Note 5: Portfolio loans

The distribution of portfolio loans at June 30, 2018 and December 31, 2017 is as follows (dollars in thousands):

	June 30, 2018		December 31, 2017
Commercial	$	1,446,061	$	1,414,631
Commercial real estate	2,355,225		2,354,684
Real estate construction	274,967		261,506
Retail real estate	1,449,476		1,460,801
Retail other	29,558		27,878

Portfolio loans	$	5,555,287	$	5,519,500

Less allowance for loan losses	53,305		53,582

Portfolio loans, net	$	5,501,982	$	5,465,918

Net deferred loan origination costs included in the table above were $5.3 million as of June 30, 2018 and $4.1 million as of December 31, 2017. Net accretable purchase accounting adjustments included in the table above reduced loans by $18.0 million as of June 30, 2018 and $23.6 million as of December 31, 2017.

The Company believes that making sound loans is a necessary and desirable means of employing funds available for investment. Recognizing the Company’s obligations to its stockholders, depositors, and to the communities it serves, authorized personnel are expected to seek to develop and make sound, profitable loans that resources permit and that opportunity affords. The Company maintains lending policies and procedures designed to focus lending efforts on the types, locations and duration of loans most appropriate for its business model and markets. While not specifically limited, the Company attempts to focus its lending on short to intermediate-term (0-7 years) loans in geographic areas within 125 miles of its lending offices. Loans might be originated outside of these areas, but such loans are generally residential mortgage loans originated for sale in the secondary market or are loans to existing customers of the Bank. The Company attempts to utilize government-assisted lending programs, such as the Small Business Administration and United States Department of Agriculture lending programs, when prudent. Generally, loans are collateralized by assets, primarily real estate, of the borrowers and guaranteed by individuals. The loans are expected to be repaid primarily from cash flows of the borrowers, or from proceeds from the sale of selected assets of the borrowers.

Management reviews and approves the Company’s lending policies and procedures on a routine basis. The policies for legacy First Community and South Side Bank loans are similar in nature to Busey Bank’s policies and the Company is migrating such loan production towards the Busey Bank policies. Management routinely (at least quarterly) reviews the Company’s allowance for loan losses in conjunction with reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. The Company’s underwriting standards are designed to encourage relationship banking rather than transactional banking. Relationship banking implies a primary banking relationship with the borrower that includes, at a minimum, an active deposit banking relationship in addition to the lending relationship. Additional significant underwriting factors beyond location, duration, a sound and profitable cash flow basis and the borrower’s character include the quality of the borrower’s financial history, the liquidity of the underlying collateral and the reliability of the valuation of the underlying collateral.

At no time is a borrower’s total borrowing relationship permitted to exceed the Company’s regulatory lending limit and the Company generally limits such relationships to amounts substantially less than the regulatory limit. Loans to related parties, including executive officers and directors of the Company and its subsidiaries, are reviewed for compliance with regulatory guidelines by the Company’s board of directors at least annually.

The Company maintains an independent loan review department that reviews the loans for compliance with the Company’s loan policy on a periodic basis. In addition, the loan review department reviews the risk assessments made by the Company’s credit department, lenders and loan committees. Results of these reviews are presented to management and the audit committee at least quarterly.

The Company’s lending activities can be summarized into five primary areas: commercial loans, commercial real estate loans, real estate construction loans, retail real estate loans, and retail other loans. A description of each of the lending areas can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The significant majority of the Company’s portfolio lending activity occurs in its Illinois and Missouri markets, with the remainder in the Indiana and Florida markets.

The Company utilizes a loan grading scale to assign a risk grade to all of its loans. A description of the general characteristics of each grade is as follows:

Pass- This category includes loans that are all considered strong credits, ranging from investment or near investment grade, to loans made to borrowers who exhibit credit fundamentals that exceed industry standards and loan policy guidelines and loans that exhibit acceptable credit fundamentals.

Watch- This category includes loans on management’s “Watch List” and is intended to be utilized on a temporary basis for a pass grade borrower where a significant risk-modifying action is anticipated in the near future.

Special mention- This category is for “Other Assets Specially Mentioned” loans that have potential weaknesses, which may, if not checked or corrected, weaken the asset or inadequately protect the Company’s credit position at some future date.

Substandard- This category includes “Substandard” loans, determined in accordance with regulatory guidelines, for which the accrual of interest has not been stopped. 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 the deficiencies are not corrected.

Doubtful- This category includes “Doubtful” loans that have all the characteristics of a “Substandard” loan with additional factors that make collection in full highly questionable and improbable. Such loans are placed on non-accrual status and may be dependent on collateral with a value that is difficult to determine.

All loans are graded at their inception. Most commercial lending relationships that are $1.0 million or less are processed through an expedited underwriting process. If the credit receives a pass grade, it is aggregated into a homogenous pool of either: $0.35 million or less, or $0.35 million to $1.0 million. These pools are monitored on a regular basis and reviewed annually. Most commercial loans greater than $1.0 million are included in a portfolio review at least annually. Commercial loans greater than $0.35 million that have a grading of special mention or worse are reviewed on a quarterly basis. Interim reviews may take place if circumstances of the borrower warrant a more timely review.

Portfolio loans in the highest grades, represented by the pass and watch categories, totaled $5.3 billion at June 30, 2018 and December 31, 2017. Portfolio loans in the lowest grades, represented by the special mention, substandard and doubtful categories, totaled $237.2 million at June 30, 2018, compared to $193.8 million at December 31, 2017.

The following table is a summary of risk grades segregated by category of portfolio loans (excluding accretable purchase accounting adjustments and clearings) (dollars in thousands):

	June 30, 2018
	Pass		Watch		Special Mention		Substandard		Doubtful

Commercial	$	1,192,414	$	137,423	$	43,455	$	65,337	$	9,135
Commercial real estate	2,127,522		147,242		36,408		46,430		8,597
Real estate construction	252,778		15,644		3,846		3,257		23
Retail real estate	1,417,838		8,401		7,933		5,316		7,385
Retail other	29,787		—		7		27		75

Total	$	5,020,339	$	308,710	$	91,649	$	120,367	$	25,215

	December 31, 2017
	Pass		Watch		Special Mention		Substandard		Doubtful

Commercial	$	1,175,421	$	141,776	$	51,366	$	43,933	$	5,285
Commercial real estate	2,169,420		130,056		21,151		36,482		11,997
Real estate construction	212,952		41,292		3,880		3,071		608
Retail real estate	1,436,156		6,883		5,162		4,135		6,714
Retail other	28,300		9		—		7		20

Total	$	5,022,249	$	320,016	$	81,559	$	87,628	$	24,624

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of the principal due. Loans may be returned to accrual status when all of the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

A summary of portfolio loans that are past due and still accruing or on a non-accrual status is as follows (dollars in thousands):

	June 30, 2018
	Loans past due, still accruing						Non-accrual
	30-59 Days		60-89 Days		90+Days		Loans
Commercial	$	122	$	—	$	—	$	9,135
Commercial real estate	1,504		349		750		8,597
Real estate construction	599		123		—		23
Retail real estate	6,093		1,177		390		7,385
Retail other	47		3		2		75

Total	$	8,365	$	1,652	$	1,142	$	25,215

	December 31, 2017
	Loans past due, still accruing						Non-accrual
	30-59 Days		60-89 Days		90+Days		Loans
Commercial	$	1,615	$	323	$	1,808	$	5,285
Commercial real estate	1,856		2,737		—		11,997
Real estate construction	—		—		—		608
Retail real estate	4,840		1,355		933		6,714
Retail other	166		5		—		20

Total	$	8,477	$	4,420	$	2,741	$	24,624

A loan is classified as impaired when, based on current information and events, it is probable the Company will be unable to collect scheduled principal and interest payments when due according to the terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans graded substandard or doubtful and loans classified as a troubled debt restructuring (“TDR”) are reviewed by the Company for potential impairment.

Impairment is measured on a loan-by-loan basis for commercial and construction loans based on the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. PCI loans are considered impaired. Large groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment unless such loans are the subject of a restructuring agreement.

The gross interest income that would have been recorded in the three and six months ended June 30, 2018 if impaired loans had been current in accordance with their original terms was $0.3 million and $0.7 million, respectively. The gross interest income that would have been recorded in the three and six months ended June 30, 2017 if impaired loans had been current in accordance with their original terms was $0.2 million and $0.5 million, respectively. The amount of interest collected on those loans and recognized on a cash basis that was included in interest income was insignificant for the three and six months ended June 30, 2018 and 2017.

The Company’s loan portfolio includes certain loans that have been modified in a TDR, where concessions have been granted to borrowers who have experienced financial difficulties. The Company will restructure a loan for its customer after evaluating whether the borrower is able to meet the terms of the loan over the long term, though unable to meet the terms of the loan in the near term due to individual circumstances.

The Company considers the customer’s past performance, previous and current credit history, the individual circumstances surrounding the customer’s current difficulties and the customer’s plan to meet the terms of the loan in the future prior to restructuring the terms of the loan. Generally, restructurings consist of short-term interest rate relief, short-term principal payment relief, short-term principal and interest payment relief or forbearance (debt forgiveness). Once a restructured loan exceeds 90 days past due or is placed on non-accrual status, it is classified as non-performing. A summary of restructured loans is as follows (dollars in thousands):

	June 30, 2018		December 31, 2017

In compliance with modified terms	$	9,096	$	9,873
30 — 89 days past due	22		108
Included in non-performing loans	1,734		1,919

Total	$	10,852	$	11,900

All TDRs are considered to be impaired for purposes of assessing the adequacy of the allowance for loan losses and for financial reporting purposes. When the Company modifies a loan in a TDR, it evaluates any possible impairment similar to other impaired loans based on present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. If the Company determines that the fair value of the TDR is less than the recorded investment in the loan, impairment is recognized through an allowance estimate in the period of the modification and in periods subsequent to the modification.

Performing loans classified as a TDR during the three and six months ended June 30, 2018 included one retail real estate modification for short-term interest rate relief, with a recorded investment of $0.1 million. Performing loans classified as TDRs during the three and six months ended June 30, 2017 included one commercial modification for short-term principal payment relief, with a recorded investment of $1.6 million and one retail real estate modification for short-term interest rate relief, with a recorded investment of $0.3 million.

The gross interest income that would have been recorded in the three and six months ended June 30, 2018 and 2017 if performing TDRs had been performing in accordance with their original terms compared with their modified terms was insignificant.

There were no TDRs that were entered into during the last twelve months that were subsequently classified as non-performing and had payment defaults (a default occurs when a loan is 90 days or more past due or transferred to non-accrual) during the three and six months ended June 30, 2018. There were no TDRs that were entered into during the prior twelve months that were subsequently classified as non-performing and had payment defaults during the three and six months ended June 30, 2017.

The following tables provide details of impaired loans, segregated by category. The unpaid contractual principal balance represents the recorded balance prior to any partial charge-offs. The recorded investment represents customer balances net of any partial charge-offs recognized on the loan. The average recorded investment is calculated using the most recent four quarters (dollars in thousands).

	June 30, 2018
	Unpaid Contractual Principal Balance		Recorded Investment with No Allowance		Recorded Investment with Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment

Commercial	$	11,787	$	6,932	$	2,343	$	9,275	$	1,272	$	9,386
Commercial real estate	16,614		12,029		3,494		15,523		1,246		17,423
Real estate construction	440		415		—		415		—		836
Retail real estate	17,029		14,171		25		14,196		25		14,244
Retail other	162		78		—		78		—		46

Total	$	46,032	$	33,625	$	5,862	$	39,487	$	2,543	$	41,935

	December 31, 2017
	Unpaid Contractual Principal Balance		Recorded Investment with No Allowance		Recorded Investment with Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment

Commercial	$	10,604	$	7,192	$	191	$	7,383	$	138	$	10,184
Commercial real estate	22,218		16,472		1,964		18,436		704		15,195
Real estate construction	1,040		1,016		—		1,016		—		692
Retail real estate	18,517		14,957		25		14,982		25		13,009
Retail other	40		20		—		20		—		44

Total	$	52,419	$	39,657	$	2,180	$	41,837	$	867	$	39,124

Management’s evaluation as to the ultimate collectability of loans includes estimates regarding future cash flows from operations and the value of property, real and personal, pledged as collateral. These estimates are affected by changing economic conditions and the economic prospects of borrowers.

Allowance for Loan Losses

The allowance for loan losses represents an estimate of the amount of probable losses believed to be inherent in the Company’s loan portfolio at the Consolidated Balance Sheet date. The allowance for loan losses is calculated geographically, by class of loans. The allowance calculation involves a high degree of estimation that management attempts to mitigate through the use of objective historical data where available. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Overall, the Company believes the allowance methodology is consistent with prior periods and the balance was adequate to cover the estimated losses in the Company’s loan portfolio at June 30, 2018 and December 31, 2017.

The general portion of the Company’s allowance contains two components: (i) a component for historical loss ratios, and (ii) a component for adversely graded loans. The historical loss ratio component is an annualized loss rate calculated using a sum-of-years digits weighted 20-quarter historical average.

The Company’s component for adversely graded loans attempts to quantify the additional risk of loss inherent in the special mention and substandard portfolios. The substandard portfolio has an additional allocation of 3.0% placed on such loans, which is an estimate of the additional loss inherent in these loan grades based upon a review of overall historical charge-offs. As of June 30, 2018, the Company believed this reserve remained adequate. Special mention loans have an additional allocation of 1.0% placed on such loans, which is an estimate of the additional loss inherent in these loan grades. As of June 30, 2018, the Company believed this reserve remained adequate.

The specific portion of the Company’s allowance relates to loans that are impaired, which includes non-performing loans, TDRs and other loans determined to be impaired. Impaired loans are excluded from the determination of the general allowance for non-impaired loans and are allocated specific reserves as discussed above. Impaired loans are reported at the fair value of the underlying collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Collateral values are estimated using a combination of observable inputs, including recent appraisals discounted for collateral specific changes and current market conditions, and unobservable inputs based on customized discounting criteria.

The general reserve quantitative allocation that is based upon historical charge off rates is adjusted for qualitative factors based on current general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) Management & Staff; (ii) Loan Underwriting, Policy and Procedures; (iii) Internal/External Audit & Loan Review; (iv) Valuation of Underlying Collateral; (v) Macro and Local Economic Factors; (vi) Impact of Competition, Legal & Regulatory Issues; (vii) Nature and Volume of Loan Portfolio; (viii) Concentrations of Credit; (ix) Net Charge-Off Trends; and (x) Non-Accrual, Past Due and Classified Trends. Management evaluates the probable impact from the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Based on each component’s risk factor, a qualitative adjustment to the reserve may be applied to the appropriate loan categories. The Company monitors its qualitative factors on a quarterly basis.

The Company holds acquired loans from business combinations with uncollected principal balances. These loans are carried net of a fair value adjustment for credit risk and interest rates and are only included in the allowance calculation to the extent that the reserve requirement exceeds the fair value adjustment. As the acquired loans renew, it is generally necessary to establish an allowance, which represents an amount that, in management’s opinion, will be adequate to absorb probable credit losses in such loans. The balance of all acquired loans as of June 30, 2018 totaled approximately $1.5 billion.

The following table details activity in the allowance for loan losses. Allocation of a portion of the allowance to one category does not preclude its availability to absorb losses in other categories (dollars in thousands):

	As of and for the Three Months Ended June 30, 2018
	Commercial			Commercial Real Estate			Real Estate Construction		Retail Real Estate			Retail Other			Total
Beginning balance	$	17,577		$	22,090		$	2,799	$	9,836		$	347		$	52,649
Provision for loan loss	1,720			909			35		(548		)	142			2,258
Charged-off	(1,916		)	(110		)	—		(412		)	(115		)	(2,553		)
Recoveries	205			158			81		417			90			951

Ending Balance	$	17,586		$	23,047		$	2,915	$	9,293		$	464		$	53,305

	As of and for the Six Months Ended June 30, 2018
	Commercial			Commercial Real Estate			Real Estate Construction			Retail Real Estate			Retail Other			Total
Beginning balance	$	14,779		$	21,813		$	2,861		$	13,783		$	346		$	53,582
Provision for loan loss	4,723			2,445			37			(4,210		)	271			3,266
Charged-off	(2,697		)	(1,425		)	(97		)	(942		)	(322		)	(5,483		)
Recoveries	781			214			114			662			169			1,940

Ending Balance	$	17,586		$	23,047		$	2,915		$	9,293		$	464		$	53,305

	As of and for the Three Months Ended June 30, 2017
	Commercial			Commercial Real Estate			Real Estate Construction			Retail Real Estate			Retail Other			Total
Beginning balance	$	13,260		$	19,848		$	2,021		$	12,978		$	335		$	48,442
Provision for loan losses	(1,572		)	1,279			(197		)	1,020			(30		)	500
Charged-off	(78		)	(1,101		)	(48		)	(641		)	(93		)	(1,961		)
Recoveries	1,318			98			385			324			95			2,220

Ending balance	$	12,928		$	20,124		$	2,161		$	13,681		$	307		$	49,201

	As of and for the Six Months Ended June 30, 2017
	Commercial			Commercial Real Estate			Real Estate Construction			Retail Real Estate			Retail Other			Total
Beginning balance	$	13,303		$	20,623		$	1,870		$	11,648		$	351		$	47,795
Provision for loan losses	(2,221		)	1,059			(63		)	2,240			(15		)	1,000
Charged-off	(181		)	(1,689		)	(48		)	(1,092		)	(183		)	(3,193		)
Recoveries	2,027			131			402			885			154			3,599

Ending balance	$	12,928		$	20,124		$	2,161		$	13,681		$	307		$	49,201

The following table presents the allowance for loan losses and recorded investments in portfolio loans by category (dollars in thousands):

	As of June 30, 2018
	Commercial		Commercial Real Estate		Real Estate Construction		Retail Real Estate		Retail Other		Total
Amount allocated to:
Loans individually evaluated for impairment	$	1,272	$	1,246	$	—	$	25	$	—	$	2,543
Loans collectively evaluated for impairment	16,314		21,801		2,915		9,268		464		50,762

Ending balance	$	17,586	$	23,047	$	2,915	$	9,293	$	464	$	53,305


Loans:
Loans individually evaluated for impairment	$	8,846	$	13,173	$	415	$	12,926	$	78	$	35,438
Loans collectively evaluated for impairment	1,436,786		2,339,702		274,552		1,435,280		29,480		5,515,800
PCI loans evaluated for impairment	429		2,350		—		1,270		—		4,049

Ending balance	$	1,446,061	$	2,355,225	$	274,967	$	1,449,476	$	29,558	$	5,555,287

	As of December 31, 2017
	Commercial		Commercial Real Estate		Real Estate Construction		Retail Real Estate		Retail Other		Total
Amount allocated to:
Loans individually evaluated for impairment	$	138	$	704	$	—	$	25	$	—	$	867
Loans collectively evaluated for impairment	14,641		21,109		2,861		13,758		346		52,715

Ending balance	$	14,779	$	21,813	$	2,861	$	13,783	$	346	$	53,582


Loans:
Loans individually evaluated for impairment	$	6,572	$	11,491	$	435	$	12,673	$	20	$	31,191
Loans collectively evaluated for impairment	1,407,248		2,336,248		260,490		1,445,819		27,858		5,477,663
PCI loans evaluated for impairment	811		6,945		581		2,309		—		10,646

Ending balance	$	1,414,631	$	2,354,684	$	261,506	$	1,460,801	$	27,878	$	5,519,500