Bank of Marin Bancorp

Good morning and thank you for joining Bank of Marin Bancorp's earnings call for the first quarter ended March 31, 2023. I am Andrea Henderson, Director of Marketing for Bank of Marin. During the presentation, all participants will be in a listen-only mode. After the call, we will conduct a question and answer session. At that time, if you have questions, please press 1 followed by 4 on your telephone. If at any time during the conference call you need to reach an operator, please press star zero. This conference call is being recorded on April 24th, 2023. Joining us on the call today are Tim Myers, President and CEO, and Tani Gurdon, Executive Vice President and Chief Financial Officer. Our earnings press release, which we issued this morning, and a supplementary presentation can be found in the investor relations portion of our website at bankofmarin.com where this call is also being webcast. Closed captioning is available during the live webcast as well as on the webcast replay. Before we get started, I want to note that we will be discussing some non-GAAP financial measures. Please refer to the reconciliation table in our earnings press release for both GAAP and non-GAAP measures. Additionally, the discussion on this call is based on information we know as of Friday, April 21st, 2023, and may contain forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those set forth in such statements. For discussion of these risks and uncertainties, please review the forward-looking statements disclosure in our earnings press release, as well as our SEC filings. Following our prepared remarks, Tim, Tani, and Chief Credit Officer Misako Stewart will be available to answer your questions. And now I'll turn the call over to Tim.

Thank you, Andrea. Good morning, everyone, and welcome to our first quarter earnings call. I'd like to begin by addressing the regional bank failures and subsequent events that occurred late in the quarter and highlight how Bank of Marin's business model enabled us to effectively manage through these challenges. These failures, while idiosyncratic in nature and isolated to banks that operated much differently than Bank of Marin and most community banks, did create near-term uncertainty among depositors that resulted in outflows across the industry. While many depositors initially sought the perceived security and returns of money market funds outside of the banking system, according to the latest Federal Reserve data, those transfers have since stabilized. Overall, we have continued our efforts to maintain an industry-leading cost of deposits in light of pandemic-related surge balances exacerbated by our American River Bank acquisition and its lower loan-to-deposit ratio. It is not unusual for Bank of Marin to experience deposit decreases in the first quarter of the year due to the working capital needs of our customers. In fact, in four of the last eight years, we showed link quarter declines in Q1 deposits. This year, the 9% decrease of $323 million was due to a number of factors concurrent with but largely unrelated to the regional bank failures. Subsequent to these failures, the factors contributing to deposit outflows include, first, outflows due to what we consider singular transactions, such as disbursement of proceeds from the sale of businesses, real property acquisitions for cash, Trust Distributions or Estate Settlements. Second, cash needs from our customers to fund ongoing business operations such as vendor payments, payroll, and taxes. And third, deposit movements to outside brokerage firms and financial institutions for safety and or higher yields. Just over $200 million of the net outflows occurred after the bank failures and were concentrated among 100 larger relationships that overshadowed the impact of accumulated smaller transactions. Among those 100 relationship net outflows, 83% was considered normal activity, including vendor payments, taxes, payroll, and the singular events as I mentioned earlier. 14% moved to brokerage firms or other financial institutions and the remaining 3% were referrals to our wealth management and trust group. From March 22nd through April 18th, deposit levels have stabilized. In 2022, we maintained excess liquidity and expectation of pandemic surge outflows and managed our deposit costs in order to optimize deposit levels. In early 2023, we increased engagement with customers to discuss pricing and the appropriate deposit mix for their needs. After March 10, those discussions accelerated and expanded to include the safety and soundness of the bank, as well as information about our reciprocal deposit network programs that offer depositors expanded FDIC insurance. The result was approximately 80 million dollars of incremental funds placed into these programs and we now have 220 million dollars with Raishin Tang and Intrify and are continuing to see interest from our customers. I would also like to note that throughout the first quarter we successfully opened over 1,000 accounts with 60 million dollars in new deposits. At the same time, we did not see a notable number of account closures with funds leaving the bank. At quarter end, our deposit mix was steady with non-interest bearing deposits accounting for just over 50% of total deposits down only slightly from the prior quarter and another indication of our strong deposit franchise. Many of these are commercial accounts that tend to carry larger balances that will fluctuate with our customers operating cash needs. Approximately 67% of our deposits are FDIC insured. At quarter end, our liquidity was roughly $1.9 billion and consisted of cash, unencumbered securities, and borrowing availability from the FHLB and Federal Reserve Bank, an amount that covers all of our estimated uninsured deposits by approximately 181%. Since 2013, we have had internal policies, controls, and processes that set minimum liquidity requirements similar to the liquidity coverage ratio that larger banks are required to report. Later, Tani will explain some of the longstanding practices that uphold our robust liquidity risk management standards. Importantly, despite the decrease in deposits quarter over quarter, our average cost of deposits remain low by industry standards at 20 basis points, 40 basis points in the month of March, though this was up from eight basis points the prior quarter. Our increase in deposit rates has lagged the general market, which benefited our net interest margin by approximately 10 basis points in the fourth quarter. We will continue to carefully manage deposit pricing on a customer specific basis and diligently defend our industry leading deposit franchise. Now I'll shift to a discussion about our loan portfolio and overall credit quality. We grew loans by $20 million or just under 1% during the quarter. While loan demand has eased from the peak levels of 2022, Our teams continue to focus on building pipelines that will achieve risk adjusted returns and maintain credit quality. Even as we grew loans in the first quarter, our team's efforts to carefully manage asset quality resulted in continued strong credit metrics. We have consistently maintained our principled underwriting and our policies have remained unchanged. Total non-accrual loans declined during the quarter and amounted to just 10 basis points of total loans. We are confident in our allowance for credit loss, which represents 1.1% of total loans. Our loan portfolio remains diversified across borrowers, loan, and property types, as well as geography, and 93% of our loans are borrower guaranteed. Our largest concentration in the loan portfolio is in commercial real estate, which represents 73% of our total loan balances. 77% of our commercial real estate portfolio is non-owner occupied, with 89% of these loans being borrower guaranteed. Additionally, since 2000, cumulative net charge-offs in the CRE non-owner occupied portfolio have been minimal at $740,000. As there has been a good deal of press regarding office buildings, we are providing more granularity on our non-owner occupied office building portfolio this quarter. Our $370 million of non owner occupied office portfolio consists of more than 140 loans with an average loan balance of $2.6 million. The largest loan being $17.2 million. The average loan to value was 55% and the average debt service coverage ratio was 1.67 times based on the most recent information received in our annual review process. Of the non-owner-occupied office portfolio, 19% is located in the San Francisco market, with the remainder spread across our Northern California footprint. Drilling down further into the San Francisco non-owner-occupied office portfolio, we have 11 loans totaling $72 million with an average loan size of $7 million and average loan-to-value of 60%. 10 of these buildings are considered low-rise office and eight of them report 100% occupancy. Vacancies averaged around 50% on the other three. 19 million or 26% of the $72 million portfolio is graded as a substandard as first reported in our Q4 2021 earnings and remains performing. While we understand the heightened concerns that the investment community has regarding the office sector, We believe that given our conservative underwriting and the relatively small loan sizes, our office building exposure is manageable. We have a strong historical track record of minimal losses from this sector. During the first quarter, we also delivered on the final phase of our plans to gain efficiencies from our acquisition of American River Bank by consolidating four Northern Sonoma County branches into two that had overlapping customer coverage. In addition we closed two other branches where we can serve customers effectively from nearby branches. This strategic decision enables us to optimize our physical footprint without sacrificing customer service and, by extension, generate savings that we can reinvest into talent and technology. Finally, I am excited to share that we welcomed our new Chief Information Officer, Sathis Arasadi. His extensive and unique experience as a software engineer and technology leader directing large-scale digital and technology transformations will help us execute our bank strategic priorities. Throughout our 33-year history, we have not wavered from our guiding principles of relationship banking and discipline fundamentals and continue to serve the banking needs of local, small to mid-sized businesses, not-for-profit organizations, and commercial real estate investors. Our business model has proven successful throughout various economic cycles, allowing us to navigate this or any challenging environment. Now I'll turn the call over to Tani to discuss our financial results in greater detail.

Thank you, Tim, and good morning. First, I'll start with some key highlights. We generated net income of $9.4 million in the first quarter, or 59 cents per diluted share. Net income was down from the fourth quarter as we began raising interest rates on deposits and borrowing balances increased. Our low cost of deposits was a significant benefit last year and Bank of Marin achieved record earnings in both the fourth quarter and full year of 2022. Our first quarter tax equivalent net interest margin of 3.04% was down 22 basis points from the fourth quarter, 37 basis points of which was related to higher deposit and borrowing costs, partially offset by a 17 basis point improvement from higher loan yields. We expect continued pressure on the margin as recent increases in deposit costs are in place for a full quarter. So far this cycle, increases in rates on non-maturity interest-bearing deposits reflect a beta of 15%, while our interest rate risk models assume a beta of 45%. Non-interest expenses were well controlled at just under 20 million for the quarter. Our first quarter earnings translated into a return on assets of 92 basis points and a return on equity of 9.12% down from 1.21% and 12.77% in the previous quarter. Our board of directors declared a cash dividend of 25 cents per share payable on May 12, 2023. This represents the 72nd consecutive quarterly dividend paid by Bank of Marin Bancorp. I'd like to add a little more detail on our results beginning with the $350,000 provision for credit losses on loans in the first quarter compared to no provision in the prior quarter. This was due to qualitative risk factor adjustments to account for continued uncertainty about inflation, recession, concentration, and heightened portfolio management risks in the current environment that were not fully captured in the quantitative portion of the allowance calculation. Additionally, there was a 174,000 credit loss provision reversal due to a $37.4 million reduction in unfunded commitments. As Tim mentioned, credit quality remains strong. Classified loans of 31 million increased 2.9 million, primarily due to higher usage of a revolving line of credit that was previously downgraded. Other changes include $1.7 million in payoffs and paydowns, $314,000 in upgrades to pass risk rating, partially offset by $1.4 million in downgrades. All of the downgrades in the first quarter were for loans that are secured by real estate collateral. Accruing loans past due 30 to 89 days totaled $1.2 million at March 31, 2023 compared to $664,000 at December 31, 2022. First quarter non-interest income was up 13% from the fourth quarter at $2.9 million due in large part to higher earnings on bank-owned life insurance while other line items showed modest increases and decreases. Non-interest expense of $19.8 million in the first quarter was up from $18.3 million in the fourth quarter and the efficiency ratio increased to 60.24% from 50.92% in the prior quarter due to both higher interest and non-interest expenses. The first quarter typically has elevated non-interest expense related to 401 matching and lower utilization of vacation accruals. Additionally, the first quarter of 2023 included adjustments related to estimated incentive and retirement plan accruals, as well as accelerated amortization and lease expenses associated with branch closures. On the flip side, technology expenses fell as a result of our recent core processor contract renegotiation. and we expect branch closures to generate net savings of $470,000 in 2023 and $1.4 million per year thereafter. All capital ratios were above well-capitalized regulatory requirements. The total risk-based capital ratio for Bancorp was 16.2% at the end of the first quarter compared to 15.9% at December 31, and the bank's total risk-based capital ratio was 15.6% at March 31 compared to 15.7% at the close of 2022. Quarter-end tangible common equity of 8.7% for Bancorp and 8.3% for Bank of Marin were up from 8.2% and 8.1% respectively in the previous quarter. Increases were due to earnings and a $16.2 million improvement in AOCI as the value of our Available for Sales securities portfolio increased with falling interest rates. After adjusting for $76.4 million after-tax unrealized losses in our held-to-maturity securities portfolio, our tangible common equity ratio would be 6.9% for Bancorp. Our strong capital position and high quality investment portfolio provide strength and liquidity for the ongoing operations and investments in the future of Bank of Marin. We evaluate the bank's interest rate, liquidity, economic value, and market price risks under various scenarios regularly, and we stress test underlying assumptions. We conduct capital planning on a regular basis and evaluate various scenarios, stress tests, and potential capital actions. We monitor markets daily for systemic and idiosyncratic risks and maintain contingency plans that support rapid and comprehensive responses if warranted. We also make it a priority to learn from developing situations and we are incorporating enhancements to current scenarios, assumptions, and stress factors to reflect the heightened potential for deposit volatility in a world of social media and digital banking. We have pledged securities to the Federal Reserve's bank term funding program and ran a small overnight test to ensure access if ever needed. The FHLB and Federal Reserve borrowing facilities were established in large part to ensure that banks would not be forced to sell securities at a loss. The FHLB facility proved extremely effective during the global financial crisis and the BTFP will undoubtedly do the same with its favorable rates and availability tied to the par value of securities. Overall, Bank of Marin's strong balance sheet, liquidity, and capital continue to generate profitability, as has been the case across many interest rate and economic cycles. With that, I'll turn it back to Tim to share some final comments.