ALLOWANCE FOR CREDIT LOSSES

6 Months Ended

Jun. 30, 2020

ALLOWANCE FOR CREDIT LOSSES

ALLOWANCE FOR CREDIT LOSSES

NOTE 6: ALLOWANCE FOR CREDIT LOSSES

The Company’s effective date for the adoption of CECL was January 1, 2020. As a result of this adoption, the Company’s ACL for the loan portfolio has two main components: a reserve for expected losses determined from the historical loss rates, adjusted for qualitative factors, and forecasted expected losses on the segments associated with the individual loan classes with similar risk characteristics, or general reserve; and a separate allowance representing the reserves assigned to individually evaluated loans that do not share similar risk characteristics with other loans, or specific reserve. The Company defines the loan class to be the grouping of the loan receivable based on risk characteristics and the method for monitoring and assessing credit risk, which is represented by the loan type or major category of loans.  

For specific reserves, loans identified as not sharing similar risk characteristics with other assets are individually evaluated for the net amount expected to be collected and reserves are determined for them outside of general reserve computation. For determination of credit losses on loans individually evaluated, the Company utilizes various methods such as discounted cash flow analysis, appraisal valuation on collateral, among others, to determine any impairment of the loan and need for additional allowance for expected losses.  

For the general reserve computation, the Company selected an aged-based vintage model, or the Vintage model, based on the model’s ability to predict credit risks associated with the loan portfolio and capture the expected life of loan losses associated with each segment of loans. The Company primarily manages credit quality and determines credit risk of its loans based on the risk grade assigned to each individual loan within the loan class. See the risk grade discussion later in this footnote. The factors considered include the age of the loan, interest rate, loan size, payment structure, term, risk ratings, loan to value, collateral type, geographical pattern, and industrial sector. The breakdown of the loan classes into portfolio segments was a judgement election based upon identified risk criteria. The Company has limited specific historical loss experience to directly tie to an attribute and thus the use of one factor over another is based on management’s perceived risk of the identified factor in combination with the data analyzed.

After consideration of the factors previously discussed, the Company segmented the portfolio based on the identified risk characteristics present within each segment. These risk characteristics are determined based various factors including call code, collateral types and loan terms. The Company believes that this segmentation best represents the portfolio segments at a level to develop the systematic methodology in the determination of the ACL.

Historical net losses are used to calculate a historical loss rate for each vintage within each portfolio segment and then subjective adjustments for internal and external qualitative risk factors are applied to the historical loss rates to generate a total expected loss rate for each vintage within each portfolio segment. For portfolio segments of loans with no historical losses, the Company is using the weighted average of its annual historical loss rates as a proxy loss rate floor or, specifically, for oil and gas and oil and gas real estate portfolio segments, historical average loss rate based on peer group data.

There are multiple qualitative factors, both internal and external, that could impact potential collectability of the underlying loans. The various internal factors that may be considered include, among other things, (i) effectiveness of loan policies, procedures and internal controls; (ii) portfolio growth and changes in loan concentrations; (iii) changes in loan quality; (iv) experience, ability and effectiveness of lending management and staff; (v) legal and regulatory compliance requirements associated with underwriting, originating and servicing a loan and the impact of exceptions; and (vi) the effectiveness of the internal loan review function. The various external factors that may be considered include, among other things, (i) current national and local economic conditions; (ii) changes in the political, legal and regulatory landscape; (iii) industry trends, in particular those related to loan quality; and (iv) forecasted changes in the economy.

As part of its assessment, the Company considers the need to adjust historical information to reflect the extent to which current conditions and forecasts differ from the conditions that existed for the period over which historical information was evaluated. The Company uses an economic forecast qualitative factor as noted above to adjust the expected loss rates for the effects of forecasted changes in the economy. The Company uses economic indicators and indexes including, but not limited to, inflation indexes, unemployment rates, fluctuations of interest rates, economic growth, government expenditures, gross domestic product indexes, productivity indicators, leading indexes and debt levels and narratives such as those supplied by the Federal Reserve’s beige book and Moody’s Analytics that provide information for determining an appropriate impact ratio for macro-economic conditions. The Company has determined that a two-year forecast period provides a balance between the level of forecast periods reasonably available and forecast accuracy. The Company utilized, at adoption and during the six months ended June 30, 2020, an immediate reversion to historical levels after the two-year forecast period. As of June 30, 2020, the Company continues to believe that a two-year period is the limit of a reasonable and supportable forecast and chose to revert to historical levels immediately afterward as current adjusted loss history is the more relevant indicator of expected losses beyond the forecast period.

The historical loss rates, adjusted for current conditions and forecasting assumptions, are multiplied by the respective loan’s amortized cost balances in each vintage within each segment to compute an estimated quantitative reserve for expected losses in the portfolio. The quantitative reserve for expected loan losses and the qualitative reserve for expected loan losses combined together make up the total estimated loan loss reserve.

Loan amortized costs, as defined by GAAP, includes principal, deferred fees or costs associated with the loan, premiums, discounts and accrued interest. The Company made a policy election to exclude accrued interest in the determination of an ACL. The Company continues its policy of reversing previously accrued interest when it has been deemed uncollectible and accrued interest receivable is included in other assets in the consolidated balance sheets. Loans held for sale are excluded from the computation of expected loan loss as they are carried at the lower of cost or market value.

As part of the implementation of CECL, the Company changed its methodology for determining the ACL for loans. As a result of the adoption of CECL, the ratio of the ACL for loans to total loans increased from 0.96% at December 31, 2019 to 0.99% at January 1, 2020.  At June 30, 2020, the ratio of the ACL for loans to total loans was 1.35%, reflecting the expected impact of COVID-19 and the sustained instability in the oil and gas industry during the first and second quarters of 2020 on the local and national economy and on current and forecasted expected credit losses. The total of the Company’s qualitative and quantitative factors ranged from 0.67% to 2.42% at January 1, 2020 and ranged from 1.08% to 2.81% at June 30, 2020. All factors were reassessed at the end of the second quarter. The increase in the ACL in the second quarter of 2020 reflects the Company’s assessment based on the information available at the time.

Risk Grading

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management assigns and tracks loan grades as described below that are used as credit quality indicators.

Pass—Credits in this category contain an acceptable amount of risk.

Special Mention—Credits in this category contain more than the normal amount of risk and are referred to as “special mention” in accordance with regulatory guidelines. These credits possess clearly identifiable temporary weaknesses or trends that, if not corrected or revised, may result in a condition that exposes the Company to a higher level of risk of loss.

Substandard—Credits in this category are “substandard” in accordance with regulatory guidelines and of unsatisfactory credit quality with well-defined weaknesses or weaknesses that jeopardize the liquidation of the debt. Credits in this category are inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Often, the assets in this category will have a valuation allowance representative of management’s estimated loss that is probable to be incurred. Loans deemed substandard and on nonaccrual status are considered impaired and are individually evaluated for impairment.

Doubtful—Credits in this category are considered “doubtful” in accordance with regulatory guidelines, are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon

some near-term event which lacks certainty. Generally, these credits will have a valuation allowance based upon management’s best estimate of the losses probable to occur in the liquidation of the debt.

Loss—Credits in this category are considered “loss” in accordance with regulatory guidelines and are considered uncollectible and of such little value as to question their continued existence as assets on the Company’s financial statements. Such credits are to be charged off or charged down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. This category does not intend to imply that the debt or some portion of it will never be paid, nor does it in any way imply that the debt will be forgiven.

The methodology used by the Company in the determination of its ACL, which is performed at least on a quarterly basis, is designed to be responsive to changes in the credit quality of the loan portfolio as well as forecasted economic conditions. The credit quality of the loan portfolio is assessed through different processes. At origination, a risk grade is assigned to each loan based on underwriting procedures and criteria. The Company monitors the credit quality of the loan portfolio on an on-going basis by performing loan reviews, both internally and through a third-party vendor, on loans meeting certain risk and exposure criteria. Through these reviews, loans that require risk grade changes are approved by executive management. In addition, executive management reviews classified and criticized loans to assess changes in credit quality of the underlying loan, and when determined appropriate based on an individual evaluation, approve specific reserves. The review of the appropriateness of the ACL, which includes evaluation of historical loss trends, qualitative adjustments and forecasted economic conditions applied to general reserves, is performed by executive management and presented to the Board of Directors for its review on a quarterly basis as part of the Company’s interim and annual consolidated financial statements.

The loans by risk grades, loan class and year of origination, or vintage, at June 30, 2020 were as follows:

(Dollars in thousands)	2020		2019		2018		2017		2016		Prior		Revolving Loans		Converted Revolving Loans		Total
Commercial and industrial:
Pass	$	358,270	$	123,340	$	59,931	$	16,374	$	11,020	$	7,459	$	233,552	$	9,178	$	819,124
Special mention		49		—		42		15		—		—		440		—		546
Substandard		1,000		1,240		4,362		32		309		2,366		3,554		5,134		17,997
Total commercial and industrial		359,319		124,580		64,335		16,421		11,329		9,825		237,546		14,312		837,667
Commercial real estate:
Pass		99,446		223,035		191,495		135,581		80,303		116,384		29,130		2,830		878,204
Special mention		—		331		—		—		1,559		—		—		—		1,890
Substandard		—		1,900		9,690		211		2,609		2,998		10,525		—		27,933
Total commercial real estate		99,446		225,266		201,185		135,792		84,471		119,382		39,655		2,830		908,027
Construction and development:
Pass		67,963		176,375		178,456		45,270		8,294		35,021		27,634		1,328		540,341
Substandard		—		506		1,500		10,532		—		—		—		—		12,538
Total construction and development		67,963		176,881		179,956		55,802		8,294		35,021		27,634		1,328		552,879
1-4 family residential:
Pass		13,806		38,376		62,172		46,787		27,580		66,678		9,719		1,036		266,154
Special mention		—		—		39		—		388		382		—		—		809
Substandard		—		545		—		323		18		2,897		—		1,507		5,290
Total 1-4 family residential		13,806		38,921		62,211		47,110		27,986		69,957		9,719		2,543		272,253
Multi-family residential:
Pass		6,351		8,951		28,421		46,161		4,325		160,987		77		—		255,273
Total multi-family residential		6,351		8,951		28,421		46,161		4,325		160,987		77		—		255,273
Consumer:
Pass		5,589		5,054		2,760		2,282		243		79		19,821		507		36,335
Substandard		—		—		—		—		—		3		—		—		3
Total consumer		5,589		5,054		2,760		2,282		243		82		19,821		507		36,338
Agriculture:
Pass		3,034		979		450		124		34		—		3,089		8		7,718
Substandard		—		—		—		—		—		27		50		—		77
Total agriculture		3,034		979		450		124		34		27		3,139		8		7,795
Other:
Pass		3,728		10,316		4,590		155		110		1,515		38,331		12,518		71,263
Substandard		—		—		1,326		—		1,241		—		3,705		—		6,272
Total other		3,728		10,316		5,916		155		1,351		1,515		42,036		12,518		77,535
Total	$	559,236	$	590,948	$	545,234	$	303,847	$	138,033	$	396,796	$	379,627	$	34,046	$	2,947,767

Loans individually evaluated and collectively evaluated as of the dates shown below were as follows:

	June 30, 2020						December 31, 2019
	Individually		Collectively				Individually		Collectively
	Evaluated		Evaluated		Total		Evaluated		Evaluated		Total
(Dollars in thousands)	Loans		Loans		Loans		Loans		Loans		Loans
Commercial and industrial	$	9,414	$	828,253	$	837,667	$	999	$	526,608	$	527,607
Real estate:
Commercial real estate		15,442		892,585		908,027		1,404		899,342		900,746
Construction and development		12,538		540,341		552,879		—		527,812		527,812
1-4 family residential		3,741		268,512		272,253		3,651		276,541		280,192
Multi-family residential		—		255,273		255,273		—		277,209		277,209
Consumer		—		36,338		36,338		210		36,572		36,782
Agriculture		—		7,795		7,795		—		9,812		9,812
Other		6,272		71,263		77,535		6,653		79,860		86,513
Total	$	47,407	$	2,900,360	$	2,947,767	$	12,917	$	2,633,756	$	2,646,673

Loans by risk grades and loan class as of the dates shown below were as follows:  

(Dollars in thousands)	Pass		Special Mention		Substandard		Total Loans
June 30, 2020
Commercial and industrial	$	819,124	$	546	$	17,997	$	837,667
Real estate:
Commercial real estate		878,204		1,890		27,933		908,027
Construction and development		540,341		—		12,538		552,879
1-4 family residential		266,154		809		5,290		272,253
Multi-family residential		255,273		—		—		255,273
Consumer		36,335		—		3		36,338
Agriculture		7,718		—		77		7,795
Other		71,263		—		6,272		77,535
Total loans	$	2,874,412	$	3,245	$	70,110	$	2,947,767

(Dollars in thousands)	Pass		Special Mention		Substandard		Total Loans
December 31, 2019
Commercial and industrial	$	513,417	$	2,963	$	11,227	$	527,607
Real estate:
Commercial real estate		876,207		18,570		5,969		900,746
Construction and development		515,247		12,565		—		527,812
1-4 family residential		274,731		594		4,867		280,192
Multi-family residential		277,209		—		—		277,209
Consumer		36,566		—		216		36,782
Agriculture		9,733		50		29		9,812
Other		79,860		—		6,653		86,513
Total loans	$	2,582,970	$	34,742	$	28,961	$	2,646,673

Charge-offs and recoveries by loan class and vintage for the six months ended June 30, 2020 were as follows:

(Dollars in thousands)	2020		2019		2018		2017		2016		Prior		Revolving Loans		Total
Commercial and industrial:
Charge-off	$	—	$	—	$	—	$	(36)	$	(42)	$	—	$	(1)	$	(79)
Recovery		—		2		92		33		19		155		194		495
Total commercial and industrial		—		2		92		(3)		(23)		155		193		416
Commercial real estate:
Charge-off		—		—		—		—		—		(24)		—		(24)
Total commercial real estate loans		—		—		—		—		—		(24)		—		(24)
1-4 family residential:
Charge-off		—		(65)		—		—		—		(1)		—		(66)
Recovery		—		—		—		—		—		1		—		1
Total 1-4 family residential		—		(65)		—		—		—		—		—		(65)
Consumer:
Charge-off		—		—		(8)		(95)		—		—		—		(103)
Recovery		10		—		—		—		—		1		—		11
Total consumer		10		—		(8)		(95)		—		1		—		(92)
Agriculture
Recovery		—		—		—		—		12		—		—		12
Total agriculture		—		—		—		—		12		—		—		12
Other:
Recovery		—		—		—		1		—		—		—		1
Total other		—		—		—		1		—		—		—		1
Total	$	10	$	(63)	$	84	$	(97)	$	(11)	$	132	$	193	$	248

Activity in the total ACL for loans for the six months ended June 30, 2020 and 2019, was as follows:

			Real Estate
	Commercial				Construction
	and		Commercial		and		1-4 family		Multi-family
(Dollars in thousands)	industrial		real estate		development		residential		residential		Consumer		Agriculture		Other		Total
June 30, 2020
Beginning balance	$	7,671	$	7,975	$	4,446	$	2,257	$	1,699	$	388	$	74	$	770	$	25,280
Impact of CECL adoption		852		(140)		100		(275)		294		(25)		64		4		874
Provision for credit losses for loans		3,169		4,613		2,504		1,256		887		258		(16)		605		13,276
Charge-offs		(79)		(24)		—		(66)		—		(103)		—		—		(272)
Recoveries		495		—		—		1		—		11		12		1		520
Net (charge-offs) recoveries		416		(24)		—		(65)		—		(92)		12		1		248
Ending balance	$	12,108	$	12,424	$	7,050	$	3,173	$	2,880	$	529	$	134	$	1,380	$	39,678
Period-end amount allocated to:
Specific reserve	$	2,403	$	—	$	—	$	—	$	—	$	—	$	—	$	468	$	2,871
General reserve		9,705		12,424		7,050		3,173		2,880		529		134		912		36,807
Total	$	12,108	$	12,424	$	7,050	$	3,173	$	2,880	$	529	$	134	$	1,380	$	39,678

			Real Estate
	Commercial				Construction
	and		Commercial		and		1-4 family		Multi-family
(Dollars in thousands)	industrial		real estate		development		residential		residential		Consumer		Agriculture		Other		Total
June 30, 2019
Beginning balance	$	7,719	$	6,730	$	4,298	$	2,281	$	1,511	$	387	$	62	$	705	$	23,693
Provision (recapture) for credit losses for loans		257		637		281		(35)		667		143		11		(7)		1,954
Charge-offs		(425)		—		—		(12)		—		(87)		—		(43)		(567)
Recoveries		241		4		—		2		—		15		—		—		262
Net (charge-offs) recoveries		(184)		4		—		(10)		—		(72)		—		(43)		(305)
Ending balance	$	7,792	$	7,371	$	4,579	$	2,236	$	2,178	$	458	$	73	$	655	$	25,342
Period-end amount allocated to:
Specific reserve	$	699	$	29	$	—	$	46	$	—	$	22	$	—	$	—	$	796
General reserve		7,093		7,342		4,579		2,190		2,178		436		73		655		24,546
Total	$	7,792	$	7,371	$	4,579	$	2,236	$	2,178	$	458	$	73	$	655	$	25,342

The ACL for loans by loan class as of the periods indicated was as follows:

	June 30, 2020				December 31, 2019
(Dollars in thousands)	Amount		Percent		Amount		Percent
Commercial and industrial	$	12,108	30.5	%	$	7,671	30.3	%
Real estate:
Commercial real estate		12,424	31.3	%		7,975	31.6	%
Construction and development		7,050	17.8	%		4,446	17.6	%
1-4 family residential		3,173	8.0	%		2,257	8.9	%
Multi-family residential		2,880	7.3	%		1,699	6.7	%
Consumer		529	1.3	%		388	1.5	%
Agriculture		134	0.3	%		74	0.3	%
Other		1,380	3.5	%		770	3.1	%
Total allowance for credit losses for loans	$	39,678	100.0	%	$	25,280	100.0	%

Allocation of a portion of the ACL to one class of loans above does not preclude its availability to absorb losses in other classes. The Company had no collateral dependent loans pending foreclosure at June 30, 2020.

The recorded investment in impaired loans as of December 31, 2019, as determined in accordance with ASC 310 prior to the Company’s adoption of CECL was as follows:

	Unpaid		Recorded								Average
	Contractual		Investment		Recorded		Total				Recorded
	Principal		with No		Investment		Recorded		Related		Investment
(Dollars in thousands)	Balance		Allowance		with Allowance		Investment		Allowance		Year-to-Date
December 31, 2019
Commercial and industrial	$	1,111	$	300	$	699	$	999	$	416	$	2,452
Real estate:
Commercial real estate		1,407		1,404		—		1,404		—		2,165
1-4 family residential		3,761		2,166		1,485		3,651		15		4,020
Consumer		210		210				210		—		128
Other		6,653		5,411		1,242		6,653		6		6,825
Total loans	$	13,142	$	9,491	$	3,426	$	12,917	$	437	$	15,590

The Company has unfunded commitments, comprised of letters of credit and commitments to extend credit that are not unconditionally cancellable by the Company. See Note 16: Commitments and Contingencies and Financial Instruments with Off-Balance-Sheet Risk. Unfunded commitments have similar characteristics as funded loans based on segment type and their expected credit losses were determined using the Vintage model and established qualitative factors as well as consideration for historical and expected utilization levels. Activity in the ACL for unfunded commitments for the six months ended June 30, 2020, was as follows:

(Dollars in thousands)	June 30, 2020
Beginning balance	$	378
Impact of CECL adoption		2,981
Provision for credit losses for unfunded commitments		1,643
Ending balance	$	5,002