pass
$
195,560

$
224,903

$
701,642

$
71,290

$
108,059

$
73,896

$
23,383

$
2,431

$
1,401,164

Special Mention
13,627

3,252

367

—

1,120

—

—

—

18,366

Substandard
3,843

9,155

3,612

3,238

1,644

—

399

418

22,309

Total loans
$
213,030

$
237,310

$
705,621

$
74,528

$
110,823

$
73,896

$
23,782

$
2,849

$
1,441,839

December 31, 2015
 

 

 

 

 

 

 

 

 

Pass
$
192,560

$
219,060

$
710,042

$
62,255

$
109,959

$
73,154

$
22,307

$
3,260

$
1,392,597

Special Mention
22,457

12,371

372

—

1,100

—

—

—

36,300

Substandard
4,260

9,167

3,739

3,239

1,173

—

332

421

22,331

Total loans
$
219,277

$
240,598

$
714,153

$
65,494

$
112,232

$
73,154

$
22,639

$
3,681

$
1,451,228

 
Troubled Debt Restructuring
 
Our loan portfolio includes certain loans that have been modified in a troubled debt restructuring (“TDR”), where economic concessions have been granted to borrowers experiencing financial difficulties. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs on nonaccrual status at the time of restructure may be returned to accruing status after Management considers the borrower’s sustained repayment performance for a reasonable period, generally six months, and obtains reasonable assurance of repayment and performance.
 
A loan may no longer be reported as a TDR if all of the following conditions are met:
•
The loan is subsequently refinanced or restructured at current market interest rates and the new terms are consistent with the treatment of creditworthy borrowers under regular underwriting standards;
•
The borrower is no longer considered to be in financial difficulty;
•
Performance on the loan is reasonably assured; and;
•
Existing loan did not have any forgiveness of principal or interest.

The removal of TDR status must be approved by the same management level that approved the upgrading of the loan classification.

There were no loans removed from TDR designation during 2016. During the first three months in 2015, one loan with a recorded investment totaling $108 thousand was removed from TDR designation.
 
The table below summarizes outstanding TDR loans by loan class as of March 31, 2016 and December 31, 2015. The summary includes both TDRs that are on non-accrual status and those that continue to accrue interest.
(in thousands)
As of
Recorded investment in Troubled Debt Restructurings 1
March 31, 2016

December 31, 2015

Commercial and industrial
$
3,825

$
4,698

Commercial real estate, owner-occupied
6,993

6,993

Commercial real estate, investor
2,052

514

Construction
3,238

3,238

Home equity
458

460

Other residential
1,997

2,010

Installment and other consumer
1,161

1,168

Total
$
19,724

$
19,081


1 Includes $19.7 million and $19.0 million of TDR loans that were accruing interest as of March 31, 2016 and December 31, 2015, respectively. Includes $621 thousand and $137 thousand of acquired loans at March 31, 2016 and December 31, 2015, respectively.


Page-19


The table below presents the following information for loans modified in a TDR during the presented periods: number of contracts modified, the recorded investment in the loans prior to modification, and the recorded investment in the loans after being restructured. The table below excludes fully charged-off TDR loans and loans modified in a TDR and subsequently paid-off during the years presented. There were no loans modified in a TDR during the three months ended March 31, 2015.
(dollars in thousands)
Number of Contracts Modified

Pre-Modification Outstanding Recorded Investment

Post-Modification Outstanding Recorded Investment

Post-Modification Outstanding Recorded Investment at period end

Troubled Debt Restructurings during the three months ended March 31, 2016:
 
 
 

Commercial real estate, investor
1

$
1,549

$
1,546

$
1,541

 
 
 
 
 
 
 
 
The modification during the three months ended March 31, 2016 primarily involved an interest rate concession and other changes to loan terms. During the first three months of 2016 and 2015, there were no defaults on loans that had been modified in a TDR within the prior twelve-month period. We report defaulted TDRs based on a payment default definition of more than ninety days past due.

Impaired Loan Balances and Their Related Allowance by Major Classes of Loans

The tables below summarize information on impaired loans and their related allowance. Total impaired loans include non-accrual loans, accruing TDR loans and accreting PCI loans that have experienced post-acquisition declines in cash flows expected to be collected.
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Total

March 31, 2016
 

 

 

 

 

 

 

Recorded investment in impaired loans:
 
 
 
 
 
 
With no specific allowance recorded
$
317

$
—

$
1,789

$
2,688

$
791

$
1,205

$
113

$
6,903

With a specific allowance recorded
3,529

6,993

2,052

550

386

793

1,113

15,416

Total recorded investment in impaired loans
$
3,846

$
6,993

$
3,841

$
3,238

$
1,177

$
1,998

$
1,226

$
22,319

Unpaid principal balance of impaired loans
$
3,846

$
6,993

$
5,833

$
3,238

$
1,193

$
1,998

$
1,226

$
24,327

Specific allowance
$
829

$
129

$
466

$
4

$
4

$
69

$
107

$
1,608

Average recorded investment in impaired loans during the quarter ended March 31, 2016
$
4,283

$
6,993

$
3,129

$
3,238

$
868

$
2,004

$
1,239

$
21,754

Interest income recognized on impaired loans during the quarter ended March 31, 2016
$
57

$
66

$
16

$
38

$
4

$
23

$
13

$
217

Average recorded investment in impaired loans during the quarter ended March 31, 2015
$
3,718

$
8,443

$
2,915

$
5,681

$
627

$
2,041

$
1,743

$
25,168

Interest income recognized on impaired loans during the quarter ended March 31, 2015
$
62

$
66

$
6

$
9

$
5

$
23

$
19

$
190

(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Total

December 31, 2015
 

 

 

 

 

 

 

Recorded investment in impaired loans:
 

 

 

 

 

 

With no specific allowance recorded
$
2,198

$
4,111

$
2,416

$
2,687

$
171

$
1,214

$
131

$
12,928

With a specific allowance recorded
2,522

2,882

—

551

388

797

1,120

8,260

Total recorded investment in impaired loans
$
4,720

$
6,993

$
2,416

$
3,238

$
559

$
2,011

$
1,251

$
21,188

Unpaid principal balance of impaired loans
$
4,763

$
6,993

$
4,408

$
3,424

$
559

$
2,011

$
1,251

$
23,409

Specific allowance
$
912

$
70

$
—

$
1

$
3

$
67

$
116

$
1,169



Page-20


Management monitors delinquent loans continuously and identifies problem loans, generally loans graded substandard or worse, to be evaluated individually for impairment testing. Generally, the recorded investment in impaired loans is net of any charge-offs from estimated losses related to specifically-identified impaired loans when they are deemed uncollectible. The charged-off portion of impaired loans outstanding at March 31, 2016 and December 31, 2015 totaled approximately $2.0 million and 2.1 million, respectively.  In addition, the recorded investment in impaired loans is net of purchase discounts or premiums on acquired loans. At March 31, 2016 and December 31, 2015, unused commitments to extend credit on impaired loans, including loans to borrowers whose terms have been modified in TDRs, totaled $1.5 million and 1.3 million, respectively.

The following tables disclose loans by major portfolio category and activity in the ALLL, as well as the related ALLL disaggregated by impairment evaluation method.
Allowance for Loan Losses Rollforward for the Period
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Unallocated

Total

Three months ended March 31, 2016







Allowance for loan losses:
 
 
 
 
 
 
 
Beginning balance
$
3,023

$
2,249

$
6,178

$
724

$
910

$
394

$
425

$
1,096

$
14,999

Provision (reversal)
(247
)
(630
)
388

98

133

36

9

213

—

Charge-offs
(9
)
—

—

—

—

—

—

—

(9
)
Recoveries
32

—

5

—

1

—

—

—

38

Ending balance
$
2,799

$
1,619

$
6,571

$
822

$
1,044

$
430

$
434

$
1,309

$
15,028

Three months ended March 31, 2015
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
Beginning balance
$
2,837

$
1,924

$
6,672

$
839

$
859

$
433

$
566

$
969

$
15,099

Provision (reversal)
(275
)
170

(383
)
(61
)
63

(3
)
(99
)
588

—

Charge-offs
(2
)
—

—

—

—

—

(6
)
—

(8
)
Recoveries
60

—

3

—

1

—

1

—

65

Ending balance
$
2,620

$
2,094

$
6,292

$
778

$
923

$
430

$
462

$
1,557

$
15,156


Allowance for Loan Losses and Recorded Investment in Loans
(dollars in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Unallocated

Total

As of March 31, 2016:
Ending ALLL related to loans collectively evaluated for impairment
$
1,970

$
1,490

$
6,105

$
818

$
1,040

$
361

$
327

$
1,309

$
13,420

Ending ALLL related to loans individually evaluated for impairment
829

129

466

4

4

69

107

—

1,608

Ending ALLL related to purchased credit-impaired loans
—

—

—

—

—

—

—

—

—

Total
$
2,799

$
1,619

$
6,571

$
822

$
1,044

$
430

$
434

$
1,309

$
15,028

Loans outstanding:
 

 

 

 

 

 

 

Collectively evaluated for impairment
$
209,184

$
230,317

$
701,780

$
71,290

$
109,646

$
71,898

$
22,556

$
—

$
1,416,671

Individually evaluated for impairment
3,846

6,993

3,841

3,238

1,177

1,998

1,226

—

22,319

Purchased credit-impaired
38

1,022

1,719

—

70

—

—

—

2,849

Total
$
213,068

$
238,332

$
707,340

$
74,528

$
110,893

$
73,896

$
23,782

$
—

$
1,441,839

Ratio of allowance for loan losses to total loans
1.31
%
0.68
%
0.93
%
1.10
%
0.94
%
0.58
%
1.82
%
NM

1.04
%
Allowance for loan losses to non-accrual loans
13,329
%
NM

367
%
NM

132
%
NM

668
%
NM

564
%

NM - Not Meaningful

Page-21


Allowance for Loan Losses and Recorded Investment in Loans
(dollars in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Unallocated

Total

As of December 31, 2015:
Ending ALLL related to loans collectively evaluated for impairment
$
2,111

$
2,179

$
6,178

$
723

$
907

$
327

$
309

$
1,096

$
13,830

Ending ALLL related to loans individually evaluated for impairment
904

70

—

—

3

67

116

—

1,160

Ending ALLL related to purchased  credit-impaired loans
8

—

—

1

—

—

—

—

9

Total
$
3,023

$
2,249

$
6,178

$
724

$
910

$
394

$
425

$
1,096

$
14,999

Loans outstanding:
 

 

 

 

 

 

 

Collectively evaluated for impairment
$
214,695

$
233,605

$
711,737

$
62,256

$
111,673

$
71,143

$
21,388

$
—

$
1,426,497

Individually evaluated for impairment1
4,582

6,993

2,416

3,238

559

2,011

1,251

—

21,050

Purchased credit-impaired
175

1,711

1,726

1

68

—

—

—

3,681

Total
$
219,452

$
242,309

$
715,879

$
65,495

$
112,300

$
73,154

$
22,639

$
—

$
1,451,228

Ratio of allowance for loan losses to total loans
1.38
%
0.93
%
0.86
%
1.11
%
0.81
%
0.54
%
1.88
%
NM

1.03
%
Allowance for loan losses to non-accrual loans
14,395
%
NM

325
%
72,400
%
532
%
NM

512
%
NM

688
%

1 Total excludes $138 thousand PCI loans that have experienced credit deterioration post-acquisition declines in cash flows expected to be collected. These loans are included in the "purchased credit-impaired" amount in the next line below.

NM - Not Meaningful

Purchased Credit-Impaired Loans
 
We evaluated loans purchased in acquisitions in accordance with accounting guidance in ASC 310-30 related to loans acquired with deteriorated credit quality. Acquired loans are considered credit-impaired if there is evidence of significant deterioration of credit quality since origination and it is probable, at the acquisition date, that we will be unable to collect all contractually required payments receivable. Management has determined certain loans purchased in our two acquisitions to be PCI loans based on credit indicators such as nonaccrual status, past due status, loan risk grade, loan-to-value ratio, etc. Revolving credit agreements (e.g., home equity lines of credit and revolving commercial loans) are not considered PCI loans as cash flows cannot be reasonably estimated.
 
For acquired loans not considered credit-impaired, the difference between the contractual amounts due (principal amount) and the fair value is accounted for subsequently through accretion. We recognize discount accretion based on the acquired loan’s contractual cash flows using an effective interest rate method. The accretion is recognized through the net interest margin.

The following table presents the outstanding balances and related carrying values of PCI loans as of March 31, 2016 and December 31, 2015.
 
March 31, 2016
December 31, 2015
PCI Loans
(in thousands)
Unpaid principal balance

Carrying value

Unpaid principal balance

Carrying value

Commercial and industrial
$
53

$
38

$
237

$
175

Commercial real estate
3,124

2,741

4,329

3,437

Construction
—

—

187

1

Home equity
223

70

224

68

Total purchased credit-impaired loans
$
3,400

$
2,849

$
4,977

$
3,681

 
The activities in the accretable yield, or income expected to be earned, for PCI loans were as follows:

Page-22


Accretable Yield
Three months ended
(in thousands)
March 31, 2016
March 31, 2015
Balance at beginning of period
$
2,618

$
4,027

Removals 1
(778
)
(77
)
Accretion
(98
)
(119
)
Reclassifications from nonaccretable difference 2
—

—

Balance at end of period
$
1,742

$
3,831


1 Represents the accretable difference that is relieved when a loan exits the PCI population due to pay-off, full charge-off, or transfer to repossessed assets, etc.

2 Primarily relates to changes in expected credit performance and changes in expected timing of cash flows.

Pledged Loans
 
Our FHLB line of credit is secured under terms of a blanket collateral agreement by a pledge of certain qualifying loans with an unpaid principal balance of $866.3 million and $833.8 million at March 31, 2016 and December 31, 2015, respectively. In addition, we pledge a certain residential loan portfolio, which totaled $47.6 million and $45.2 million at March 31, 2016 and December 31, 2015, respectively, to secure our borrowing capacity with the Federal Reserve Bank (“FRB”). Also see Note 6, Borrowings.
 
Note 6: Borrowings
 
Federal Funds Purchased – The Bank had unsecured lines of credit totaling $92.0 million with correspondent banks for overnight borrowings at March 31, 2016 and December 31, 2015.  In general, interest rates on these lines approximate the federal funds target rate. At March 31, 2016 we had $2.0 million in overnight borrowings under these credit facilities. We had no overnight borrowings outstanding at December 31, 2015.
 
Federal Home Loan Bank Borrowings – As of March 31, 2016 and December 31, 2015, the Bank had lines of credit with the FHLB totaling $507.8 million and $470.6 million, respectively, based on eligible collateral of certain loans.  At March 31, 2016 and December 31, 2015 we had $2.4 million and $52.0 million in FHLB overnight borrowings, respectively.

On February 5, 2008, the Bank entered into a ten-year borrowing agreement under the same FHLB line of credit for $15.0 million at a fixed rate of 2.07%, which remained outstanding at March 31, 2016. Interest-only payments are required every three months until the entire principal is due on February 5, 2018. The FHLB has the unconditional right to accelerate the due date on November 5, 2015 and every three months thereafter (the “put dates”). If the FHLB exercises its right to accelerate the due date, the FHLB will offer replacement funding at the current market rate, subject to certain conditions. The Bank must comply with the put date, but are not required to accept replacement funding.

At March 31, 2016 and December 31, 2015, $490.2 million and $403.4 million, respectively, was remaining as available for borrowing from the FHLB, net of the overnight borrowings, term borrowings, and an unused standby letter of credit totaling $241 thousand.
 
Federal Reserve Line of Credit – The Bank has a line of credit with the FRB secured by certain residential loans.  At March 31, 2016 and December 31, 2015, the Bank had borrowing capacity under this line totaling $39.3 million and $37.8 million, respectively, and had no outstanding borrowings with the FRB.

As part of the NorCal Acquisition, Bancorp assumed two subordinated debentures due to NorCal Community Bancorp Trusts I and II (the "Trusts"), established for the sole purpose of issuing trust preferred securities on September 22, 2003 and December 29, 2005, respectively. The subordinated debentures were recorded at fair values totaling $4.95 million at acquisition date with contractual values totaling $8.2 million. The difference between the contractual balance and the fair value at acquisition date is accreted into interest expense over the lives of the debentures. Accretion on the subordinated debentures totaled $50 thousand in the first three months of 2016 and $53 thousand in the first three months of 2015. Bancorp has the option to defer payment of the interest on the subordinated debentures for a period of up to five years, as long as there is no default on the subordinated debentures. In the event of interest deferral, dividends to Bancorp common stockholders are prohibited. The trust preferred securities were sold and issued in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. Bancorp has guaranteed, on a subordinated basis, distributions and other payments due on trust preferred securities totaling

Page-23


$8.0 million issued by the Trusts which have identical maturity, repricing and payment terms as the subordinated debentures.

The following is a summary of the contractual terms of the subordinated debentures due to the Trusts as of March 31, 2016:
(in thousands)
 
 
Subordinated debentures due to NorCal Community Bancorp Trust I on October 7, 2033 with interest payable quarterly, based on 3-month LIBOR plus 3.05%, repricing quarterly (3.67% as of March 31, 2016), redeemable, in whole or in part, on any interest payment date
 
$
4,124

Subordinated debentures due to NorCal Community Bancorp Trust II on March 15, 2036 with interest payable quarterly, based on 3-month LIBOR plus 1.40%, repricing quarterly (2.03% as of March 31, 2016), redeemable, in whole or in part, on any interest payment date
 
4,124

   Total
 
$
8,248


Note 7:  Stockholders' Equity
 
Warrant
 
Under the United States Department of the Treasury Capital Purchase Program (the “TCPP”), Bancorp issued to the U.S. Treasury a warrant to purchase 154,242 shares of common stock at a per share exercise price of $27.23. The warrant was immediately exercisable and had an expiration date of December 5, 2018. The warrant was subsequently auctioned to two institutional investors in November 2011 and was exercised in September 2015. The warrant represented the right to purchase 157,711 shares of common stock at $26.63 per share. The cashless exercise resulted in the net issuance of 70,591 shares of common stock in September 2015.
 
Dividends
 
Presented below is a summary of cash dividends paid to common shareholders, recorded as a reduction of retained earnings.
 
Three months ended
(in thousands, except per share data)
March 31, 2016
March 31, 2015
Cash dividends to common stockholders
$
1,518

$
1,307

Cash dividends per common share
$
0.25

$
0.22


Share-Based Payments
 
The fair value of stock options as of the grant date is recorded as stock-based compensation expense in the consolidated statements of comprehensive income over the requisite service period with a corresponding increase in common stock. Stock-based compensation also includes compensation expense related to the issuance of unvested restricted stock awards and performance-based stock awards pursuant to the 2007 Equity Plan. The grant-date fair value of the restricted stock awards and performance-based stock awards, which is equal to the intrinsic value on that date, is being recorded as compensation expense over the requisite service period with a corresponding increase in common stock as the shares vest.

Beginning in 2015, performance-based stock awards were issued to a selected group of employees. Stock award vesting is contingent upon the achievement of pre-established long-term performance goals set by the Compensation Committee of the Board of Directors. Performance is measured over a three-year period and cliff vested. These performance-based stock awards were granted at a maximum opportunity level, and based on the achievement of the pre-established goals, the actual payouts can range from 0% to 200% of the target award. For performance-based stock awards, an estimate is made of the number of shares expected to vest based on the probability that the performance criteria will be achieved to determine the amount of compensation expense to be recognized. The estimate is re-evaluated quarterly and total compensation expense is adjusted for any change in the current period.


Page-24


In addition, we record excess tax benefits on the exercise of non-qualified stock options, the disqualifying disposition of incentive stock options and vesting of restricted stock awards as an addition to common stock with a corresponding decrease in current taxes payable.
 
The holders of unvested restricted stock awards and performance-based stock awards are entitled to dividends on the same per-share ratio as holders of common stock. Dividends paid on the portion of share-based awards not expected to vest are also included in stock-based compensation expense. Tax benefits on dividends paid on the portion of share-based awards expected to vest are recorded as an increase to common stock with a corresponding decrease in current taxes payable.

Note 8:  Commitments and Contingencies
 
Financial Instruments with Off-Balance Sheet Risk
 
We make commitments to extend credit in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being fully drawn upon, the total commitment amount does not necessarily represent future cash requirements.
 
We are exposed to credit loss equal to the contract amount of the commitment in the event of nonperformance by the borrower. We use the same credit policies in making commitments as we do for on-balance-sheet instruments and we evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us, is based on Management's credit evaluation of the borrower. Collateral types pledged may include accounts receivable, inventory, other personal property and real property.
 
The contractual amount of loan commitments and standby letters of credit not reflected on the consolidated statements of condition was $391.0 million at March 31, 2016. This amount included $202.4 million under commercial lines of credit (these commitments are generally contingent upon customers maintaining specific credit standards), $136.4 million under revolving home equity lines, $37.5 million under undisbursed construction loans, $3.8 million under standby letters of credit, and a remaining $10.9 million under personal and other lines of credit. We record an allowance for losses on these off-balance sheet commitments based on an estimate of probabilities of these commitments being drawn upon according to our historical utilization experience on different types of commitments and expected loss severity. We set aside an allowance for losses on off-balance sheet commitments in the amount of $749 thousand as of both March 31, 2016 and December 31, 2015, which is recorded in interest payable and other liabilities on the consolidated statements of condition.
 

Page-25


Operating Leases
 
We rent certain premises and equipment under long-term, non-cancelable operating leases expiring at various dates through the year 2032. Most of the leases contain certain renewal options and escalation clauses. At March 31, 2016, the approximate minimum future commitments payable under non-cancelable contracts for leased premises are as follows:
(in thousands)
2016

2017

2018

2019

2020

Thereafter

Total

Operating leases1
$
2,670

$
3,576

$
3,594

$
3,567

$
3,328

$
5,895

$
22,630

 1 Minimum payments have not been reduced by minimum sublease rentals of $224 thousand due in the future under non-cancelable subleases.

Rent expense included in occupancy expense totaled $1.0 million for the three months ended March 31, 2016 and 2015.

Litigation Matters
 
We may be party to legal actions which arise from time to time as part of the normal course of our business.  We believe, after consultation with legal counsel, that we have meritorious defenses in these actions, and that litigation contingent liability, if any, will not have a material adverse effect on our financial position, results of operations, or cash flows.

We are responsible for our proportionate share of certain litigation indemnifications provided to Visa U.S.A. ("Visa") by its member banks in connection with lawsuits related to anti-trust charges and interchange fees ("Covered Litigation"). Visa Inc. maintains an escrow account from which settlements of, or judgments in, the Covered Litigation are paid. While the accrual related to the Covered Litigation could be higher or lower than the litigation escrow account balance, Visa did not record an additional accrual for the Covered Litigation during 2016. At March 31, 2016, the balance of the escrow account was $1.1 billion. According to the latest SEC Form 10-Q filed by VISA, Inc. on April 25, 2016, Visa has reached settlement agreements with a number of opt-out merchants. They represent approximately 51% of the Visa-branded payment card sales volume of merchants who opted out of interchange multidistrict litigation class settlement agreement, under which an estimated $4.0 billion is due to the class plaintiffs. The conversion rate of Visa Class B common stock held by us to Class A common stock (as discussed in Note 4, Investment Securities) may decrease if Visa makes more Covered Litigation settlement payments in the future, and the full effect on member banks is still uncertain. However, we are not aware of significant future cash settlement payments required by us on the Covered Litigation.

Note 9: Derivative Financial Instruments and Hedging Activities

We have entered into interest rate swap agreements, primarily as an asset/liability management strategy, in order to mitigate the changes in the fair value of specified long-term fixed-rate loans (or firm commitments to enter into long-term fixed-rate loans) caused by changes in interest rates. These hedges allow us to offer long-term fixed rate loans to customers without assuming the interest rate risk of a long-term asset. Converting our fixed-rate interest payments to floating-rate interest payments, generally benchmarked to the one-month U.S. dollar LIBOR index, protects us against changes in the fair value of our loans associated with fluctuating interest rates.

The fixed-rate payment features of the interest rate swap agreements are generally structured at inception to mirror substantially all of the provisions of the hedged loan agreements. These interest rate swaps, designated and qualified as fair value hedges, are carried on the consolidated statements of condition at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). The unrealized gain or loss in fair value of the hedged fixed-rate loan due to LIBOR interest rate movements is recorded as an adjustment to the hedged loan.

From time to time, we make firm commitments to enter into long-term fixed-rate loans with borrowers backed by yield maintenance agreements and simultaneously enter into forward interest rate swap agreements with correspondent banks to mitigate the change in fair value of the yield maintenance agreement. Prior to loan funding, yield maintenance agreements with net settlement features that meet the definition of a derivative are considered as non-designated hedges and are carried on the consolidated statements of condition at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). The offsetting changes in the fair value of the forward swap and the yield maintenance agreement are recorded in interest income. When the fixed-rate loans are originated, the forward swaps are designated to offset the change in fair value in the loans. Subsequent to the point

Page-26


of the swap designations, the related yield maintenance agreements are no longer considered derivatives. Their fair value at the designation date is recorded in other assets and is amortized using the effective yield method over the life of the respective designated loans.

The net effect of the change in fair value of interest rate swaps, the amortization of the yield maintenance agreements and the change in the fair value of the hedged loans result in an insignificant amount of hedge ineffectiveness recognized in interest income.

Our credit exposure, if any, on interest rate swaps is limited to the favorable value (net of any collateral pledged to us) and interest payments of all swaps by each counterparty. Conversely, when an interest rate swap is in a liability position exceeding a certain threshold, we may be required to post collateral to the counterparty in an amount determined by the agreements. Collateral levels are monitored and adjusted on a regular basis for changes in interest rate swap values.

As of March 31, 2016, we had seven interest rate swap agreements, which are scheduled to mature in June 2020, August 2020, June 2031, October 2031, July 2032, August 2037 and October 2037. All of our derivatives are accounted for as fair value hedges. In April 2016, one interest rate swap scheduled to mature in June 2020 was terminated as the hedged loan was paid off. A prepayment penalty was collected from the borrower to settle our interest rate swap liability, resulting in no net gain or loss on the termination of the swap and loan payoff. Our interest rate swaps are settled monthly with counterparties. Accrued interest on the swaps totaled $26 thousand and $28 thousand as of March 31, 2016 and December 31, 2015, respectively. Information on our derivatives follows:
 
 
Asset derivatives
 
Liability derivatives
(in thousands)
 
March 31, 2016
 
December 31, 2015
 
March 31, 2016
 
December 31, 2015
Fair value hedges:
 
 
 
 
 
 
 
 
Interest rate contracts notional amount
 
$
—

 
$
4,407

 
$
26,092

 
$
22,187

Interest rate contracts fair value1
 
$
—

 
$
3

 
$
2,531

 
$
1,658

 
Three months ended
(in thousands)
March 31, 2016
 
 
March 31, 2015
Decrease in value of designated interest rate swaps recognized in interest income
$
(876
)
 
 
$
(546
)
Payment on interest rate swaps recorded in interest income
(174
)
 
 
(235
)
Increase in value of hedged loans recognized in interest income
1,050

 
 
571

Decrease in value of yield maintenance agreement recognized against interest income
(12
)
 
 
(14
)
Net loss on derivatives recognized against interest income 2
$
(12
)
 
 
$
(224
)
 
 
 
 
1 See Note 3 for valuation methodology.
2 Includes hedge ineffectiveness gain of $162 thousand and gain of $11 thousand for the quarters ended March 31, 2016 and March 31, 2015, respectively. Changes in value of swaps were included in the assessment of hedge effectiveness. Hedge ineffectiveness is the measure of the extent to which the change in the fair value of the hedging instruments does not exactly offset the change in the fair value of the hedged items from period to period.

Our derivative transactions with counterparties are under International Swaps and Derivative Association (“ISDA”) master agreements that include “right of set-off” provisions. “Right of set-off” provisions are legally enforceable rights to offset recognized amounts and there may be an intention to settle such amounts on a net basis. We do not offset such financial instruments for financial reporting purposes.


Page-27


Information on financial instruments that are eligible for offset in the consolidated statements of condition follows:
Offsetting of Financial Assets and Derivative Assets
 
 
Gross Amounts
Net Amounts of
Gross Amounts Not Offset in
 
 
Gross Amounts
Offset in the
Assets Presented
the Statements of Condition
 
 
of Recognized
Statements of
in the Statements
Financial
Cash Collateral
 
(in thousands)
Assets1
Condition
of Condition1
Instruments
Received
Net Amount
As of March 31, 2016
 
 
 
 
 
 
Derivatives by Counterparty
 
 
 
 
 
 
None
$
—

$
—

$
—

$
—

$
—

$
—

As of December 31, 2015
 
 
 
 
 
 
Derivatives by Counterparty
 
 
 
 
 
 
Counterparty A
$
3

$
—

$
3

$
(3
)
$
—

$
—

1 Amounts exclude accrued interest totaling zero and $1 thousand at March 31, 2016 and December 31, 2015, respectively.

Offsetting of Financial Liabilities and Derivative Liabilities
 
 
Gross Amounts
Net Amounts of
Gross Amounts Not Offset in
 
 
Gross Amounts
Offset in the
Liabilities Presented
the Statements of Condition
 
 
of Recognized
Statements of
in the Statements of
Financial
Cash Collateral
 
(in thousands)
Liabilities2
Condition
Condition2
Instruments
Pledged
Net Amount
As of March 31, 2016
 
 
 
 
 
 
Derivatives by Counterparty
 
 
 
 
 
 
   Counterparty A
$
2,258

$
—

$
2,258

$
—

$
(2,258
)
$
—

   Counterparty B
273

—

273

—

(273
)
—

Total
$
2,531

$
—

$
2,531

$
—

$
(2,531
)
$
—

As of December 31, 2015
 
 
 
 
 
 
Derivatives by Counterparty
 
 
 
 
 
 
   Counterparty A
$
1,390

$
—

$
1,390

$
(3
)
$
(1,387
)
$
—

   Counterparty B
268

—

268

—

(268
)
—

Total
$
1,658

$
—

$
1,658

$
(3
)
$
(1,655
)
$
—


2 Amounts exclude accrued interest totaling $26 thousand and $27 thousand at March 31, 2016 and December 31, 2015, respectively.



Page-28


ITEM 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Management's discussion of the financial condition and results of operations, which is unaudited, should be read in conjunction with the related consolidated financial statements in this Form 10-Q and with the audited consolidated financial statements and accompanying notes included in our 2015 Annual Report on Form 10-K. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.
 
Forward-Looking Statements
 
This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.
 
Our forward-looking statements include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs preceded by "will," "would," "should," "could" or "may."
 
Forward-looking statements are based on Management's current expectations regarding economic, legislative, and regulatory issues that may affect our earnings in future periods. A number of factors, many of which are beyond Management’s control, could cause future results to vary materially from current Management expectations. Such factors include, but are not limited to, general economic conditions and the economic uncertainty in the United States and abroad, including changes in interest rates, deposit flows, real estate values, and expected future cash flows on loans and securities; integration of acquisitions and competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; adverse weather conditions, including droughts in California; and other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services.

Important factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements are detailed in Item 1A. Risk Factors section of our 2015 Form 10-K as filed with the SEC, copies of which are available from us at no charge. Forward-looking statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.




Page-29


RESULTS OF OPERATIONS
 
Highlights of the financial results are presented in the following table:
 
At March 31,
At December 31,
(dollars in thousands)
2016
2015
Selected financial condition data:
 
 
Total assets
$
1,943,602

$
2,031,134

Loans, net
1,426,811

1,436,229

Deposits
1,681,346

1,728,226

Borrowings
24,795

72,395

Stockholders' equity
221,646

214,473

 
 
 
Asset quality ratios:
 
 
Allowance for loan losses to total loans
1.04%

1.03
%
Allowance for loan losses to non-performing loans 1
5.64
x
6.88x

Non-performing loans to total loans 1
0.18%

0.15
%
 
 
 
Capital ratios:
 
 
Equity to total assets ratio
11.40
%
10.60
%
Total capital (to risk-weighted assets)
13.92
%
13.37
%
Tier 1 capital (to risk-weighted assets)
12.97
%
12.44
%
Tier 1 capital (to average assets)
11.03
%
10.67
%
Common equity Tier 1 capital (to risk weighted assets)
12.67
%
12.16
%
 
 
 
 
For the three months ended March 31,
(dollars in thousands, except per share data)
2016
2015
Selected operating data:
 
 
Net interest income
$
18,638

$
16,598

Provision for loan losses
—

—

Non-interest income
2,163

2,189

Non-interest expense
12,010

11,848

Net income
5,646

4,457

Net income per common share:
 
 
Basic
$
0.93

$
0.75

Diluted
$
0.93

$
0.74

 
 
 
Performance and other financial ratios:
 
 
Return on average assets
1.15%

1.00%

Return on average equity
10.38%

8.92%

Tax-equivalent net interest margin
4.04%

4.00%

Efficiency ratio
57.74%

63.07%


1 Non-performing loans include loans on non-accrual status and loans past due 90 days or more and still accruing interest.

Page-30


Executive Summary
 
Earnings in the first quarter of 2016 totaled $5.6 million, compared to $4.9 million in the fourth quarter of 2015 and $4.5 million in the first quarter of 2015. Diluted earnings per share totaled $0.93 in the first quarter of 2016, compared to $0.81 in the prior quarter and $0.74 in the same quarter last year.

The following are highlights of our operating and financial performance for the three months ended March 31, 2016:

•
Loans totaled $1,441.8 million at March 31, 2016, compared to $1,451.2 million at December 31, 2015. New loan origination of approximately $29 million in the first quarter of 2016 was offset by payoffs of approximately $37 million.

•
Non-interest bearing deposits make up 45.1% of total deposits and the cost of total deposits is 0.08%.

•
Credit quality remains strong with non-accrual loans representing 0.18% of total loans at March 31, 2016. There was no provision for loan losses recorded in 2016.

•
The net interest margin increased 34 basis points to 4.04% for the first quarter of 2016 from 3.70% when compared to the fourth quarter of 2015. Gains on payoffs of acquired loans had a positive impact on net interest margin in the first quarter of 2016.

•
Return on assets ("ROA") was 1.15% for the quarter ended March 31, 2016, compared to 0.98% last quarter and 1.00% for the first quarter last year. Return on equity ("ROE") was 10.38% for the quarter ended March 31, 2016, compared to 9.12% last quarter and 8.92% for the first quarter of 2015.

•
All capital ratios are above regulatory requirements for a well-capitalized institution. The total risk-based capital ratio for Bancorp was 13.9% at March 31, 2016 compared to 13.4% at December 31, 2015.

Net interest income totaled $18.6 million in the first quarter of 2016, compared to $17.2 million in the prior quarter and $16.6 million in the same quarter a year ago. The tax-equivalent net interest margin was 4.04%, 3.70% and 4.00%, for those respective periods. The increase in tax-equivalent net interest margin from the prior quarter includes 10 basis points related to a shift in the mix of interest-earning assets from lower yielding interest-bearing cash and investment securities to higher yielding loans.  Another 21 basis points came from purchased credit-impaired loan payoffs and market value adjustments on interest rate swaps.

Non-interest income in the first quarter of 2016 totaled $2.2 million, compared to $2.1 million in the prior quarter and $2.2 million in the same quarter a year ago. The increase compared to the prior quarter relates to a $110 thousand gain on the sale of four government agency debentures.

Non-interest expense totaled $12.0 million in the first quarter of 2016, compared to $11.1 million in the prior quarter and $11.8 million in the same quarter a year ago. Non-interest expense was higher than the prior quarter and the first quarter of 2015 due to no provision for losses on off-balance sheet commitments in the first quarter of 2016, compared to reversals of $277 thousand last quarter and $201 thousand in the same quarter of last year. The first quarter of 2016 non-interest expense was higher than the prior quarter also due to higher employer matching contributions to the 401(k) benefit plan , a decline in deferred loan origination costs related to the lower level of loan originations and a reversal of accrued incentive bonus in December 2015. Our efficiency ratio (the ratio of non-interest expense divided by the sum of net interest income and non-interest income) was 57.74%, 57.57% and 63.07% for the quarters ended March 31, 2016, December 31, 2015 and March 31, 2015, respectively.

Assets totaled $1,943.6 million at March 31, 2016, a decrease of $87.5 million, or 4.3% from $2,031.1 million at December 31, 2015. Refer to the Financial Condition Summary section for further discussion on the change in total assets.

The investment securities portfolio totaled $399.5 million at March 31, 2016, a decline of $87.9 million from December 31, 2015. In addition to paydowns and maturities in the portfolio, $54.9 million in securities were sold in 2016 at gains totaling $110 thousand.

Loans totaled $1,441.8 million at March 31, 2016, a decrease of $9.4 million from $1,451.2 million at December 31, 2015. Loan originations of approximately $29 million were distributed across our markets. Investor commercial real

Page-31


estate and commercial and industrial, including related owner-occupied commercial real estate, accounted for the majority of the new loan volume in the first three months of 2016. Payoffs of approximately $37 million offset the new loan volume, and combined with utilization of lines of credit and amortization on existing loans resulted in the decrease in loan balances since December 31, 2015.

Credit quality remains strong with non-accrual loans totaling $2.7 million at March 31, 2016, compared to $2.2 million at December 31, 2015, and representing 0.18% of total loans compared to 0.15% at year end. Classified loans totaled $22.3 million at March 31, 2016, unchanged from December 31, 2015. Accruing loans past due 30 to 89 days totaled $584 thousand at March 31, 2016, compared to $2.1 million at December 31, 2015.

There was no provision for loan losses recorded in the first quarter of 2016 as the existing level of loan loss reserve did not warrant a provision, consistent with the same quarter a year ago. A provision for loan losses of $500 thousand was recorded in the prior quarter primarily due to the significant loan growth in the fourth quarter. The ratio of allowance for loan losses to total loans increased to 1.04% at March 31, 2016, compared to 1.03% at December 31, 2015.

Deposits totaled $1,681.3 million at March 31, 2016, compared to $1,728.2 million at December 31, 2015. The $46.9 million decline was due to normal business activity for new and existing commercial customers and the nature of their businesses. Non-interest bearing deposits totaled $758.9 million, or 45.1% of total deposits at March 31, 2016, compared to 44.6% at December 31, 2015. Overnight borrowings also declined $47.7 million.

The total risk-based capital ratio for Bancorp was 13.9% at March 31, 2016, compared to 13.4% at December 31, 2015. The common equity tier one ratio, a regulatory ratio under Basel III (Basel Committee on Bank Supervision guidelines for determining regulatory capital), was 12.7% at March 31, 2016, compared to 12.2% at December 31, 2015. As reported in the Capital Adequacy section of this document, all four of our capital ratios are adequately capitalized under the Basel III requirements that took effect January 1, 2015.

In 2016, we will continue to focus on relationship banking:

•
We have ample liquidity and capital to support both organic growth and acquisitions in the coming quarters.

•
Acquisitions remain a component of our strategic plan. The Bay Area is an economically attractive area and we intend to expand our footprint through organic growth and strategic acquisitions.

•
Credit quality and expense control remain key priorities.

•
Our net interest margin in 2016 may compress if current market interest rates do not increase.

•
We cannot predict the timing of early payoffs of acquired loans and their effect on our future net interest margin.

Critical Accounting Policies and Estimates

Critical accounting policies are those that are both very important to the portrayal of our financial condition and results of operations and require Management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and imprecise.

Management believes that the following four accounting policies would be considered critical: Allowance for Loan Losses, Other-than-temporary Impairment of Investment Securities, Accounting for Income Taxes, and Fair Value Measurements. Except for the Allowance for Loan Losses, as described below, there have been no material changes to our critical accounting policies, which are described in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 1 to the Consolidated Financial Statements included in our 2015 Form 10-K filed with the SEC on March 11, 2016.

Allowance for Loan Losses

Allowance for Loan Losses is based upon estimates of loan losses and is maintained at a level considered adequate to provide for probable losses inherent in the loan portfolio. The allowance is increased by provisions for loan losses charged against earnings and reduced by charge-offs, net of recoveries.


Page-32


In periodic evaluations of the adequacy of the allowance balance, Management considers current economic conditions, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, our past loan loss experience and other factors. The ALLL is based on estimates, and ultimate losses may vary from current estimates. Our Board of Directors' Asset/Liability Management Committee (“ALCO”) reviews the adequacy of the ALLL at least quarterly.

The overall allowance consists of 1) specific allowances for individually identified impaired loans ("ASC 310-10") and 2) general allowances for pools of loans ("ASC 450-20"), which incorporate quantitative (e.g., loan loss rates) and qualitative risk factors (e.g., portfolio growth and trends, credit concentrations, economic and regulatory factors, etc.).

The first component, specific allowances, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable. Through Management's ongoing loan grading and credit monitoring process, individual loans are identified that have conditions indicating the borrower may be unable to pay all amounts due in accordance with the contractual terms. These loans are evaluated for impairment individually by Management. Management considers an originated loan to be impaired when it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. When the fair value of the impaired loan is less than the recorded investment in the loan, the difference is recorded as an impairment through the establishment of a specific allowance. For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate at origination (for originated loans), based on the loan's observable market price, or based on the fair value of the collateral if the loan is collateral dependent or if foreclosure is imminent. Generally with problem credits that are collateral dependent, we obtain appraisals of the collateral at least annually. We may obtain appraisals more frequently if we believe the collateral value is subject to market volatility, if a specific event has occurred to the collateral, or if we believe foreclosure is imminent.

Specific allowances may also be established on acquired loans. We apply judgment to develop our estimate of cash flows expected to be collected on purchased credit impaired ("PCI") loans, given the current economic environment, changes in collateral values, loan workout plans, changing probability of default, loss severities and prepayments. If we have probable decreases in cash flows expected to be collected on PCI loans, specific allowances are established to account for credit deterioration subsequent to acquisition. Subsequent to acquisition, if the probable and estimable losses for non-credit-impaired purchased loans exceed the amount of the remaining unaccreted discount, the excess is also established as an allowance for loan losses.

The second component is an estimate of the probable inherent losses in each loan pool with similar characteristics. This analysis encompasses the entire loan portfolio, excluding individually identified impaired loans and acquired loans whose purchase discount has not been fully accreted. Under our allowance model, loans are evaluated on a pool basis by Federal regulatory reporting codes ("CALL codes" or "segments"), which are further delineated by assigned credit risk ratings, as described in Note 5 to the Consolidated Financial Statements of this Form 10-Q. Segments include the following:

•
Loans secured by real estate:
-     1-4 family residential construction loans
-     Other construction loans and all land development and other land loans
-     Secured by farmland (including residential and other improvements)
-     Revolving, open-end loans secured by 1-4 family residential properties and extended under lines of credit
-     Closed-end loans secured by 1-4 family residential properties, secured by first liens
-     Closed-end loans secured by 1-4 family residential properties, secured by junior liens
-     Secured by multifamily (5 or more) residential properties
-     Loans secured by owner-occupied non-farm nonresidential properties
-     Loans secured by other non-farm nonresidential properties
•
Loans to finance agricultural production and other loans to farmers
•
Commercial and industrial loans
•
Loans to individuals for household, family and other personal expenditures (i.e., consumer loans)
•
Other loans

The model determines general allowances by loan segment based on quantitative (loss history) and qualitative risk factors. Qualitative internal and external risk factors include, but are not limited to, the following:

•
Changes in the nature and volume of the loan portfolio.

Page-33


•
Changes in the volume and severity of past due loans, the volume of non-accruals loans, and the volume and severity of adversely classified or graded loans.
•
The existence and effect of any credit concentrations (when the credit segment exceeds a certain percentage of our capital), and changes in the levels of such concentrations.
•
Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere.
•
Changes in the experience, ability, and depth of lending management and other relevant staff.
•
Changes in the quality of our systematic loan review processes.
•
Changes in economic and business conditions, and developments that affect the collectability of the portfolio.
•
Changes in the value of underlying collateral, where applicable.
•
The effect of other external factors such as legal and regulatory requirements on the level of estimated credit losses in the portfolio.
•
The effect of acquisitions of other loan portfolios on our infrastructure, including risk associated with entering new geographic areas as a result of such acquisitions.
•
The presence of specialized lending segments in the portfolio.

Beginning with the quarter ended March 31, 2016, Management enhanced its methodology for determining the quantitative and qualitative risk factors assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, increase efficiencies related to performing the calculations, and refine how we incorporate environmental and other unique risk elements into our estimation of credit losses. The changes in methodology did not result in a material difference in general allowances. Prior to March 31, 2016, under the Bank's allowance model, each segment was assigned a quantitative loss factor that was primarily based on a rolling twenty-quarter look-back at our historical losses for that particular segment, as well as a number of other assumptions. As of March 31, 2016, the quantitative risk factor for each segment utilizes historical loss or migration analysis loss methods based on loss history that ranges from March 2010 to the most recent reporting period.

Under the historical loss method, quarterly loss rates are calculated for each segment by dividing annualized net charge-offs during each quarter by the quarter's average segment balances. The quarterly loss rates are averaged over the entire loss history period. Under the migration analysis method, loss rates are calculated at the risk grade and segment levels by dividing the net charge-off amount by each of the five preceding March 31 balances for the corresponding risk grade and segment where the charged-off loan in question was present. Migration loss rates are averaged for each risk grade and segment for the five migration periods. For each segment, the larger of the migration loss reserves or segment historical loss reserves is applied to the current loan balance. Qualitative factors are combined with these quantitative factors to arrive at the overall general allowances.

While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in local and national economic conditions, or significant changes in other assumptions, could result in a material increase in the allowance for loan losses and may adversely affect our financial condition and results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.

For further information regarding the allowance for loan losses, see Note 5 - Loans and Allowance for Loan Losses in the Consolidated Financial Statements of this Form 10-Q.

Other-than-temporary Impairment of Investment Securities: For additional information regarding how we evaluate our investment securities for other-than-temporary impairment, see Note 4, Investment Securities in Item 1 - Financial Statements of this Form 10-Q.

Accounting for Income Taxes: For additional information regarding our accounting for income taxes, see the Provision for Income Taxes section of Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q.

Fair Value Measurements: For additional information on our fair value measurements, valuation methodologies, and significant assumptions used, see Note 3, Fair Value of Assets and Liabilities in Item 1- Financial Statements of this Form 10-Q.



Page-34


Net Interest Income
 
Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is impacted by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in the net interest income due to an imbalance in the timing of repricing or maturity of assets and liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on net interest income.
 
Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity.
 
The following table, Average Statements of Condition and Analysis of Net Interest Income, compares interest income and average interest-earning assets with interest expense and average interest-bearing liabilities for the periods presented. The table also presents net interest income, net interest margin and net interest rate spread for each period reported.

Page-35



Average Statements of Condition and Analysis of Net Interest Income











Three months ended

Three months ended


March 31, 2016

March 31, 2015



Interest



Interest



Average
Income/
Yield/

Average
Income/
Yield/
(dollars in thousands)
Balance
Expense
Rate

Balance
Expense
Rate
Assets








Interest-bearing due from banks 1
$
8,996

$
11

0.48
%

$
38,295

$
21

0.22
%

Investment securities 2, 3
428,055

2,264

2.12
%

311,978

1,927

2.47
%

Loans 1, 3, 4
1,442,601

17,456

4.79
%

1,351,791

15,675

4.64
%

   Total interest-earning assets 1
1,879,652

19,731

4.15
%

1,702,064

17,623

4.14
%

Cash and non-interest-bearing due from banks
29,823




41,073




Bank premises and equipment, net
9,143




9,839




Interest receivable and other assets, net
58,195




58,132



Total assets
$
1,976,813




$
1,811,108



Liabilities and Stockholders' Equity








Interest-bearing transaction accounts
$
100,990

$
27

0.11
%

$
92,376

$
30

0.13
%

Savings accounts
142,499

14

0.04
%

133,877

12

0.04
%

Money market accounts
528,984

111

0.08
%

486,830

127

0.11
%

Time accounts
160,943

196

0.50
%

154,118

231

0.59
%
 
Overnight borrowings1
20,567

22

0.42
%
 
397

—

—
%

FHLB borrowing and overnight borrowings 1
15,000

78

2.07
%

15,000

78

2.07
%

Subordinated debenture 1
5,418

109

7.96
%

5,207

104

7.99
%

   Total interest-bearing liabilities
974,401

557

0.23
%

887,805

582

0.27
%

Demand accounts
767,579




705,024




Interest payable and other liabilities
15,980




15,594




Stockholders' equity
218,853




202,685



Total liabilities & stockholders' equity
$
1,976,813




$
1,811,108



Tax-equivalent net interest income/margin 1

$
19,174

4.04
%


$
17,041

4.00
%
Reported net interest income/margin 1

$
18,638

3.92
%


$
16,598

3.90
%
Tax-equivalent net interest rate spread


3.92
%



3.88
%
 
 
 
 
 
 
 
 
 
1 Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable.
2 Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity. Investment security interest is earned on 30/360 day basis monthly.
3 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 35 percent.
4 Average balances on loans outstanding include non-performing loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield.

First Quarter of 2016 Compared to First Quarter of 2015

The tax-equivalent net interest margin was 4.04% in the first quarter of 2016, compared to 4.00% in the same quarter a year ago.  The increase of four basis points relates to higher gains on the payoff of PCI loans of 15 basis points as seen in the table below and market value adjustments on interest rate swaps. This positive impact is partially offset by lower yields on investment securities and new loans resulting from the continued low interest rate environment. The net interest spread also increased four basis points over the same period for the same reasons.

The yield on average interest-earning assets increased one basis point in the first quarter of 2016 compared to the first quarter of 2015 due to the reasons listed above. Average loans as a percentage of average interest-earning assets were 76.7% and 79.4% at March 31, 2016 and 2015, respectively. Total average interest-earning assets increased $177.6 million, or 10.4%, in the first quarter of 2016, compared to the first quarter of 2015, due to an increase

Page-36


in average securities of $116.1 million and average loans of $90.8 million, partially offset by a decrease of $29.3 million in average interest-bearing due from banks.

Market interest rates are, in part, based on the target federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the Federal Reserve Open Market Committee ("FOMC"). In December 2015, the FOMC raised the target federal funds rate by 25 basis points to a range of 0.25% to 0.50% from the historic low of 0.00% to 0.25% that had not changed during the previous seven years. The prolonged low interest rate environment has resulted in downward pricing pressure on our interest-earning assets. We have experienced significant net interest margin compression over the last several years, despite the increase in the first quarter, and our net interest margin in 2016 may continue to compress if the current market interest rates do not increase.

Early payoffs or prepayments of our acquired loans with significant unamortized purchase discount/premium could result in volatility in our net interest margin and cannot be predicted. As our acquired loans continue to pay off, we expect the accretion on acquired loans to continue to decline. Accretion and gains on payoffs of purchased loans recorded to interest income were as follows:
 
Three months ended
 
 
March 31, 2016

March 31, 2015
 
(dollars in thousands)
Dollar Amount
Basis point impact to net interest margin

Dollar Amount
Basis point impact to net interest margin
 
Accretion on PCI loans
$
98

2 bps

$
119

3 bps
 
Accretion on non-PCI loans
$
330

7 bps

$
371

9 bps
 
Gains on pay-offs of PCI loans
$
740

16 bps

$
43

1 bps
 


Provision for Loan Losses
 
Management assesses the adequacy of the allowance for loan losses on a quarterly basis based on several factors including growth of the loan portfolio, analysis of probable losses in the portfolio, historical loss experience and the current economic climate.  Actual losses on loans are charged against the allowance, and the allowance is increased by loss recoveries and provisions for loan losses charged to expense.  For further discussion, see the section captioned “Critical Accounting Policies.”
 
There was no provision for loan losses recorded in the first quarter of 2016, consistent with the same quarter a year ago, as the existing level of loan loss reserve did not warrant a provision. Net recoveries in the first quarter of 2016 totaled $29 thousand, compared to $57 thousand in the same quarter a year ago.

The allowance for loan losses totaled 1.04% of loans at March 31, 2016, compared to 1.03% at December 31, 2015. Non-accrual loans totaled $2.7 million, or 0.18% of Bancorp's loan portfolio at March 31, 2016, compared to $2.2 million, or 0.15% at December 31, 2015.

Impaired loan balances totaled $22.3 million at March 31, 2016, compared to $21.2 million at December 31, 2015, with specific valuation allowances of $1.6 million and $1.2 million for the same respective dates. The increase in both impaired loan balances and the related specific valuation allowance primarily relates to the addition of a performing commercial real estate loan modified in a Troubled Debt Restructuring (“TDR”) and a home equity loan transfered to non-accrual status. Classified loans, which have risk grades of "substandard" or "doubtful", totaled $22.3 million at both March 31, 2016 and December 31, 2015.


Non-interest Income
 
The table below details the components of non-interest income.

Page-37


 
 
Three months ended
 
Amount
 
Percent
(dollars in thousands)
March 31, 2016
March 31, 2015
 
Increase (Decrease)
 
Increase (Decrease)
Service charges on deposit accounts
$
456

$
525

 
$
(69
)
 
(13.1
)%
Wealth Management and Trust Services
566

638

 
(72
)
 
(11.3
)%
Debit card interchange fees
338

347

 
(9
)
 
(2.6
)%
Merchant interchange fees
113

130

 
(17
)
 
(13.1
)%
Earnings on bank-owned life insurance
201

203

 
(2
)
 
(1.0
)%
Dividends on FHLB stock
169

148

 
21

 
14.2
 %
Gains on investment securities, net
110

8

 
102

 
NM

Other income
210

190

 
20

 
10.5
 %
Total non-interest income
$
2,163

$
2,189

 
$
(26
)
 
(1.2
)%
 
 
 
 
 
 
 
NM - Not Meaningful

Non-interest income decreased $26 thousand from the first quarter of 2015 to $2.2 million. The slight decrease is due to lower wealth management and trust services income due to higher corporate trustee fees received in the first quarter of 2015 and lower service charges on deposit accounts. These decreases were partially offset by the $110 thousand gain on the sale of four available-for-sale securities in the first quarter of 2016.

Non-interest Expense
 
The table below details the components of non-interest expense.
 
Three months ended
 
Amount
 
Percent
(dollars in thousands)
March 31, 2016
 
March 31, 2015
 
Increase (Decrease)
 
Increase (Decrease)
Salaries and related benefits
$
6,748

 
$
6,790

 
$
(42
)
 
(0.6
)%
Occupancy and equipment
1,281

 
1,342

 
(61
)
 
(4.5
)%
Depreciation and amortization
453

 
421

 
32

 
7.6
 %
Federal Deposit Insurance Corporation insurance
261

 
236

 
25

 
10.6
 %
Data processing
856

 
786

 
70

 
8.9
 %
Professional services
498

 
564

 
(66
)
 
(11.7
)%
Directors' expense
189

 
191

 
(2
)
 
(1.0
)%
Information technology
193

 
152

 
41

 
27.0
 %
Reversal of losses on off-balance sheet commitments
—

 
(201
)
 
201

 
NM

Other non-interest expense
 
 
 
 
 
 
 
Advertising
103

 
76

 
27

 
35.5
 %
    Other expense
1,428

 
1,491

 
(63
)
 
(4.2
)%
Total other non-interest expense
1,531

 
1,567

 
(36
)
 
(2.3
)%
Total non-interest expense
$
12,010

 
$
11,848

 
$
162

 
1.4
 %
 
 
 
 
 
 
 
 
NM - Not Meaningful

Non-interest expense increased $162 thousand to $12.0 million in the first quarter of 2016 compared to $11.8 million in the first quarter of 2015. The increase was primarily due to a reduction in the off-balance sheet reserve in the first quarter of 2015.


Page-38


Provision for Income Taxes

The provision for income taxes for the first quarter of 2016 totaled $3.1 million at an effective tax rate of 35.8%, compared to $2.5 million at an effective tax rate of 35.8% in the same quarter last year. These provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income, and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities, BOLI, and certain tax-exempt loans). We forecast annual pre-tax income and these permanent differences to project our effective tax rates. As a result, there are fluctuations in the effective rate from period to period based on the relationship of net permanent differences to income before tax.

We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal or state income tax examinations at the issuance of this report. At March 31, 2016, neither the Bank nor Bancorp had accruals for interest and penalties related to unrecognized tax benefits.

FINANCIAL CONDITION SUMMARY

At March 31, 2016, assets totaled $1,943.6 million, a decrease of $87.5 million when compared to $2,031.1 million at December 31, 2015, primarily due to a decrease in investment securities of $87.9 million with corresponding reductions in overnight borrowings and deposits totaling $46.9 million and $47.7 million, respectively. New loan volume of approximately $29 million in the first quarter of 2016 was offset by pay-offs of approximately $37 million, and combined with scheduled payments and advances on existing loan commitments, produced a net decrease of $9.4 million from December 31, 2015. We believe our loan and deposit pipelines are presently robust, reflecting growth prospects in all of our markets. We have rebuilt our loan pipeline which is at its highest level since the end of the year after we funded $114 million in loans during the fourth quarter.

Investment Securities

Investment securities in our portfolio that may be backed by mortgages having sub-prime or Alt-A features (certain privately issued CMOs) represent 0.2% of our total investment portfolio at both March 31, 2016 and December 31, 2015.

We sold four available-for-sale securities in 2016 at net gains of $110 thousand with total proceeds of $55.0 million to pay down our overnight borrowings.

The table below summarizes our investment in obligations of state and political subdivisions at March 31, 2016 and December 31, 2015.
 
 
March 31, 2016
 
December 31, 2015
 
(dollars in thousands)
Amortized Cost
Fair Value
% of Total State and Political Subdivisions
 
Amortized Cost
Fair Value
% of Total State and Political Subdivisions
 
Within California:
 
 
 
 
 
 
 
 
 
General obligation bonds
$
18,566

$
18,842

18.8
%
 
$
18,642

$
18,830

18.6
%
 
 
Revenue bonds
15,360

15,770

15.6

 
15,453

15,767

15.5

 
 
Tax allocation bonds
5,386

5,586

5.5

 
5,411

5,603

5.4

 
Total in California
39,312

40,198

39.9

 
39,506

40,200

39.5

 
Outside California:
 
 
 
 
 
 
 
 
 
General obligation bonds
50,809

52,131

51.4

 
51,920

52,990

51.9

 
 
Revenue bonds
8,545

8,624

8.7

 
8,603

8,629

8.6

 
Total outside California
59,354

60,755

60.1

 
60,523

61,619

60.5

 
Total obligations of state and political subdivisions
$
98,666

$
100,953

100.0
%
 
$
100,029

$
101,819

100.0
%
 

The portion of the portfolio outside the state of California is distributed among nineteen states. The largest concentrations are in Washington (8.3%), Minnesota (7.1%), and Texas (6.4%). Revenue bonds, both within and

Page-39


outside California, primarily consisted of bonds relating to essential services (such as public improvements and utilities) and school district bonds.

Investments in states, municipalities and political subdivisions are subject to an initial pre-purchase credit assessment and ongoing monitoring. Key considerations include:

•
The soundness of a municipality’s budgetary position and stability of its tax revenues
•
Debt profile and level of unfunded liabilities, diversity of revenue sources, taxing authority of the issuer
•
Local demographics/economics including unemployment data, largest taxpayers and local employers, income indices and home values
•
For revenue bonds, the source and strength of revenue for municipal authorities including the obligor’s financial condition and reserve levels, annual debt service and debt coverage ratio, and credit enhancement (such as insurer’s strength)
•
Credit ratings by major credit rating agencies

Loans

New loan originations were strong at approximately $29 million in the first three months of 2016. Investor commercial real estate and commercial and industrial, including related owner-occupied commercial real estate, accounted for the majority of the new loan volume for the first quarter. Loan originations were offset by pay-offs of approximately $37 million. One $13 million investor commercial real estate loan accounted for approximately 36% of quarter one pay-offs. The Bank chose not to match a competitor's highly aggressive loan terms as they were not consistent with our credit policy.

Our residential loan portfolio does not include sub-prime loans, nor is it our practice to underwrite loans commonly referred to as "Alt-A mortgages," the characteristics of which are loans lacking full documentation, borrowers having low FICO scores, or collateral compositions reflecting high loan-to-value ratios. Refer to Note 5 for the composition of outstanding loans by class.
 
Liabilities

During the first three months of 2016, total liabilities decreased $94.7 million to $1,722.0 million. At March 31, 2016, deposits totaled $1,681.3 million, a decrease of $46.9 million from December 31, 2015. Fluctuation in deposits was due to normal business activity for new and existing commercial customers and the nature of their businesses. Overnight borrowings decreased by $47.7 million from December 31, 2015, primarily due to reductions in the investment portfolio mentioned previously.

Capital Adequacy
 
We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the Bank’s prompt corrective action classification are also subject to qualitative judgments by the regulators about components of capital, risk weightings and other factors.
 
Quantitative measures established by regulation to ensure capital adequacy require Bancorp and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to quarterly average assets.
 
Capital ratios are reviewed by Management on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet our anticipated future needs.  For all periods presented, the Bank’s ratios exceed the regulatory definition of “well capitalized” under the regulatory framework for prompt corrective action and Bancorp’s ratios exceed the required minimum ratios for capital adequacy purposes.

In July 2013, the Board of Governors of the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency, finalized regulatory capital rules known as "Basel III". The rules became effective beginning January 2015, and will be phased-in and become fully implemented by January 2019. The guidelines, among other things, changed the

Page-40


minimum capital requirements of bank holding companies, by increasing the Tier 1 capital to risk-weighted assets ratio to 6%, and introducing a new requirement to maintain a minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%. By 2019, when fully phased in, the rules will require further increases to certain minimum capital requirements and a capital conservation buffer of an additional 2.5% of risk-weighted assets. Basel III permits certain banks such as us to exclude accumulated other comprehensive income or loss from regulatory capital through a one-time election in the first quarter of 2015. As it was consistent with our existing treatment, there were no changes to our capital ratios as a result of making this election. The changes that affected us most significantly include:
•
shifting off-balance sheet items with an original maturity of one year or less from 0% to 20% risk weight,
•
moving past due loan balances from 100% to 150% risk weight,
•
deducting deferred tax assets associated with NOLs and tax credits from common equity Tier 1 capital, and
•
subjecting deferred tax assets related to temporary timing differences that exceed certain thresholds to 250% risk-weighting, beginning in 2018.

We have modeled our ratios under the fully phased-in Basel III rules and, based on present facts, we do not expect that we will be required to raise additional capital as a result of the fully phased-in rules.

To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, Tier 1 leverage, and common equity Tier 1 ratios as set forth in the second table below. The most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action as of September 30, 2015. There are no conditions or events since that notification that Management believes have changed the Bank’s categories, and we expect the Bank to remain well capitalized for prompt corrective action purposes.

The Bancorp’s and Bank’s capital adequacy ratios as of March 31, 2016 and December 31, 2015 are presented in the following tables. Bancorp's Tier 1 capital includes the subordinated debentures, which are not included at the Bank level. We continued to build capital in 2016 through the accumulation of net income.
Capital Ratios for Bancorp
(dollars in thousands)
Actual Ratio
 
Adequately Capitalized Threshold1
March 31, 2016
Amount

 
Ratio

 
Amount
 
Ratio
Total Capital (to risk-weighted assets)
$
232,569

 
13.92
%
 
≥ $144,147
 
≥ 8.625%
Tier 1 Capital (to risk-weighted assets)
$
216,792

 
12.97
%
 
≥ $110,721
 
≥ 6.625%
Tier 1 Capital (to average assets)
$
216,792

 
11.03
%
 
≥ $ 78,623
 
≥ 4.00%
Common Equity Tier 1 (to risk-weighted assets)
$
211,745

 
12.67
%
 
≥ $ 85,652
 
≥ 5.125%
December 31, 2015
 

 
 

 
 
 
 
Total Capital (to risk-weighted assets)
$
227,269

 
13.37
%
 
≥ $135,996
 
≥ 8.00%
Tier 1 Capital (to risk-weighted assets)
$
211,521

 
12.44
%
 
≥ $101,997
 
≥ 6.00%
Tier 1 Capital (to average assets)
$
211,521

 
10.67
%
 
≥ $ 79,296
 
≥ 4.00%
Common Equity Tier 1 (to risk-weighted assets)
$
206,724

 
12.16
%
 
≥ $ 76,498
 
≥ 4.50%

1 The 2016 adequately capitalized threshold includes the capital conservation buffer that was effective January 1, 2016. These ratios are not reflected on a fully phased-in basis, which will occur in January 2019.


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Capital Ratios for the Bank
(dollars in thousands)
Actual Ratio
 
Adequately Capitalized Threshold1
 
Ratio to be Well Capitalized under Prompt Corrective Action Provisions
March 31, 2016
Amount

 
Ratio

 
Amount
 
Ratio
 
Amount
 
Ratio
Total Capital (to risk-weighted assets)
$
226,787

 
13.57
%
 
≥ $144,110
 
≥ 8.625%
 
≥ $167,084
 
≥10.00%
Tier 1 Capital (to risk-weighted assets)
$
211,010

 
12.63
%
 
≥ $110,693
 
≥ 6.625%
 
≥ $133,667
 
≥ 8.00%
Tier 1 Capital (to average assets)
$
211,010

 
10.74
%
 
≥ $ 78,607
 
≥ 4.00%
 
≥ $ 98,259
 
≥ 5.00%
Common Equity Tier 1 (to risk-weighted assets)
$
211,010

 
12.63
%
 
≥ $ 85,631
 
≥ 5.125%
 
≥ $108,605
 
≥ 6.50%
December 31, 2015
 

 
 

 
 
 
 
 
 
 
 
Total Capital (to risk-weighted assets)
$
222,830

 
13.11
%
 
≥ $135,968
 
≥ 8.00%
 
≥ $169,960
 
≥10.00%
Tier 1 Capital (to risk-weighted assets)
$
207,082

 
12.18
%
 
≥ $101,976
 
≥ 6.00%
 
≥ $135,968
 
≥ 8.00%
Tier 1 Capital (to average assets)
$
207,082

 
10.45
%
 
≥ $ 79,268
 
≥ 4.00%
 
≥ $ 99,085
 
≥ 5.00%
Common Equity Tier 1 (to risk-weighted assets)
$
207,082

 
12.18
%
 
≥ $ 76,482
 
≥ 4.50%
 
≥ $110,474
 
≥ 6.50%

1 The 2016 adequately capitalized threshold includes the capital conservation buffer that was effective January 1, 2016. These ratios are not reflected on a fully phased-in basis, which will occur in January 2019.

Liquidity
 
The goal of liquidity management is to provide adequate funds to meet loan demand and fund operating activities and deposit withdrawals. We accomplish this goal by maintaining an appropriate level of liquid assets and formal lines of credit with the FHLB, FRBSF and correspondent banks that enable us to borrow funds as needed. Our ALCO, which is comprised of certain directors of the Bank, is responsible for approving and monitoring our liquidity targets and strategies. ALCO has adopted a contingency funding plan that provides early detection of a potential shortfall in liquidity below internal requirements and institutes prompt responses that may prevent or alleviate a potential liquidity crisis.
 
We obtain funds from the repayment and maturity of loans as well as deposit inflows, investment security maturities and paydowns, federal funds purchases, FHLB advances, and other borrowings.  Our primary uses of funds are the origination of loans, the purchase of investment securities, withdrawals of deposits, maturity of certificate of deposits, repayment of borrowings and dividends to common stockholders.
 
Management monitors our liquidity position daily. Our liquid assets totaled $303.6 million at March 31, 2016 which included unencumbered available-for-sale securities (after applying valuation haircut) and cash. We attract and retain new deposits, which depends upon the variety and effectiveness of our customer account products, service and convenience, and rates paid to customers, as well as our financial strength. Any long-term decline in retail deposit funding would adversely affect our liquidity. We had an influx of deposits from several large commercial depositors in late 2015 that were withdrawn in early 2016 due to their business operation models. As a result, our liquid assets declined $71.4 million from December 31, 2015 to March 31, 2016. Management regularly adjusts our investments in liquid assets based upon our assessment of expected loan demand and payoff activities, expected deposit flows, desired mix and yields on interest-earning assets, and the objectives of our asset/liability management program. In addition, we have secured borrowing capacity through the FHLB and FRBSF that can be drawn upon. Management anticipates our current strong liquidity position and core deposit base will provide adequate liquidity to fund our operations.
 
As presented in the accompanying unaudited consolidated statements of cash flows, the sources of liquidity vary between periods. Our cash and cash equivalents at March 31, 2016 totaled $39.8 million, a increase of $13.4 million from December 31, 2015. The primary sources of funds during the first three months of 2016 included $90.1 million in proceeds from sales, pay-downs and maturities of investment securities, net of purchases, $10.8 million in loan principal collections (net of loan originations), and $7.6 million net cash provided by operating activities. The primary uses of liquidity during the first quarter of 2016 was repayment of $47.7 million in borrowings and a decline in net deposits of $46.9 million.

In addition to cash and cash equivalents, we have substantial additional borrowing capacity as discussed in Note 6 to the consolidated financial statements.
 

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Undisbursed credit commitments, as discussed in Note 8 to the consolidated financial statements, totaled $391.0 million at March 31, 2016. These commitments, to the extent used, are expected to be funded primarily through the repayment of existing loans, deposit growth and liquid assets. Over the next twelve months, $117.7 million of time deposits will mature. We expect these funds to be replaced with new deposits. Our emphasis on local deposits combined with our well capitalized equity position, provides a very stable funding base.
 
Since Bancorp is a holding company and does not conduct regular banking operations, its primary sources of liquidity are dividends from the Bank. Under the California Financial Code, payment of a dividend from the Bank to Bancorp without advance regulatory approval is restricted to the lesser of the Bank’s retained earnings or the amount of the Bank’s undistributed net profits from the previous three fiscal years. The primary uses of funds for Bancorp are shareholder dividends and ordinary operating expenses.  Bancorp held $5.3 million of cash at March 31, 2016. Bancorp obtained dividend distributions from the Bank in the amount of $3.0 million in January 2016. Cash on hand is deemed sufficient to cover Bancorp's operational needs and cash dividends to shareholders through the end of 2016. Management anticipates that there will be sufficient earnings at the Bank to provide dividends to Bancorp to meet its funding requirements for the foreseeable future.


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ITEM 3.     Quantitative and Qualitative Disclosure about Market Risk

Market risk is defined as the risk of loss arising from an adverse change in the market value (or prices) of financial instruments. A significant form of market risk is interest rate risk, which is inherent in our investment, borrowing, lending and deposit gathering activities. The Bank manages interest rate sensitivity to minimize the exposure of our net interest margin, earnings, and capital to changes in interest rates. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities.

To mitigate interest rate risk, the structure of the Consolidated Statement of Condition is managed with the objective of correlating the effects of interest rate changes on loans and investments with those of deposits and borrowings. The asset liability management policy sets limits on the acceptable amount of change to net interest income and economic value of equity in different interest rate environments.

From time to time, we enter into interest rate swap contracts to mitigate the changes in the fair value of specified long-term fixed-rate loans and firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates. See Note 9 to the Consolidated Financial Statements in this Form 10-Q.

Exposure to interest rate risk is reviewed at least quarterly by ALCO and the Board of Directors. Simulation models are used to measure interest rate risk and to evaluate strategies to improve profitability. A simplified statement of condition is prepared on a quarterly basis as a starting point, using instrument level data of our actual loans, investments, borrowings and deposits as inputs. If potential changes to net equity value and net interest income resulting from hypothetical interest rate changes are not within the limits established by the Board of Directors, Management may adjust the asset and liability mix to bring the risk position within approved limits.

In December 2015, the FOMC raised the target federal funds rate by 25 basis points to a range of 0.25% to 0.50%, from the historic low of 0.00% to 0.25%, which had been maintained since December 2008. The Bank currently has low interest rate risk. Net interest margin is expected to increase after interest rates go up, but there may be a lag between repricing of certain floating rate loans at their floors and increases in rates.

Based on our most recent simulation, net interest income is projected to decrease by approximately 1% in year one given an immediate 200 basis point increase in interest rates and increase by approximately 5% in year two. The interest rate risk is within policy guidelines established by ALCO and the Board of Directors.

ITEM 4.       Controls and Procedures
 
Bank of Marin Bancorp and its subsidiary (the "Company") conducted an evaluation under the supervision and with the participation of our Management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Exchange Act of 1934 (the “Act”)) as of the end of the period covered by this report. The term disclosure controls and procedures means controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Act is accumulated and communicated to our Management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

During the last fiscal quarter there was no significant change in our internal control over financial reporting that has materially affected, or is reasonably likely to affect, our internal control over financial reporting.



Page-44


PART II       OTHER INFORMATION
 
ITEM 1         Legal Proceedings
 
We may be party to legal actions which arise from time to time as part of the normal course of our business.  We believe, after consultation with legal counsel, that we have meritorious defenses in these actions, and that litigation contingency liability, if any, will not have a material adverse effect on our financial position, results of operations, or cash flows.
 
We are responsible for our proportionate share of certain litigation indemnifications provided to Visa U.S.A. by its member banks in connection with lawsuits related to anti-trust charges and interchange fees. For further details, see Note 13 to the Consolidated Financial Statements in Item 8 of our 2015 Form 10-K and Note 8 to the Consolidated Financial Statements in this Form 10-Q herein.

ITEM 1A      Risk Factors
 
There have been no material changes from the risk factors previously disclosed in our 2015 Form 10-K. Refer to “Risk Factors” in Item 1A of our 2015 Form 10-K, pages 11 through 20.

ITEM 2       Unregistered Sales of Equity Securities and Use of Proceeds
 
We did not have any unregistered sales or repurchases of our equity securities during the three months ended March 31, 2016.
 
ITEM 3       Defaults Upon Senior Securities
 
None.
 
ITEM 4      Mine Safety Disclosures
 
Not applicable.

ITEM 5      Other Information
 
None.
 

Page-45

ITEM 6       Exhibits

The following exhibits are filed as part of this report or hereby incorporated by references to filings previously made with the SEC.

 
 
 
 
Incorporated by Reference
 
 
Exhibit Number
 
Exhibit Description
 
Form
 
File No.
 
Exhibit
 
Filing Date
 
Herewith
2.01
 
Modified Whole Bank Purchase and Assumption Agreement dated February 18, 2011 among Federal Deposit Insurance Corporation, Receiver of Charter Oak Bank, Napa, California, Federal Deposit Insurance Corporation, and Bank of Marin
 
8-K
 
001-33572
 
99.2
 
February 28, 2011
 
 
2.02
 
Agreement and Plan of Merger with NorCal Community Bancorp, dated July 1, 2013
 
8-K
 
001-33572
 
2.1
 
July 5, 2013
 
 
3.01
 
Articles of Incorporation, as amended
 
10-Q
 
001-33572
 
3.01
 
November 7, 2007
 
 
3.02
 
Bylaws
 
10-Q
 
001-33572
 
3.02
 
May 9, 2011
 
 
3.02a
 
Bylaw Amendment
 
8-K
 
001-33572
 
3.03
 
July 6, 2015
 
 
4.01
 
Rights Agreement dated as of July 2, 2007
 
8-A12B
 
001-33572
 
4.1
 
July 2, 2007
 
 
10.01
 
2007 Employee Stock Purchase Plan
 
S-8
 
333-144810
 
4.1
 
July 24, 2007
 
 
10.02
 
1989 Stock Option Plan
 
S-8
 
333-144807
 
4.1
 
July 24, 2007
 
 
10.03
 
1999 Stock Option Plan
 
S-8
 
333-144808
 
4.1
 
July 24, 2007
 
 
10.04
 
2007 Equity Plan
 
S-8
 
333-144809
 
4.1
 
July 24, 2007
 
 
10.05
 
2010 Director Stock Plan
 
S-8
 
333-167639
 
4.1
 
June 21, 2010
 
 
10.06
 
Form of Indemnification Agreement for Directors and Executive Officers dated August 9, 2007
 
10-Q
 
001-33572
 
10.06
 
November 7, 2007
 
 
10.07
 
Form of Employment Agreement dated January 23, 2009
 
8-K
 
001-33572
 
10.1
 
January 26, 2009
 
 
10.08
 
Intentionally left blank
 
 
 
 
 
 
 
 
 
 
10.09
 
2010 Annual Individual Incentive Compensation Plan
 
8-K
 
001-33572
 
99.1
 
October 21, 2010
 
 
10.10a
 
Salary Continuation Agreements with executive officers, Russell Colombo, Chief Executive Officer and Peter Pelham, Director of Retail Banking, dated January 1, 2011
 
8-K
 
001-33572
 
10.1
10.4
 
January 6, 2011
 
 
10.10b
 
Salary Continuation Agreements with executive officers, Tani Girton, Chief Financial Officer, dated October 18, 2013 and Elizabeth Reizman, Chief Credit Officer, dated July 20, 2014
 
8-K
 
001-33572
 
10.2
10.3
 
November 4, 2014
 
 
10.10c
 
Salary Continuation Agreements for executive officer Timothy Myers, Executive Vice President and Commercial Banking Manager, dated May 28, 2015
 
8-K
 
001-33572
 
10.4
 
June 2, 2015
 
 
10.11
 
2007 Form of Change in Control Agreement
 
8-K
 
001-33572
 
10.1
 
October 31, 2007
 
 
10.12
 
Information Technology Services Agreement with Fidelity Information Services, LLC, dated July 11, 2012
 
8-K
 
001-33572
 
10.1
 
July 17, 2012
 
 
11.01
 
Earnings Per Share Computation - included in Note 1 to the Consolidated Financial Statements
 
 
 
 
 
 
 
 
 
Filed
14.02
 
Code of Ethical Conduct, dated October 17, 2014
 
10-K
 
001-33572
 
14.02
 
March 12, 2015
 
 


31.01
 
Certification of Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
Filed
31.02
 
Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
Filed
32.01
 
Certification pursuant to 18 U.S.C. §1350 as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
Filed
101.01*
 
XBRL Interactive Data File
 
 
 
 
 
 
 
 
 
Furnished
*
As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.



SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
 
 
 
 
 
 
Bank of Marin Bancorp
 
 
 
(registrant)
 
 
 
 
 
 
 
 
 
May 9, 2016
 
/s/ Russell A. Colombo
 
Date
 
Russell A. Colombo
 
 
 
President &
 
 
 
Chief Executive Officer
 
 
 
(Principal Executive Officer)
 
 
 
 
 
 
 
 
 
May 9, 2016
 
/s/ Tani Girton
 
Date
 
Tani Girton
 
 
 
Executive Vice President &
 
 
 
Chief Financial Officer
 
 
 
(Principal Financial Officer)
 
 
 
 
 
 
 
 
 
May 9, 2016
 
/s/ Cecilia Situ
 
Date
 
Cecilia Situ
 
 
 
First Vice President &
 
 
 
Manager of Finance & Treasury
 
 
 
(Principal Accounting Officer)


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