Good morning, and thank you for joining Bank of Marin Bancorp's Earnings Call for the Third Quarter ended September 30, 2022. I'm Andrea Henderson, Director of Marketing for Bank of Marin. [Operator Instructions] This conference call is being recorded on October 24, 2022.

Joining us on the call today are Tim Myers, President and CEO; and Tani Girton, Executive Vice President and Chief Financial Officer. Our earnings press release, which we issued this morning, can be found on our website at bankofmarin.com, where this call is also being webcast.

Before we get started, I want to note that we will be discussing some non-GAAP financial measures on the call. Please refer to the reconciliation table on Page 3 of our earnings press release for both GAAP and non-GAAP measures.

Additionally, the discussion on this call is based on information we know as of Friday, October 21, 2022, and may contain forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those set forth in such statements.

For a discussion of these risks and uncertainties, please review the forward-looking statements disclosure in our earnings press release as well as our SEC filings. Following our prepared remarks, Tim and Tani will be available to answer your questions. And now, I'd like to turn the call over to Tim Myers..

Thank you, Andrea. Good morning, everyone, and welcome to our call. Our record third quarter results highlighted our unwavering commitment to disciplined fundamentals. Our balanced and measured approach supported solid loan originations, excellent credit quality and improved efficiency.

We also continued to benefit from ongoing earnings accretion from our 2021 acquisition of American River Bank. We remain focused on building long-term customer relationships based on great service and local market expertise. As such, with rates rising, our funding costs have remained low as our customers continue to value our high-touch approach.

We have an exceptionally strong base of core non-interest bearing deposits that allows us to grow methodically and efficiently while delivering consistent performance in all rate environments. More than half of total deposits were non-interest bearing as of September 30.

While our cost of deposits was flat, rising rates positively impacted our earning asset portfolio, increasing our net interest margin by 11 basis points in the third quarter. Positive loan origination trends persisted in the quarter on a year-over-year basis. We grew our core loan portfolio, boosted net interest income and expanded our margins.

Excluding PPP, our loans were up $5.1 million in the quarter, offset primarily by payoffs related to construction project completion. We generated $52 million in originations in the quarter, up 60% from the year earlier quarter. Our year-to-date originations of $204 million double what we produced during the first nine months of 2021.

That noted, we are seeing some easing in demand in certain segments of our business as rising rates impact borrowing costs and borrower sentiment. We are mindful of recessionary concerns, but from where we sit today, we are cautiously optimistic about the economic health of our markets through the remainder of the year.

Additionally, our excellent asset quality and strong credit culture position us well to weather any slowdown. In fact, our credit quality continues to improve, with classified loans down almost 10% and non-accrual loans representing just 0.5% of total loans.

Subsequent to quarter end, $7.1 million in long-standing substandard loans paid off, and this will lead to further improvement in our credit metrics. As a result, there are no longer any pandemic-related payment relief loans on our books. Now, I'll turn to some final highlights from the third quarter.

We delivered record net income of $12.2 million compared to $11.1 million in the second quarter. Diluted earnings per share of $0.76 compared to $0.69 in the second quarter. We are realizing the expected earnings accretion from the American River Bank acquisition and remain on track to meet the targets announced when the merger became public.

With 53% of total deposits being non-interest bearing, the average cost of deposits was just 6 basis points, unchanged from the prior quarter and better by 1 basis point on a year-to-date basis.

With rates rising, we anticipate that deposit costs will increase in the coming quarters, but we expect a gradual shift, and we will carefully manage this on a customer-specific basis. Given the enduring strength of our financial performance, our Board of Directors declared a quarterly cash dividend of $0.25 per share payable on November 14, 2022.

This represents the 70th consecutive quarterly dividend paid by Bank of Marin Bancorp. Now, I'll turn the call over to Tani to discuss our financial results in greater detail..

Thank you, Tim. Good morning. Our third quarter earnings translated into a return on assets of 1.11% and return on equity of 11.65%, up from 1.03% and 10.74% in the second quarter. Net interest income totaled $33 million in the third quarter compared to $31.2 million in the second quarter.

The increase was primarily driven by higher average balances and yields on investment securities that added $1.4 million in interest income, while our cost of deposits remained flat. Year-to-date, net interest income of $94 million was more than 25% higher than the first three quarters of 2021.

This demonstrates the value added by our acquisitions, other deposit growth and higher interest rates, which overwhelmed the $6 million decline in PPP income year-over-year.

Other changes during the third quarter included increases in cash and deposit balances as network deposits were returned to the balance sheet to replenish expected deposit outflow. Also, stockholders' equity decreased due to market value adjustments to the available for sale investment portfolio, partially offset by earnings.

As Tim highlighted, our third quarter tax equivalent net interest margin improved 11 basis points, driven by higher average balances and yields on interest-earning assets and a stable cost of funds. We recognized $260,000 in PPP fees during the quarter, down from $573,000 in the second quarter.

At the end of the third quarter, our loan portfolio had only $7.6 million remaining in PPP loans, net of $161,000 in unrecognized fees and costs. There was a provision for credit losses on loans of $422,000 in the third quarter compared to no provision in the second quarter.

The provision this quarter was primarily due to an increase in qualitative factors to account for the ongoing deterioration in the economic outlook not captured in the quantitative portion of the allowance. There was no provision for credit losses on unfunded commitments in either the third or second quarter.

Third quarter non-interest income was consistent with the second quarter at $2.7 million, with some line items increasing and others showing modest declines.

Of note, we took the opportunity to replace some short-term lower-yielding securities in the investment portfolio with higher-yielding investments, which generated the $63,000 loss on sale of investment securities. That loss will be recovered before year-end with the additional yield on the new investments.

Non-interest expense of $18.7 million in the third quarter was down $200,000 from the second quarter. Charitable contributions were down as grant funding related to the bank's corporate giving program substantially occurs in the second quarter.

Additionally, there was a $345,000 valuation adjustment to other real estate owned based on a recent appraisal. Finally, a favorable resolution on a vendor contract termination fee in the third quarter resulted in a partial reversal of amounts accrued in the second quarter, reducing expenses by $200,000 quarter-over-quarter.

As we continue to integrate and build on our most recent acquisitions, efficiency ratio illustrates - integrate and build on our most recent acquisition, the efficiency ratio illustrate [technical difficulty] quarter and year-to-date respectively, both improved from 55.7% in the prior quarter and 65.7% in the first 9 months of 2021, as there were substantially more acquisition-related expenses in the comparable period.

The improvements on a non-GAAP basis were 257 basis points quarter-over-quarter and 433 basis points year-over-year. All capital ratios were above well-capitalized regulatory requirements.

The total risk-based capital ratio for Bancorp was 15.1% at September 30 compared to 14.7% at June 30, and the bank's total risk-based capital ratio was 14.7% at September 30 compared to 14.2% at June 30.

September 30, tangible common equity of 7.5% for Bancorp and 7.3% for Bank of Marin were down 24 and 53 basis points respectively due to a $22 million increase in after-tax unrealized losses on available-for-sale securities associated with rising interest rates during the third quarter, partially offset by earnings.

Overall, Bank of Marin's strong balance sheet, liquidity and capital continue to generate profitability across interest rate and economic cycles, and enable us to execute on strategic initiatives going forward. With that, I'll turn it back to Tim to share some final comments..

Thank you, Tani. We believe that Bank of Marin is well positioned to build upon our long track record of delivering strong and consistent performance and attractive returns to our shareholders throughout all cycles.

We have a well-established franchise built upon a disciplined banking model, one of the lowest cost deposit bases in the sector and a carefully-constructed loan portfolio and solid credit quality.

We are focused on deepening relationships with long-standing clients and continuing to expand our commercial lending to new clients across Northern California. While we know that excellent in-person service and financial expertise of our bankers will always be vital, we also know that customers increasingly manage their finances online.

As a result, we continuously evaluate enhanced digital offerings. By optimizing our delivery channels, we will continue to identify cost-saving opportunities to offset potential investments in technology. In closing, I want to thank everyone on today's call for your interest and support. We will now open the call to your questions..

[Operator Instructions] Our first question comes from Matthew Clark with Piper Sandler. Please proceed..

Hi, good morning..

Good morning, Matthew..

Thank you, Tim..

Good morning.

How are you?.

Good, thanks. Maybe just starting on deposit pricing, it sounds like you're starting to see a little bit of pressure. Obviously, costs were unchanged this quarter.

But, I guess, what are you assuming for your deposit beta through the cycle at this point when you budget?.

So the deposit beta is much - we haven't changed our assumption since we last published it. We brought it down to closer to our historical betas but not quite all the way. The historical betas were running a little over 20%, but the model betas are a little higher than that. We do understand that we're in a different environment.

We do see competitors raising their rates and we are hearing a little bit of noise, so we will continue to evaluate a rate change request on a relationship-by-relationship basis. It's really about the whole relationship, not about sort of raising rates across the board, so..

Yes. And I would just say that the runoff that we did show of net bringing stuff back on the balance sheet was really both - sorry, the result of significant deposit customers and their seasonal or normal course of business. So it was not deposit outflow due to our lagging in raising rates.

We will raise categories where prudent, but as Tani said, we'll look at all these relationships on a case-by-case basis and be prudent about it. But we continue to believe we can manage that with our strong non-interest bearing base..

Okay.

And then 20% historical, is that interest-bearing? Or is that total deposit cost like double check, but --?.

Yes, that was total..

Okay, okay. And then just on rates on new loans, I guess how are they trending here on the third quarter and even in the fourth? Trying to get a sense for the weighted average rate on new production..

Yes, they're trending up. There are some categories that will trend up faster in the fourth quarter. If you look at, I think, the loans that came on in the quarter, we're up in every category but one versus the prior quarter. We just had some high ups.

That's - it's a finite pool so it's affected by individual examples, but we had a couple of loans that paid off that were a higher rate. So the loans that paid off were actually 10 basis points higher on a dollar weighted average than the loans that came on. But if you look at it on a category-by-category basis, we are trending up in every category..

Okay.

And then Tani, do you happen to have the monthly NIM monthly margin in September?.

You want the September net interest margin?.

If you had it..

Why don't you go ahead and I'll give you that. I just have to pull it out..

Sure. And then maybe, Tim, back on loan growth, loan balance is down a little bit.

I guess, what are your thoughts on production basically got cut in half? It sounds like demand has obviously slowed for obvious reasons, but I guess what's your sense for net loan growth going forward? I mean, do you feel like you can kind of hold the line or do you feel like we might shrink a little bit?.

So we feel positive. I mean, I look at it a little bit differently. Ex the payoffs and PPP, loans were up slightly. And I'm not trying to overemphasize it's slightly up, but the production was up $20 million over last year's quarter. Yes, it was down on a linked quarter basis.

But like a lot of people in the industry, that prior quarter had a lot of pull-through because of rates. And so our pipeline, we're happy with the pipeline going into the fourth quarter.

If you look at the payoffs that we've had, $169 million of commercial loan payoffs year-to-date, $105 million of that were in categories that really aren't controllable. Asset sales, cash deleveraging or deleveraging with cash and project completions.

And so sometimes it takes some time to bring some of that back on, for example, when the construction loans pay off, those tend to be lumpy. We brought in $13 million of payoffs last quarter, but we brought in $18 million of new loans, 12 of them not committed or not used yet. So we feel good about where we're at in terms of trends.

It's just unfortunately, we can't predict the timing of these payoffs but we don't expect them to continue at that pace. There's no reason to believe, but it did have an unfortunate offset to what's been really, really good loan production this year..

Okay. And then last one for me. Just on the bump up in non-accruals, the five new credits, I think three of them are related.

Just can you give us a situation there and any plans for resolution, including any potential loss content?.

I'm sorry, Matthew. I was going through my notes.

Can you repeat your question again?.

Sure. I just want to touch on the five new credits on non-accrual. I think three of them are related to one relationship. I just wanted to get a sense of what the situation is there, and plans for resolution..

Yes. So that, to some extent, was a pandemic impact customer. However, that customer is exploring, selling assets and reducing our debt, so we have a plan for that. But the biggest one in that category was, frankly, the one that happened as a subsequent event because that loan has been in that category for a long, long time.

So getting that monkey off our back was great..

Thank you..

So Matthew, going back to your question. Let's go with roughly 5 basis points higher than third quarter NIM for September..

Great. Thanks again..

Our next question comes from Jeff Rulis with D.A. Davidson. Please proceed..

Thanks. Good morning..

Good morning, Jeff..

Good morning..

Just a few follow-ups on a couple of those topics. Tim, I - while the originations may be down linked quarter, certainly the payoff activity, difficult to forecast, but that was down meaningfully.

And I just wanted to get your sense, and that's a tough number to peg, but given where we are with rates, do you think that that headwind going forward - I mean, the trend linked quarter was down quite a bit.

How has that translated into the fourth quarter and your expectations for payoffs in, call it, '23 on a relative basis to '22?.

Well, that is a tough one to predict, Jeff. I mean, we feel good about our pipeline going into the fourth quarter. We do have some payoffs that we know we're going to have, but by and large, there's no reason to believe. I think overall, outside some specific cases, the rate environment is going to affect sales.

Not dissimilar to how it's affecting everyone's pipeline activity, which is people taking a pause because borrowing costs are way up. And certainly, we're seeing that in fixed rate commercial real estate lending. Rates aren't historically high in the bigger scheme of things, so we think activity will continue.

It's just hard to predict how long people sit on the sidelines. So yes, demand is down from where it was in Q2. We don't, outside those specific payoffs, have any reason to believe they're going to continue at the pace that they have, and we're going to continue originating loans.

And like I said, loans have a bit of a seasonal character for us, and we feel good about where we were this quarter relative to the same period last year. And our - I guess, what's the word, tentatively optimistic about the fourth quarter net growth..

Got it. And then just looking at the - within on the funding side, I guess a little surprised that the average rate on money market came in linked quarter that was down.

Is there anything going on with that balance that that would be sequentially lower?.

So we have some customers that have seasonality to their own businesses with high inflows and outflows. And one of those customers had significant outflows during the quarter, and they had significant balances in money market..

Okay. Fair enough. And then - just the last one on the subsequent payoffs.

Again, what type - any detail on the type of loans that were paid off within that $7 million?.

That was one loan. It was a - one of the pandemic payment relief loans, but it also has been a substandard for many years and non-accrual for some time. I'd rather not give specifics on the type of business, but the business was sold and as this was sold, then we will pay it off..

Is there any recoveries or relative to the mark, anything that we can expect in fourth quarter? The balance is coming down, but anything else tied to that?.

Not to that one, no..

Okay. All right, I'll step back. Thank you..

Our next question comes from David Feaster with Raymond James. Please proceed..

Hi. Good morning, everybody..

Good morning, David..

I don't want to beat the loan side of debt, but I just want to get your sense on the pulse of the market.

Are you seeing - I mean, you talked about higher rates kind of starting to impact things, but are you seeing much change in demand, just given the uncertainty in the economic backdrop? And like you said, maybe some projects that just don't pencil and are falling out of the pipeline? And then just any commentary on the competitive landscape from your perspective? And if you could remind us of the seasonality in your loan portfolio, that would be helpful..

Yes, so that's a good question. There's a lot in there. There's no question the pipeline is down from what it was in Q1, Q2 and everyone was starting to get settled through, right? At those low rates, demand was very strong. We have seen a falloff in demand. We haven't seen a fall out because as you said, deals don't pencil out.

Meaning, credit quality of the things we're working on seems to be generally within our appetite. There's always ones we pass on, but they tend to follow the pipeline pretty quickly. So it's more the demand side. Again, we feel good about our prospects for net growth in Q4. We expect payouts to be down in the quarter linked.

Seasonality, I do tend to compare year-over-year. It's not always equal in it's seasonality, but you tend to have that really strong production quarters, lower production quarters, and there were a number of years where Q4 was just a blowout quarter from an origination standpoint.

So I do tend to look, and it's just positive when I look and say, okay, well, yes, it's down linked quarter because of the rate movements. We are up significantly over where we were last year, it means we're still doing a lot right. Nikki Sloan and her group are continue to drive really hard to build a strong pipeline.

Would I like it to be bigger? Yes, that is where I think the demand at these rate levels is affecting it. But there's nothing that leads me to believe we won't be able to be competitive. I think throughout the quarter, you saw - I would have liked to say our commercial loan rate yields go up more than they did.

But especially early in the quarter, there was a lot of competition that was sort of camping that down from going up at the rate the market rates were. So I think going into this quarter, that will be more on even footing..

Okay. That's good color. And then bringing some of the off-balance sheet deposits back. On balance sheet, we saw the liquidity position increase.

Just curious how you think about that near term? Would you expect to deploy that or - whether in the loans or securities? Or do you think you're reserving that for potential deposit flows, which it sounds like it was really more a function of seasonality? But just curious how you think about that..

Yes, exactly. So we tend to maintain a higher - a fairly high level of liquidity on the balance sheet because we do have some large customers that have big movements in their cash. So the movements of balances tend to be a little bit on the lumpy side. So that's what we were doing there.

The other thing is that as rates have increased, the earnings on the off-balance sheet deposits or with the deposit networks are not as competitive as they were.

And so to the extent that we have a little bit - we're leaning a little bit more towards investing in the securities portfolio as opposed to our balance sheet, that's to capture these higher yields..

Okay. That makes sense. And then staying on the securities book, you took a bit of securities actions in the quarter. You talked about the low earnbacks, makes all the sense in the world.

Just curious if there's - as you look at the securities book, are there other opportunities on the docket? And how do you think about the securities portfolio going forward? I mean, how are cash flows, quarterly cash flows? What are roll-off yield? And with those cash flows, are you likely to invest into the securities book or would you rather use that to potentially fund some of the loan growth?.

Well, we'll always fund the loan growth first. We've got healthy cash flows off of the investment portfolio. Depending on the rate scenario, they run from $75 million to $150 million a year. And so we have - with our loan-to-deposit ratio down in the mid-50s, we have plenty of room to grow the loan portfolio.

So our number one priority on the securities portfolio is to support loan growth, so to the extent we can redeploy that money into loans, we will do that. That said, it will take us a while probably to get back up to our desired loan-to-deposit ratio. And so in the meantime, we can use the loan - I mean, the securities portfolio.

And that's why we were able to transfer a significant portion to held to maturity back in March, because we do still have ample balances in the AFS portfolio..

Okay. That's helpful. Thanks everybody..

Thank you, David..

Next question comes from Andrew Terrell with Stephens. Please proceed..

Good morning, Andrew..

Good morning, Tim. Good morning, Tani..

If I could maybe just start going back to the margin. Tani, I think you mentioned the month of September was maybe 5 basis points above the 3Q average. I heard the commentary just around rising kind of deposit costs, but it sounds like the loan production is coming in at a better yield as well.

I'm just curious as you look out over the next kind of few quarters, do you think the margin can move higher from that, call it, low 320 level from here? Or will deposit costs mainly offset that potential expansion?.

I am optimistic that our margin will increase. We continue to be asset sensitive, and we continue to manage the deposit costs very closely. So I - if I had to make a projection, I'd say we're still moving in an upward - in an upward direction..

Yes, I agree with that. Again, if you look at the loans that came on versus loans that came off, the yields on those, some of the ones that went off were lumpy. Like in construction, those tend to have a higher rate that were - that was variable and went up with the market, and so it didn't have the same net impact we'd like.

New loans we've been funding in that group as well as other categories, we think will expand the yield side. We can't predict the timing of when deposit costs might increase. But as Tani said, we're being very cautious, and we're all optimistic about further NIM expansion..

Great. That's very helpful. Tani, I think maybe it was last quarter, you mentioned there might be some lingering cost saves coming out of - coming out of the American River deal.

Are those completely layered into the 3Q expense run rate at this point? And then I guess, just how should we be thinking about the cadence of expense growth into 2023, just given maybe what seems like a tougher macro backdrop?.

Yes, so we are not completely done with all of the ARB synergies. So there's more cost saves come - and again, this could - it could be a little lumpy to the extent that when we do initiate actions, there might be some upfront costs and then the follow-on savings. But obviously, the returns on those are pretty good, which is why we would do them.

Tim, did you want to add something to that? Okay. But I think I'd say the run rate, absent all of that activity, is the third quarter run rate is - it's a good proxy..

Okay, very good. And if I could, Tim, I saw there were no buybacks this quarter.

Just any update you can provide from a capital standpoint? How are you feeling about capital? Are you targeting, trying to grow the capital base from here? And then any appetite for buyback at this point?.

Yes. I would say right now, we continue to be cautious for capital - or leading towards capital preservation. It doesn't mean that as this progresses, that doesn't change. We continue to look at the impact of AOCI adjustments and potential opportunities out in the market and just continue to weigh all those.

But it's, by and large, a concept we're still committed to. It's more a matter of timing. And right now, we're still leaning towards the cautious capital preservation side for this quarter..

Yes, understood. Okay. Thanks for taking the question..

Thank you..

Our next question comes from Woody Lay from KBW. Please proceed..

Hi, good morning guys..

Good morning, Woody..

The non-accrual takes up, but that feels like a pretty one-time in nature event and they're still at a low level.

But just overall, how are you feeling about credit in your local markets?.

We feel good. Those moved over - there was three loans, I think, that moved over that were all tied to one relationship. Like I said, we expect some resolution relative on some of that. We feel very good about the large one that dropped off subsequent, that's been the big one there for a long time.

In a lot of our markets with a lot of our customers, we're not seeing a lot of signs of recessionary pressure on sales or rents. We continue to see pressure on office rents and occupancy in certain markets, and places like San Francisco remain a concern.

But we haven't seen material deterioration from prior quarters of some of the properties or issues we've already talked about..

Got it. And then you did increase the reserve just based on increasing some qualitative factors.

How do you think about the reserve going forward, especially just as unemployment rate remains below but there is a considerable amount of macro uncertainty?.

Well, there is, and that's a very good question because under the CECL model, an increase to the forecast Moody's unemployment rate in California and some of the other macro factors, which are frankly somewhat redundant, and the qualitative factors would drive that number up.

We spent a lot of time talking about that this quarter and feel comfortable with the reserve we took here. But there's no question that when that number moves, that's going to affect all of us using those qualitative factors in our provision..

I would add that to the extent that the underlying forecast starts to reflect that, that could lead to a reduction in the qualitative factors. Right now, we just feel that forecast is not quite onerous enough..

All right. That's good color. That's all from me. Thanks guys..

Thank you, Woody..

Thanks..

Our next question comes from Tim Coffey with Janney Montgomery Scott. Please proceed..

Hi, good morning everybody..

Good morning, Tim..

Good morning..

Tim, I appreciate your commentary on the local economies and what you're seeing in your footprint there. So most of my questions have been asked and answered already, but I just want to kind of circle the wagons on the deposit outlook. You have a lot of levers to pull to maintain a low deposit cost.

And I'm wondering, if we look out forward and recognize a really good quarter in deposit growth, do you anticipate deposit balances to be static to slightly down? Would that be the right way to think about them?.

I think it would, but our balances have been somewhat hard to predict. Like Tani has talked about, we have some large clients with some seasonal and sometimes as non-seasonal large inflows and outflows. And so the timing of that, I think we alluded to the large outflow we saw from one of those this quarter at the end of last quarter.

We don't always know exactly the timing of that, so it is hard to predict. But you're right, we have a lot of levers. We have a lot of liquidity.

It's a strong balance sheet Tani has managed, and Randy and the retail side of the bank are doing a really good job of managing this on an incremental case-by-case basis, and we'll just continue that approach. And we have to be fair with customers, but - and on our relationships, but we are being very cautious to manage the overall impact.

And if that shows a net runoff to some manageable extent, that might be the case. But it's really been hard to predict because we've had some big inflows as well from other ongoing business activities of existing clients..

Yes. I would add that what we do is we plan for it, and we've been planning for outflows for quite some time. And even after the financial crisis, we plan for outflows. But on a trend - historical trend basis, it's always gone up, and that's what we try to do.

But I think what's really important in this environment is we're really focused on rightsizing at the right price, so not bringing deposits in with pricing. It's really relationship-focused..

Okay. That's right. Great, that's very helpful color. Thank you very much..

There are no further questions at this time..

Well, thank you, everybody, for joining us on this call. If you have any questions and want to discuss further, please give me a ring. Thank you..

That does conclude the conference call for today. We thank you for your participation, and ask that you please disconnect your lines..