UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2023

OR

☐ 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: 001-37886

CAPSTAR FINANCIAL HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

Tennessee	81-1527911
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
1201 Demonbreun Street, Suite 700 Nashville, Tennessee (Address of principal executive offices)	37203 (zip code)

(615) 732-6400

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock, $1.00 par value per share	CSTR	Nasdaq Global Select Market

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer	☐	Accelerated Filer	☒
Non-Accelerated Filer	☐	Smaller Reporting Company	☐
		Emerging Growth Company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

	Shares outstanding as of November 1, 2023
Common Stock, par value $1.00 per share	20,711,969

CAPSTAR FINANCIAL HOLDINGS, INC.

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

Item		Page
PART I – FINANCIAL INFORMATION			5
Item 1.	Financial Statements	5
	Consolidated Balance Sheets	5
	Consolidated Statements of Income	6
	Consolidated Statements of Comprehensive Income (Loss)	7
	Consolidated Statements of Changes in Shareholders’ Equity	8
	Consolidated Statements of Cash Flows	9
	Notes to Consolidated Financial Statements	10
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	34
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	48
Item 4.	Controls and Procedures	48
PART II – OTHER INFORMATION			49
Item 1.	Legal Proceedings	49
Item 1A.	Risk Factors	49
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	51
Item 5.	Other Information	51
Item 6.	Exhibits	52
SIGNATURES			53

2

TERMINOLOGY

The terms “we,” “our,” “us,” “CapStar,” “the Company,” “CSTR” and “CapStar Financial” that appear in this Quarterly Report on Form 10-Q (this “Report”) refer to CapStar Financial Holdings, Inc. and its wholly-owned subsidiary, CapStar Bank, which we sometimes refer to as “CapStar Bank,” “our bank subsidiary,” “the Bank” and “our Bank”. The term “Old National” refers to Old National Bancorp, an Indiana corporation.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements reflect our current views with respect to, among other things, statements relating to the Company’s assets, business, cash flows, condition (financial or otherwise), credit quality, financial performance, liquidity, short and long-term performance goals, prospects, results of operations, strategic initiatives, the benefits, cost and synergies of completed acquisitions or dispositions, and the timing, benefits, costs and synergies of future acquisitions, disposition and other growth opportunities. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “aspire,” “estimate,” “intend,” “plan,” “project,” “projection,” “forecast,” “roadmap,” “goal,” “target,” “would,” and “outlook,” or the negative version of those words or other comparable words of a future or forward-looking nature. Forward-looking statements express only management's beliefs regarding future results or events and are subject to inherent uncertainty, risks and changes in circumstances, many of which are outside of management's control. Uncertainty, risks, changes in circumstances and other factors could cause the Company's actual results to differ materially from those projected in the forward-looking statements. Factors that could cause actual results to differ from those discussed in such forward-looking statements include, but are not limited to: (1) difficulty attracting and retaining highly-effective employees; (2) our ability to successfully execute our business plan; (3) difficulty growing or sustaining deposit and loan balances; (4) changes in consumer preferences, spending and borrowing habits, and demand for our products and services; (5) negative economic and political conditions that adversely affect the general economy, especially in the communities and markets in which we conduct our business, the banking sector, housing prices, the real estate market, the job market, consumer confidence, the financial condition of our borrowers and consumer spending habits, which may affect, among other things, the levels of non-performing assets, charge-offs and provision expense; (6) credit risk, including the risk that negative credit quality trends may lead to a deterioration of asset quality, risk that our allowance for credit losses may not be sufficient to absorb actual losses in our loan portfolio, and risk from concentrations within our loan portfolio; (7) market risk, including interest rate and liquidity risk; (8) operational risk, including cybersecurity risk and risk of fraud, data processing system failures, and network breaches; (9) increased competition, including competition from non-bank financial institutions; (10) changes in regulations, laws, taxes, government policies, monetary policies and accounting policies affecting bank holding companies and their subsidiaries; (11) regulatory enforcement actions and adverse legal actions; (12) other economic, competitive, technological, operational, governmental, regulatory, and market factors affecting our operations; and (13) risks relating to our proposed acquisition by Old National Bancorp, including, without limitation, (i) the risk that the proposed merger may not be completed in a timely manner or at all; (ii) the failure to satisfy the conditions to the consummation of the proposed merger, including obtaining the requisite approval of the Company’s shareholders or required regulatory approvals within the time period provided in the merger agreement; (iii) the occurrence of any event, change or other circumstance that could give rise to the termination of the merger agreement; (iv) effect of the announcement or pendency of the proposed merger on the Company’s business relationships, operating results and business generally; (v) risks that the proposed transaction disrupts current plans and operations of the Company; (vi) potential difficulties in retaining the Company’s customers and employees as a result of the proposed transaction; (vii) diversion of management’s attention from ongoing business operations and opportunities; (viii) certain restrictions during the pendency of the proposed transaction that may impact the Company’s ability to pursue certain business opportunities; and (ix) expected cost savings, synergies and other financial benefits from the merger not being realized within the expected time frames and costs or difficulties relating to integration matters being greater than expected. The foregoing factors should not be construed as exhaustive and should be read in conjunction with the section entitled “Risk Factors” included in this Report. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from our forward-looking statements. Accordingly, you should not place undue reliance on any such forward-looking statements. Forward-looking statements made herein reflect management's expectations as of the date such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances that arise after the date such statements are made.

The foregoing factors should not be construed as exhaustive and should be read in conjunction with the section entitled “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2022 (the “2022 Form 10-K”) and in future reports that we file with the Securities and Exchange Commission. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from our forward-looking statements. Accordingly, you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date of this Report, and we do not undertake any obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by law. New risks and uncertainties may

3

emerge from time to time, and it is not possible for us to predict their occurrence or how they will affect us.

4

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CAPSTAR FINANCIAL HOLDINGS, INC. & SUBSIDIARY

Consolidated Balance Sheets

(In thousands, except share data)

	September 30, 2023			December 31, 2022
	(unaudited)
Assets
Cash and due from banks	$	21,403		$	25,280
Interest-bearing deposits in financial institutions		322,076			105,558
Federal funds sold		8,914			4,467
Total cash and cash equivalents		352,393			135,305
Securities available-for-sale, at fair value net of allowance for credit losses of $2,000 and $0 at September 30, 2023 and December 31, 2022, respectively		354,024			396,416
Securities held-to-maturity, fair value of $0 and $1,240 at September 30, 2023 and December 31, 2022, respectively		—			1,240
Loans held for sale, includes $15,981 and $12,636 measured at fair value at September 30, 2023 and December 31, 2022, respectively		36,391			44,708
Loans held for investment		2,292,241			2,312,798
Less allowance for credit losses on loans		(24,157	)		(23,806	)
Loans, net		2,268,084			2,288,992
Premises and equipment, net		23,150			24,855
Restricted equity securities		13,441			16,632
Accrued interest receivable		12,299			10,511
Goodwill and other intangibles		44,965			46,069
Other real estate owned, net		11			—
Other assets		159,782			152,441
Total assets	$	3,264,540		$	3,117,169
Liabilities and Shareholders’ Equity
Deposits:
Noninterest-bearing	$	432,203		$	512,076
Interest-bearing		947,998			749,857
Savings and money market accounts		618,609			709,190
Time		797,870			708,696
Total deposits		2,796,680			2,679,819
Federal Home Loan Bank advances		50,000			15,000
Subordinated notes		29,766			29,666
Other liabilities		42,455			38,502
Total liabilities		2,918,901			2,762,987
Shareholders’ equity:
Common stock, voting, $1 par value; 25,000,000 shares authorized; 20,739,942 and    21,714,380 shares issued and outstanding at September 30, 2023 and December 31,    2022, respectively		20,740			21,714
Additional paid-in capital		227,195			240,863
Retained earnings		154,696			141,657
Accumulated other comprehensive loss, net of tax		(56,992	)		(50,052	)
Total shareholders’ equity		345,639			354,182
Total liabilities and shareholders’ equity	$	3,264,540		$	3,117,169

See accompanying notes to consolidated financial statements (unaudited).

5

CAPSTAR FINANCIAL HOLDINGS, INC. & SUBSIDIARY

Consolidated Statements of Income (Unaudited)

(In thousands, except share and per share data)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2023			2022			2023			2022
Interest income:
Loans, including fees	$	35,441		$	27,335		$	102,215		$	71,476
Securities:
Taxable		1,964			1,966			5,940			5,643
Tax-exempt		301			314			923			958
Federal funds sold		40			7			163			31
Restricted equity securities		300			215			788			544
Interest-bearing deposits in financial institutions		3,218			617			6,305			1,076
Total interest income		41,264			30,454			116,334			79,728
Interest expense:
Interest-bearing deposits		6,672			1,205			14,092			2,279
Savings and money market accounts		4,393			1,603			10,906			2,401
Time deposits		8,777			1,332			21,713			2,271
Federal funds purchased		—			2			—			2
Federal Home Loan Bank advances		660			365			2,283			461
Subordinated notes		393			394			1,181			1,181
Total interest expense		20,895			4,901			50,175			8,595
Net interest income		20,369			25,553			66,159			71,133
Provision for credit losses:
(Recovery of) provision for credit losses on loans		(1,017	)		867			(447	)		926
Provision for credit losses on available-for-sale securities		—			—			2,000			—
Recovery of provision for credit losses on unfunded commitments		(544	)		—			(650	)		—
Total (recovery of) provision for credit losses		(1,561	)		867			903			926
Net interest income after provision for credit losses		21,930			24,686			65,256			70,207
Noninterest income:
Deposit service charges		1,347			1,251			3,979			3,575
Interchange and debit card transaction fees		1,195			1,245			3,293			3,803
Mortgage banking		749			765			2,997			4,436
Tri-Net		19			(2,059	)		46			39
Wealth management		441			385			1,241			1,284
SBA lending		531			560			2,599			1,054
Net gain on sale of securities		—			7			5			8
Other noninterest income		1,996			1,118			4,605			4,038
Total noninterest income		6,278			3,272			18,765			18,237
Noninterest expense:
Salaries and employee benefits		9,573			8,712			30,447			28,191
Data processing and software		3,245			2,861			9,750			8,355
Occupancy		1,161			1,092			3,451			3,266
Equipment		591			743			2,087			2,235
Professional services		674			468			2,361			1,653
Regulatory fees		435			269			1,267			814
Amortization of intangibles		352			415			1,104			1,291
Other noninterest expense		1,041			3,371			4,831			6,935
Total noninterest expense		17,072			17,931			55,298			52,740
Income before income taxes		11,136			10,027			28,723			35,704
Income tax expense		2,211			1,988			5,548			7,018
Net income	$	8,925		$	8,039		$	23,175		$	28,686
Per share information:
Basic net income per share of common stock	$	0.43		$	0.37		$	1.10		$	1.30
Diluted net income per share of common stock	$	0.43		$	0.37		$	1.09		$	1.30
Weighted average shares outstanding:
Basic		20,808,677			21,938,259			21,142,177			22,051,950
Diluted		20,823,971			21,988,085			21,172,712			22,104,687

See accompanying notes to consolidated financial statements (unaudited).

6

CAPSTAR FINANCIAL HOLDINGS, INC. & SUBSIDIARY

Consolidated Statements of Comprehensive Income (Loss) (Unaudited)

(In thousands)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2023			2022			2023			2022
Net income	$	8,925		$	8,039		$	23,175		$	28,686
Other comprehensive income (loss):
Unrealized gains (losses) on securities available-for-sale:
Unrealized losses arising during the period		(9,220	)		(22,230	)		(9,369	)		(68,202	)
Reclassification adjustment for gains included in    net income		—			(8	)		(5	)		(8	)
Tax effect		2,388			5,784			2,434			17,700
Other comprehensive loss, net of tax		(6,832	)		(16,454	)		(6,940	)		(50,510	)
Comprehensive income (loss)	$	2,093		$	(8,415	)	$	16,235		$	(21,824	)

See accompanying notes to consolidated financial statements (unaudited).

7

CAPSTAR FINANCIAL HOLDINGS, INC. & SUBSIDIARY

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

(In thousands, except share and per share data)

	Common Stock, voting						Additional paid-in			Retained			Accumulated other comprehensive			Total shareholders’
	Shares			Amount			capital			earnings			loss			equity
Balance December 31, 2021		22,166,129		$	22,166		$	248,709		$	110,489		$	(1,270	)	$	380,094
Net restricted common stock activity		65,550			66			(153	)		—			—			(87	)
Stock-based compensation expense		—			—			388			—			—			388
Repurchase of common stock		(36,608	)		(37	)		(730	)		—			—			(767	)
Common stock dividends declared ($0.06 per share)		—			—			—			(1,320	)		—			(1,320	)
Net income		—			—			—			10,673			—			10,673
Other comprehensive loss		—			—			—			—			(20,064	)		(20,064	)
Balance March 31, 2022		22,195,071			22,195			248,214			119,842			(21,334	)		368,917
Net restricted common stock activity		(3,719	)		(4	)		4			—			—			—
Stock-based compensation expense		—			—			325			—			—			325
Net exercise of common stock options		5,800			6			45			—			—			51
Repurchase of common stock		(262,598	)		(263	)		(5,091	)		—			—			(5,354	)
Common stock dividends declared ($0.10 per share)		—			—			—			(2,184	)		—			(2,184	)
Net income		—			—			—			9,972			—			9,972
Other comprehensive loss		—			—			—			—			(13,992	)		(13,992	)
Balance June 30, 2022		21,934,554			21,934			243,497			127,630			(35,326	)		357,735
Net restricted common stock activity		(2,930	)		(2	)		(39	)		—			—			(41	)
Stock-based compensation expense		—			—			258			—			—			258
Common stock dividends declared ($0.10 per share)		—			—			—			(2,172	)		—			(2,172	)
Net income		—			—			—			8,039			—			8,039
Other comprehensive loss		—			—			—			—			(16,454	)		(16,454	)
Balance September 30, 2022		21,931,624		$	21,932		$	243,716		$	133,497		$	(51,780	)	$	347,365
Balance December 31, 2022		21,714,380		$	21,714		$	240,863		$	141,657		$	(50,052	)	$	354,182
Net restricted common stock activity		113,068			113			(211	)		—			—			(98	)
Stock-based compensation expense		—			—			399			—			—			399
Repurchase of common stock		(465,834	)		(465	)		(7,174	)		—			—			(7,639	)
Common stock dividends declared ($0.10 per share)		—			—			—			(2,136	)		—			(2,136	)
Net income		—			—			—			6,446			—			6,446
Other comprehensive income		—			—			—			—			6,201			6,201
Adoption of new accounting standard, net of tax		—			—			—			(3,444	)		—			(3,444	)
Balance at March 31, 2023		21,361,614			21,362			233,877			142,523			(43,851	)		353,911
Net restricted common stock activity		(30,900	)		(32	)		31			—			—			(1	)
Stock-based compensation expense		—			—			361			—			—			361
Net exercise of common stock options		7,600			8			59			—			—			67
Repurchase of common stock		(453,822	)		(454	)		(5,623	)		—			—			(6,077	)
Common stock dividends declared ($0.11 per share)		—			—			—			(2,291	)		—			(2,291	)
Net income		—			—			—			7,804			—			7,804
Other comprehensive loss		—			—			—			—			(6,309	)		(6,309	)
Balance at June 30, 2023		20,884,492			20,884			228,705			148,036			(50,160	)		347,465
Net restricted common stock activity		(12,061	)		(12	)		(61	)		-			-			(73	)
Stock-based compensation expense		-			-			426			-			-			426
Net exercise of common stock options		7,621			8			60			-			-			68
Repurchase of common stock		(140,110	)		(140	)		(1,935	)		-			-			(2,075	)
Common stock dividends declared ($0.11 per share)		-			-			-			(2,265	)		-			(2,265	)
Net income		-			-			-			8,925			-			8,925
Other comprehensive loss		-			-			-			-			(6,832	)		(6,832	)
Balance at September 30, 2023		20,739,942		$	20,740		$	227,195		$	154,696		$	(56,992	)	$	345,639

See accompanying notes to consolidated financial statements (unaudited).

8

CAPSTAR FINANCIAL HOLDINGS, INC. & SUBSIDIARY

Consolidated Statements of Cash Flows (Unaudited)

(In thousands)

	Nine Months Ended
	September 30,
	2023			2022
Cash flows from operating activities:
Net income	$	23,175		$	28,686
Adjustments to reconcile net income to net cash    provided by (used in) operating activities:
Provision for credit losses		903			926
Amortization of discounts on acquired loans and deferred fees, net		373			473
Depreciation and amortization		2,186			2,391
Net amortization of premiums on investment securities		1,079			1,426
Net gain on sale of securities		(5	)		(8	)
Mortgage banking		(2,997	)		(4,436	)
Tri-Net		(46	)		(39	)
SBA lending		(2,599	)		(1,054	)
Net gain on disposal of premises and equipment		(5	)		(14	)
Net gain on sale of other real estate owned		—			(7	)
Stock-based compensation		1,186			971
Deferred income tax expense		(403	)		2,394
Origination of loans held for sale		(200,616	)		(533,326	)
Proceeds from loans held for sale		214,575			448,369
Cash payments arising from operating leases		(910	)		(1,633	)
Amortization of debt issuance expense		100			101
Net increase in accrued interest receivable and other assets		(4,271	)		(7,098	)
Net decrease in accrued interest payable and other liabilities		531			(4,674	)
Net cash provided by (used in) operating activities		32,256			(66,552	)
Cash flows from investing activities:
Activities in securities available-for-sale:
Purchases		—			(66,512	)
Sales		2,506			—
Maturities, prepayments and calls		27,448			54,955
Activities in securities held-to-maturity:
Maturities, prepayments and calls		1,230			—
Net redemption (purchase) of restricted equity securities		3,191			(2,172	)
Net decrease (increase) in loans		19,678			(194,087	)
Purchase of premises and equipment		(674	)		(428	)
Proceeds from the sale of premises and equipment		1,310			415
Proceeds from sale of other real estate		—			108
Proceeds from bank owned life insurance		802			1,545
Net cash provided by (used in) investing activities		55,491			(206,176	)
Cash flows from financing activities:
Net increase (decrease) in deposits		116,861			(50,608	)
Proceeds from Federal Home Loan Bank advances		535,500			300,000
Payments on Federal Home Loan Bank advances		(500,500	)		(180,000	)
Repurchase of common stock		(15,791	)		(6,123	)
Exercise of common stock options, net of repurchase of restricted shares		(37	)		(75	)
Common stock dividends paid		(6,692	)		(5,678	)
Net cash provided by financing activities		129,341			57,516
Net increase (decrease) in cash and cash equivalents		217,088			(215,212	)
Cash and cash equivalents at beginning of period		135,305			415,125
Cash and cash equivalents at end of period	$	352,393		$	199,913
Supplemental disclosures of cash paid:
Interest paid	$	41,727		$	7,513
Income taxes paid		6,552			9,305
Supplemental disclosures of noncash transactions:
Transfer of loans to other real estate	$	11		$	—
Loans charged off to the allowance for credit losses on loans		972			556
Lease liabilities arising from obtaining right-of-use assets		721			570
Unrealized losses on securities available for sale, net of tax		(6,940	)		(50,510	)
Loans transferred from held for sale to held for investment		—			131,079

See accompanying notes to consolidated financial statements (unaudited).

9

CAPSTAR FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited consolidated financial statements as of and for the period ended September 30, 2023 include CapStar Financial Holdings, Inc. and its wholly owned subsidiary, CapStar Bank (the “Bank”, together referred to as the “Company”). Significant intercompany transactions and accounts are eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with instructions to Form 10-Q and do not include all information and notes required by U.S. generally accepted accounting principles (“U.S. GAAP”) for complete financial statements. All adjustments consisting of normally recurring accruals that, in the opinion of management, are necessary for a fair presentation of the financial position and results of operations for the periods presented have been included. These unaudited consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes appearing in the 2022 Form 10-K.

Certain amounts, previously reported, have been reclassified to state all periods on a comparable basis and had no effect on shareholders' equity or net income.

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Adoption of New Accounting Standards

On January 1, 2023, the Company adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended, which replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss ("CECL") methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) ("unfunded commitments"). In addition, ASC 326 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities management does not intend to sell or believes that it is more likely than not they will be required to sell.

The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost and unfunded commitments credit exposures. Results for reporting periods beginning after January 1, 2023 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP ("incurred loss"). The Company recorded a net decrease to retained earnings of $3.4 million as of January 1, 2023 for the cumulative adoption effect of adopting ASC 326. The transition adjustment includes a $1.5 million increase in the allowance for credit losses ("ACL") on loans inclusive of a $0.2 million reclassification of purchased accounting discounts reclassified to the ACL on loans, a $3.4 million increase in the ACL on unfunded commitments credit exposures, and a $1.3 million increase in deferred tax assets.

The Company adopted ASC 326 using the prospective transition approach for financial assets purchased with credit deterioration ("PCD") that were previously classified as purchased credit impaired ("PCI") and accounted for under ASC 310-30. In accordance with the standard, management did not reassess whether PCI assets met the criteria of PCD assets as of the date of adoption. On January 1, 2023, the amortized cost basis of the PCD assets were adjusted to reflect the addition of $0.2 million of the ACL. The remaining noncredit discount (based on the adjusted amortized cost basis) will be accreted into interest income at the effective interest rate as of January 1, 2023. As allowed by ASC 326, the Company elected to maintain pools of loans accounted for under ASC 310-30.

Debt Securities

Debt securities are classified as held-to-maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities not classified as held-to-maturity are classified as available-for-sale. Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.

Interest income includes amortization of purchase premiums or discounts. Premiums and discounts on securities are generally amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Premiums on callable debt securities are amortized to their earliest call date. Gains and losses on sale are recorded on the trade date and determined using the specific identification method.

A debt security is placed on non-accrual status at the time any principal or interest payments become over 90 days delinquent. Interest accrued but not received for a security placed on non-accrual is reversed against interest income.

ACL - Available-for-Sale Securities

For available-for-sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or if it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security's amortized cost basis is written down to fair value through income. For debt securities available-for sale that do not meet the aforementioned criteria, the Company evaluated whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considered the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an ACL is recognized in other comprehensive income.

Changes in the ACL are recorded as credit loss expense (or reversal). Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met.

Accrued interest receivable on available-for-sale debt securities totaled $1.8 million at September 30, 2023 and is excluded from the estimate of credit losses.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at amortized cost, net of the ACL. Amortized cost is the principal balance outstanding, net of purchase premiums and discounts, and deferred loan fees and costs. Accrued interest receivable totaled $10.5 million at September 30, 2023 and was reported in accrued interest receivable on the consolidated balance sheets and is excluded from the estimate of credit losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

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Interest income on mortgage and commercial loans is discontinued and placed on non-accrual status at the time the loan is 90 days delinquent unless the loan is well secured and in process of collection. Mortgage loans are charged off at 180 days past due, and commercial loans are charged off to the extent principal or interest is deemed uncollected. Consumer and credit card loans continue to accrue interest until they are charged off no later than 120 days past due unless the loan is in the process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not received for loans placed on non-accrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Under the cost-recovery method, interest income is not recognized until the loan balance is reduced to zero. Under the cash-basis method, interest income is not recognized until the loan balance is reduced to zero. Under the cash-basis method, interest income is recorded when the payment is received in cash. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Purchase Credit Deteriorated ("PCD") Loans

The Company has purchased loans, some of which have experienced more than insignificant credit deterioration since origination. PCD loans are recorded at the amount paid. An ACL is determined using the same methodology as other loans held for investment. The initial ACL determined on a collective basis is allocated to individual loans. The sum of the loan's purchase price and ACL becomes its initial amortized cost basis. The differences between the initial amortized cost basis and the par value of the loan is a noncredit discount or premium, which is amortized into interest income over the life of the loan. Subsequent changes to the ACL are recorded through credit loss expense.

Upon adoption of ASC 326, the Company elected to maintain pools of loans that were previously accounted for under ASC 310-30 and will continue to account for these pools as a unit of account. Loans are only removed from the existing pools if they are written off, paid off, or sold. Upon adoption of ASC 326, the ACL was determined for each pool and added to the pool's carrying amount to establish a new amortized cost basis. The difference between the unpaid principal balance of the pool and the new amortized cost basis is the noncredit premium or discount which will be amortized into interest income over the remaining life of the pool. Changes to the ACL after adoption are recorded through credit loss expense.

ACL - Loans

The ACL is a valuation account that is deducted from the loans' amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the ACL when management believes the uncollectibility of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off.

Management estimates the ACL balance using relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. Historical credit loss experience provides the basis for the estimation of expected credit losses. Adjustments to historical loss information are made for differences in current loan-specific risk characteristics such as differences in underwriting standards, portfolio mix, delinquency level, or term as well as for changes in environmental conditions, such as changes in unemployment rates, property values, or other relevant factors.

The ACL is measured on a collective (pool) basis when similar risk characteristics exist. The Company has identified the following portfolio segments and measures the ACL for each using a discounted cash flow methodology at the loan level, with loss rates, prepayment assumptions and curtailment assumptions driven by each loan’s collateral type.

Owner occupied commercial real estate - Loans in this category are susceptible to business failure and general economic conditions.

Non owner occupied commercial real estate - Common risks for this loan category are declines in general economic conditions, declines in real estate value, declines in occupancy rates, and lack of suitable alternative use for the property.

Commercial & industrial - Risks to this loan category include the inability to monitor the condition of the collateral, which often consists of inventory, accounts receivable and other non-real estate assets. Equipment and inventory obsolescence can also pose a risk. Declines in general economic conditions and other events can cause cash flows to fall to levels insufficient to service debt.

Commercial construction - Risks common to commercial construction loans are cost overruns, changes in market demand for property, inadequate long-term financing arrangements and declines in real estate values.

Residential mortgage - Residential mortgage loans are susceptible to weakening general economic conditions, increases in unemployment rates and declining real estate values.

Home equity lines of credit - Risks common to home equity lines of credit are general economic conditions, including an increase in unemployment rates, and declining real estate values that reduce or eliminate the borrower’s home equity.

Residential construction - Residential construction loans are susceptible to the same risks as residential mortgage loans. Changes in market demand for property lead to longer marketing times resulting in higher carrying costs and declining values.

Consumer - Risks common to consumer direct loans include unemployment and changes in local economic conditions as well as the inability to monitor collateral consisting of personal property.
 

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Loans that do not share risk characteristics are evaluated on an individual basis. Loans evaluated individually are not included in the collective evaluation. When management determines that foreclosure is probable expected credit losses are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate.

Discounted Cash Flow Method

The Company uses the discounted cash flow method to estimate expected credit losses for all loan segments. The Company generates cash flow projections at the instrument level and adjusts payment expectations for estimated prepayment speed, curtailments, time to recovery, probability of default, and loss given default. The modeling of expected prepayment speeds and curtailment rates are based on historical internal data. The prepayment speeds additionally use peer data to backfill a complete time series and utilizes a forward-looking third-party prepayment model, which considers current conditions and reasonable and supportable forecasts of future economic conditions.

The Company uses regression analysis of historical internal and peer data to determine suitable loss drivers to utilize when modeling lifetime probability of default and loss given default. This analysis also determines how expected probability of default and loss given default will react to forecasted levels of the loss drivers.

For all discounted cash flow models, management has determined that four quarters represents a reasonable and supportable forecast period and reverts back to a historical loss rate over four quarters on a straight-line basis. Management leverages economic projections around unemployment rates from the Federal Open Market Committee to inform its loss driver forecasts over the four-quarter forecast period.

The combination of adjustments for credit expectations (default and loss) and timing expectations (prepayment, curtailment, and time to recovery) produces an expected cash flow stream at the instrument level. Instrument effective yield is calculated, net of the impacts of prepayment assumptions, and the instrument expected cash flows are then discounted at that effective yield to produce an instrument-level net present value of expected cash flows (“NPV”). An ACL is established for the difference between the instrument’s NPV and amortized cost basis.

Qualitative Factors

The Company uses qualitative factors for model limitations and risk uncertainty as well as for loan segment specific risks that cannot be addressed in the quantitative methods. Any additional qualitative factor reserves needed will be approved by the Allowance Committee quarterly.

Individually Evaluated Assets

Loans that do not share risk characteristics are evaluated on an individual basis. When the Company has determined that foreclosure on a collateral dependent loan is probable, or when the borrower is experiencing financial difficulty and the Company expects repayment of the loan to be provided substantially through the operation or sale of the collateral, the ACL is measured based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. When repayment is expected to be from the operation of the collateral, expected credit losses are calculated as the amount by which the amortized cost basis of the loan exceeds the present value of expected cash flows from the operation of the collateral. The Company may, in the alternative, measure the expected credit loss as the amount by which the amortized cost basis of the loan exceeds the estimated fair value of the collateral. When repayment is expected to be from the sale of the collateral, expected credit losses are calculated as the amount by which the amortized costs basis of the loan exceeds the fair value of the underlying collateral less estimated cost to sell. The ACL may be zero if the fair value of the collateral at the measurement date exceeds the amortized cost basis of the loan.

Determining the Contractual Term: Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals, and modifications unless either of the following applies: management has a reasonable expectation at the reporting date that a modification will be executed with an individual borrower or the extension or renewal options included in the original or modified contract at the reporting date are not unconditionally cancellable by the Company.

ACL - Unfunded commitments

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The ACL on unfunded commitments is adjusted through credit loss expense. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The ACL is calculated using the same aggregate reserve rates calculated for the funded portion of loans at the portfolio level applied to the amount of commitments expected to fund. The Company has identified pools of unfunded commitments which align with loans held for investment. The ACL on unfunded commitments is recorded on the other liabilities line item of the balance sheet.

ASU 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures

In March 2022, the FASB issued ASU 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, which eliminates the accounting guidance for troubled debt restructurings by creditors in ASC 310-40, Receivables – Troubled Debt Restructurings by Creditors, while enhancing disclosure requirements for certain loan refinancings and restructurings involving borrowings that are experiencing financial difficulty. Specifically, rather than applying the troubled debt restructuring

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recognition and measurement guidance, creditors will evaluate all loan modifications to determine if they result in a new loan or a continuation of the existing loan. Losses associated with troubled debt restructurings should be incorporated in a creditor’s estimate of its ACL. Additionally, public business entities are required to disclose current-period gross write-offs by year of origination for loan financing receivables and net investment in leases. The Company has adopted the standard as of January 1, 2023 with little to no impact to its accounting, and has included the additional required disclosures herein.

NOTE 2 – SECURITIES

The amortized cost and fair value of securities available-for-sale and held-to-maturity at September 30, 2023 and December 31, 2022 are summarized as follows (in thousands):

	September 30, 2023									December 31, 2022
	Amortized Cost		Gross unrealized gains		Gross unrealized (losses)			Estimated fair value		Amortized Cost		Gross unrealized gains		Gross unrealized (losses)			Estimated fair value
Securities available-for-sale:
U. S. government agency securities	$	13,175	$	—	$	(1,903	)	$	11,272	$	14,537	$	—	$	(1,635	)	$	12,902
State and municipal securities		74,807		4		(9,910	)		64,901		77,562		129		(9,379	)		68,312
Mortgage-backed securities		277,630		—		(60,725	)		216,905		300,488		—		(55,660	)		244,828
Asset-backed securities		3,189		—		(90	)		3,099		3,332		—		(62	)		3,270
Other debt securities		64,642		30		(6,825	)		57,847		70,542		3		(3,441	)		67,104
Total	$	433,443	$	34	$	(79,453	)	$	354,024	$	466,461	$	132	$	(70,177	)	$	396,416
Securities held-to-maturity:
State and municipal securities	$	—	$	—	$	—		$	—	$	1,240	$	—	$	—		$	1,240
Total	$	—	$	—	$	—		$	—	$	1,240	$	—	$	—		$	1,240

*Amortized cost of other debt securities is net of ACL totaling $2.0 million at September 30, 2023.

Results from sales, maturities, prepayments and calls of securities available for sale were as follows (in thousands):

	Three Months Ended				Nine Months Ended
	September 30, 2023		September 30, 2022		September 30, 2023			September 30, 2022
Proceeds	$	9,675	$	13,430	$	29,954		$	54,955
Gross gains		—		8		6			8
Gross losses		—		—		(1	)		—

The amortized cost and fair value of securities at September 30, 2023, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date are shown separately.

	Available-for-sale
	Amortized cost		Estimated fair value
Due in less than one year	$	1,162	$	1,080
Due one to five years		17,624		16,214
Due five to ten years		98,688		86,619
Due beyond ten years		35,150		30,107
Mortgage-backed securities		277,630		216,905
Asset-backed securities		3,189		3,099
Total	$	433,443	$	354,024

Securities with a market value of $186.8 million at September 30, 2023 were pledged to collateralize public deposits, and Federal Home Loan Bank advances.

Securities in an unrealized loss position for which an ACL has not been recorded as of September 30, 2023 and December 31, 2022, and the length of time they were in continuous loss positions as of such dates are as follows (in thousands):

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	Less than 12 months					12 months or more					Total
September 30, 2023	Estimated fair value		Gross unrealized losses			Estimated fair value		Gross unrealized losses			Estimated fair value		Gross unrealized losses
U. S. government agency securities	$	—	$	—		$	11,272	$	(1,903	)	$	11,272	$	(1,903	)
State and municipal securities		16,581		(241	)		46,798		(9,669	)		63,379		(9,910	)
Mortgage-backed securities		1,280		(73	)		215,624		(60,652	)		216,904		(60,725	)
Asset-backed securities		—		—			3,099		(90	)		3,099		(90	)
Other debt securities		1,889		(111	)		55,928		(6,714	)		57,817		(6,825	)
Total temporarily impaired securities	$	19,750	$	(425	)	$	332,721	$	(79,028	)	$	352,471	$	(79,453	)
December 31, 2022
U. S. government agency securities	$	6,243	$	(836	)	$	6,659	$	(799	)	$	12,902	$	(1,635	)
State and municipal securities		12,952		(422	)		41,779		(8,957	)		54,731		(9,379	)
Mortgage-backed securities		81,751		(7,647	)		161,708		(48,013	)		243,459		(55,660	)
Asset-backed securities		3,270		(62	)		—		—			3,270		(62	)
Other debt securities		41,018		(2,028	)		24,084		(1,413	)		65,102		(3,441	)
Total temporarily impaired securities	$	145,234	$	(10,995	)	$	234,230	$	(59,182	)	$	379,464	$	(70,177	)

At adoption of ASC 326 on January 1, 2023, calculated credit losses and, thus, the related ACL on held-to-maturity debt securities were not material due to the high credit quality of the portfolio. As a result, no ACL was recorded on the held-to-maturity portfolio at January 1, 2023. There are no held-to-maturity debt securities as of September 30, 2023.

At December 31, 2022, the Company owned certain securities related to Signature Bank ("Signature") which, following the first quarter failure of Signature, were deemed to have significant credit losses and no probable recovery. As such, a $2.0 million provision for credit loss was recorded with a corresponding ACL in the three months ended March 31, 2023. The Company has performed an assessment of its portfolio in an unrealized loss position and has determined no other credit losses present as of September 30, 2023. See Note 1 for additional details on the adoption of ASC 326 as it relates to the securities portfolio.

At September 30, 2023, there were 314 debt securities available-for-sale that were in an unrealized loss position. The Company does not intend to sell nor believes it will be required to sell securities in an unrealized loss position prior to the recovery of their amortized cost basis. Unrealized losses at September 30, 2023 were primarily attributable to the rising interest rate environment. The majority of the investment portfolio was either government guaranteed or an issuance of a government sponsored entity or highly rated by major credit rating agencies.

As of September 30, 2023, the Signature securities for which an ACL has been recorded are on non-accrual. No other securities are past due or on non-accrual.

The following table shows a rollforward of the ACL on available for sale securities for the nine months ended September 30, 2023:

	Other debt securities
Balance at December 31, 2022	$	—
Adoption of CECL		—
Additions for securities for which no previous expected credit losses were recognized		2,000
Total	$	2,000

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NOTE 3 – LOANS AND ALLOWANCE FOR CREDIT LOSSES

A summary of the loans held for investment portfolio as of September 30, 2023 and December 31, 2022 follows (in thousands):

	September 30, 2023			December 31, 2022
Commercial real estate - owner occupied	$	280,273		$	246,109
Commercial real estate - non-owner occupied		799,084			803,611
Consumer real estate		429,028			402,615
Construction and land development		205,486			229,972
Commercial and industrial		485,028			496,347
Consumer		50,860			53,382
Other		42,482			80,762
Total		2,292,241			2,312,798
Allowance for credit losses on loans		(24,157	)		(23,806	)
Total loans, net	$	2,268,084		$	2,288,992

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Non-accrual and Past Due Loans

The following table presents the recorded investment in loans by aging category and accrual status of September 30, 2023 and December 31, 2022 by class of loans (in thousands):

	Accruing
	30 - 59		60 - 89		Greater Than
	Days		Days		89 Days		Total		Loans Not		Non-Accrual
	Past Due		Past Due		Past Due		Past Due		Past Due		Loans		Total
September 30, 2023
Commercial real estate - owner occupied	$	—	$	—	$	5	$	5	$	280,155	$	113	$	280,273
Commercial real estate - non-owner occupied		—		—		—		—		798,634		450		799,084
Consumer real estate		661		118		225		1,004		426,153		1,871		429,028
Construction and land development		—		—		—		—		205,481		5		205,486
Commercial and industrial		597		26		463		1,086		481,713		2,229		485,028
Consumer		270		98		139		507		48,591		1,762		50,860
Other		—		—		—		—		42,482		—		42,482
Total	$	1,528	$	242	$	832	$	2,602	$	2,283,209	$	6,430	$	2,292,241

	Accruing
	30 - 59		60 - 89		Greater Than
	Days		Days		89 Days		Total		Loans Not		Non-Accrual
	Past Due		Past Due		Past Due		Past Due		Past Due		Loans		Total
December 31, 2022
Commercial real estate - owner occupied	$	—	$	—	$	—	$	—	$	239,351	$	4,982	$	244,333
Commercial real estate - non-owner occupied		—		—		—		—		802,107		—		802,107
Consumer real estate		456		231		87		774		393,893		456		395,123
Construction and land development		—		—		—		—		229,896		8		229,904
Commercial and industrial		76		53		744		873		489,842		4,065		494,780
Consumer		178		39		14		231		52,731		54		53,016
Other		—		—		37		37		80,535		—		80,572
Purchased credit impaired		175		149		143		467		11,347		1,149		12,963
Total	$	885	$	472	$	1,025	$	2,382	$	2,299,702	$	10,714	$	2,312,798

The following table presents the recorded investment in nonaccrual loans as of September 30, 2023 by class of loans (in thousands):

	Non-Accrual loans with no allowance		Non-Accrual loans with allowance		Total Non-Accrual Loans
Commercial real estate - owner occupied	$	—	$	113	$	113
Commercial real estate - non-owner occupied		—		450		450
Consumer real estate		769		1,102		1,871
Construction and land development		—		5		5
Commercial and industrial		—		2,229		2,229
Consumer		1,707		55		1,762
Other		—		—		—
Total	$	2,476	$	3,954	$	6,430

The Company recognized no interest income on nonaccrual loans during the three or nine months ended September 30, 2023.

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Risk Ratings

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes all commercial loans individually and assigns each loan a risk rating. This analysis is performed at origination by the relationship manager and credit department personnel. On at least an annual basis, an independent party performs a formal credit risk review of a sample of the loan portfolio. Among other things, this review assesses the appropriateness of the loan’s risk rating. The Company uses the following definitions for risk ratings:

•Pass – Loans in this category are considered to have a low probability of default and do not meet the criteria of the risk categories below.

•Special Mention – A special mention asset possesses deficiencies or potential weaknesses deserving of management’s attention. If uncorrected, such weaknesses or deficiencies may expose the Company to an increased risk of loss in the future.

•Substandard – A substandard asset is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.

•Doubtful – A doubtful asset has all weaknesses inherent in one classified substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable. The probability of loss is extremely high, but certain important and reasonable specific pending factors which may work to the advantage and strengthening of the asset exist, therefore, its classification as an estimated loss is deferred until a more exact status may be determined. Pending factors include proposed merger, acquisition or liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans.

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The following table provides the risk category of loans by applicable class of loans and vintage year as of September 30, 2023 (in thousands):

	Term Loans by Origination Year
	2023		2022		2021		2020		2019		Prior		Revolvers		Revolvers converted to term loans		Total
Commercial real estate - owner occupied
Pass	$	19,566	$	90,202	$	86,763	$	32,044	$	19,490	$	23,846	$	1,842	$	—	$	273,753
Special Mention		—		—		2,490		—		—		1,708		—		—		4,198
Substandard		—		1,583		—		—		158		581		—		—		2,322
Doubtful		—		—		—		—		—		—		—		—		—
Total	$	19,566	$	91,785	$	89,253	$	32,044	$	19,648	$	26,135	$	1,842	$	—	$	280,273
Current period gross charge-offs		—		—		—		—		—		—		—		—		—
Commercial real estate - non-owner occupied
Pass	$	34,448	$	293,182	$	219,866	$	104,411	$	39,937	$	87,736	$	19,053	$	—	$	798,633
Special Mention		—		—		—		—		—		—		—		—		—
Substandard		—		236		—		—		—		—		215		—		451
Doubtful		—		—		—		—		—		—		—		—		—
Total	$	34,448	$	293,418	$	219,866	$	104,411	$	39,937	$	87,736	$	19,268	$	—	$	799,084
Current period gross charge-offs		—		—		—		—		—		—		—		—		—
Consumer real estate
Pass	$	27,492	$	87,441	$	35,727	$	16,490	$	14,821	$	42,165	$	197,553	$	2,146	$	423,835
Special Mention		164		2,194		—		—		—		235		—		12		2,605
Substandard		—		912		26		36		188		1,176		164		1		2,503
Doubtful		47		—		—		—		—		—		38		—		85
Total	$	27,703	$	90,547	$	35,753	$	16,526	$	15,009	$	43,576	$	197,755	$	2,159	$	429,028
Current period gross charge-offs		38		—		—		—		—		—		—		—		38
Construction and land development
Pass	$	18,303	$	121,171	$	53,105	$	3,880	$	5,779	$	2,237	$	1,006	$	—	$	205,481
Special Mention		—		—		—		—		—		—		—		—		—
Substandard		—		—		—		—		—		5		—		—		5
Doubtful		—		—		—		—		—		—		—		—		—
Total	$	18,303	$	121,171	$	53,105	$	3,880	$	5,779	$	2,242	$	1,006	$	—	$	205,486
Current period gross charge-offs		—		—		—		—		—		—		—		—		—
Commercial and industrial
Pass	$	50,514	$	135,912	$	78,551	$	43,961	$	15,090	$	8,282	$	135,303	$	—	$	467,613
Special Mention		127		1,073		2,132		6,012		—		—		1,995		—		11,339
Substandard		7		—		58		3,299		—		—		2,307		245		5,916
Doubtful		—		—		—		109		22				29		—		160
Total	$	50,648	$	136,985	$	80,741	$	53,381	$	15,112	$	8,282	$	139,634	$	245	$	485,028
Current period gross charge-offs		—		92		167		98		59		—		122		—		538
Consumer
Pass	$	15,185	$	11,783	$	4,790	$	1,938	$	540	$	386	$	14,219	$	101	$	48,942
Special Mention		—		—		—		—		—		—		—		—		—
Substandard		15		136		1,740		16		10		—		—		—		1,917
Doubtful		—		—		1		—		—		—		—		—		1
Total	$	15,200	$	11,919	$	6,531	$	1,954	$	550	$	386	$	14,219	$	101	$	50,860
Current period gross charge-offs		11		58		32		30		12		144		—		—		287
Other
Pass	$	5,574	$	6,752	$	20,209	$	4,902	$	364	$	1,911	$	2,207	$	—	$	41,919
Special Mention		—		69		—		—		395		—		—		—		464
Substandard		46		—		1		52		—		—		—		—		99
Doubtful		—		—		—		—		—		—		—		—		—
Total	$	5,620	$	6,821	$	20,210	$	4,954	$	759	$	1,911	$	2,207	$	—	$	42,482
Current period gross charge-offs		—		—		—		—		—		109		—		—		109
Total Portfolio
Pass	$	171,082	$	746,443	$	499,011	$	207,626	$	96,021	$	166,563	$	371,183	$	2,247	$	2,260,176
Special Mention		291		3,336		4,622		6,012		395		1,943		1,995		12		18,606
Substandard		68		2,867		1,825		3,403		356		1,762		2,686		246		13,213
Doubtful		47		—		1		109		22		—		67		—		246
Total	$	171,488	$	752,646	$	505,459	$	217,150	$	96,794	$	170,268	$	375,931	$	2,505	$	2,292,241
Current period gross charge-offs	$	49	$	150	$	199	$	128	$	71	$	253	$	122	$	-	$	972

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The following table provides the risk category of loans by applicable class of loans as of December 31, 2022 (in thousands):

	Non-impaired Loans
December 31, 2022	Pass		Special Mention		Substandard		Doubtful		Total Impaired Loans		Total
Commercial real estate - owner occupied	$	234,619	$	4,731	$	440	$	—	$	4,543	$	244,333
Commercial real estate - non-owner occupied		802,107		—		—		—		—		802,107
Consumer real estate		393,734		555		467		—		367		395,123
Construction and land development		229,897		—		—		—		7		229,904
Commercial and industrial		477,081		516		12,751		127		4,305		494,780
Consumer		52,911		—		84		2		19		53,016
Other		80,504		—		68		—		—		80,572
Purchased credit impaired		11,595		68		1,259		41		—		12,963
Total	$	2,282,448	$	5,870	$	15,069	$	170	$	9,241	$	2,312,798

Modifications

Occasionally, the Company modifies loans to borrowers in financial distress by providing principal forgiveness, term extension, an other-than-insignificant payment delay or interest rate reduction. When principal forgiveness is provided, the amount of forgiveness is charged-off against the ACL.

In some cases, the Company provides multiple types of concessions on one loan. Typically, one type of concession, such as a term extension, is granted initially. If the borrower continues to experience financial difficulty, another concession, such as principal forgiveness, may be granted.

The following table represents the loans at September 30, 2023 that were both experiencing financial difficulty and modified during the nine months ended September 30, 2023, by class and by type of modification. No modifications were made during the three months ended September 30, 2023. The percentage of loans that were modified to borrowers in financial distress as compared to the total loans of each class is also presented below.

	Payment Delay		Term Extension		Total Class of Loans
Commercial and industrial	$	5,049	$	320		1.11	%
Total	$	5,049	$	320		0.23	%

The Company has not committed to lend additional amounts to the borrowers included in the previous table.

The Company closely monitors the performance of loans that are modified to borrowers experiencing financial difficulty to understand the effectiveness of its modification efforts. Such loans that had been modified in the last 12 months are all current with no loans past due.

The following table presents the financial effect of the loan modifications represented above to borrowers experiencing financial difficulty for the nine months ended September 30, 2023:

	Weighted-Average	Weighted-Average
	Payment	Term
	Delay	Extension
Commercial and industrial	4 mos.	3 mos.
Total	4 mos.	3 mos.

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No loans modified during the three or nine months ended September 30, 2023 are in payment default.

Upon the Company's determination that a modified loan has subsequently been deemed uncollectible, the loan is written off. Therefore, the recorded investment of the loan is reduced by the uncollectible amount and the allowance for credit losses is adjusted by the same amount.

The following table presents collateral dependent loans, which are individually evaluated to determine expected credit losses, as of September 30, 2023 by class of loan and type of collateral.

	Real Estate	Total
Commercial real estate - owner occupied	$1,169	$1,169
Total	$1,169	$1,169

Allowance for Credit Loss

The following table details the changes in the ACL for the three and nine month periods ended September 30, 2023 and 2022 (in thousands):

	CECL												Incurred Loss
For the three months ended September 30,	2023												2022
	Beginning Balance		Charge-Offs			Recoveries		Provision			Ending Balance		Beginning Balance		Charge-Offs			Recoveries		Provision			Ending Balance
Commercial real estate - owner occupied	$	2,362	$	—		$	—	$	(16	)	$	2,346	$	1,852	$	—		$	—	$	14		$	1,866
Commercial real estate - non-owner occupied		6,907		—			—		(382	)		6,525		5,297		—			—		678			5,975
Consumer real estate		3,811		(38	)		—		(43	)		3,730		2,555		—			1		392			2,948
Construction and land development		3,949		—			—		(650	)		3,299		3,271		—			—		40			3,311
Commercial and industrial		5,998		(231	)		45		(57	)		5,755		7,464		(46	)		7		(419	)		7,006
Consumer		1,501		(119	)		35		355			1,772		498		(64	)		14		3			451
Other		996		(51	)		9		(224	)		730		747		(37	)		5		159			874
Total allowance for credit losses - loans	$	25,524	$	(439	)	$	89	$	(1,017	)	$	24,157	$	21,684	$	(147	)	$	27	$	867		$	22,431
Allowance for credit losses - unfunded commitments	$	3,563	$	-		$	-	$	(544	)	$	3,019	$	319	$	-		$	-	$	-		$	319

	CECL							Incurred Loss
For the nine months ended September 30,	2023							2022
	Beginning Balance	Adoption of CECL	Jan. 1, 2023	Charge-Offs	Recoveries	Provision	Ending Balance	Beginning Balance	Charge-Offs	Recoveries	Provision	Ending Balance
Commercial real estate - owner occupied	$1,967	$209	$2,176	$—	$—	$170	$2,346	$1,685	$(12)	$225	$(32)	$1,866
Commercial real estate - non-owner occupied	5,967	(632)	5,335	—	—	1,190	6,525	5,439	—	—	536	5,975
Consumer real estate	3,153	650	3,803	(38)	44	(79)	3,730	2,412	—	2	534	2,948
Construction and land development	3,830	(266)	3,564	—	—	(265)	3,299	3,769	—	—	(458)	3,311
Commercial and industrial	7,654	(995)	6,659	(538)	50	(416)	5,755	7,441	(205)	30	(260)	7,006
Consumer	430	1,127	1,557	(287)	163	339	1,772	397	(211)	95	170	451
Other	805	1,404	2,209	(109)	16	(1,386)	730	555	(128)	11	436	874
Total	$23,806	$1,497	$25,303	$(972)	$273	$(447)	$24,157	$21,698	$(556)	$363	$926	$22,431
Allowance for credit losses - unfunded commitments	$319	$3,350	$3,669	$-	$-	$(650)	$3,019	$319	$-	$-	$-	$319

As of September 30, 2023, the Company used a one-year reasonable and supportable forecast period. The changes in loss rates used as the basis for the estimate of credit losses during this period were modeled using both the Company's own historical data and historical data from peer banks and macroeconomic forecast data obtained from a third party vendor, which were then applied to the Company’s recent default experience as a starting point. The decrease in the ACL compared to January 1, 2023 was primarily attributable to a decrease in the loan portfolio, changes in various loan attributes at the instrument level, qualitative factors and an improvement in

21

economic metrics such as forecasted unemployment. For periods beyond the reasonable and supportable forecast period of one year, the Company reverted to historical credit loss information on a straight line basis over two years.

The Company maintains an allowance for unfunded commitments exposures. The allowance for unfunded commitments credit exposures is adjusted as a provision for credit loss expense. The estimate includes consideration of the likelihood that funding will occur, which is based on a historical funding study derived from internal information, and an estimate of expected credit losses on commitments expected to be funded over its estimated life, which are the same loss rates that are used in computing the allowance for credit losses on loans. The ACL for unfunded loan commitments of $3.0 million and $0.3 million at September 30, 2023 and December 31, 2022, respectively, is separately classified on the balance sheet within Other Liabilities.

Incurred Loss Impairment Methodology

A breakdown of the ALL and the loan portfolio by loan category as previously required by ASC Topic 310 at December 31, 2022 follows (in thousands):

	Commercial real estate - owner occupied		Commercial real estate - non-owner occupied		Consumer real estate		Construction and land development		Commercial and industrial		Consumer		Other		Total
December 31, 2022
Allowance for Loan Losses:
Collectively evaluated for impairment	$	1,967	$	5,967	$	3,153	$	3,830	$	6,909	$	378	$	805	$	23,009
Individually evaluated for impairment		—		—		—		—		716		—		—		716
Purchased credit impaired		—		—		—		—		29		52		—		81
Balances, end of period	$	1,967	$	5,967	$	3,153	$	3,830	$	7,654	$	430	$	805	$	23,806
Loans:
Collectively evaluated for impairment	$	239,790	$	802,107	$	394,756	$	229,897	$	490,475	$	52,997	$	80,572	$	2,290,594
Individually evaluated for impairment		4,543		—		367		7		4,305		19		—		9,241
Purchased credit impaired		1,776		1,504		7,492		68		1,567		366		190		12,963
Balances, end of period	$	246,109	$	803,611	$	402,615	$	229,972	$	496,347	$	53,382	$	80,762	$	2,312,798

The following table presents additional detail on loans individually evaluated for impairment as previously required by ASC Topic 310 as of December 31, 2022 (in thousands):

	December 31, 2022
	Recorded investment		Unpaid principal balance		Related allowance
With no related allowance recorded:
Commercial real estate - owner occupied	$	4,543	$	4,551	$	—
Commercial real estate - non-owner occupied		—		—		—
Consumer real estate		367		393		—
Construction and land development		7		8		—
Commercial and industrial		420		412		—
Consumer		19		19		—
Other		—		—		—
Subtotal		5,356		5,383		—
With an allowance recorded:
Commercial real estate - owner occupied		—		—		—
Commercial real estate - non-owner occupied		—
Consumer real estate		—		—		—
Construction and land development		—		—		—
Commercial and industrial		3,885		4,061		716
Consumer		—		—		—
Other		—		—		—
Subtotal		3,885		4,061		716
Total	$	9,241	$	9,444	$	716

22

The average balances of impaired loans and income recognized on impaired loans while they were considered impaired under Incurred Loss are presented below for the period indicated (in thousands).

	Three Months Ended				Nine Months Ended
	September 30, 2022				September 30, 2022
	Average recorded investment		Interest income recognized		Average recorded investment		Interest income recognized
With no related allowance recorded:
Commercial real estate - owner occupied	$	4,988	$	59	$	5,075	$	234
Commercial real estate - non-owner occupied		—		—		—		—
Consumer real estate		548		6		337		7
Construction and land development		8		—		9		—
Commercial and industrial		106		2		79		3
Consumer		11		—		12		—
Other		—		—		—		—
Subtotal		5,661		67		5,512		244
With an allowance recorded:
Commercial real estate - owner occupied		—		—		—		—
Commercial real estate - non-owner occupied		—		—
Consumer real estate		—		—		—		—
Construction and land development		—		—		—		—
Commercial and industrial		—		—		—		—
Consumer		—		—		—		—
Other		—		—		—		—
Subtotal		—		—		—		—
Total	$	5,661	$	67	$	5,512	$	244

The following table presents changes in the carrying value of PCI loans (in thousands) for the periods indicated:

	Three Months Ended			Nine Months Ended
	September 30, 2022
Balance at beginning of period	$	15,809		$	19,261
Change due to payments received and accretion		(1,439	)		(4,810	)
Reclassification of discount to allowance for loan losses		—			(81	)
Balance at end of period	$	14,370		$	14,370

The following table presents changes in the accretable yield for PCI loans (in thousands) for the periods indicated:

	Three Months Ended			Nine Months Ended
	September 30, 2022
Balance at beginning of period	$	4,992		$	5,763
Accretion		(376	)		(1,245	)
Reclassification from nonaccretable difference		—			304
Other, net		—			(206	)
Balance at end of period	$	4,616		$	4,616

PCI loans had no impact on the ALL for the three or nine months ended September 30, 2022.

Loans Held for Sale

23

A summary of the loans held for sale as of September 30, 2023 and December 31, 2022 follows (in thousands):

	September 30, 2023		December 31, 2022
Residential mortgage	$	15,981	$	12,636
Guaranteed portion of SBA loans		20,410		32,072
Total	$	36,391	$	44,708

NOTE 4 – SHORT TERM BORROWINGS AND LONG-TERM DEBT

Short-Term Borrowings

The Company had outstanding advances of $50.0 million and $15.0 million as of September 30, 2023 and December 31, 2022, respectively.

	September 30, 2023					December 31, 2022
Year	Amount		Interest Rates			Amount		Interest Rates
2023	$	50,000		5.17	%	$	15,000		4.33	%

Advances from the FHLB are collateralized by investment securities with a market value of $17.5 million and certain commercial and residential real estate mortgage loans totaling $735.7 million under a blanket mortgage collateral agreement. At September 30, 2023, the amount of available credit from the FHLB totaled $426.6 million.

Subordinated Notes

The Company issued $30.0 million of fixed-to-floating rate subordinated notes during the third quarter of 2020, which were recorded net of issuance costs of $0.6 million, that mature June 30, 2030. Beginning on or after June 30, 2025, the Company may redeem the notes, in whole or in part, at their principal amount plus any accrued and unpaid interest. The notes have a fixed interest rate of 5.25% per annum for the first five years. Thereafter, the interest rate will reset quarterly to an interest rate per annum equal to a benchmark rate (which is expected to be Three-Month Term SOFR) plus 513 basis points. The carrying value of subordinated notes was $29.8 million as of September 30, 2023 and $29.7 million as of December 31, 2022.

NOTE 5– ACCUMULATED OTHER COMPREHENSIVE LOSS

The following were changes in accumulated other comprehensive loss by component, net of tax, for the periods ended September 30, 2023 and 2022 (in thousands):

	Unrealized Gains
	and Losses
	on Available
	for Sale
	Securities
Nine Months Ended September 30, 2023
Beginning balance	$	(50,052	)
Other comprehensive loss before reclassification, net of tax		(6,936	)
Amounts reclassified from accumulated other comprehensive loss, net of tax		(4	)
Net current period other comprehensive loss		(6,940	)
Ending Balance	$	(56,992	)
Nine Months Ended September 30, 2022
Beginning balance	$	(1,270	)
Other comprehensive loss before reclassification, net of tax		(50,504	)
Amounts reclassified from accumulated other comprehensive loss, net of tax		(6	)
Net current period other comprehensive loss		(50,510	)
Ending Balance	$	(51,780	)

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The following amounts were reclassified out of each component of accumulated other comprehensive income (loss) for the nine months ended September 30, 2023 and 2022 (in thousands). No reclassifications occurred in the three months ended September 30, 2023 or 2022.

							Affected Line Item
Details about Accumulated Other	Nine Months Ended September 30,						in the Statement Where
Comprehensive Income (Loss) Components	2023			2022			Net Income is Presented
Realized gains on available- for-sale securities	$	5		$	8		Net gain on sale of securities
		(1	)		(2	)	Income tax expense
	$	4		$	6		Net of tax

NOTE 6 – COMMITMENTS AND CONTINGENCIES

In the normal course of business, the Company has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making such commitments as it does for instruments that are included in the balance sheet.

The following table sets forth outstanding financial instruments whose contract amounts represent credit risk as of September 30, 2023 and December 31, 2022 (in thousands):

	Contract or notional amount
	September 30, 2023		December 31, 2022
Financial instruments whose contract amounts represent    credit risk:
Unused commitments to extend credit	$	1,013,932	$	1,112,950
Standby letters of credit		9,331		7,288
Total	$	1,023,263	$	1,120,238

The Company is party to litigation and claims arising in the normal course of business. Management believes that the liabilities, if any, arising from such litigation and claims as of September 30, 2023, will not have a material impact on the financial statements of the Company.

NOTE 7 – DERIVATIVES

The Company utilizes interest rate swap agreements as part of its asset liability management strategy to help manage its interest rate risk position. The notional amount of the interest rate swaps does not represent amounts exchanged by the parties. The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest rate swap agreements.

Interest Rate Swaps

The Company enters into swaps to facilitate customer transactions and meet their financing needs. Upon entering into these transactions the Company enters into offsetting positions with large U.S. financial institutions in order to minimize market risk to the Company. A summary of the Company’s customer related interest rate swaps was as follows (in thousands):

	September 30, 2023					December 31, 2022
	Notional		Estimated			Notional		Estimated
	amount		fair value			amount		fair value
Interest rate swap agreements:
Pay fixed/receive variable swaps	$	35,173	$	2,250		$	35,641	$	(2,343	)
Pay variable/receive fixed swaps		35,173		(2,250	)		35,641		2,343
Total	$	70,346	$	—		$	71,282	$	—

Mortgage Banking Derivatives

The Company enters into various derivative agreements with customers in the form of interest-rate lock commitments, which are commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding and the customers have locked into that interest rate. The derivatives are valued using a model that utilizes market interest rates and other unobservable inputs. Changes in the fair value of these commitments due to fluctuations in interest rates that are to be originated to our loans held for sale

25

portfolio are economically hedged through the use of forward sale commitments of mortgage-backed securities. The gains and losses arising from this derivative activity are reflected in current period earnings under mortgage banking income. Interest rate lock commitments are valued using a model with significant unobservable market parameters. Forward sale commitments are valued based on quoted prices for similar assets in an active market with inputs that are observable.

The net (losses) gains relating to mortgage banking derivative instruments included in mortgage banking income were as follows (in thousands):

	Three Months Ended						Nine Months Ended
	September 30, 2023			September 30, 2022			September 30, 2023		September 30, 2022
Mortgage loan interest rate lock commitments	$	(77	)	$	(870	)	$	243	$	(940	)
Mortgage-backed securities forward sales commitments		(10	)		350			10		356
Total	$	(87	)	$	(520	)	$	253	$	(584	)

The amount and fair value of mortgage banking derivatives included in the consolidated balance sheets were as follows (in thousands):

	September 30, 2023				December 31, 2022
	Notional		Estimated		Notional		Estimated
	amount		fair value		amount		fair value
Included in other assets:
Mortgage loan interest rate lock commitments	$	18,889	$	249	$	19,413	$	6
Mortgage-backed securities forward sales commitments		16,750		37		12,500		27

NOTE 8 – REGULATORY CAPITAL REQUIREMENTS

The Company and the Bank are subject to regulatory capital requirements administered by the Federal Reserve and the Bank is also subject to the regulatory capital requirements of the Tennessee Department of Financial Institutions. Failure to meet capital requirements can initiate certain mandatory – and possibly additional discretionary – actions by regulators that could, in that event, have a material adverse effect on the institutions’ financial statements. The relevant regulations require the Company and the Bank to meet specific capital adequacy guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting principles. The capital classifications of the Company and the Bank are also subject to qualitative judgments by their regulators about components, risk weightings, and other factors. Those qualitative judgments could also affect the capital status of the Company and the Bank and the amount of dividends the Company and the Bank may distribute. The net unrealized gain or loss on available for sale securities is not included in computing regulatory capital. Management believes as of September 30, 2023, the Company and the Bank met all regulatory capital adequacy requirements to which they are subject.

26

The Company’s and the Bank’s capital amounts and ratios as of September 30, 2023 and December 31, 2022 are presented in the following table (dollars in thousands).

	Actual					Minimum capital requirement (1)					Minimum to be well-capitalized (2)
	Amount		Ratio			Amount		Ratio			Amount		Ratio
At September 30, 2023:
Total capital to risk-weighted assets:
CapStar Financial Holdings, Inc.	$	412,219		15.36	%	$	214,661		8.0	%	N/A		N/A
CapStar Bank		399,089		14.85			215,064		8.0		$	268,830		10	%
Tier I capital to risk-weighted assets:
CapStar Financial Holdings, Inc.		358,912		13.38			160,996		6.0		N/A		N/A
CapStar Bank		375,548		13.97			161,298		6.0			215,064		8.00
Common equity Tier 1 capital to risk weighted    assets:
CapStar Financial Holdings, Inc.		358,912		13.38			120,747		4.5		N/A		N/A
CapStar Bank		359,048		13.36			120,974		4.5			174,740		6.50
Tier I capital to average assets:
CapStar Financial Holdings, Inc.		358,912		11.08			129,591		4.0		N/A		N/A
CapStar Bank		375,548		11.60			129,533		4.0			161,916		5.00
At December 31, 2022:
Total capital to risk-weighted assets:
CapStar Financial Holdings, Inc.	$	410,704		14.51	%	$	226,491		8.0	%	N/A		N/A
CapStar Bank		402,453		14.22			226,407		8.0		$	283,009		10	%
Tier I capital to risk-weighted assets:
CapStar Financial Holdings, Inc.		356,913		12.61			169,868		6.0		N/A		N/A
CapStar Bank		378,328		13.37			169,805		6.0			226,407		8.00
Common equity Tier 1 capital to risk weighted    assets:
CapStar Financial Holdings, Inc.		356,913		12.61			127,401		4.5		N/A		N/A
CapStar Bank		361,828		12.79			127,354		4.5			183,956		6.50
Tier I capital to average assets:
CapStar Financial Holdings, Inc.		356,913		11.40			125,202		4.0		N/A		N/A
CapStar Bank		378,328		12.10			125,089		4.0			156,361		5.00

(1) For the calendar year 2023, the Company must maintain a capital conservation buffer of Tier 1 common equity capital in excess of minimum risk-based capital ratios by at least 2.5% to avoid limits on capital distributions and certain discretionary bonus payments to executive officers and similar employees.

(2) For the Company to be well-capitalized, the Bank must be well-capitalized and the Company must not be subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the Federal Reserve to meet and maintain a specific capital level for any capital measure.

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NOTE 9 – EARNINGS PER SHARE

The following is a summary of the basic and diluted earnings per share calculation for the three and nine month periods ended September 30, 2023 and 2022 (in thousands except share and per share data):

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2023		2022		2023		2022
Basic net income per share calculation:
Numerator – Net income	$	8,925	$	8,039	$	23,175	$	28,686
Denominator – Average common shares outstanding		20,808,677		21,938,259		21,142,177		22,051,950
Basic net income per share	$	0.43	$	0.37	$	1.10	$	1.30
Diluted net income per share calculation:
Numerator – Net income	$	8,925	$	8,039	$	23,175	$	28,686
Denominator – Average common shares outstanding		20,808,677		21,938,259		21,142,177		22,051,950
Dilutive shares contingently issuable		15,294		49,826		30,535		52,737
Average diluted common shares outstanding		20,823,971		21,988,085		21,172,712		22,104,687
Diluted net income per share	$	0.43	$	0.37	$	1.09	$	1.30

NOTE 10 – FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Bank used the following methods and significant assumptions to estimate fair value:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2), using matrix pricing. Matrix pricing is a mathematical technique commonly used to price debt securities that are not actively traded and values debt securities by relying on quoted prices for the specific securities and the securities’ relationship to other benchmark quoted securities (Level 2 inputs). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). See below for additional discussion of Level 3 valuation methodologies and significant inputs. The fair values of all securities are determined from third party pricing services without adjustment.

Derivatives-Interest Rate Swaps: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2). The Bank’s derivatives are traded in an over-the-counter market where quoted market prices are not always available. Therefore, the fair values of derivatives are determined using quantitative models that utilize multiple market inputs. The inputs will vary based on the type of derivative, but could include interest rates, prices and indices to generate continuous yield or pricing curves, prepayment rates, and volatility factors to value the position. The majority of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services. The fair values of all interest rate swaps are determined from third party pricing services without adjustment.

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Individually Evaluated Loans: The fair value of individually evaluated loans, formerly "impaired" under incurred loss methodology, with specific allocations of the ACL is generally based on recent appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available for similar loans and collateral underlying such loans. Such adjustments result in a Level 3 classification of the inputs for determining fair value. Collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Individually evaluated loans are evaluated on at least a quarterly basis for additional impairment and adjusted in accordance with the loan policy.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach with data from comparable properties. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Appraisals may be adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and/or management’s expertise and knowledge of the collateral. Such adjustments result in a Level 3 classification of the inputs for determining fair value. Real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly. The Company had no other real estate owned carried at fair value at September 30, 2023 or December 31, 2022.

Loans Held For Sale: Loans held for sale are carried at either fair value, if elected, or the lower of cost or fair value on a pool-level basis. Origination fees and costs for loans held for sale recorded at lower of cost or market are capitalized in the basis of the loan and are included in the calculation of realized gains and losses upon sale. Origination fees and costs are recognized in earnings at the time of origination for loans held for sale that are recorded at fair value. Fair value is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

Derivatives-Mortgage Loan Interest Rate Lock Commitments: Interest rate lock commitments that relate to the origination of mortgage loans that will be held for sale are recorded at fair value, determined as the amount that would be required to settle each derivative instrument at the balance sheet date. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded (a “pull through” rate). The expected pull through rates are applied to the fair value of the unclosed mortgage pipeline, resulting in a Level 3 fair value classification. The pull through rate is a statistical analysis of our actual rate lock fallout history to determine the sensitivity of the residential mortgage loan pipeline compared to interest rate changes and other deterministic values. New market prices are applied based on updated loan characteristics and new fallout ratios (i.e., the inverse of the pull through rate) are applied accordingly. Significant increases (decreases) in the pull through rate in isolation result in a significantly higher (lower) fair value measurement. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time.

Derivatives-Mortgage-Backed Securities Forward Sales Commitments: The Company utilizes mortgage-backed securities forward sales commitments to hedge mortgage loan interest rate lock commitments. Mortgage-backed securities forward sales commitments are recorded at fair value based on quoted prices for similar assets in an active market with inputs that are observable, resulting in a Level 2 fair value classification.

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Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

	Fair value measurements at September 30, 2023
				Quoted prices
				in active		Significant
				markets for		other			Significant
				identical		observable			unobservable
	Carrying			assets		inputs			inputs
	Value			(Level 1)		(Level 2)			(Level 3)
Assets:
Securities available-for-sale:
U. S. government agency securities	$	11,272		$	—	$	11,272		$	—
State and municipal securities		64,901			—		64,901			—
Mortgage-backed securities		216,905			—		216,905			—
Asset-backed securities		3,099			—		3,099			—
Other debt securities		57,847			—		57,847			—
Loans held for sale		15,981			—		15,981			—
Derivative assets:
Interest rate swaps - customer related		2,250			—		2,250			—
Mortgage loan interest rate lock commitments		249			—		—			249
Mortgage-backed securities forward sales commitments		37			—		37			—
Liabilities:
Derivative liabilities:
Interest rate swaps - customer related		(2,250	)		—		(2,250	)		—

	Fair value measurements at December 31, 2022
			Quoted prices
			in active		Significant
			markets for		other	Significant
			identical		observable	unobservable
	Carrying		assets		inputs	inputs
	Value		(Level 1)		(Level 2)	(Level 3)
Assets:
Securities available-for-sale:
U. S. government agency securities	$	12,902	$	—