Macatawa Bank (MCBC) 10-K2023 FY Annual report

Forward-Looking Statements

This report contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and Macatawa Bank Corporation. Forward-looking statements are identifiable by words or phrases such as “outlook”, “plan” or “strategy”; that an event or trend “could”, “may”, “should”, “will”, “is likely”, or is “possible” or “probable” to occur or “continue”, has “begun” or “is scheduled” or “on track” or that the Company or its management “anticipates”, “believes”, “estimates”, “plans”, “forecasts”, “intends”, “predicts”, “projects”, or “expects” a particular result, or is “committed”, “confident”, “optimistic” or has an “opinion” that an event will occur, or other words or phrases such as “ongoing”, “future”, “signs”, “efforts”, “tend”, “exploring”, “appearing”, “until”, “near term”, “concern”, “going forward”, “focus”, “starting”, “initiative,” “trend” and variations of such words and similar expressions. Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, those related to future levels of earning assets, future composition of our loan portfolio, trends in credit quality metrics, future capital levels and capital needs, real estate valuation, future levels of repossessed and foreclosed properties and nonperforming assets, future levels of losses and costs associated with the administration and disposition of repossessed and foreclosed properties and nonperforming assets, future levels of loan charge-offs, future levels of other real estate owned, future levels of provisions for credit losses and reserve recoveries, the rate of asset dispositions, future dividends, future growth and funding sources, future cost of funds, future liquidity levels, future profitability levels, future interest rate levels, future net interest margin levels, the effects on earnings of changes in interest rates, future economic conditions, future effects of new or changed accounting standards, future loss recoveries, loan demand and loan growth, future amounts of unrecognized tax benefits and the future level of other revenue sources. Management's determination of the provision and allowance for credit losses, the appropriate carrying value of intangible assets (including deferred tax assets) and other real estate owned, and the fair value of investment securities involves judgments that are inherently forward-looking. All statements with references to future time periods are forward-looking. All of the information concerning interest rate sensitivity is forward-looking. Our ability to sell other real estate owned at its carrying value or at all, successfully implement new programs and initiatives, increase efficiencies, maintain our current levels of deposits and other sources of funding, maintain liquidity, respond to declines in collateral values and credit quality, respond to a changing interest rate environment, increase loan volume, originate high quality loans, maintain or improve mortgage banking income, realize the benefit of our deferred tax assets, continue payment of dividends and improve profitability is not entirely within our control and is not assured. The future effect of changes in the real estate, financial and credit markets and the national and regional economy on the banking industry, generally, and Macatawa Bank Corporation, specifically, are also inherently uncertain. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Macatawa Bank Corporation does not undertake to update forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.

Risk factors include, but are not limited to, the risk factors described in “Item 1A - Risk Factors” of this report. These and other factors are representative of the risk factors that may emerge and could cause a difference between an ultimate actual outcome and preceding forward-looking statements.

PART I

As used in this report, the terms "we," "us," "our,” ”Macatawa” and “Company” mean Macatawa Bank Corporation and its subsidiaries, unless the context indicates another meaning. The term "Bank" means Macatawa Bank.

Macatawa Bank Corporation is a Michigan corporation, incorporated in 1997, and is a registered bank holding company. It wholly owns Macatawa Bank, a Michigan chartered bank with depository accounts insured by the FDIC. The Bank operates twenty-six branch offices and a lending and operational service facility, providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan.

At December 31, 2023, we had total assets of $2.75 billion, total loans of $1.34 billion, total deposits of $2.42 billion and shareholders' equity of $287.1 million.  We recognized net income of $43.2 million in 2023 compared to net income of $34.7 million in 2022.  As of December 31, 2023, the Company’s and the Bank’s risk-based regulatory capital ratios were significantly above those required under the regulatory standards and the Bank continued to be categorized as “well capitalized” at December 31, 2023.

The Company paid a cash dividend of $0.08 per share for each quarter of 2022 and the first three quarters of 2023.  The Company paid a cash dividend of $0.09 for the fourth quarter of 2023.

Throughout 2022 and at the beginning of 2023, we were in a significant asset-sensitive position, so increases in short-term interest rates had a net positive impact on our net interest income as our interest-earning assets repriced faster than our interest-bearing liabilities; however, decreases in short-term interest rates would have had a net negative impact on net interest income.  At December 31, 2023, our interest rate risk position was far less asset-sensitive than it was twelve months prior.  As a result, if the Federal Reserve were to hold their rates steady or decrease them in the foreseeable future, the negative impact on our net interest income would be significantly lower than it would have been twelve months ago.  The aggressive rate increases by the Federal Reserve in 2022 and early 2023 to combat inflation have had a positive impact on our net interest income in 2023.

Over the past several years, our nonperforming asset levels have been low.  The following table reflects period end balances of these nonperforming assets as well as total loan delinquencies.

The following table reflects the provision for credit losses for the past three years along with certain metrics that impact the determination of the level of the provision for credit losses.

We recorded a provision for credit losses expense of $550,000 in 2023.  We recorded a provision for credit losses benefit of $1.1 million in 2022 and we recorded a provision for credit losses benefit of $2.1 million in 2021.  The level of provisions in each year was impacted by loan portfolio growth, recoveries from our collection efforts, and certain declines in our historical charge-off levels from prior years.  The provision in 2022 benefitted from reduction of certain COVID-19 qualitative adjustments.

Economic conditions in our market areas of Grand Rapids and Holland, Michigan were good during the several years leading up to the COVID-19 pandemic and have generally recovered from the second quarter 2020 low point caused by the pandemic and mitigation efforts.  The state of Michigan’s unemployment rate at the end of 2023 was 4.3%.  The Grand Rapids and Holland area unemployment rate was 2.6% at the end of 2023.

In the housing markets in our primary market areas strong purchase demand exists which has caused a shortage in the inventory of existing homes for sale.  In response, new living unit starts increased significantly in 2022.  While 2023 showed reductions in new living unit starts, prices still remain elevated. In the Grand Rapids market during 2023, total living unit starts were down 58% compared to 2022 as 2022 had very high growth in apartment units.  The Holland-Grand Haven/Lakeshore region showed living units starts down 16% in 2023 over 2022.  Generally speaking, residential housing property values have increased during 2023.

Commercial banking is an important focus for us. Most of our emphasis has been on growing commercial and industrial loans.  We saw strong growth in our commercial portfolio in 2023, but overall loan portfolio balances remain slightly below pre-pandemic levels (before 2020).

We have no material foreign loans, assets or activities. No material part of our business is dependent on a single customer or very few customers.  Our loan portfolio is not concentrated in any one industry.

Our internet website address is www.macatawabank.com.  We make available free of charge through this website our annual report on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after filing or furnishing such reports with the Securities and Exchange Commission.  The information on our website address is not incorporated by reference into this report, and the information on the website is not part of this report.

Products and Services

Loan Portfolio

We have historically offered a broad range of loan products to business customers, including commercial and industrial and commercial real estate loans, and to retail customers, including residential mortgage and consumer loans.  Select, well-managed loan renewal activity is taking place and we are seeing growth in our commercial loan portfolios and pipelines.  Following is a discussion of our various types of lending activities.

Commercial and Industrial Loans

Our commercial and industrial lending portfolio contains loans with a variety of purposes and security, including loans to finance operations and equipment. Generally, our commercial and industrial lending has been limited to borrowers headquartered, or doing business, in our primary market area.  These credit relationships typically require the satisfaction of appropriate loan covenants and debt formulas, and generally require that the Bank be the primary depository bank of the business.  These loan covenants and debt formulas are monitored through periodic, required reporting of accounts receivable aging schedules and financial statements, and in the case of larger business operations, reviews or audits by independent professional firms.

Commercial and industrial loans typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business.  As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself and economic conditions.  Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.

Commercial Real Estate Loans

Our commercial real estate loans consist primarily of construction and development loans and multi-family and other non-residential real estate loans.

Construction and Development Loans.   These consist of construction loans to commercial customers for the construction of their business facilities.  They also include construction loans to builders and developers for the construction of one- to four-family residences and the development of one- to four-family lots, residential subdivisions, condominium developments and other commercial developments.

This portfolio can be affected by job losses, declines in real estate value, declines in home sale volumes, and declines in new home building.  As such, we limit our exposure to residential land development and other construction and development loans.

Multi-Family and Other Non-Residential Real Estate Loans.   These are permanent loans secured by multi-family and other non-residential real estate and include loans secured by apartment buildings, condominiums, small office buildings, small business facilities, medical facilities and other non-residential building properties, substantially all of which are located within our primary market area.

Multi-family and other non-residential real estate loans generally present a higher level of risk than loans secured by owner occupied one- to four-family residences.  This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties and the increased difficulty of evaluating and monitoring these types of loans.  Furthermore, the repayment of these loans is typically dependent upon the successful operation of the related real estate project.  For example, if leases are not obtained or renewed, or a bankruptcy court modifies a lease term, or a major tenant is unable to fulfill its lease obligations, cash flow from the project will be reduced.   If cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired.

Retail Loans

Our retail loans are loans to consumers and consist primarily of residential mortgage loans and consumer loans.

Residential Mortgage Loans.   We originate construction loans to individuals for the construction of their residences and owner-occupied residential mortgage loans, which are generally long-term with either fixed or adjustable interest rates.  Our general policy is to sell the majority of our fixed rate residential mortgage loans in the secondary market due primarily to the interest rate risk associated with these loans.  In 2023, with the rising rate environment, more of the production was in adjustable rate loans which we hold in portfolio, and we also began holding more of our fixed rate production in portfolio given the higher rates.  For 2023, we retained loans representing 94% of the total dollar volume originated, compared to 63% in 2022.

Our borrowers generally qualify and are underwritten using industry standards for quality residential mortgage loans.  We do not originate loans that are considered "sub-prime".  Residential mortgage loan originations derive from a number of sources, including advertising, direct solicitation, real estate broker referrals, existing borrowers and depositors, builders and walk-in customers.  Loan applications are accepted at most of our offices and online. The substantial majority of these loans are secured by one-to-four family properties in our market area.

Consumer Loans.   We originate a variety of different types of consumer loans, including automobile loans, home equity lines of credit and installment loans, home improvement loans, deposit account loans and other loans for household and personal purposes.  We also originate home equity lines of credit utilizing the same underwriting standards as for home equity installment loans. Home equity lines of credit are revolving line of credit loans.  The majority of our existing home equity line of credit portfolio has variable rates with floors and ceilings, interest only payments and a maximum maturity of ten years.

The underwriting standards that we employ for consumer loans include a determination of the applicant's payment history on other debts and ability to meet existing obligations and payments on the proposed loan.  Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount.  Consumer loans may entail greater credit risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles.  In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.  In addition, consumer loan collections are dependent on the borrower's continuing financial stability and are more likely to be affected by adverse personal circumstances.  Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

Loan Portfolio Composition

The following table reflects the composition of our loan portfolio and the corresponding percentage of our total loans represented by each class of loans as of the dates indicated.

At December 31, 2023, there was no concentration of loans exceeding 10% of total loans which were not otherwise disclosed as a category of loans in the table above.

Maturities and Sensitivities of Loans to Changes in Interest Rates

The following table shows the amount of total loans outstanding at December 31, 2023 which, based on maturity dates, are due in the periods indicated.

Loan Loss Experience

A summary of our loan balances at the end of 2023 and 2022 and the daily average balances of these loans as well as changes in the allowance for credit losses arising from loans charged-off and recoveries on loans previously charged-off, and additions to the allowance which we have expensed is shown in Item 7 of this report under the headings "Portfolio Loans and Asset Quality" and “Allowance for Credit Losses” included in "Management's Discussion and Analysis of Results of Operations and Financial Condition."

Additional information about our allowance for credit losses, including a table showing the allocation of the allowance for credit losses at the end of 2023 and 2022 and the factors which influenced management’s judgment in determining the amount of the additions to the allowance charged to operating expense, may be found in Item 7 of this report under the heading "Allowance for Credit Losses" in "Management's Discussion and Analysis of Results of Operations and Financial Condition."

Deposit Portfolio

We offer a broad range of deposit services, including checking accounts, savings accounts and time deposits of various types.  Transaction accounts and savings and time certificates are tailored to the principal market area at rates competitive with those offered in the area.  All deposit accounts are insured by the FDIC up to the maximum amount permitted by law.

We solicit deposit services from individuals, businesses, associations, churches, nonprofit organizations, financial institutions and government authorities.  Deposits are gathered primarily from the communities we serve through our network of 26 branches.   We offer business and consumer checking accounts, regular and money market savings accounts, and certificates of deposit with many term options. We operate in a competitive environment, competing with other local banks similar in size and with significantly larger regional banks. We monitor rates at other financial institutions in the area to ascertain that our rates are competitive with the market.  We also attempt to offer a wide variety of products to meet the needs of our customers.  We set our deposit pricing to be competitive with other banks in our market area.

We may utilize alternative funding sources as needed, including short-term borrowings, advances from the Federal Home Loan Bank of Indianapolis or the Federal Reserve Bank of Chicago, securities sold under agreements to repurchase ("repo borrowings") and brokered deposits.  We had no brokered deposits or repo borrowings at December 31, 2023 or 2022.

Deposit Portfolio Composition

The following table sets forth the average deposit balances and the weighted average rates paid.

The following table summarizes deposits exceeding the FDIC insured limit of $250,000 by time remaining until maturity (dollars in thousands).

As of the date of this report, the Bank had no material foreign deposits.

Securities Portfolio

Our securities portfolio is classified as either "available for sale" or "held to maturity."  Securities classified as "available for sale" may be sold prior to maturity due to changes in interest rates, prepayment risks, and availability of alternative investments, or to meet our liquidity needs.

The primary objective of our investing activities is to provide for the safety of the principal invested. Our secondary considerations include the maximization of earnings, liquidity and to help decrease our overall exposure to changes in interest rates.  We have generally invested in bonds with lower credit risk, primarily those secured by government agencies or insured municipalities, to assist in the diversification of credit risk within our asset base.

We have not experienced any credit losses within our securities portfolio in 2023.

The following table reflects the composition of our securities portfolio as of the dates indicated (including securities available for sale and held to maturity at fair value and amortized cost, respectively).

At December 31, 2023, other than our holdings in U.S. Treasury and U.S. Government Agency securities, we had no investments in securities of any one issuer with an aggregate book value in excess of 10% of shareholders' equity.  At December 31, 2023, we had no securities of issuers outside of the United States.

Schedule of Maturities of Investment Securities and Weighted Average Yields

The following is a schedule of investment securities maturities and their weighted average yield by category at December 31, 2023.

Trust Services

We offer trust services to further provide for the financial needs of our customers.  As of December 31, 2023, the Trust Department managed assets of approximately $1.152 billion.  Our types of service include both personal trust and retirement plan services.

Our personal trust services include financial planning, investment management services, trust and estate administration and custodial services.  As of December 31, 2023, personal trust assets under management totaled approximately $625.8 million.  Our retirement plan services encompass all types of qualified retirement plans, including profit sharing, 401(k) and pension plans.  As of December 31, 2023, retirement plan assets under management totaled approximately $526.6 million.

Market Area

Our primary market area includes Ottawa, Kent and northern Allegan Counties, all located in western Michigan. This area includes two mid-sized cities, Grand Rapids and Holland, and rural areas. Grand Rapids is the second largest city in Michigan.  Holland is the largest city in Ottawa County. Both cities and surrounding areas have a solid and diverse economic base, which includes health and life sciences, tourism, office and home furniture, automotive components and assemblies, pharmaceutical, transportation, equipment, food and construction supplies.  Grand Valley State University, a 25,000-student regional university with more than 3,500 employees, has its three main campuses in our market area.  GVSU and several smaller colleges and university affiliates located in our market area help stabilize the local economy because they are not as sensitive to the fluctuations of the broader economy.  Companies operating in the market area include the Van Andel Institute, Steelcase, Herman Miller, Amway, Gentex, Corewell Health (previously Spectrum Health), Haworth, Wolverine World Wide, Johnson Controls, General Motors, Gerber, Magna, SpartanNash and Meijer.

Competition

There are many bank, thrift, credit union and other financial institution offices located within our market area.  Most are branches of larger financial institutions.  We also face competition from finance companies, insurance companies, mortgage companies, securities brokerage firms, money market funds and other providers of financial services.  Many of our competitors have been in business a number of years, have established customer bases, are larger and have higher lending limits than we do.  We compete for loans, deposits and other financial services based on our ability to communicate effectively with our customers, to understand and meet their needs and to provide high quality customer service.  Our management believes that our personal service philosophy, our local decision-making and diverse delivery channels enhances our ability to compete favorably in attracting individuals and small businesses.  We actively solicit customers by offering our customers personal attention, professional service, and competitive interest rates.

Human Capital

As of December 31, 2023, we had 314 full-time equivalent employees consisting of 287 full-time and 53 part-time employees.  We have assembled a staff of experienced, dedicated and qualified professionals whose goal is to meet the financial needs of our customers while providing outstanding service.  The majority of our management team has at least 10 years of banking experience, and several key personnel have more than 20 years of banking experience.  None of our employees are represented by collective bargaining agreements with us.

SUPERVISION AND REGULATION

The following is a summary of statutes and regulations affecting Macatawa Bank Corporation and Macatawa Bank. A change in applicable laws or regulations may have a material effect on us and our business.

The information under Item 1 – Business of this report is incorporated here by reference.

General

Financial institutions and their holding companies are extensively regulated under federal and state law. Consequently, our growth and earnings performance can be affected not only by management decisions and general economic conditions, but also by the statutes administered by, and the regulations and policies of, various governmental regulatory authorities.  Those authorities include, but are not limited to, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Consumer Financial Protection Bureau ("CFPB"), the FDIC, the State of Michigan’s Department of Insurance and Financial Services (“DIFS”), the Internal Revenue Service, and state taxing authorities. The effect of such statutes, regulations and policies can be significant, and cannot be predicted with a high degree of certainty.

Federal and state laws and regulations generally applicable to financial institutions and their holding companies regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, lending activities and practices, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and declaration and payment of dividends.  The system of supervision and regulation applicable to us and our bank establishes a comprehensive framework for our respective operations and is intended primarily for the protection of the FDIC's deposit insurance fund, our depositors, and the public, rather than our shareholders.

Federal law and regulations establish supervisory standards applicable to our lending activities, including internal controls, credit underwriting, loan documentation and loan-to-value ratios for loans secured by real property.

Macatawa Bank Corporation

General.  Macatawa Bank Corporation is registered as a bank holding company with, and subject to regulation by, the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended (the "BHCA").  Under the BHCA, Macatawa Bank Corporation is subject to periodic examination by the Federal Reserve Board, and is required to file with the Federal Reserve Board periodic reports of our operations and such additional information as the Federal Reserve Board may require.

In accordance with Federal Reserve Board policy, Macatawa Bank Corporation is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank.  In addition, if the DIFS deems the Bank's capital to be impaired, the DIFS may require the Bank to restore its capital by a special assessment upon Macatawa Bank Corporation as the Bank's sole shareholder.  If Macatawa Bank Corporation were to fail to pay any such assessment, the directors of the Bank would be required, under Michigan law, to sell all or part of the shares of the Bank's stock owned by Macatawa Bank Corporation to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the Bank's capital.

Investments and Activities.  In general, any direct or indirect acquisition by us of any voting shares of any bank which would result in our direct or indirect ownership or control of more than 5% of any class of voting shares of such bank, and any merger or consolidation between us and another bank holding company or financial holding company, will require the prior written approval of the Federal Reserve Board under the BHCA.

The merger or consolidation of the Bank with another bank, or the acquisition by the Bank of assets of another bank, or the assumption of liability by the Bank to pay any deposits of another bank, will require the prior written approval of the FDIC under the Bank Merger Act and DIFS under the Michigan Banking Code.  In addition, in certain such cases, an application to, and the prior approval of, the Federal Reserve Board under the BHCA may be required.

Capital Requirements.  The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies.  If capital falls below minimum guidelines, a bank holding company may, among other things, be denied approval to acquire or establish additional banks or non-bank businesses.

Additional information on our capital ratios may be found in Item 7 of this report under the heading "Capital Resources" included in "Management’s Discussion and Analysis of Results of Operations and Financial Condition" and in Item 8 of this report in the Notes to the Consolidated Financial Statements, and is here incorporated by reference.

Dividends.  Macatawa Bank Corporation is a corporation separate and distinct from the Bank.  Most of our revenues are dividends paid by the Bank.  Thus, Macatawa Bank Corporation's ability to pay dividends to our shareholders is indirectly limited by restrictions on the Bank's ability to pay dividends described below.  Further, in a policy statement, the Federal Reserve Board has expressed its view that a bank holding company should not pay cash dividends if its net income available to shareholders for the past four quarters, net of dividends paid during that period, is not sufficient to fully fund the dividends, its prospective rate of earnings retention is not consistent with capital needs and overall current and prospective financial condition, or it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.  The Federal Reserve Board possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.  Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.  Similar enforcement powers over our Bank are possessed by the FDIC.  The "prompt corrective action" provisions of federal law and regulation authorizes the FDIC to restrict the payment of dividends to Macatawa Bank Corporation by our Bank if the Bank fails to meet specified capital levels.

In addition, the Michigan Business Corporation Act provides that dividends may be legally declared or paid only if after the distribution a corporation can pay its debts as they come due in the usual course of business and its total assets equal or exceed the sum of its liabilities plus the amount that would be needed to satisfy the preferential rights upon dissolution of any holders of preferred stock whose preferential rights are superior to those receiving the distribution.

Additional information about restrictions on the payment of dividends by the Bank may be found in Item 8 of this report in Notes 1 and 18 to the Consolidated Financial Statements and is here incorporated by reference.

Federal Securities Regulation.   Our common stock is registered under the Securities Exchange Act of 1934, as amended (the "Exchange Act").  We are subject to the reporting, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.  We are subject to the Sarbanes-Oxley Act, which imposes numerous reporting, accounting, corporate governance and business practices on companies, as well as financial and other professionals who have involvement with the U.S. public markets.  We are generally subject to these requirements and applicable SEC rules and regulations.

Macatawa Bank

General.  Macatawa Bank is a Michigan banking corporation, and its deposit accounts are insured by the Deposit Insurance Fund (the "Insurance Fund") of the FDIC.  The Bank is subject to the examination, supervision, reporting and enforcement requirements of the DIFS, as the chartering authority for Michigan banks, and the FDIC, as administrator of the Insurance Fund.  These agencies, and the federal and state laws applicable to the Bank and its operations, extensively regulate various aspects of the banking business, including, among other things, permissible types and amounts of loans, investments and other activities, capital adequacy, branching, interest rates on loans and on deposits, the maintenance of noninterest bearing reserves on deposit accounts, and the safety and soundness of banking practices.

Deposit Insurance.  As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC.  The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of four categories and assessed insurance premiums, based upon their respective levels of capital and results of supervisory evaluation.  Institutions categorized as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium, while institutions that are categorized as less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern pay the highest premium.  Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.

The FDIC’s deposit insurance assessment base methodology uses average consolidated total assets less average tangible equity as the assessment base.  Under this calculation, most well capitalized banks will pay 5 to 9 basis points annually, increasing up to 35 basis points for banks that pose significant supervisory concerns.  This base rate may be adjusted for the level of unsecured debt and brokered deposits, resulting in adjusted rates ranging from 2.5 to 9 basis points annually for most well capitalized banks to 30 to 45 basis points for banks that pose significant supervisory concerns.  We estimate our annual assessment rate to be 5 basis points in 2024.

Capital Requirements.  The FDIC has established the following minimum capital standards for FDIC insured banks that are not relying on the Community Bank Leverage Ratio, such as the Bank:  a leverage requirement consisting of a ratio of Tier 1 capital to total average assets and risk-based capital requirements consisting of a ratio of total capital to total risk-weighted assets, a ratio of Tier 1 capital to total risk-weighted assets, and a ratio of common equity Tier 1 (CET1) capital to risk weighted assets.  Tier 1 capital consists principally of shareholders' equity.  Common equity Tier 1 capital excludes forms of stock that are not common stock.

Basel III.  The regulatory capital requirements include a common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which effectively results in a minimum CET1 ratio of 7.0%. The minimum ratio of Tier 1 capital to risk-weighted assets is 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5%), which effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer). The minimum leverage ratio is 4.0%.  The capital ratios for the Company and the Bank under Basel III continue to exceed the well capitalized minimum capital requirements.

Federal regulations define these capital categories as follows:

Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions.  Depending upon the capital category to which an institution is assigned, the regulators' corrective powers include:  requiring the submission of a capital restoration plan; placing limits on asset growth and restrictions on activities; requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; restricting transactions with affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and ultimately, appointing a receiver for the institution.

In general, a depository institution may be reclassified to a lower category than is indicated by its capital levels if the appropriate federal depository institution regulatory agency determines the institution to be otherwise in an unsafe or unsound condition or to be engaged in an unsafe or unsound practice.  This could include a failure by the institution, following receipt of a less-than-satisfactory rating on its most recent examination report, to correct the deficiency.

As of December 31, 2023, the Bank was categorized as “well capitalized” under the standards set forth in the rules implementing Basel III.   Additional information on our capital ratios may be found in Item 8 of this report in the Notes to the Consolidated Financial Statements, and is here incorporated by reference.

Dividends.  Under Michigan law, the Bank is restricted as to the maximum amount of dividends it may pay on its common stock.  The Bank may not pay dividends except out of net income after deducting its losses and bad debts. A Michigan state bank may not declare or pay a dividend unless the bank will have surplus amounting to at least 20% of its capital after the payment of the dividend.

Federal law generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized.  The FDIC may prevent an insured bank from paying dividends if the bank is in default of payment of any assessment due to the FDIC.  In addition, the FDIC may prohibit the payment of dividends by the Bank, if such payment is determined to be an unsafe and unsound banking practice.

Additional information about restrictions on payment of dividends by the Bank may be found in Item 8 of this report in Notes 1 and 19 to the Consolidated Financial Statements, and is here incorporated by reference.

Insider Transactions.  The Bank is subject to certain restrictions imposed by federal law on any extensions of credit to Macatawa or any subsidiary of Macatawa, on investments in the stock or other securities of Macatawa or any subsidiary of Macatawa and the acceptance of the stock or other securities of Macatawa or any subsidiary of Macatawa as collateral for loans.  Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to Macatawa's directors and officers, to our principal shareholders and to "related interests" of such directors, officers and principal shareholders.  In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of our company or any subsidiary or a principal shareholder in our company may obtain credit from banks with which the Bank maintains a correspondent relationship.

Safety and Soundness Standards.  The federal banking agencies have adopted guidelines to promote the safety and soundness of federally insured depository institutions.  These guidelines establish standards for, among other things, internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

Investments and Other Activities.  Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank.  Federal law, as implemented by FDIC regulations, also prohibits FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the Insurance Fund.  Impermissible investments and activities must be divested or discontinued within certain time frames set by the FDIC in accordance with federal law.

Consumer Protection Laws.  The Bank's business includes making a variety of types of loans to individuals. In making these loans, we are subject to state usury and regulatory laws and to various federal laws and regulations, including the privacy of consumer financial information provisions of the Gramm-Leach-Bliley Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Servicemembers Civil Relief Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Real Estate Settlement Procedures Act, and the Home Mortgage Disclosure Act, which prohibit discrimination, specify disclosures to be made to borrowers regarding credit and settlement costs, and regulate the mortgage loan servicing activities of the Bank, including the maintenance and operation of escrow accounts and the transfer of mortgage loan servicing.  In receiving deposits, the Bank is subject to extensive regulation under state and federal law and regulations, including the Truth in Savings Act, the Expedited Funds Availability Act, the Electronic Funds Transfer Act, the Federal Deposit Insurance Act and the privacy of consumer financial information provisions of the Gramm-Leach-Bliley Act.  Violation of these laws could result in the imposition of significant damages and fines upon the Bank and its directors and officers.

Anti-Money Laundering and OFAC Regulation.  A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing.  The Bank Secrecy Act of 1970 (“BSA”) and subsequent laws and regulations require the Bank to take steps to prevent the use of the Bank or its systems from facilitating the flow of illegal or illicit money or terrorist funds.  Those requirements include ensuring effective Board and management oversight, establishing policies and procedures, performing comprehensive risk assessments, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive independent audit of BSA compliance activities.

The USA PATRIOT Act of 2001 ("Patriot Act") significantly expanded the anti-money laundering ("AML") and financial transparency laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. Regulations promulgated under the Patriot Act impose various requirements on financial institutions, such as standards for verifying client identification at account opening and maintaining expanded records (including "Know Your Customer" and "Enhanced Due Diligence" practices) and other obligations to maintain appropriate policies, procedures and controls to aid the process of preventing, detecting, and reporting money laundering and terrorist financing. An institution subject to the Patriot Act must provide AML training to employees, designate an AML compliance officer and annually audit the AML program to assess its effectiveness. The FDIC continues to issue regulations and additional guidance with respect to the application and requirements of BSA and AML.

The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. Based on their administration by the United States Department of the Treasury's Office of Foreign Assets Control ("OFAC"), these are typically known as the "OFAC" rules. The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on "United States persons" engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to United States jurisdiction (including property in the possession or control of United States persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC.

Failure of a financial institution to maintain and implement adequate BSA, AML and OFAC programs, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution and result in material fines and sanctions.

Branching Authority.   Michigan banks have the authority under Michigan law to establish branches anywhere in the State of Michigan, subject to receipt of all required regulatory approvals.  Banks may establish interstate branch networks through acquisitions of other banks.  The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.

Michigan law permits both U.S. and non-U.S. banks to establish branch offices in Michigan.  The Michigan Banking Code permits, in appropriate circumstances and with the approval of the DIFS, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan.  A Michigan bank holding company may acquire a non-Michigan bank and a non-Michigan bank holding company may acquire a Michigan bank.

Risks related to our Business

Changes in interest rates may negatively affect our earnings and the value of our assets.

Our earnings and cash flows depend substantially upon our net interest income.  Net interest income is the difference between interest income earned on interest-earning assets, such as loans and investment securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds.  Interest rates are sensitive to many factors that are beyond our control, including general economic conditions, competition and policies of various governmental and regulatory agencies and, in particular, the policies of the Federal Reserve Board.  Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investment securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect: (i) our ability to originate loans and obtain deposits; (ii) the fair value of our financial assets and liabilities, including our securities portfolio; and (iii) the average duration of our interest-earning assets.  This also includes the risk that interest-earning assets may be more responsive to changes in interest rates than interest-bearing liabilities, or vice versa (repricing risk), the risk that the individual interest rates or rates indices underlying various interest-earning assets and interest-bearing liabilities may not change in the same degree over a given time period (basis risk), and the risk of changing interest rate relationships across the spectrum of interest-earning asset and interest-bearing liability maturities (yield curve risk), including a prolonged flat or inverted yield curve environment.  Any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations.

National, state and local economic conditions could have a material adverse effect on the Company's results of operations and financial condition.

The results of operations for financial institutions, including our Bank, may be materially and adversely affected by changes in prevailing national, state and local economic conditions. Our profitability is heavily influenced by the quality of the Company's loan portfolio and the stability of the Company's deposits. Unlike larger national or regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in Ottawa, Kent and Allegan Counties of western Michigan. The local economic conditions in these areas have a significant impact on the demand for the Company's products and services, and the ability of the Company's customers to repay loans, the value of the collateral securing loans and the stability of the Company's deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities, an outbreak of a widespread epidemic or pandemic of disease (or widespread fear thereof) or other international or domestic occurrences, unemployment, changes in securities, financial, capital or credit markets or other factors, could impact national and local economic conditions and have a material adverse effect on the Company's results of operations and financial condition.

Our credit losses could increase and our allowance for credit losses may not be adequate to cover actual loan losses.

The risk of nonpayment of loans is inherent in all lending activities and nonpayment of loans may have a material adverse effect on our earnings and overall financial condition, and the value of our common stock. We make various assumptions and judgments about the collectability of our loan portfolio and provide an allowance for credit losses based on a number of factors. If our assumptions are wrong, our allowance for credit losses may not be sufficient to cover our losses, which could have an adverse effect on our operating results and may cause us to increase the allowance in the future. The actual amount of future provisions for credit losses cannot now be determined and may exceed the amounts of past provisions for credit losses. Federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for credit losses. These regulatory agencies may require us to increase our provision for credit losses or to recognize further loan charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for credit losses could have a negative effect on our regulatory capital ratios, net income, financial condition and results of operations.

The Current Expected Credit Loss accounting standard could add volatility to our allowance for credit losses and may have a material adverse effect on our financial condition and results of operations.

Effective January 1, 2023, we adopted the Financial Accounting Standards Board ("the FASB") Account Standards Update 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, commonly referred to as "CECL".  CECL changed the allowance for credit losses methodology from an incurred loss impairment methodology to an expected loss methodology, which is more dependent on future economic forecasts, assumptions and models than previous accounting standards and could result in increases in, and add volatility to, our allowance for credit losses and future provisions for credit losses.  These forecasts, assumptions and models are inherently uncertain and are based upon management's reasonable judgment in light of information currently available.

We are subject to liquidity risk in our operations, which could adversely affect our ability to fund various obligations.

Liquidity risk is the possibility of being unable to meet obligations as they come due, pay deposits when withdrawn, and fund loan and investment opportunities as they arise because of an inability to liquidate assets or obtain adequate funding on a timely basis, at a reasonable cost and within acceptable risk tolerances. Liquidity is required to fund various obligations, including credit obligations to borrowers, mortgage originations, withdrawals by depositors, repayment of debt, operating expenses and capital expenditures. Liquidity of the Bank is derived primarily from retail deposit growth and retention, principal and interest payments on loans and investment securities, net cash provided from operations and access to other funding sources. Liquidity is essential to our business. We must maintain sufficient funds to respond to the needs of depositors and borrowers. An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a material adverse effect on our liquidity.  An inability to retain the current level of deposits, including the loss of one or more of the Bank's larger deposit relationships, could have a material adverse effect on the Bank's liquidity.  Our access to funding sources in amounts adequate to finance activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of the business activity due to a market downturn or regulatory action that limits or eliminates access to alternate funding sources, including brokered deposits discussed above. Our ability to borrow could also be impaired by factors that are nonspecific to the Company, such as severe disruption of the financial markets or negative expectations about the prospects for the financial services industry as a whole.

Our construction and development lending exposes us to significant risks.

Construction and development loans consist of loans to commercial customers for the construction of their business facilities.  They also include construction loans to builders and developers for the construction of one- to four-family residences and the development of one- to four-family lots, residential subdivisions, condominium developments and other commercial developments.  This portfolio may be particularly adversely affected by job losses, declines in real estate values, declines in home sale volumes, and declines in new home building. Declining real estate values may result in sharp increases in losses, particularly in the land development and construction loan portfolios to residential developers.  This type of lending is generally considered to have more complex credit risks than traditional single-family residential lending because the principal is concentrated in a limited number of loans with repayment dependent on the successful completion and sales of the related real estate project.  Consequently, these loans are often more sensitive to adverse conditions in the real estate market or the general economy than other real estate loans.  These loans are generally less predictable and more difficult to evaluate and monitor and collateral may be difficult to dispose of in a market decline. Additionally, we may experience significant construction loan losses if independent appraisers or project engineers inaccurately estimate the cost and value of construction loan projects.

We have significant exposure to risks associated with commercial and residential real estate.

A substantial portion of our loan portfolio consists of commercial and residential real estate-related loans, including real estate development, construction and residential and commercial mortgage loans.  As of December 31, 2023, we had approximately $585.1 million of commercial real estate loans outstanding, which represented approximately 43.7% of our total loan portfolio.  As of that same date, we had approximately $189.8 million in residential real estate loans outstanding, or approximately 14.2% of our total loan portfolio. Consequently, real estate-related credit risks are a significant concern for us. The adverse consequences from real estate-related credit risks tend to be cyclical and are often driven by national economic developments that are not controllable or entirely foreseeable by us or our borrowers.

Commercial loans may expose us to greater financial and credit risk than other loans.

Our commercial loan portfolio, including commercial mortgages, was approximately $1.092 billion at December 31, 2023, comprising approximately 81.6% of our total loan portfolio. Commercial loans generally carry larger loan balances and can involve a greater degree of financial and credit risk than other loans. Any significant failure to pay on time by our customers would hurt our earnings. The increased financial and credit risk associated with these types of loans are a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the size of loan balances, the effects of general economic conditions on income-producing properties and the increased difficulty of evaluating and monitoring these types of loans. In addition, when underwriting a commercial or industrial loan, we may take a security interest in commercial real estate, and, in some instances upon a default by the borrower, we may foreclose on and take title to the property, which may lead to potential financial risks for us under applicable environmental laws. If hazardous substances were discovered on any of these properties, we may be liable to governmental agencies or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination.

Our loan portfolio has and will continue to be affected by the housing market.

Loans to residential developers involved in the development or sale of 1-4 family residential properties were approximately $19.2 million, $21.4 million and $16.1 million at December 31, 2023, 2022 and 2021, respectively. As we continue our on-going portfolio monitoring, we will make credit and reserve decisions based on the current conditions of the borrower or project combined with our expectations for the future. If the housing market deteriorates, we could experience higher charge-offs and delinquencies in this portfolio.

We are subject to significant government regulation, and any regulatory changes may adversely affect us.

The banking industry is heavily regulated under both federal and state law.  These regulations are primarily intended to protect customers and the Deposit Insurance Fund, not our creditors or shareholders.  We are subject to extensive regulation by the Federal Reserve, the FDIC and the DIFS, in addition to other regulatory and self-regulatory organizations.  Future regulatory changes or accounting pronouncements may increase our regulatory capital requirements or adversely affect our regulatory capital levels.  Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of such changes, which could have a material adverse effect on our profitability or financial condition.

The Company could be adversely affected by the soundness of other financial institutions, including defaults by larger financial institutions.

The Company's ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of credit, trading, clearing, counterparty or other relationships between financial institutions. The Company has exposure to multiple counterparties, and the Company routinely executes transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by the Company or by other institutions. This is sometimes referred to as "systemic risk" and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which the Company interacts on a daily basis, and therefore could adversely affect the Company.

We rely heavily on our management and other key personnel, and the loss of any of them may adversely affect our operations.

We are and will continue to be dependent upon the services of our management team and other key personnel. During 2023, we experienced a transition in the chief executive officer and chief financial officer positions.  Challenges with these transitions could adversely affect our operations. Additionally, losing the services of one or more key members of our management team could adversely affect our operations.

Our controls and procedures may fail or be circumvented.

Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met.  If we fail to identify and remediate control deficiencies, it is possible that a material misstatement of interim or annual financial statements will not be prevented or detected on a timely basis.  In addition, any failure or circumvention of our other controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.

The Bank may be required to pay additional insurance premiums to the FDIC, which could negatively impact earnings.

Depending upon any future losses that the FDIC insurance fund may suffer, there can be no assurance that there will not be additional premium increases in order to replenish the fund. The FDIC may need to set a higher base rate schedule or impose special assessments due to future financial institution failures and updated failure and loss projections. Increased FDIC assessment rates could have an adverse impact on our results of operations.

If we cannot raise additional capital when needed, our ability to further expand our operations through organic growth and acquisitions could be materially impaired.

We are required by federal and state regulatory authorities to maintain specified levels of capital to support our operations.  We may need to raise additional capital to support our current level of assets or our growth.  Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance.  We cannot assure that we will be able to raise additional capital in the future on terms acceptable to us or at all.  If we cannot raise additional capital when needed, our ability to expand our operations through organic growth or acquisitions could be materially limited.  Additional information on the capital requirements applicable to the Bank may be found under the heading "Regulatory Capital" in Note 18 in Item 8.

We may be a defendant in a variety of litigation and other actions, which may have a material adverse effect on our financial condition and results of operations.

We may be involved from time to time in a variety of litigation arising out of our business. Our insurance may not cover all claims that may be asserted against us, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation or cause us to incur unexpected expenses, which could be material in amount. Should the ultimate expenses, judgments or settlements in any litigation exceed our insurance coverage, they could have a material adverse effect on our financial condition and results of operations. In addition, we may not be able to obtain appropriate types or levels of insurance in the future, and we may not be able to obtain adequate replacement of our existing policies with acceptable terms, if at all.

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

We face substantial competition in all phases of our operations from a variety of different competitors.  Our future growth and success will depend on our ability to compete effectively in this highly competitive environment.  We compete for deposits, loans and other financial services with numerous Michigan-based and out-of-state banks, thrifts, credit unions and other financial institutions as well as other entities which provide financial services, including technology-oriented financial services (FinTech) companies.  Some of the financial institutions and financial services organizations with which we compete are not subject to the same degree of regulation as we are.  Most of our competitors have been in business for many years, have established customer bases, are larger, and have substantially higher lending limits than we do.  The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services.  Competition for limited, high-quality lending opportunities and core deposits in an increasingly competitive marketplace may adversely affect our results of operations.

Evaluation of investment securities for allowance for credit losses involves subjective determinations and could materially impact our results of operations and financial condition.

The evaluation of impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments require the establishment of an allowance for credit losses. The risks and uncertainties include changes in general economic conditions, the issuer's financial condition or future recovery prospects and the effects of changes in interest rates or credit spreads. Estimating future cash flows involves incorporating information received from third-party sources and making internal assumptions and judgments regarding the future performance of the underlying collateral and assessing the probability that an adverse change in future cash flows has occurred. The determination of an allowance for credit losses is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available.  Our management considers a wide range of factors about the security issuer and uses reasonable judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for recovery. Inherent in management's evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Additions to the allowance for credit losses for our investment securities may need to be taken in the future, which could have a material adverse effect on our results of operations and financial condition.

We depend upon the accuracy and completeness of information about customers.

In deciding whether to extend credit to customers, we rely on information provided to us by our customers, including financial statements and other financial information. We also rely on representations of customers as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. Our financial condition and results of operations could be negatively impacted to the extent that we extend credit in reliance on financial statements or other information provided by customers that is false, misleading or incomplete.

Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of computer systems or otherwise, or failure or interruption of the Company's communication or information systems, could severely harm the Company’s business.

As part of its business, the Company collects, processes and retains sensitive and confidential client and customer information on behalf of the Company and other third parties. Despite the security measures the Company has in place for its facilities and systems, and the security measures of its third party service providers, the Company may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors or other similar events.

The Company relies heavily on communications and information systems to conduct its business. Any failure or interruption of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems.  In addition, customers could lose access to their accounts and be unable to conduct financial transactions during a period of failure or interruption of these systems.

Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information, whether such information is held by the Company or by its vendors, or failure or interruption of the Company's communication or information systems, could severely damage the Company’s reputation, expose it to risks of regulatory scrutiny, litigation and liability, disrupt the Company’s operations, or result in a loss of customer business, the occurrence of any of which could have a material adverse effect on the Company’s business.

Cybersecurity incidents could disrupt business operations, result in the loss of critical and confidential information, and adversely impact our reputation and results of operations.

Cybersecurity threats and incidents can range from uncoordinated individual attempts to gain unauthorized access to information technology (IT) systems to sophisticated and targeted measures known as advanced persistent threats, directed at the Company and/or its third party service providers. While we have experienced, and expect to continue to experience, these types of threats and incidents, none of them to date have been material to the Company. Although we employ comprehensive measures to prevent, detect, address and mitigate these threats (including access controls, employee training, data encryption, vulnerability assessments, continuous monitoring of our IT networks and systems and maintenance of backup and protective systems), cybersecurity incidents, depending on their nature and scope, could potentially result in the misappropriation, destruction, corruption or unavailability of critical data and confidential or proprietary information (our own or that of third parties) and the disruption of business operations. The potential consequences of a material cybersecurity incident include reputational damage, litigation with third parties and increased cybersecurity protection and remediation costs, which in turn could materially adversely affect our results of operations.

We continually encounter technological change, and we may have fewer resources than our competitors to continue to invest in technological improvements.

The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services.  In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs.  Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations.  Many of our competitors have substantially greater resources to invest in technological improvements.  There can be no assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers.

An "ownership change" for purposes of Section 382 of the Internal Revenue Code could materially impair our ability to use our deferred tax assets.

At December 31, 2023, our gross deferred tax asset was $10.0 million. Our ability to use our deferred tax assets to offset future taxable income will be limited if we experience an "ownership change" as defined in Section 382 of the Internal Revenue Code. In general, an ownership change will occur if there is a cumulative increase in our ownership by "5-percent shareholders" (as defined in the Code) that exceeds 50 percentage points over a rolling three-year period. A corporation that experiences an ownership change will generally be subject to an annual limitation on the use of its pre-ownership change deferred tax assets equal to the equity value of the corporation immediately before the ownership change, multiplied by the long-term tax-exempt rate.

If an "ownership change" occurs, we could lose certain built-in losses that have not been recognized for tax purposes. The amount of the permanent loss would depend on the size of the annual limitation (which is in part a function of our market capitalization at the time of an "ownership change") and the remaining carry forward period (U.S. federal net operating losses generally may be carried forward for a period of 20 years).

Our ability to maintain, attract and retain customer relationships is highly dependent on our reputation.

Our customers rely on us to deliver superior, personalized financial services with the highest standards of ethics, performance, professionalism and compliance. Damage to our reputation could undermine the confidence of our current customers and our ability to attract potential customers. Such damage could also impair the confidence of our contractual counterparties and vendors and ultimately affect our ability to effect transactions. Maintenance of our reputation depends not only on our success in maintaining our service-focused culture and controlling and mitigating the various risks described herein, but also on our success in identifying and appropriately addressing issues that may arise in areas such as potential conflicts of interest, anti-money laundering, client personal information and privacy issues, employee, customer and other third party fraud, record-keeping, regulatory investigations and any litigation that may arise from the failure or perceived failure of us to comply with legal and regulatory requirements.

Employee misconduct could expose us to significant legal liability and reputational harm.

We are vulnerable to reputational harm because we operate in an industry in which integrity and the confidence of our customers are of critical importance. Our employees could engage in misconduct that adversely affects our customers, other employees, and/or our business. For example, if an employee were to engage in fraudulent, illegal, wrongful or suspicious activities, and/or activities resulting in consumer harm, we could be subject to litigation, regulatory sanctions or penalties, and suffer serious harm to our reputation (as a consequence of the negative perception resulting from such activities), financial position, customer relationships and ability to attract new customers. Our business often requires that we deal with confidential information. If our employees were to improperly use or disclose this information, even if inadvertently, we could suffer serious harm to our reputation, financial position and current and future business relationships. It is not always possible to deter employee misconduct, and the precautions we take to detect and prevent this activity may not always be effective. Misconduct or harassment by our employees, or even unsubstantiated allegations of misconduct or harassment, or improper use or disclosure of confidential information by our employees, even inadvertently, could result in a material adverse effect on our business, financial condition or results of operations.

Our operations could be interrupted if certain external vendors on which we rely experience difficulty, terminate their services or fail to comply with banking laws and regulations.

We depend to a significant extent on relationships with third party service providers. Specifically, we utilize third party core banking services and receive credit card and debit card services, branch capture services, Internet banking services and services complementary to our banking products from various third party service providers. If these third party service providers experience difficulties or terminate their services and we are unable to replace them with other service providers, our operations could be interrupted. It may be difficult for us to replace some of our third party vendors, particularly vendors providing our core banking, credit card and debit card services, in a timely manner if they were unwilling or unable to provide us with these services in the future for any reason. If an interruption were to continue for a significant period of time, it could have a material adverse effect on our business, financial condition or results of operations. Even if we are able to replace them, it may be at higher cost to us, which could have a material adverse effect on our business, financial condition or results of operations.

Risks Associated With the Company's Stock

The market price of our common stock can be volatile, which may make it more difficult to resell our common stock at a desired time and price.

Stock price volatility may make it more difficult for a shareholder to resell our common stock when a shareholder wants to and at prices a shareholder finds attractive or at all.  Our stock price can fluctuate significantly in response to a variety of factors, regardless of operating results.  These factors include, among other things:

The Company may issue additional shares of its common stock in the future, which could dilute a shareholder's ownership of common stock.

The Company's articles of incorporation authorize its Board of Directors, without shareholder approval, to, among other things, issue additional shares of common or preferred stock. The issuance of any additional shares of common or preferred stock could be dilutive to a shareholder's ownership of Company common stock.

To the extent that the Company issues options or warrants to purchase common stock in the future and the options or warrants are exercised, the Company's shareholders may experience further dilution. Holders of shares of Company common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series and, therefore, shareholders may not be permitted to invest in future issuances of Company common or preferred stock.

Although publicly traded, our common stock has substantially less liquidity than the average liquidity of stocks listed on The Nasdaq Global Select Market.

Although our common stock is listed for trading on The Nasdaq Global Select Market, our common stock has substantially less liquidity than the average liquidity for companies listed on The Nasdaq Global Select Market.  A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This marketplace depends on the individual decisions of investors and general economic and market conditions over which we have no control. This limited market may affect a shareholder’s ability to sell their shares on short notice, and the sale of a large number of shares at one time could temporarily depress the market price of our common stock. For these reasons, our common stock should not be viewed as a short-term investment.

The Company's common stock is not insured by any governmental entity.

Our common stock is not a deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental entity.  Investment in Company common stock is subject to risk, including possible loss.

The Company may issue debt and equity securities that are senior to Company common stock as to distributions and in liquidation, which could negatively affect the value of Company common stock.

The Company has in the past and may in the future increase its capital by entering into debt or debt-like financing or issuing debt or equity securities, which could include issuances of senior notes, subordinated notes, preferred stock or common stock. In the event of the Company's liquidation, its lenders and holders of its debt securities would receive a distribution of the Company's available assets before distributions to the holders of Company common stock. The Company's decision to incur debt and issue securities in future offerings will depend on market conditions and other factors beyond its control. The Company cannot predict or estimate the amount, timing or nature of its future offerings and debt financings. Future offerings could reduce the value of shares of Company common stock and dilute a shareholder's interest in the Company.

Our articles of incorporation and bylaws and Michigan laws contain certain provisions that could make a takeover more difficult.

Our articles of incorporation and bylaws, and the laws of Michigan, include provisions which are designed to provide our Board of Directors with time to consider whether a hostile takeover offer is in our best interest and the best interests of our shareholders. These provisions could discourage potential acquisition proposals and could delay or prevent a change in control. The provisions also could diminish the opportunities for a holder of our common stock to participate in tender offers, including tender offers at a price above the then-current price for our common stock. These provisions could also prevent transactions in which our shareholders might otherwise receive a premium for their shares over then current market prices, and may limit the ability of our shareholders to approve transactions that they may deem to be in their best interests.

The Michigan Business Corporation Act contains provisions intended to protect shareholders and prohibit or discourage certain types of hostile takeover activities. In addition to these provisions and the provisions of our articles of incorporation and bylaws, federal law requires the Federal Reserve Board's approval prior to acquisition of "control" of a bank holding company. All of these provisions may have the effect of delaying or preventing a change in control of the Company without action by our shareholders, and therefore, could adversely affect the price of our common stock.

If an entity holds as little as a 5% interest in our outstanding securities, that entity could, under certain circumstances, be subject to regulation as a "bank holding company."

Any entity, including a "group" composed of natural persons, owning or controlling with the power to vote 25% or more of our outstanding securities, or 5% or more if the holder otherwise exercises a "controlling influence" over us, may be subject to regulation as a "bank holding company" in accordance with the Bank Holding Company Act of 1956, as amended (the "BHC Act").  In addition, any bank holding company or foreign bank with a U.S. presence may be required to obtain the approval of the Federal Reserve Board under the BHC Act to acquire or retain 5% or more of our outstanding securities.  Becoming a bank holding company imposes statutory and regulatory restrictions and obligations, such as providing managerial and financial strength for its bank subsidiaries.  Regulation as a bank holding company could require the holder to divest all or a portion of the holder's investment in our securities or those nonbanking investments that may be deemed impermissible or incompatible with bank holding company status, such as a material investment in a company unrelated to banking.

Any person not defined as a company by the BHC Act may be required to obtain the approval of the Federal Reserve Board under the Change in Bank Control Act of 1978, as amended, to acquire or retain 10% or more of our outstanding securities.

Any person not otherwise defined as a company by the BHC Act and its implementing regulations may be required to obtain the approval of the Federal Reserve Board under the Change in Bank Control Act of 1978, as amended, to acquire or retain 10% or more of our outstanding securities.  Applying to obtain this approval could result in a person incurring substantial costs and time delays.  There can be no assurance that regulatory approval will be obtained.

None.

Cybersecurity Risk Management and Strategy

The Company is exposed to cybersecurity threats and incidents that can range from uncoordinated individual attempts to gain unauthorized access to information systems to sophisticated and targeted measures known as advanced persistent threats, directed at the Company or its third party service providers. While we have experienced, and expect to continue to experience, cybersecurity threats, we have not experienced a material cybersecurity incident in the three year period ended December 31, 2023.  Management considers various factors in assessing the materiality of a cybersecurity incident, including the potential for misappropriation, destruction, corruption or unavailability of critical data and confidential or proprietary information (our own or that of third parties) and the business operation disruption.  The potential consequences of a material cybersecurity incident could include reputational damage, litigation with third parties, regulatory criticism or proceedings and increased cybersecurity protection and remediation costs, which in turn could materially adversely affect our results of operations.  We evaluate the risks of data theft (including theft of sensitive, proprietary and other data categories, in addition to personal data), and harm to customer or third party relationships or the possibility of litigation or regulatory investigation or actions that could materially adversely affect our results of operations and our reputation. 

The Company maintains a number of processes to identify and respond to cybersecurity threats and incidents.  The Company’s information security and third party risk management programs evaluate cybersecurity threats posed by internal and external factors and support daily operational functions that prevent unauthorized access or compromise. 

The information security and third party risk management programs report functionally to the Company’s overall risk management function, led by the Chief Risk Officer.  The information security function, led by the Information Security Officer and the Chief Technology Officer, evaluates internal and external cybersecurity threat factors according to a written policy statement approved by the Board periodically.  The Company maintains processes to evaluate third parties whose information systems support critical Company operations.

Risk management evaluates cybersecurity risks and information systems of third parties at onboarding and on an ongoing basis.  Processes include evaluating reports or performing assessments of a third party’s information systems leveraging cybersecurity frameworks such as International Organization for Standardization (ISO) ISO 27001, Cybersecurity Framework (CSF) published by the US National Institute of Standards and Technology, as well as evaluating reports issued by a third party’s auditors developed under the attestation standards issued by the American Institute of Certified Public Accountants (AICPA).  The Company integrates risk mitigation into additional onboarding requirements to address identified risk factors, such as developing service level agreements and minimum required information security performance expectations to enable cybersecurity threats and incidents to be managed within applicable industry or regulatory standards.  The Company requires contracts of third parties to incorporate industry and regulatory standard clauses requiring reporting to the Company of the occurrence and mitigation of cyber security threats and incidents as well as to maintain adequate levels of cybersecurity insurance coverage. 

The information security function performs periodic risk assessments of the Company’s information systems and cybersecurity threats using industry standard methodologies based on NIST CSF and MITRE Att&ck® methodologies, as well as regulatory guidance issued by the Federal Financial Institutions Examination Council (FFIEC) and state and federal regulators, including the Federal Deposit Insurance Corporation and the Michigan Department of Insurance and Financial Services.  Based on risk, the Company’s information security function performs internal engagements to provide assurance to senior management and the Board that the company’s information systems are able to identify, escalate and mitigate cybersecurity threats on a routine basis.  The Company also engages external independent parties to perform independent audit engagements, as well as other assessments of the Company’s information security and third party risk management program and information systems. 

Cybersecurity Governance

On a periodic basis, typically monthly, management’s technology steering committee receives reporting summarizing cybersecurity threat and incident monitoring activity, along with details of remediation to address threats and incidents.  The summary considers both internal as well as external threat events and outlines management’s approach to enable the timely identification and notice of a material incident, should one occur, without unreasonable delay.  The results of internal and external assessments of the Company’s cybersecurity threat monitoring capabilities are provided to the committee.  Meeting minutes of the committee are maintained and made available to the Board of Directors. 

The Board of Directors receives periodic training related to cyber security and is responsible for approval and oversight of management’s policies governing information system security and cybersecurity threats and incidents, as well as oversight of management’s approach to secure the Company’s information systems.  The Board of Directors delegates the oversight of risk management to the Audit Committee of the Board.

The Audit Committee receives and reviews reports on the Company’s risk management processes, which include assessments of management’s cybersecurity threats and incident management functions.  The committee receives periodic reporting of certain cybersecurity risks from the information security officer, including reports related to social engineering, effectiveness of cyber security training, as well as vulnerability and penetration assessments performed on management’s information systems by internal and by external parties and audit reports of information systems and cybersecurity threat and incident monitoring. 

Any event that could become a cybersecurity incident is reviewed by risk management and information security and the technology steering committee.  The evaluation of reported events by the committee includes reporting of any mitigation or remediation determined necessary to address the threat posed by the reported event.  If any event rose to the level of a material incident, management maintains a response plan to mitigate the impact, maintain business continuity and provide for internal and external communication, including required communication. 

We own or lease facilities located in Ottawa County, Allegan County and Kent County, Michigan.  Our administrative offices are located at 10753 Macatawa Drive, Holland, Michigan 49424.  Our administrative offices are approximately 49,000 square feet and contain our administration, human resources, loan underwriting and processing, and deposit operations. We believe our facilities are well-maintained and adequately insured.  We own each of the facilities except those identified in the “Use” column as “(Leased facility)”.  Our facilities as of February 15, 2024, were as follows:

As of the date of this report, there were no material pending legal proceedings, other than routine litigation incidental to the business of banking, to which Macatawa Bank Corporation or the Bank are a party or of which any of our properties are the subject.

Not applicable.

PART II

Our common stock is quoted on The Nasdaq Global Select Market under the symbol MCBC.  High and low closing prices (as reported on The Nasdaq Global Select Market) of our common stock for each quarter for the years ended December 31, 2023 and 2022 are set forth in the table below.

Information on restrictions on payments of dividends by us may be found in Item 1 of this report under the heading “Supervision and Regulation” and is here incorporated by reference.   Information regarding our equity compensation plans may be found in Item 12 of this report and is here incorporated by reference.

On February 15, 2024, there were approximately 724 owners of record and approximately 8,410 beneficial owners of our common stock.

Shareholder Return Performance Graph

The following graph shows the cumulative total shareholder return on an investment in the Company’s common stock compared to the Russell 2000 Index and the KBW Bank NASDAQ Index.  The comparison assumes a $100 investment on December 31, 2018 at the initial price of $9.62 per share (adjusted for all stock dividends and splits) and assumes that dividends are reinvested.  The comparisons in this table are set forth in response to Securities and Exchange Commission (SEC) disclosure requirements and therefore are not intended to forecast or be indicative of future performance of the common stock.

Issuer Purchases of Equity Securities

The following table provides information regarding the Company’s purchase of its own common stock during the fourth quarter of 2023.  All employee transactions are under stock compensation plans.  These include shares of Macatawa Bank Corporation common stock surrendered for cancellation to satisfy tax withholding obligations that occur upon the vesting of restricted shares.  The value of the shares withheld is determined based on the closing price of Macatawa Bank Corporation common stock at the date of vesting.  The Company has no publicly announced repurchase plans or programs.

Selected Historical Consolidated Financial Information.

The following unaudited table sets forth selected historical consolidated financial information as of and for the years ended December 31, 2023, 2022, 2021, 2020 and 2019, which is derived from our audited consolidated financial statements. You should read this information in conjunction with our consolidated financial statements and related notes included elsewhere in this report.

*Retroactively adjusted to reflect the effect of all stock splits and dividends

Management’s discussion and analysis of results of operations and financial condition contains forward-looking statements.  Please refer to the discussion of forward-looking statements at the beginning of this report.

The following section presents additional information to assess our results of operations and financial condition.  This section should be read in conjunction with the consolidated financial statements and the supplemental financial data contained elsewhere in this report.

The information under Item 1 – Business of this report is incorporated here by reference.

RESULTS OF OPERATIONS

Summary: Net income was $43.2 million ($53.7 million on a pretax basis) for 2023, compared to $34.7 million ($43.1 million on a pretax basis) for 2022.  Earnings per common share on a diluted basis were $ 1.26 for 2023 and $ 1.01 for 2022.

During 2023, the improvement in our earnings was the result of growth in net interest income while expenses were relatively stable.  Throughout 2022, the Federal Reserve Bank increased the federal funds rate several times, bringing the high end of their rate range from 0.25% at the beginning of the year to 4.50% by the end of 2022.  They increased rates by another 100 basis points during 2023, ending the year at 5.50%.  Given our asset sensitive balance sheet posture, this had a very positive impact on our earnings in 2023.  Net interest income increased to $87.4 million in 2023 compared to $70.1 million in 2022.  Gains on sales of mortgage loans were $65,000 in 2023 compared to $706,000 in 2022 with the decrease reflecting the impact of higher interest rates in 2023.  Other categories of noninterest income were down $937,000 in 2023, partially offsetting the impact of net interest income growth.  Total noninterest expense was $51.6 million in 2023 compared to $48.2 million in 2022.

We recorded a provision for credit losses of $550,000 in 2023 and a provision for credit losses benefit of $1.1 million in 2022.   Adoption of ASU 2016-13, commonly referred to as CECL, effective January 1, 2023, resulted in an increase to the allowance for credit losses of $1.5 million.  The provision in 2023 was determined following the new CECL standard and in 2022 was determined using incurred loss methodology.  The provision in both periods was favorably impacted by low levels of nonperforming loans, strong asset quality and the levels of net loan charge-offs to recoveries realized in recent periods.  The provision in 2022 was favorably impacted by the effect of reversals of the additional qualitative factors related to the COVID-19 pandemic.  These items are discussed more fully below.

Net Interest Income: Net interest income totaled $87.4 million during 2023 compared to $70.1 million during 2022.

The increase in net interest income during 2023 compared to 2022 was due primarily to an increase in yields on interest earning assets, particularly overnight deposits and variable rate loans as the federal funds rate was increased by 425 basis points in 2022 and 100 basis points in 2023.  Average yields on securities, interest earning assets and net interest margin are presented on a fully taxable equivalent basis.  Our net interest income as a percentage of average interest earning assets (i.e. "net interest margin" or "margin") was 3.36% for the year ended December 31, 2023 and 2.56% for the year ended December 31, 2022.

The yield on interest earning assets increased 164 basis points from 2.73% for 2022 to 4.37% for 2023.  The increase from 2022 to 2023 was generally due to an increase of average short-term interest rates earned on overnight deposits and variable rate commercial loans.  The average rate on overnight deposits increased from 1.53% in 2022 to 5.07% in 2023.  Our margin in recent years had been negatively impacted by our decision to hold significant balances in liquid and short-term investments.  In 2022 and 2023, our margin benefitted significantly from this strategy. Net interest income also benefitted in 2023 from growth in our investment portfolio.  Our average investment portfolio balance in 2023 was $888.4 million compared to $749.8 million in 2022.  Total average interest earning assets totaled $2.60 billion for 2023 compared to $2.74 billion in 2022.

Net interest income for 2023 increased $17.3 million compared to the same period in 2022.  Of this increase, $18.4 million was from changes in the rates earned or paid, partially offset by a $1.1 million reduction from changes in volume of average interest earning assets and interest bearing liabilities. The largest changes occurred in interest income on federal funds (our overnight deposits), interest income on commercial loans and interest income in our investment portfolio as we deployed more of our excess investable funds primarily into commercial and residential mortgage loans and taxable securities.  Interest income from federal funds sold and other short-term investments increased by $9.6 million in 2023 compared to 2022. The increases in 2022 and 2023 of the federal funds rate caused an $18.5 million increase in interest income, partially offset by an $8.9 million decrease in net interest income due to a decrease in average balances of federal funds sold and other short-term investments in 2023.  The net change in interest income for commercial loans was an increase of $18.2 million in 2023 as compared to 2022, with a $14.0 million increase due to rate and $4.2 million due to an increase in average balances.  The net change in interest income for taxable securities was an increase of $6.8 million with $3.6 million due to an increase in average balances and $3.2 million due to rate.

Yield on commercial loans increased from 4.23% in 2022 to 5.60% in 2023.  Yield on residential mortgage loans increased from 3.36% in 2022 to 4.09% in 2023, while yield on consumer loans increased from 4.88% in 2022 to 7.74% in 2023.  The increases in yields on commercial loans and consumer loans were the result of the predominance of loans in these categories with variable rates of interest tied to prime and SOFR, which increased throughout 2023.

Our net interest margin for 2023 was negatively impacted from a 124 basis point increase in our cost of funds from 0.28% for 2022 to 1.52% for 2023. Average interest bearing liabilities increased $15.3 million from $1.72 billion in 2022 to $1.74 billion in 2023.  Increases in the rates paid on certain deposit account types in response to the sharp market rate increases were the primary cause of the increase in our cost of funds.  In addition, we have experienced a shifting between deposit types to higher interest bearing types, with average certificates of deposit increasing $142.1 million from $88.2 million in 2022 to $230.3 million in 2023.  While our funding costs have increased, the yields on our interest earning assets increased to a larger extent, causing net interest income and net interest margin to increase from 2022 to 2023.

In 2024, we expect pressure on deposit costs may slow further improvement in net interest margin.  That said, expected repricing of maturing low-rate fixed rate loans and securities should partially offset the funding cost pressure and provide some protection to net interest income when interest rates begin to fall.

The following table shows an analysis of net interest margin for the years ended December 31, 2023 and 2022 (dollars in thousands).

The following table presents the dollar amount of changes in net interest income due to changes in volume and rate.

(1)  The change in interest due to changes in both balance and rate has been allocated to change in balance and change due to rate in proportion to the relationship of the absolute dollar amounts of change in each.

Provision for Credit Losses: The provision for credit losses for 2023 was $550,000 compared to a benefit of $1.1 million for 2022. The provision for credit losses for 2023 and 2022 were impacted by our continued strong asset quality metrics. We adopted CECL effective January 1, 2023 using the modified retrospective method for all financial assets measured at amortized cost and off-balance sheet credit exposures. Results for reporting periods beginning after January 1, 2023 are presented under CECL while prior period amounts continue to be reported in accordance with the probable incurred loss accounting standards. The transition adjustment of the CECL adoption included an increase in the allowance for credit losses of $1.5 million, $62,000 to establish a reserve for unfunded commitments and a $1.2 million decrease to retained earnings to reflect the cumulative effect of adoption of CECL, with the $323,000 tax impact portion being recorded as part of the deferred tax asset on our Consolidated Balance Sheet.

In 2022, economic conditions improved allowing for reductions in the additional qualitative adjustments made in 2020 related to the COVID-19 pandemic.  This contributed to the level of provision benefit recorded in 2022.  Specific reserves on collateral dependent loans increased by $7,000 in 2023.  Specific reserves on impaired loans decreased by $270,000 in 2022 from 2021.  Net loan recoveries were $131,000 in 2023 compared to $521,000 in 2022.

Our overall weighted average commercial loan grade has been below 4.00 for the past several years.  Our weighted average commercial loan grade was 3.49 at December 31, 2023 and 3.53 at December 31, 2022.

The amounts of credit loss provision in each period were the result of establishing our allowance for credit losses at levels believed necessary based upon our methodology for determining the adequacy of the allowance. More information about our allowance for credit losses and our methodology for establishing its level may be found in Item 7 of this report under the heading “Allowance for Credit Losses” below and in Item 8 of this report in Note 3 of the Consolidated Financial Statements.

Noninterest Income: Noninterest income totaled $18.4 million in 2023 compared to $20.0 million in 2022.  The components of noninterest income are shown in the table below (in thousands):

Net gains on sales of mortgage loans decreased $641,000 from 2022 to 2023 due to much lower volumes of mortgage loans originated for sale in 2023.   Net gains on mortgage loans represent gains on the sale of real estate mortgage loans in the secondary market.  We typically sell the majority of the fixed-rate mortgage loans we originate, however in 2023, with the high rate environment, we have held more of this production in portfolio. We do not retain the servicing rights for the loans we sell.

A summary of gain on sales of loans and related loan volume was as follows (in thousands):

As demonstrated in the table above, the volume of mortgage loans originated for sale was down significantly in 2023 compared to 2022.  The rapid increase in interest rates during 2022 and 2023 significantly impacted mortgage sale production volume.  As long-term market interest rates impacting mortgage rates began to rise in the latter half of 2021, mortgage production slowed and resulting gains declined.  As rates increased further in 2022 and 2023, refinancing activity all but stopped and more customers chose variable rate products, which we hold in portfolio.  We also determined it appropriate to hold more of the fixed rate production in portfolio in 2023 given the higher rates and assumed shorter duration, as many loans likely will be refinanced when rates decline. We expect our residential mortgage loan activity to remain below normal levels as we enter 2024 given the existing rate environment.

Deposit service charges were down $660,000, primarily driven by a higher level of earnings credits due to higher deposit rates in 2023 which offset treasury management service charges to our commercial customers.  Treasury management fee income pre-earnings credit improved as a result of success in growing the number of business and municipal customers using these services in the last two years.  

Trust service revenue increased $189,000 in 2023.   This increase was due primarily to market valuations of assets on which fees are assessed.

ATM and debit card processing income decreased $74,000 in 2023 to $6.7 million compared to $6.8 million in 2022.  This decrease reflected a decrease in debit card interchange charged to our account holders, as transaction volume was slightly lower in 2023 than in 2022.  

We did not sell any securities in 2023 or 2022.  We continually review our securities portfolio and will dispose of securities that pose higher than desired credit or market risk, or as warranted from overall portfolio maintenance or asset-liability management.

Investment services fees decreased $134,000 in 2023 due to slightly lower volumes of investment products sold in 2023 versus 2022.

Earnings from bank owned life insurance increased by $25,000 in 2023 compared to 2022 due to the general performance of the underlying investments.

Other income was down by $283,000 in 2023 due largely to lower swap fee income in 2023. We also experienced a reduction of title insurance fees of $63,000 as mortgage volume was down due to the higher interest rate environment. 

Noninterest Expense: Noninterest expense was $51.6 million in 2023 and $48.2 million in 2022.  The components of noninterest expense are shown in the table below (in thousands):

Salaries and benefits expense was the largest component of noninterest expense and was $28.6 million in 2023 and $26.2 million in 2022.  The increase in 2023 was primarily due to $1.3 million in expenses related to the CEO retirement agreement effective November 1, 2023 incurred in the fourth quarter 2023.  The remainder of the increase was driven by higher base compensation, higher medical insurance costs from increased claims and higher 401(k) contributions.  The table below identifies the primary components of salaries and benefits (in thousands):

Legal and professional fees increased to $1.4 million in 2023 compared to $961,000 in 2022. Of the $464,000 increase in 2023, $241,000 was due to higher audit and examination costs due to outsourcing of certain core internal audit services and $223,000 was due to higher legal expenses.  Legal expense in 2023 included additional costs associated with new accounting and proxy disclosures, regulatory compliance matters referred to legal counsel and inflationary increases and consultation related to executive transitions.

Costs associated with nonperforming assets remained at low levels, totaling $3,000 in 2023 and $20,000 in 2022.   During 2023, we did not add any other real estate owned properties.  On January 30, 2023, we sold the remaining other real estate owned property at a gain of $356,000, bringing the balance of other real estate owned to $0.  In 2022, we did not add any other real estate properties and sold one real estate property.  

FDIC assessment expense increased to $1.3 million in 2023 compared to $789,000 in 2022 primarily due to higher premiums assessed by the FDIC beginning in 2023.  Further discussion regarding the determination of FDIC assessments for the Bank may be found in Item 1 of this report under the heading "Supervision and Regulation." We expect this expense to remain elevated in 2024 until the FDIC bank insurance fund reaches the level imposed by regulations.

Occupancy expense increased by $8,000 in 2023 primarily due to an increase in snow removal and building maintenance costs, partially offset by depreciation of our buildings.  Furniture and equipment expense increased by $191,000 in 2023 primarily due to an increase in equipment and service contracts, partially offset by a decrease in furniture and equipment depreciation and software amortization costs.

Data processing expenses were $4.0 million in 2023 and $3.8 million in 2022.  Increases in data processing for our systems and card programs in 2023 were the primary reasons for the increase in 2023.

Outside services decreased by $234,000 in 2023 primarily due to lower recruiting costs and certain outsourced services.

Federal Income Tax Expense: We recorded federal income tax expense of $10.5 million in 2023 and $8.3 million in 2022.  Our effective tax rate was 19.58% for 2023 and 19.35% for 2022.  The increase in the effective tax rate in 2023 over 2022 was due to higher levels of taxable income from rising interest rates while our tax-exempt income has remained relatively flat.

FINANCIAL CONDITION

Summary:   Total assets were $2.75 billion at December 31, 2023, a decrease of $158.2 million from $2.91 billion at December 31, 2022. This change reflected increases of $160.6 million in our loan portfolio, $9.5 million in securities available for sale, $1.4 million in accrued interest receivable and $904,000 in bank owned life insurance, offset by decreases of $304.8 million in cash and cash equivalents, $17.2 million in held to maturity securities, $1.4 million in premises and equipment, $2.3 million in other real estate owned, and $2.5 million in net deferred tax assets. Total deposits decreased by $199.4 million and other borrowed funds were unchanged at December 31, 2023 compared to December 31, 2022.

Total shareholders’ equity increased by $40.0 million from December 31, 2022 to December 31, 2023.  Shareholders’ equity was increased by $43.2 million of net income in 2023, partially offset by cash dividends of $11.3 million, or $0.33 per share.  Shareholders’ equity also increased by $8.7 million in 2023 as a result of a favorable swing in accumulated other comprehensive income due to the effect of the change in fair value of our available for sale securities portfolio. As of December 31, 2023 and 2022, the Bank was categorized as “well capitalized” under applicable regulatory guidelines.

Cash and Cash Equivalents: Our cash and cash equivalents, which include federal funds sold and short-term investments, were $450.4 million at December 31, 2023 compared to $755.2 million at December 31, 2022. This $304.8 million decrease was primarily the result of growth in our loan portfolio and reduction of deposits during 2023.

Securities: Securities available for sale ("AFS") were $508.8 million at December 31, 2023 compared to $499.3 million at December 31, 2022. The balance at December 31, 2023 primarily consisted of U.S. Treasury and agency securities, agency mortgage backed securities and various municipal investments. The growth in securities AFS was primarily the result of an improvement in the net unrealized losses of $11.0 in the investment portfolio in 2023.  Our held to maturity ("HTM") portfolio decreased from $348.8 million at December 31, 2022 to $331.5 million at December 31, 2023.  Our HTM portfolio is comprised of U.S. Treasury securities and state municipal and privately placed commercial bonds.  The commercial bond component of this category increased by $10.2 million in 2023.  These bonds represent financing provided to some of our non-profit commercial customers who qualified for borrowing on a tax-exempt basis.  The municipal bond component of this category decreased by $27.4 million in 2023.  

On January 1, 2022, we reclassified ten U.S. Treasury securities with an amortized cost of $123.5 million from available for sale to held to maturity, as we have the intent and ability to hold these securities to maturity. All ten of these U.S. Treasury securities were purchased within the fourth quarter of 2021.  Subsequently and upon further analysis of these purchases, management decided to reclassify them to held to maturity given their short-term nature. These securities had net unrealized gains of $113,000 at the date of transfer, which will continue to be reported in accumulated comprehensive income, and will be amortized over the remaining life of the securities as an adjustment of yield.  The effect on interest income of the amortization of net unrealized gains is offset by the amortization of the premium on the securities transferred. 

Portfolio Loans and Asset Quality: Total portfolio loans increased by $160.6 million to $1.34 billion at December 31, 2023 compared to $1.18 billion at December 31, 2022. During 2023, our commercial portfolio increased by $112.8 million, while our residential mortgage portfolio increased by $50.7 million and our consumer portfolio decreased by $2.8 million.  

We experienced stronger year over year growth in commercial loans in 2023 than in 2022.  Commercial loans increased $43.0 million in 2022 and increased $112.8 million in 2023.  The improved growth in 2023 related to a general increase in business activity in our market beginning in late 2022.

Commercial and commercial real estate loans remained our largest loan segment and accounted for 81.6% of the total loan portfolio at December 31, 2023 and 83.2% at December 31, 2022. Residential mortgage and consumer loans comprised 18.4% of total loans at December 31, 2023 and 16.8% at December 31, 2022.

A further breakdown of the composition of the loan portfolio is shown in the table below (in thousands):

Commercial real estate loans increased $47.5 million since December 31, 2022 and accounted for 43.7% of our total loan portfolio at year-end 2023 and consisted primarily of loans to business owners and developers of owner and non-owner occupied commercial properties and loans to developers of single and multi-family residential properties. In the table above, we show our commercial real estate portfolio by loans secured by residential and commercial real estate, and by stage of development. Improved loans are generally secured by properties that are under construction or completed and placed in use. Development loans are secured by properties that are in the process of development or fully developed. Vacant and unimproved loans are secured by raw land for which development has not yet begun and agricultural land.

Our overall commercial and industrial loan portfolio increased by $65.3 million to $507.0 million at December 31, 2023 and represented 37.9% of our total loan portfolio.  Of the $65.3 million increase in 2023, approximately $27.4 million was due to growth in balances to transportation leasing businesses and $31.4 million growth in automotive dealer floorplan balances.   This growth included the addition of new dealer accounts as well as higher usage of existing lines.

Our consumer residential mortgage loan portfolio, which also includes residential construction loans made to individual homeowners, comprised approximately 14.2% of portfolio loans at December 31, 2023 and 11.8% at December 31, 2022.  We expect to continue to retain in our loan portfolio certain types of residential mortgage loans (primarily high quality, low loan to value loans) in an effort to continue to diversify our credit risk and deploy our excess liquidity. Typically, a large portion of our residential mortgage loan production is sold on the secondary market with servicing released.  However, given the significant increase in residential mortgage loan rates, we have increased the amount of such loans retained in portfolio as they will typically have lower duration due to refinancings that occur when interest rates decline.

The volume of residential mortgage loans originated for sale during 2023 decreased from 2022 as interest rates increased in 2022 and remained high throughout 2023 and demand for refinancings declined as many potential borrowers had recently refinanced in the extended low interest rate environment.  In addition, customer preference drove more production in loan product types we retain in portfolio (i.e. variable rate, short term mortgages).     We expect residential mortgage originations for sale to continue to be below normal levels as we enter 2024 given the existing rate environment.   Residential mortgage loans originated for sale were $4.1 million in 2023 compared to $26.2 million in 2022.  The Company had no repurchase demands or claims related to residential mortgage loans sold on the secondary market during the five-year period ended December 31, 2023.

The following table shows our residential mortgage loan portfolio broken down by fixed and variable rate (in thousands):

Our portfolio of other consumer loans includes loans secured by personal property and home equity fixed term and line of credit loans. Consumer loans decreased by $2.8 million to $56.5 million at December 31, 2023 from $59.3 million at December 31, 2022 primarily due to a decrease in home equity loans due to the high rate environment.  Consumer loans comprised approximately 4.2% of our portfolio loans at December 31, 2023 and 5.0% at December 31, 2022.

The following table shows our loan origination activity for portfolio loans during 2023 and 2022, broken out by loan type and also shows average originated loan size (dollars in thousands):