Document
 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-K


(Mark One)
 
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2018
 
OR
 
 o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the transition period from __________________ to __________________
 
Commission File Number  001-33572

Bank of Marin Bancorp
(Exact name of Registrant as specified in its charter)
 
California  
 
20-8859754
(State or other jurisdiction of incorporation)  
 
(IRS Employer Identification No.)
 
 
 
504 Redwood Boulevard, Suite 100, Novato, CA 
 
94947
(Address of principal executive office)
 
(Zip Code)
 
Registrant’s telephone number, including area code:  (415) 763-4520

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

None

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

   Common Stock, No Par Value,
 
 
and attached Share Purchase Rights
 
NASDAQ Capital Market
(Title of each class)
 
(Name of each exchange on which registered)
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes   o         No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes   o         No  x

Note - checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under these sections.




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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes x                   No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K.
x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer x
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company x
Emerging growth company o
 
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
o 
 
Indicate by check mark if the registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act.
Yes   o         No  x
 
As of June 29, 2018, the last business day of the registrant's most recently completed second fiscal quarter, the aggregate market value of the voting common equity held by non-affiliates, based upon the closing price per share of the registrant's common stock as reported by the NASDAQ, was approximately $546 million. For the purpose of this response, directors and certain officers of the Registrant are considered affiliates at that date.

As of February 28, 2019, there were 13,806,416 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on May 14, 2019 are incorporated by reference into Part III.





TABLE OF CONTENTS
 
PART I
 
 
 
 
Forward-Looking Statements
 
 
 
ITEM 1.
BUSINESS
ITEM 1A.
RISK FACTORS
ITEM 1B.
UNRESOLVED STAFF COMMENTS
ITEM 2.
PROPERTIES
ITEM 3.
LEGAL PROCEEDINGS
ITEM 4.
MINE SAFETY DISCLOSURES
 
 
 
PART II
 
 
 
 
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 6.
SELECTED FINANCIAL DATA
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Forward-Looking Statements
 
Critical Accounting Policies
 
Executive Summary
 
 
 
 
 
 
 
RESULTS OF OPERATIONS
 
Net Interest Income
 
Provision for Loan Losses
 
Non-Interest Income
 
Non-Interest Expense
 
Provision for Income Taxes
 
 
 
 
FINANCIAL CONDITION
 
Investment Securities
 
Loans
 
Allowance for Loan Losses
 
Other Assets
 
Deposits
 
Borrowings
 
Deferred Compensation Obligations
 
Off Balance Sheet Arrangements and Commitments
 
Capital Adequacy
 
Liquidity
 
 
 
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 
 
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
 
 

Page-2


 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Note 1: Summary of Significant Accounting Policies
 
Note 2: Investment Securities
 
Note 3: Loans and Allowance for Loan Losses
 
Note 4: Bank Premises and Equipment
 
Note 5: Bank Owned Life Insurance
 
Note 6: Deposits
 
Note 7: Borrowings
 
Note 8: Stockholders' Equity and Stock Plans
 
Note 9: Fair Value of Assets and Liabilities
 
Note 10: Benefit Plans
 
Note 11: Income Taxes
 
Note 12: Commitments and Contingencies
 
Note 13: Concentrations of Credit Risk
 
Note 14: Derivative Financial Instruments and Hedging Activities
 
Note 15: Regulatory Matters
 
Note 16: Financial Instruments with Off-Balance Sheet Risk
 
Note 17: Condensed Bank of Marin Bancorp Parent Only Financial Statements
 
Note 18: Acquisition
 
 
 
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
 
 
ITEM 9A.
CONTROLS AND PROCEDURES
 
 
 
ITEM 9B.
OTHER INFORMATION
 
 
 
PART III
 
 
 
 
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
 
 
ITEM 11.
EXECUTIVE COMPENSATION
 
 
 
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
 
 
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
 
 
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
 
 
PART IV
 
 
 
 
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
 
 
ITEM 16.
FORM 10-K SUMMARY
 
 
 
SIGNATURES

Page-3



PART I       

Forward-Looking Statements
 
This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.
 
Our forward-looking statements include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs preceded by "will," "would," "should," "could" or "may."
 
Forward-looking statements are based on Management's current expectations regarding economic, legislative, and regulatory issues, that may affect our earnings in future periods. A number of factors, many of which are beyond Management’s control, could cause future results to vary materially from current Management expectations. Such factors include, but are not limited to, general economic conditions and the economic uncertainty in the United States and abroad, including changes in interest rates, deposit flows, real estate values, and expected future cash flows on loans and securities; costs or effects of acquisitions; competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation (including the Tax Cuts and Jobs Act of 2017); natural disasters (such as the recent wildfires in our area); adverse weather conditions; and other economic, competitive, governmental, regulatory and technological factors (including external fraud and cybersecurity threats) affecting our operations, pricing, products and services.

Important factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements are detailed in ITEM 1A. Risk Factors of this report. Forward-looking statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.

ITEM 1        BUSINESS

Bank of Marin (the “Bank”) was incorporated in August 1989, received its charter from the California Superintendent of Banks (now the California Department of Business Oversight or "DBO") and commenced operations in January 1990. The Bank is an insured bank by the Federal Deposit Insurance Corporation (“FDIC”). Bank of Marin Bancorp (“Bancorp”) was formed in 2007 and the Bank became its sole subsidiary when each share of Bank common stock was exchanged for one share of Bancorp common stock. Bancorp is listed on NASDAQ under the symbol BMRC. Upon formation of the holding company, Bancorp became subject to regulation under the Bank Holding Company Act of 1956, as amended, and reporting and examination requirements by the Board of Governors of the Federal Reserve System ("Federal Reserve"). Bancorp files periodic reports and proxy statements with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended.

References in this report to “Bancorp” mean Bank of Marin Bancorp, parent holding company for the Bank. References to “we,” “our,” “us” mean the holding company and the Bank that are consolidated for financial reporting purposes.

Virtually all of our business is conducted through Bancorp's subsidiary, Bank of Marin, which is headquartered in Novato, California. In addition to our headquarters, we operate twenty-three offices in Marin, Sonoma, San Francisco, Napa and Alameda counties, with a strong emphasis on supporting the local communities. Our customer base is made up of business and personal banking relationships from the communities near the branch office locations. Our business banking focus is on small to medium-sized businesses, professionals and not-for-profit organizations.
 
We offer a broad range of commercial and retail deposit and lending programs designed to meet the needs of our target markets. Our lending categories include commercial real estate loans, commercial and industrial loans, construction financing, consumer loans, and home equity lines of credit. Merchant card services are available for our

Page-4



business customers. Through third-party vendors, we offer Visa® credit card programs for consumers and businesses, an American Express® credit card program, a leasing program for commercial equipment financing, prepaid business cards for handling expense reimbursements and a full suite of cash management services.

We offer a variety of personal and business checking and savings accounts, and a number of time deposit alternatives, including time certificates of deposit, Individual Retirement Accounts (“IRAs”), Health Savings Accounts ("HSA"), Certificate of Deposit Account Registry Service® ("CDARS"), Insured Cash Sweep® ("ICS"), and Demand Deposit MarketplaceSM ("DDM Sweep") accounts. CDARS, ICS and DDM Sweep accounts are networks through which we offer full FDIC insurance coverage in excess of the regulatory maximum by placing deposits in multiple banks participating in the networks. We also offer deposit options including mobile deposit, remote deposit capture, Automated Clearing House (“ACH”) services, wire transfers, and image lockbox services. A valet pick-up service is available for non-cash deposits to our professional and business clients.

Other products and services include Apple Pay®, Samsung Pay®, Google Pay®, SurePayroll®, Positive Pay (fraud detection tool), and solutions for clients with cash management needs such as Cash Vault and SafePoint.

Automated teller machines (“ATM's”) are available at most retail branch locations. Our ATM network is linked to the PLUS, CIRRUS and NYCE networks, as well as to a network of nation-wide surcharge-free ATM's called MoneyPass. We also offer our depositors 24-hour access to their accounts by telephone and through our internet and mobile banking services available to personal and business account holders.

We offer Wealth Management and Trust Services (“WMTS”), which include customized investment portfolio management, trust administration, estate settlement and custody services. We also offer 401(k) plan services to small and medium-sized businesses through a third-party vendor.

We make international banking services available to our customers indirectly through other financial institutions with whom we have correspondent banking relationships.

We hold no patents, licenses (other than licenses required by the appropriate banking regulatory agencies), franchises or concessions.  The Bank has registered the service marks "The Spirit of Marin," the words “Bank of Marin,” the Bank of Marin logo, and the Bank of Marin tagline, “Committed to your business and our community” with the United States Patent & Trademark Office.  In addition, Bancorp has registered the service marks for the words “Bank of Marin Bancorp” and for the Bank of Marin Bancorp logo with the United States Patent & Trademark Office. All service marks registered by Bancorp or the Bank are registered on the United States Patent & Trademark Office Principal Register.

Market Area

Our primary market area consists of Marin, San Francisco, Napa, Sonoma and Alameda counties. Our customer base is primarily made up of business, not-for-profit and personal banking relationships within these market areas.

As discussed in Note 18 to the Consolidated Financial Statements in ITEM 8 of this report, in November 2017, we expanded our presence in Napa County through the acquisition of Bank of Napa, N.A. This resulted in the addition of $302.1 million of assets and the assumption of $251.9 million of liabilities, as well as the addition of two branch offices serving the city of Napa.

We attract deposit relationships from small to medium-sized businesses, not-for-profit organizations and professionals, merchants and individuals who live and/or work in the communities comprising our market areas. As of December 31, 2018, approximately 59% of our deposits were in Marin County and southern Sonoma County, and approximately 58% of our deposits were from businesses and 42% from individuals.

Competition

The banking business in California generally, and in our market area specifically, is highly competitive with respect to attracting both loan and deposit relationships. The increasingly competitive environment is affected by changes in regulation, interest rates, technology and product delivery systems, and consolidation among financial service providers. The banking industry is seeing strong competition for quality loans, with larger banks expanding their activities to attract businesses that are traditionally community bank customers. In all of our five counties, we have significant competition

Page-5



from nationwide banks with much larger branch networks and greater financial resources, as well as credit unions and other local and regional banks. Nationwide banks have the competitive advantages of national advertising campaigns. Large commercial banks also have substantially greater lending limits and the ability to offer certain services, which are not offered directly by us. Other competitors for depositors' funds are money market mutual funds and non-bank financial institutions such as brokerage firms and insurance companies.

We differentiate ourselves from the numerous, and often larger, financial institutions in our primary market area, with a business model built on relationship banking, disciplined fundamentals and commitment to the communities we serve. The Bank's experienced professionals deliver innovative and custom financing, with a deep local market knowledge and a personal understanding of each customer's unique needs.

In Marin County, we have the third largest market share of total deposits at 10.8%, based upon FDIC deposit market share data as of June 30, 20181. A significant driver of our franchise value is the growth and stability of our deposits, a low-cost funding source for our loan portfolio.

Employees

At December 31, 2018, we employed 290 full-time equivalent (“FTE”) staff. The actual number of employees, including part-time employees, at year-end 2018 included seven executive officers, 120 other corporate officers and 178 staff. None of our employees are presently represented by a union or covered by a collective bargaining agreement. We believe that our employee relations are good. We have consistently been recognized as one of the “Best Places to Work” by the North Bay Business Journal.

SUPERVISION AND REGULATION

Bank holding companies and banks are extensively regulated under both federal and state law. The following discussion summarizes certain significant laws, rules and regulations affecting Bancorp and the Bank.

Bank Holding Company Regulation

Upon formation of the bank holding company on July 1, 2007, we became subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHCA”) which subjects Bancorp to Federal Reserve reporting and examination requirements. Under the Federal Reserve law and regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks. Under this requirement, we are expected to commit resources to support the Bank, including at times when we may not be in a financial position to provide such resources, and it may not be in our, or our shareholders’ or creditors’, best interests to do so. In addition, any capital loans we make to the Bank are subordinate in right of payment to depositors and to certain other indebtedness of the Bank. The BHCA regulates the activities of holding companies including acquisitions, mergers and consolidations and, together with the Gramm-Leach Bliley Act of 1999, the scope of allowable banking activities. Bancorp is also a bank holding company within the meaning of the California Financial Code. As such, Bancorp and its subsidiaries are subject to examination by, and may be required to file reports with, the DBO.

Bank Regulation

Banking regulations are primarily intended to protect consumers, depositors' funds, federal deposit insurance funds and the banking system as a whole. These regulations affect our lending practices, consumer protections, capital structure, investment practices and dividend policy.

As a state chartered bank, we are subject to regulation, supervision and examination by the DBO. We are also subject to regulation, supervision and periodic examination by the FDIC. If, as a result of an examination of the Bank, the FDIC or the DBO should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of our operations are unsatisfactory, or that we have violated any law or regulation, various remedies are available to those regulators including issuing a “cease and desist” order, monetary penalties, restitution, restricting our growth or removing officers and directors.

_______________________________________________________________________________________
1 Source: S&P Global Market Intelligence of New York, New York

Page-6



The Bank addresses the many state and federal regulations it is subject to through a comprehensive compliance program that addresses the various risks associated with these issues.

Safety and Soundness Standards (Risk Management) 

The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

During the past decade, the bank regulatory agencies have increasingly emphasized the importance of sound risk management processes and strong internal controls when evaluating the activities of the financial institutions they supervise. Properly managing risks has been identified as critical to the conduct of safe and sound banking activities and has become even more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking markets. The agencies have identified a spectrum of risks facing a banking institution including, but not limited to, credit, market, liquidity, operational, legal, and reputational. In particular, recent regulatory pronouncements have focused on operational risk, which arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses. New products and services, third-party risk management and cybersecurity are critical sources of operational risk that financial institutions are expected to address in the current environment. The Board of Directors and various sub-committees oversee Bancorp's consolidated enterprise risk management program that ensures the adequacy of policies, procedures, tolerance levels, risk measurement systems, monitoring processes, management information systems and internal controls.

Dividends

The payment of cash dividends by the Bank to Bancorp is subject to restrictions set forth in the California Financial Code (the “Code”) in addition to regulations and policy statements of the Federal Reserve. Prior to any distribution from the Bank to Bancorp, a calculation is made to ensure compliance with the provisions of the Code and to ensure that the Bank remains within capital guidelines set forth by the DBO and the FDIC. See also Note 8 to the Consolidated Financial Statements, under the heading “Dividends” in ITEM 8 of this report.

FDIC Insurance Assessments

The FDIC insures our customers' deposits to the maximum amount permitted by law, which is currently $250,000 per depositor, based on the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

Our FDIC insurance assessment base is comprised of quarterly average consolidated total assets minus average tangible equity. FDIC's assessment rates are currently between 1.5 and 40 basis points annually on the assessment base for banks in all risk categories. In deriving the risk categories, the FDIC uses a bank's capital level, supervisory ratios and other financial measures to determine a bank's ability to withstand financial stress.

Community Reinvestment Act

Congress enacted the Community Reinvestment Act (“CRA”) in 1977 to encourage financial institutions to meet the credit needs of the communities in which they are located. All banks and thrifts have a continuing and affirmative obligation, consistent with safe and sound operations, to help meet the credit needs of their entire communities, including low and moderate income neighborhoods. Regulatory agencies rate each bank's performance in assessing and meeting these credit needs. The Bank is committed to serving the credit needs of the communities in which we do business, and it is our policy to respond to all creditworthy segments of our market. As part of its CRA commitment, the Bank maintains strong philanthropic ties to the community. We invest in affordable housing projects that help economically disadvantaged individuals and residents of low- and moderate-income census tracts, in each case consistent with our long-established prudent underwriting practices. We also donate to, invest in and volunteer with organizations that serve the communities in which we do business, especially low- and moderate-income individuals. These organizations offer educational and health programs to economically disadvantaged students and families, community development services and affordable housing programs. We offer CRA reportable small business, small farm and community development loans within our assessment areas. The CRA requires a depository institution's

Page-7



primary federal regulator, in connection with its examination of the institution, to assess the institution's record in meeting CRA requirements. The regulatory agency's assessment of the institution's record is made available to the public. This record is taken into consideration when the institution establishes a new branch that accepts deposits, relocates an office, applies to merge or consolidate, or expands into other activities. The FDIC assigned a “Satisfactory” rating to its CRA performance examination completed in January 2018, which was performed under the large bank requirements.

Anti-Money-Laundering Regulations

A series of banking laws and regulations beginning with the Bank Secrecy Act in 1970 requires banks to prevent, detect, and report illicit or illegal financial activities to the federal government to prevent money laundering, international drug trafficking, and terrorism. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, financial institutions are subject to prohibitions against specified financial transactions and account relationships, requirements regarding the Customer Identification Program, as well as enhanced due diligence and “know your customer” standards in their dealings with high risk customers, foreign financial institutions, and foreign individuals and entities. The Customer Due Diligence Rules under the Bank Secrecy Act clarify and strengthen customer due diligence requirements. These rules contain explicit customer due diligence requirements which include a new requirement to identify and verify the identity of beneficial owners of legal entity customers.

Privacy and Data Security

The Gramm-Leach Bliley Act (“GLBA”) of 1999 imposes requirements on financial institutions with respect to consumer privacy and the disclosure of non-public personal information about individuals who apply for or obtain a financial product to be used for personal, family or household purposes. The GLBA generally prohibits disclosure of consumer information to most nonaffiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to consumers and the conditions under which an institution may disclose non-public information about a consumer to a nonaffiliated third-party. The GLBA also directs federal regulators, including the FDIC, to prescribe standards for the security of consumer information. We are subject to such standards, as well as standards for notifying consumers in the event of a security breach. We must disclose our privacy policy to consumers and permit consumers to "opt out" of having non-public customer information disclosed to third parties. We are required to have an information security program to safeguard the confidentiality and security of customer information and to ensure proper disposal of information that is no longer needed. We notify our customers when unauthorized disclosure involves sensitive customer information that may be misused.

Consumer Protection Regulations

Our lending activities are subject to a variety of statutes and regulations designed to protect consumers, including the CRA, Home Mortgage Disclosure Act, Fair Credit Reporting Act, Fair Lending, Fair Debt Collection Practices Act, Flood Disaster Protection Act, Equal Credit Opportunity Act, the Fair Housing Act, Truth-in-Lending Act ("TILA"), the Real Estate Settlement Procedures Act ("RESPA"), and the Secure and Fair Enforcement for Mortgage Licensing Act ("SAFE"). Our deposit operations are also subject to laws and regulations that protect consumer rights including Expedited Funds Availability, Truth in Savings Act ("TISA"), and Electronic Funds Transfers. Other regulatory requirements include: the Unfair, Deceptive or Abusive Acts and Practices ("UDAAP"), Dodd-Frank Act, Right to Financial Privacy and Privacy of Consumer Financial Information. Additional rules govern check writing ability on certain interest earning accounts and prescribe procedures for complying with administrative subpoenas of financial records.

Restriction on Transactions between Bank's Affiliates

Transactions between Bancorp and the Bank are quantitatively and qualitatively restricted under Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W. Section 23A places restrictions on the Bank's “covered transactions” with Bancorp, including loans and other extensions of credit, investments in the securities of, and purchases of assets from Bancorp. Section 23B requires that certain transactions, including all covered transactions, be on market terms and conditions. Federal Reserve Regulation W combines statutory restrictions on transactions between the Bank and Bancorp with Federal Reserve interpretations in an effort to simplify compliance with Sections 23A and 23B.

Page-8



Capital Requirements

The Federal Reserve and the FDIC have adopted risk-based capital guidelines for bank holding companies and banks. Bancorp's ratios exceed the required minimum ratios for capital adequacy purposes and the Bank meets the definition for "well capitalized." Undercapitalized depository institutions may be subject to significant restrictions. Banks that are categorized as "critically undercapitalized" under applicable FDIC regulations are subject to dividend restrictions.

In July 2013, the federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, which became effective January 1, 2015 (subject to a phase-in period). The final rule strengthened the definition of regulatory capital, increased risk-based capital requirements, made selected changes to the calculation of risk-weighted assets, and adjusted the prompt corrective action thresholds. We were in compliance throughout the phase-in period and implemented the fully phased-in capital rules as of January 1, 2019. For additional information on our risk-based capital positions, refer to the Capital Adequacy section within ITEM 7 to Management's Discussion and Analysis and the Consolidated Financial Statements within ITEM 8 of Note 15 to this report.
In December 2017, the Basel Committee published standards that it described as the finalization of the Basel III post-crisis regulatory reforms, which standards are commonly referred to as Basel IV. Among other things, these standards revise the Basel Committee’s standardized approach for credit risk (including the recalibration of the risk weights and the introduction of new capital requirements for certain “unconditionally cancellable commitments,” such as unused credit card lines of credit) and provides a new standardized approach for operational risk capital. Under the Basel framework, these standards will generally be effective on January 1, 2022, with an aggregate output floor phasing in through January 1, 2027. Under the current U.S. capital rules, operational risk capital requirements and a capital floor apply only to advanced approaches institutions, and are not applicable to the Bank. The impact of Basel IV on us will depend on how it is implemented by the federal bank regulators. See also "The Dodd-Frank Wall Street Reform and Consumer Protection Act" section in this ITEM for a discussion of a proposed joint regulatory rule relating to capital for qualifying community banking organizations such as the Bank and such proposed rule making’s impact on Basel III and IV.

The Dodd-Frank Wall Street Reform and Consumer Protection Act

The Dodd-Frank Act, a landmark financial reform bill comprised of voluminous new rules and restrictions on bank operations, included provisions aimed at preventing a repeat of the 2008 financial crisis and a new process for winding down failing, systemically important institutions in a manner as close to a controlled bankruptcy as possible. Among other things, the Dodd-Frank Act established new government oversight responsibilities, enhanced capital adequacy requirements for certain institutions, established consumer protection laws and regulations, and placed limitations on certain banking activities. The current Presidential Administration ("Administration") issued an executive order to consider reforming the Dodd-Frank Act in order to reduce the regulatory burden on U.S. companies, including financial institutions.
The Administration recently signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Economic Growth Act”), which repeals or modifies certain provisions of the Dodd-Frank Act and eases regulations on all but the largest banks. The Economic Growth Act’s highlights include improving consumer access to mortgage credit, adding certain protections for consumers, including veterans and active duty military personnel, expanding credit freezes and creating an identity theft protection database. In addition, the federal banking agencies have issued a joint proposed rule whereby most qualifying community banking organizations with less than $10 billion in total consolidated assets, that meet risk-based qualifying criteria, and have a community bank leverage ratio (“CBLR”) of greater than 9 percent would be able to opt into a new community banking leverage ratio framework. Such a community banking organization would not be subject to other risk-based and leverage capital requirements (including the Basel III and Basel IV requirements) and would be considered to have met the well capitalized ratio requirements. The CBLR is determined by dividing a financial institution’s tangible equity capital by its average total consolidated assets. The proposed rule further describes what is included in tangible equity capital and average total consolidated assets. The Bank feels that should this rule be adopted in a substantially similar format to the proposed rule, it would greatly ease the process of determining the Bank’s capital requirements.
Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us. In addition, the Economic Growth Act modifies several provisions in

Page-9



the Dodd-Frank Act, but the modifications are subject to implementing regulations. Although the reforms primarily target systemically important financial service providers, the Dodd-Frank Act’s influence has impacted and is expected to continue to impact smaller institutions over time. We will continue to evaluate the effect of the Dodd-Frank Act; however, in many respects, the ultimate impact of the Dodd-Frank Act will not be fully known for years, and no current assurance may be given that the Dodd-Frank Act, or any other new legislative changes, will not have a negative impact on the results of operations and financial condition of the Company and the Bank.

Notice and Approval Requirements Related to Control

Banking laws impose notice, approval and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect "control" of an FDIC-insured depository institution. These laws include the BHCA and the Change in Bank Control Act. Among other things, these laws require regulatory filings by a shareholder or other party that seeks to acquire direct or indirect "control" of an FDIC-insured depository institution or bank holding company. The determination whether an investor "controls" a depository institution is based on all of the facts and circumstances surrounding the investment. As a general matter, a party is deemed to control a depository institution or other company if the party owns or controls 25% or more of any class of voting stock. Subject to rebuttal, a party may be presumed to control a depository institution or other company if the investor owns or controls 10% or more of any class of voting stock. Ownership by family members, affiliated parties, or parties acting in concert, is typically aggregated for these purposes. If a party's ownership of the Company were to exceed certain thresholds, the investor could be deemed to "control" the Company for regulatory purposes. This could subject the investor to regulatory filings or other regulatory consequences.

In addition, except under limited circumstances, bank holding companies are prohibited from acquiring, without prior approval: 1) control of any other bank or bank holding company or all or substantially all the assets thereof; or 2) more than 5% of the voting shares of a bank or bank holding company that is not already a subsidiary.

Incentive Compensation

The Dodd-Frank Act required federal bank regulators and the Securities and Exchange Commission ("SEC") to establish joint regulations or guidelines prohibiting incentive-based payment arrangements that encourage inappropriate risks by providing an executive officer, employee, director or principal stockholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. These regulations apply to institutions having at least $1 billion in total assets. In addition, regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The agencies have not finalized regulations proposed in April 2016. If adopted, the proposed regulations could place limits on the manner in which we structure our executive compensation.

The Federal Reserve reviews, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations. The Federal Reserve tailors their reviews for each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives are included in reports of examination. Deficiencies, if any, are incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.


Page-10



Available Information

On our Internet web site, www.bankofmarin.com, we post the following filings as soon as reasonably practical after they are filed with or furnished to the Securities and Exchange Commission: Annual Report to Shareholders, Form 10-K, Proxy Statement for the Annual Meeting of Shareholders, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934. All such materials on our website are available free of charge. This website address is for information only and is not intended to be an active link, or to incorporate any website information into this document. In addition, copies of our filings are available by requesting them in writing or by phone from:

Corporate Secretary
Bank of Marin Bancorp    
504 Redwood Boulevard, Suite 100
Novato, CA 94947
415-763-4523
These materials are also available at the SEC’s internet website (https://www.sec.gov).

ITEM 1A      RISK FACTORS

We assume and manage a certain degree of risk in order to conduct our business. The material risks and uncertainties that Management believes may affect our business are listed below and in ITEM 7A, Quantitative and Qualitative Disclosure about Market Risk. The list is not exhaustive; additional risks and uncertainties that Management is not aware of, or focused on, or currently deems immaterial may also impair business operations. If any of the following risks, or risks that have not been identified, actually occur, our financial condition, results of operations, and stock trading price could be materially and adversely affected. We manage these risks by promoting sound corporate governance practices, which include but are not limited to, establishing policies and internal controls, and implementing internal review processes. Before making an investment decision, investors should carefully consider the risks, together with all of the other information included or incorporated by reference in this Annual Report on Form 10-K and our other filings with the SEC. This report is qualified in its entirety by these risk factors.

Earnings are Significantly Influenced by General Business and Economic Conditions

Our success depends, to a certain extent, on local, national and global economic and political conditions. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers primarily in the State of California with particular focus on the local markets in the San Francisco Bay Area. The local economic conditions in this area have a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposits as our primary funding source. Economic pressure on consumers and uncertainty regarding the sustainability of economic improvements may result in changes in consumer and business spending, borrowing and saving habits, which may affect the demand for loans and other products and services we offer. Further, loan defaults that adversely affect our earnings correlate highly with deteriorating economic conditions (such as the unemployment rate), which impact our borrowers' creditworthiness. In addition, international trade disputes, inflation risks, oil price volatility, the level of U.S. debt and global economic conditions could destabilize financial markets in which we operate. Lastly, actions of the Federal Open Market Committee ("FOMC") of the Federal Reserve could cause stock market volatility, which we observed in late 2018.

Interest Rate Risk is Inherent in Our Business

Our earnings are largely dependent upon our net interest income, which is the difference between interest income earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds. Interest rates are sensitive to many factors outside of our control, including general economic conditions and the policies of various governmental and regulatory agencies and, in particular, the FOMC, which regulates the supply of money and credit in the United States. Changes in monetary policy, including changes in interest rates, can influence not only the interest we receive on loans and securities and interest we pay on deposits and borrowings, but can also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the duration of our securities and loan portfolios. Our portfolio of loans

Page-11



and securities will generally decline in value if market interest rates increase, and increase in value if market interest rates decline. In addition, our loans and callable mortgage-backed securities are also subject to prepayment risk when interest rates fall, and the borrowers' credit risk may increase in rising rate environments. Factors such as inflation, productivity, oil prices, unemployment rates, and global demand play a role in the FOMC's consideration of future rate adjustments. In January 2019, the FOMC indicated that it will be patient with future rate hikes in light of global economic and financial uncertainties and muted inflation pressures and might plan to stop reducing the Federal Reserve’s asset holdings in late 2019.

Our net interest income is vulnerable to a falling or flat rate environment and will benefit if the prevailing market interest rates increase in the long-term. However, a rise in index rates leads to lower debt service coverage of variable rate loans if the borrower's operating cash flow does not also rise. This creates a paradox of an improving economy (leading to higher interest rates) with increased credit risk as short-term rates move up faster than the cash flow or income of the borrowers. Higher interest rates may also depress loan demand, making it more difficult for us to grow loans.
 
See the sections captioned “Net Interest Income” in Management's Discussion and Analysis of Financial Condition and Results of Operations in ITEM 7 and Quantitative and Qualitative Disclosures about Market Risk in ITEM 7A of this report for further discussion related to management of interest rate risk.

Banks and Bank Holding Companies are Subject to Extensive Government Regulation and Supervision

Bancorp and the Bank are subject to extensive federal and state governmental supervision, regulation and control. Holding company regulations affect the range of activities in which Bancorp is engaged. Banking regulations affect the Bank's lending practices, capital structure, investment practices, dividend policy, and compliance costs among other things. Compliance risk is the current and prospective risk to earnings or capital arising from violations of, or non-conformance with, laws, rules, regulations, prescribed practices, internal policies and procedures, or ethical standards set forth by regulators. Compliance risk also arises in situations where the laws or rules governing certain bank products or activities of our clients may be ambiguous or untested. This risk exposes Bancorp and the Bank to potential fines, civil money penalties, payment of damages and the voiding of contracts. Compliance risk can lead to diminished reputation, reduced franchise value, limited business opportunities, reduced expansion potential and an inability to enforce contracts. The Bank manages these risks through its extensive compliance plan, policies and procedures. For further information on supervision and regulation, see the section captioned “SUPERVISION AND REGULATION” in ITEM 1 of this report.

Competition with Other Financial Institutions to Attract and Retain Banking Customers

We are facing significant competition for customers from other banks and financial institutions located in the markets that we serve. We compete with commercial banks, savings institutions, credit unions, non-bank financial services companies, including financial technology firms, and other financial institutions operating within or near our service areas. Some of our non-bank competitors and peer-to-peer lenders may not be subject to the same extensive regulations as we are, giving them greater flexibility in competing for business. We anticipate intense competition will continue for the coming year due to the consolidation of many financial institutions and more changes in legislation, regulation and technology. National and regional banks much larger than our size have entered our market through acquisitions and they may be able to benefit from economies of scale through their wider branch networks, more prominent national advertising campaigns, lower cost of borrowing, capital market access and sophisticated technology infrastructures. Further, intense competition for creditworthy borrowers could lead to pressure for loan rate concessions and affect our ability to generate profitable loans.

Going forward, we may see continued competition in the industry as competitors seek to expand market share in our core markets. Further, our customers may withdraw deposits to pursue alternative investment opportunities in the recent bullish equity market. Technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments or other deposit accounts such as online virtual banks and non-bank service providers. Efforts and initiatives we may undertake to retain and increase deposits, including deposit pricing, can increase our costs. Based on our current strong liquidity position, our adjustment to deposit pricing has lagged the market in a rising interest rate environment. If our customers move money into higher yielding deposits or alternative investments, we may lose a relatively inexpensive source of funds, thus increasing our funding costs through more expensive wholesale borrowings.


Page-12



Activities of Our Large Borrowers and Depositors May Cause Unexpected Volatilities in Our Loan and Deposit Balances, as well as Net Interest Margin

Rising real estate values in the Bay Area market have motivated some of our borrowers to sell real estate that collateralized our loans, contributing to loan payoff activity. Payoffs of loans originated during a higher interest rate environment may be replaced by new loans with lower interest rates, causing downward pressure on our net interest margin. In addition, the top ten depositor relationships accounted for approximately 11% of our total deposit balances at December 31, 2018. The business models and cash cycles of some of our large commercial depositors may also cause short-term volatility in their deposit balances held with us. As our customers' businesses grow, the dollar value of their daily activities may also grow leading to larger fluctuations in daily balances. Any long-term decline in deposit funding would adversely affect our liquidity. For additional information on our management of deposit volatility, refer to the Liquidity section of ITEM 7, Management's Discussion and Analysis, of this report.

Negative Conditions Affecting Real Estate May Harm Our Business and Our Commercial Real Estate ("CRE") Concentration May Heighten Such Risk

Concentration of our lending activities in the California real estate sector could negatively affect our results of operations if adverse changes in our lending area occur. Although we do not offer traditional first mortgages, nor have sub-prime or Alt-A residential loans or significant amounts of securities backed by such loans in the portfolio, we are not immune to volatility in those markets. As of December 31, 2018, approximately 88% of our loans were secured by real estate, of which 67% were secured by CRE and the remaining 21% by residential real estate. Real estate valuations are influenced by demand, and demand is driven by economic factors such as employment rates and interest rates.

Loans secured by CRE include those secured by office buildings, owner-user office/warehouses, mixed-use residential/commercial properties and retail properties. There can be no assurance that the companies or properties securing our loans will generate sufficient cash flows to allow borrowers to make full and timely loan payments to us. In the event of default, the collateral value may not cover the outstanding amount due to us, especially during real estate market downturns.

Rising CRE lending concentrations may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the CRE market. Concentration risk exists when financial institutions deploy too many assets to any one industry or segment. Concentration stemming from commercial real estate is one area of regulatory concern. The CRE Concentration Guidance provides supervisory criteria, including the following numerical indicators, to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny: (i) commercial real estate loans exceeding 300% of capital and increasing 50% or more in the preceding three years; or (ii) construction and land development loans exceeding 100% of capital. The CRE Concentration Guidance does not limit banks’ levels of commercial real estate lending activities, but rather guides institutions in developing risk management practices and levels of capital that are commensurate with the level and nature of their commercial real estate concentrations. As of December 31, 2018, using regulatory definitions in the CRE Concentration Guidance, our CRE loans represented 340% of our total risk-based capital. We are actively working to manage our CRE concentration and we have discussed the CRE Concentration Guidance with the regulatory agencies and believe that our underwriting policies, management information systems, independent credit administration process, and monitoring of real estate loan concentrations are currently sufficient to address the CRE Concentration Guidance.

Severe Weather, Natural Disasters or Other Climate Change Related Matters Could Significantly Affect Our Business

Our primary market is located in an earthquake-prone zone in Northern California, which is also subject to other weather or disasters, such as severe rainstorms, wildfire, drought or flood. These events could interrupt our business operations unexpectedly. Climate-related physical changes and hazards could also pose credit risks for us. For example, our borrowers may have collateral properties or operations located in coastal areas at risk to rising sea levels and erosion or subject to the risk of drought in California. The properties pledged as collateral on our loan portfolio could also be damaged by tsunamis, landslides, floods, earthquakes or wildfires and thereby the recoverability of loans could be impaired. A number of factors can affect credit losses, including the extent of damage to the collateral, the extent of damage not covered by insurance, the extent to which unemployment and other economic conditions caused by the natural disaster adversely affect the ability of borrowers to repay their loans, and the cost of collection and foreclosure to us. Lastly, there could be increased insurance premiums and deductibles, or a decrease in the availability of coverage,

Page-13



due to severe weather-related losses. The ultimate outcome on our business of a natural disaster, whether or not caused by climate change, is difficult to predict.

We are Subject to Significant Credit Risk and Loan Losses May Exceed Our Allowance for Loan Losses in the Future

We maintain an allowance for loan losses, which is a reserve established through provisions for loan losses charged to expense, that represents Management's best estimate of probable losses that may be incurred within the existing portfolio of loans (the "incurred loss model"). The level of the allowance reflects Management's continuing evaluation of specific credit risks, loan loss experience, current loan portfolio quality and present economic, political and regulatory conditions. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Further, we generally rely on appraisals of the collateral or comparable sales data to determine the level of specific reserve and/or the charge-off amount on certain collateral dependent loans. Inaccurate assumptions in the appraisals or an inappropriate choice of the valuation techniques may lead to an inadequate level of specific reserve or charge-offs.

Changes in economic conditions affecting borrowers, new information regarding existing loans and their collateral, identification of additional problem loans, and other factors may require an increase in our allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs. If charge-offs in future periods exceed the allowance for loan losses or cash flows from acquired loans do not perform as expected, we will need to record additional provision for loan losses.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Under the new guidance, entities will be required to measure expected credit losses by utilizing forward-looking information to assess an entity's allowance for credit losses. The measurement of expected credit losses will be based on historical experience, current conditions and reasonable and supportable forecasts that affect the collectability of a credit over its remaining life. In addition, the ASU amends the accounting for potential credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Refer to Note 1 to the Consolidated Financial Statements in ITEM 8 for further information.

Securities May Lose Value due to Credit Quality of the Issuers

We invest in significant portions of investment securities issued by government-sponsored enterprises ("GSE"), such as Federal Home Loan Bank ("FHLB"), Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation ("FHLMC"), and Federal Farm Credit Banks Funding Corporation. We also hold mortgage-backed securities (“MBS”) issued by FNMA and FHLMC. While we consider FNMA and FHLMC securities to have low credit risk as they carry the explicit backing of the U.S. Government due to conservatorship, they are not direct obligations of the U.S. Government. GSE debt is sponsored but not guaranteed by the federal government and carries implicit backing, whereas government agencies such as Government National Mortgage Association ("GNMA") are divisions of the government whose securities are backed by the full faith and credit of the U.S. Government.

Since 2008, both FNMA and FHLMC have been under a U.S. Government conservatorship. As a result, securities issued by FNMA and FHLMC have benefited from this government support. However, housing finance reform may be introduced to end GSE status, place FNMA and FHLMC into receivership and replace them with multiple mortgage guarantors, which could impact the fair value of our securities issued or guaranteed by these entities. Although Congress has taken steps to improve regulation and consumer protection related to the housing finance system (e.g., Dodd-Frank Act), FNMA and FHLMC have entered their eleventh year of U.S. Government conservatorship. While Congress has considered numerous proposals to end the conservatorship, at the date of this report, its future and ultimate impact on the financial markets and our investments in GSE's are uncertain. For example, if the government support is phased-out or completely withdrawn; if the reduction in Federal Reserve's holdings of treasury and agency securities continues; or, if either FNMA or FHLMC comes under financial stress or suffers creditworthiness deterioration, the value of our investments may be significantly impacted.


Page-14



While we generally seek to minimize our exposure by diversifying the geographic location of our portfolio and investing in investment grade securities, there is no guarantee that the issuers will remain financially sound or continue their payments on these debentures.

Unexpected Early Termination of Interest Rate Swap Agreements May Affect Earnings

We have entered into interest-rate swap agreements, primarily as an asset/liability risk management tool, in order to mitigate the changes in the fair value of specified long-term fixed-rate loans and firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates. These hedges allow us to offer long-term, fixed-rate loans to customers without assuming the interest rate risk of a long-term asset by swapping our fixed-rate interest stream for a floating-rate interest stream. In the event of default by the borrowers on our hedged loans, we may have to terminate these designated interest-rate swap agreements early, resulting in prepayment penalties charged by our counterparties and negatively affect our earnings.

Growth Strategy or Potential Future Acquisitions May Produce Unfavorable Outcomes

We seek to expand our franchise safely and consistently. A successful growth strategy requires us to manage multiple aspects of the business simultaneously, such as following adequate loan underwriting standards, balancing loan and deposit growth without increasing interest rate risk or compressing our net interest margin, maintaining sufficient capital, and recruiting, training and retaining qualified professionals.

Our strategic plan also includes merger and acquisition possibilities that either enhance our market presence or have potential for improved profitability through financial management, economies of scale or expanded services, such as the Bank of Napa acquisition in 2017. We may incur significant acquisition related expenses either during the due diligence phase of acquisition targets or during integration of the acquirees. These expenses have and may continue to negatively impact our earnings prior to realizing the benefits of acquisitions. We may also be exposed to difficulties in combining the operations of acquired institutions into our own operations, which may prevent us from achieving the expected benefits from our acquisition activities. Our earnings, financial condition and prospects after the merger may affect our stock price and will depend in part on our ability to integrate the operations and management of the acquired institution while continuing to implement other aspects of our business plan. Inherent uncertainties exist in integrating the operations of an acquired institution and there is no assurance that we will be able to do so successfully. Among the issues that we could face are:
unexpected problems with operations, personnel, technology or credit;
loss of customers and employees of the acquiree;
difficulty in working with the acquiree's employees and customers;
the assimilation of the acquiree's operations, culture and personnel;
instituting and maintaining uniform standards, controls, procedures and policies; and
litigation risk not discovered during the due diligence period.

Undiscovered factors as a result of an acquisition could bring liabilities against us, our management and the management of the institutions we acquire. These factors could contribute to our not achieving the expected benefits from our acquisitions within desired time frames, if at all. Further, although we generally anticipate cost savings from acquisitions, we may not be able to fully realize those savings. Any cost savings may be offset by losses in revenues or other charges to earnings.

We May Not Be Able to Attract and Retain Key Employees

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most activities engaged by us has been intense, especially in light of the recent improvement in the job market, and we may not be able to hire skilled people or retain them. We do not have non-compete agreements with any of our senior officers. The unexpected loss of key personnel could have an unfavorable effect on our business because of the skills, knowledge of our market, years of industry experience and difficulty of promptly finding qualified replacement personnel.


Page-15



Accounting Estimates and Risk Management Processes Rely on Analytical and Forecasting Models

The processes we use to estimate probable loan losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on our financial condition and results of operations, depends upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are adequate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation. If the models we use for interest rate risk and asset-liability management are inadequate, we may incur increased or unexpected losses upon changes in market interest rates or other market measures. If the models we use for determining our probable loan losses are inadequate, the allowance for loan losses may not be sufficient to support future charge-offs. If the models we use to measure the fair value of financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what we could realize upon sale or settlement of such financial instruments. Any such failure in our analytical or forecasting models could have a material adverse effect on our business, financial condition and results of operations.

The Value of Goodwill and Other Intangible Assets May Decline in the Future

As of December 31, 2018, we had goodwill totaling $30.1 million and a core deposit intangible asset totaling $5.6 million from business acquisitions. A significant decline in expected future cash flows, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of our common stock could necessitate taking charges in the future related to the impairment of goodwill or other intangible assets. If we were to conclude that a future write-down of goodwill or other intangible assets is necessary, we would record the appropriate charge, which could have a material adverse effect on our business, financial condition and results of operations.

We May Take Filing Positions or Follow Tax Strategies That May Be Subject to Challenge

We provide for current and deferred tax provision in our consolidated financial statements based on our results of operations, business activities and business combinations, legal structure and federal and state legislation and regulations, which is still evolving from the December 2017 enactment of the Tax Cuts and Jobs Act of 2017. We may take filing positions or follow tax strategies that are subject to interpretation of tax statutes. Our net income may be reduced if a federal, state or local authority were to assess charges for taxes that have not been provided for in our consolidated financial statements. Taxing authorities could change applicable tax laws and interpretations, challenge filing positions or assess new taxes and interest charges. If taxing authorities take any of these actions, our business, results of operations or financial condition could be significantly affected.

The Financial Services Industry is Undergoing Rapid Technological Changes and, As a Result, We Have a Continuing Need to Stay Current with Those Changes to Compete Effectively and Increase Our Efficiencies. We May Not Have the Resources to Implement New Technology to Stay Current with These Changes
The financial services industry is undergoing technological changes with frequent introductions of new technology-driven products and services. In addition to providing better client service, the effective use of technology increases efficiency and reduces operational costs. Our future success will depend in part upon our ability to use technology to provide products and services that will satisfy client demands securely and cost-effectively. In connection with implementing new technology enhancements and/or products, we may experience operational challenges (e.g. human error, system error, incompatibility) which could result in us not fully realizing the anticipated benefits from such new technology or require us to incur significant costs to remedy any such challenges in a timely manner.

Risks Associated with Cybersecurity Could Negatively Affect Our Earnings and Reputation

Our business requires the secure management of sensitive client and bank information. We work diligently to implement security measures that intend to make our communications and information systems safe to conduct business. Cyber threats such as social engineering, ransomware, and phishing emails are more prevalent now than ever before. These incidents include intentional and unintentional events that may present threats designed to disrupt operations, corrupt data, release sensitive information or cause denial-of-service attacks. A cybersecurity breach of systems operated by the Bank, merchants, vendors, customers, or externally publicized breaches of other financial institutions may significantly harm our reputation, result in a loss of customer business, subject us to regulatory scrutiny, or expose us to civil litigation and financial liability. While we have systems and procedures designed to prevent security breaches,

Page-16



we cannot be certain that advances in criminal capabilities, physical system or network break-ins or inappropriate access will not compromise or breach the technology protecting our networks or proprietary client information. If a material security breach were to occur, the Bank has policies and procedures in place to ensure timely disclosure.

We Rely on Third-Party Vendors for Important Aspects of Our Operation

We depend on the accuracy and completeness of information and systems provided by certain key vendors, including but not limited to data processing, payroll processing, technology support, investment safekeeping and accounting. For example, we outsource core processing to Fidelity Information Services ("FIS") and wire processing to Finastra, which are leading financial services solution providers that allow us access to competitive technology offerings without having to invest in their development. Our ability to operate, as well as our financial condition and results of operations, could be negatively affected in the event of an interruption of an information system, an undetected error, a cyber-breach, or in the event of a natural disaster whereby certain vendors are unable to maintain business continuity.

Bancorp Relies on Dividends from the Bank to Pay Cash Dividends to Shareholders

Bancorp is a separate legal entity from its subsidiary, the Bank. Bancorp receives substantially all of its cash stream from the Bank in the form of dividends, which is Bancorp's principal source of funds to pay cash dividends to Bancorp's common shareholders, service subordinated debt, and cover operational expenses of the holding company. Various federal and state laws and regulations limit the amount of dividends that the Bank may pay to Bancorp. In the event that the Bank is unable to pay dividends to Bancorp, Bancorp may not be able to pay dividends to its shareholders or pay interest on the subordinated debentures. As a result, it could have an adverse effect on Bancorp's stock price and investment value.

Federal law would prohibit capital distributions from the Bank, with limited exceptions, if the Bank were categorized as "undercapitalized" under applicable Federal Reserve or FDIC regulations. In addition, as a California bank, Bank of Marin is subject to state law restrictions on the payment of dividends. For further information on the distribution limit from the Bank to Bancorp, see the section captioned “Bank Regulation” in ITEM 1 above and “Dividends” in Note 8 to the Consolidated Financial Statements in ITEM 8 of this report.

The Trading Volume of Bancorp's Common Stock is Less than That of Other, Larger Financial Services Companies

Our common stock is listed on the NASDAQ Capital Market exchange. Our trading volume is less than that of nationwide or larger regional financial institutions. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence of willing buyers and sellers of common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the low trading volume of our common stock, significant trades of our stock in a given time, or the expectations of these trades, could cause volatility in the stock price.

The Small to Medium-sized Businesses that we Lend to may have Fewer Resources to Weather Adverse Business Developments, which may Impair a Borrower's Ability to Repay a Loan, and such Impairment could Adversely Affect our Results of Operations and Financial Condition

We focus our business development and marketing strategy primarily on small to medium-sized businesses. Small to medium-sized businesses frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower's ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could adversely affect the business and its ability to repay its loan. If general economic conditions negatively affect the California markets in which we operate and small to medium-sized businesses are adversely affected or our borrowers are otherwise affected by adverse business developments, our business, financial condition and results of operations may be negatively affected.


Page-17



A Lack of Liquidity could Adversely Affect our Operations and Jeopardize our Business, Financial Condition and Results of Operations

Liquidity is essential to our business. We rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities, respectively, to ensure that we have adequate liquidity to fund our operations. An inability to raise funds through deposits, borrowings, securities sales, Federal Home Loan Bank advances, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our most important source of funds consists of deposits. Deposit balances can decrease when customers perceive alternative investments as providing a better risk/return trade-off. If customers move money out of bank deposits and into other investments, then we would lose a relatively low-cost source of funds, increasing our funding costs and reducing our net interest income and net income.

Other primary sources of funds consist of cash flows from operations, investment maturities and sales, loan repayments, and proceeds from the issuance and sale of any equity and debt securities to investors. Additional liquidity is provided by the ability to borrow from the Federal Reserve Bank of San Francisco and the Federal Home Loan Bank and our ability to raise brokered deposits. We also may borrow funds from third-party lenders, such as other financial institutions. Our access to funding sources in amounts adequate to finance or capitalize our activities, or on terms that are acceptable to us, could be impaired by factors that affect us directly or the bank or non-bank financial services industries or the economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the bank or non-bank financial services industries.

Based on experience, we believe that our deposit accounts are relatively stable sources of funds. If we increase interest rates paid to retain deposits, our earnings may be adversely affected, which could have an adverse effect on our business, financial condition and results of operations.

Any decline in available funding could adversely affect our ability to originate loans, invest in securities, meet our expenses, and pay dividends to our shareholders or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, financial condition and results of operations.

Changes to, or Elimination of, London Interbank Offered Rate (“LIBOR”) Could Adversely Affect our Financial Instruments with Interest Rates Currently Indexed to LIBOR

In 2017, the Financial Conduct Authority of the United Kingdom (the “FCA”) announced its intention to cease sustaining LIBOR after 2021.  While the FCA came to an agreement with panel banks to continue receiving submissions to LIBOR until the end of 2021, it is not possible to predict whether and how credible LIBOR will be as an acceptable market benchmark.  The FCA is encouraging due diligence and implementation of alternative rates prior to the phase out of LIBOR.  While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, the Alternative Reference Rates Committee (“ARRC”), a steering committee comprised of U.S. financial market participants, selected by the Federal Reserve Bank of New York, began to publish the Secured Overnight Financing Rate (“SOFR”) as an alternative to LIBOR. SOFR is a broad measure of the cost of overnight borrowings collateralized by Treasury securities selected by the ARRC. Hence, SOFR is a risk-free rate, while LIBOR is a risk-based rate. Therefore, a spread adjustment is required and will most likely be recommended by a relevant governmental body (such as ARRC). Such language has yet to be published and it is unknown to us whether during the transition period, banks like us will be permitted to retain LIBOR as a reference rate, be required to amend contracts to reference SOFR without economic impact (market, legal and documentation costs), or be allowed to amend the definition of LIBOR through a specific grandfathering protocol.

We have floating rate loans and investment securities, interest rate swap agreements and subordinated debentures whose interest rates are indexed to LIBOR that mature after December 31, 2021.  The transition from LIBOR could create additional costs as well as economic and reputation risk. We cannot predict any unfavorable effect the chosen alternative index may have on financial instruments currently indexed to LIBOR.

ITEM 1B      UNRESOLVED STAFF COMMENTS

None

Page-18



ITEM 2     PROPERTIES

We lease our corporate headquarters building in Novato, California, which houses loan production, operations, Wealth Management & Trust and administration.  We lease branch and office facilities within our primary market areas in the cities of Corte Madera, San Rafael, Novato, Sausalito, Mill Valley, Tiburon, Greenbrae, Petaluma, Santa Rosa, Healdsburg, Sonoma, Napa, San Francisco, Alameda, Oakland, and Walnut Creek.  For additional information on properties, see Notes 4 and 12 to the Consolidated Financial Statements included in ITEM 8 of this report.

ITEM 3         LEGAL PROCEEDINGS
 
Bancorp may be party to legal actions that arise from time to time as part of the normal course of business. Bancorp's Management is not aware of any pending legal proceedings to which either it or the Bank may be a party or has recently been a party that will have a material adverse effect on the financial condition or results of operations of Bancorp or the Bank.
 
The Bank is responsible for its proportionate share of certain litigation indemnifications provided to Visa U.S.A. by its member banks in connection with lawsuits related to anti-trust charges and interchange fees. Because Visa funded a litigation escrow account to insulate member banks from financial liability, we do not expect to make any cash settlement payments as a result of Visa's litigation. For further details, see Note 12 to the Consolidated Financial Statements in ITEM 8 of this report.

ITEM 4      MINE SAFETY DISCLOSURES
 
Not applicable.


Page-19



PART II     
 
ITEM 5      MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information and Holders

Bancorp common stock trades on the NASDAQ Capital Market under the symbol BMRC. On October 22, 2018, Bancorp announced a two-for-one stock split, which occurred on November 27, 2018. All share and per share data have been adjusted to reflect the stock split effective November 27, 2018. At February 28, 2019, 13,806,416 shares of Bancorp's common stock, no par value, were outstanding and held by approximately 2,900 holders of record and beneficial owners.

Five-Year Stock Price Performance Graph

The following graph, compiled by S&P Global Market Intelligence of New York, New York, shows a comparison of cumulative total shareholder return on our common stock during the five fiscal years ended December 31, 2018 compared to the Russell 2000 Stock index and the SNL Bank $1B - $5B Index. The comparison assumes the investment of $100 in our common stock on December 31, 2013 and the reinvestment of all dividends. The graph represents past performance and does not indicate future performance. In addition, total return performance results vary depending on the length of the performance period.

stockperformancechart2013201.jpg
 
2013

2014

2015

2016

2017

2018

Bank of Marin Bancorp (BMRC)
100.00

123.34

127.50

169.97

168.53

207.70

Russell 2000 Index
100.00

104.89

100.26

121.63

139.44

124.09

SNL Bank $1B - $5B Index 1
100.00

104.56

117.04

168.38

179.51

157.27

Source: S&P Global Market Intelligence
 
1 Includes all major exchange (NYSE, NYSE MKT, and Nasdaq) banks in S&P Global's coverage universe with $1 billion to $5 billion in assets as of the most recent available financial data.

Page-20



Shareholder Rights Agreement

On July 6, 2017, Bancorp executed a shareholder rights agreement (“Rights Agreement”), which is designed to discourage takeovers that involve abusive tactics or do not provide fair value to shareholders. For further information, see Note 8 to the Consolidated Financial Statements, under the heading “Preferred Stock and Shareholder Rights Plan” in ITEM 8 of this report.

Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes information as of December 31, 2018, with respect to equity compensation plans. All plans have been approved by the shareholders.
 
Shares to be issued upon exercise of outstanding options1

Weighted average exercise price of outstanding options

Shares remaining available for future issuance 2
Equity compensation plans approved by shareholders
425,700

$
25.01

1,262,182
1 Represents shares of common stock issuable upon exercise of outstanding options under the Bank of Marin Bancorp 2017 Equity Plan and 2007 Equity Plan.
2 Represents remaining shares of common stock available for future grants under the 2017 Equity Plan and the 2010 Director Stock Plan, excluding 425,700 shares to be issued upon exercise of outstanding options and 383,870 shares available to be issued under the Employee Stock Purchase Plan.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

On April 23, 2018, Bancorp announced that its Board of Directors approved a Share Repurchase Program under which Bancorp may repurchase up to $25.0 million of its outstanding common stock through May 1, 2019. From April 23, 2018 to December 31, 2018, Bancorp repurchased 171,217 shares at an average price of $40.92 and a total cost of $7.0 million. The following table reflects purchases under the Share Repurchase Program for the periods presented. For further information, see Note 8 to the Consolidated Financial Statements, under the heading “Share Repurchase Program” in ITEM 8 of this report.
(in thousands, except per share data)
Total Number of Shares Purchased 1

Average Price Paid per Share 1

Total Number of Shares Purchased as Part of Publicly Announced Programs 1

Approximate Dollar Value That May yet Be Purchased Under the Program

Period
April 23-30, 2018

$


$
25,000

May 1-31, 2018
2,796

37.03

2,796

24,896

June 1-30, 2018



24,896

July 1-31, 2018



24,896

August 1-31, 2018
8,888

44.43

8,888

24,501

September 1-30, 2018
24,202

42.99

24,202

23,460

October 1-30, 2018
29,890

40.68

29,890

22,244

November 1-30, 2018
34,754

42.10

34,754

20,779

December 1-31, 2018
70,687

39.44

70,687

17,988

Total
171,217

$
40.92

171,217

 
1 Share and per share data have been adjusted to reflect the two-for-one stock split effective November 27, 2018.


Page-21



ITEM 6        SELECTED FINANCIAL DATA

The following data has been derived from the audited consolidated financial statements of Bank of Marin Bancorp. For additional information, refer to ITEM 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and ITEM 8, Financial Statements and Supplementary Data.
 
At December 31,
(in thousands)
2018
2017
2016
2015
2014
Selected financial condition data:
 
 
 
 
 
Total assets
$
2,520,892

$
2,468,154

$
2,023,493

$
2,031,134

$
1,787,130

Loans, net
1,748,043

1,663,246

1,471,174

1,436,299

1,348,252

Deposits
2,174,840

2,148,670

1,772,700

1,728,226

1,551,619

Borrowings
9,640

5,739

5,586

72,395

20,185

Stockholders' equity
316,407

297,025

230,563

214,473

200,026

 
For the Years Ended December 31,
(dollars in thousands, except per share data)
2018
2017
2016
2015
2014
Selected operating data:
 
 
 
 
 
Net interest income
$
91,544

$
74,852

$
73,161

$
67,187

$
70,441

Provision for (reversal of) loan losses

500

(1,850
)
500

750

Non-interest income
10,139

8,268

9,161

9,193

9,041

Non-interest expense 1
58,266

53,782

47,692

46,949

47,263

Net income 1
32,622

15,976

23,134

18,441

19,771

Net income per common share:6
 
 
 
 
 
Basic
$
2.35

$
1.29

$
1.90

$
1.55

$
1.68

Diluted
$
2.33

$
1.27

$
1.89

$
1.52

$
1.65

 
At or for the Years Ended December 31,
 
2018
2017
2016
2015
2014
Performance and other financial ratios:
 
 
 
 
 
Return on average assets
1.31
%
0.75
%
1.15
%
0.98
%
1.08
%
Return on average equity
10.73
%
6.49
%
10.23
%
8.84
%
10.31
%
Tax-equivalent net interest margin 2
3.90
%
3.80
%
3.91
%
3.83
%
4.13
%
Efficiency ratio
57.30
%
64.70
%
57.93
%
61.47
%
59.46
%
Loan-to-deposit ratio
81.10
%
78.14
%
83.86
%
83.97
%
87.87
%
Cash dividend payout ratio on common stock 3
27.23
%
43.41
%
26.84
%
29.03
%
23.81
%
Cash dividends per common share 6
$
0.64

$
0.56

$
0.51

$
0.45

$
0.40

Asset quality ratios:
 
 
 
 
 
Allowance for loan losses to total loans
0.90
%
0.94
%
1.04
%
1.03
%
1.11
%
Allowance for loan losses to non-performing loans 4
22.71x

38.88x

106.5x

6.88x

1.61x

Non-performing loans to total loans 4
0.04
%
0.02
%
0.01
%
0.15
%
0.69
%
Capital ratios:
 
 
 
 
 
Equity to total assets ratio
12.55
%
12.03
%
11.39
%
10.60
%
11.20
%
Tangible common equity to tangible assets 5
 
 
 
 
 
Total capital (to risk-weighted assets)
14.93
%
14.91
%
14.32
%
13.37
%
13.94
%
Tier 1 capital (to risk-weighted assets)
14.10
%
14.04
%
13.37
%
12.44
%
12.87
%
Tier 1 capital (to average assets)
11.54
%
12.13
%
11.39
%
10.67
%
10.62
%
Common equity Tier 1 capital (to risk-weighted assets)
13.98
%
13.75
%
13.07
%
12.16
%
N/A

Other data:
 
 
 
 
 
Number of full service offices
23

23

20

20

21

Full time equivalent employees
290

291

262

259

260

1 2018, 2017 and 2014 included $962 thousand, $2.2 million, $746 thousand, respectively, in merger-related expenses.
2 Tax-equivalent net interest margin is computed by dividing taxable equivalent net interest income, which is adjusted for taxable equivalent income on tax-exempt loans and securities based on federal statutory rate of 21% in 2018 and 35% in years prior to 2018, by total average interest-earning assets.
3 Calculated as dividends on common shares divided by basic net income per common share.
4 Non-performing loans include loans on non-accrual status and loans past due 90 days or more and still accruing interest.
5 Tangible common equity to tangible assets is considered to be a meaningful non-GAAP financial measure of capital adequacy and is useful for investors to assess Bancorp's ability to absorb potential losses. Tangible common equity includes common stock, retained earnings and unrealized gains (losses) on available-for sale securities, net of tax, less goodwill and intangible assets of $281 million, $260 million, $222 million, $205 million, and $190 million at December 31, 2018, 2017, 2016, 2015, and 2014, respectively. Tangible assets exclude goodwill and intangible assets.
6 Share and per share data have been adjusted to reflect the two-for-one stock split effective November 27, 2018.

Page-22



ITEM 7     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of financial condition as of December 31, 2018 and 2017 and results of operations for each of the years in the two-year period ended December 31, 2018 should be read in conjunction with our consolidated financial statements and related notes thereto, included in Part II ITEM 8 of this report. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. All share and per share data have been adjusted to reflect the stock split effective November 27, 2018.
 
Forward-Looking Statements
 
The disclosures set forth in this item are qualified by important factors detailed in Part I captioned Forward-Looking Statements and ITEM 1A captioned Risk Factors of this report and other cautionary statements set forth elsewhere in the report.

Critical Accounting Policies and Estimates

Critical accounting policies are those that are both very important to the portrayal of our financial condition and results of operations and require Management's most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and imprecise.

Management has determined the following four accounting policies to be critical:

Allowance for Loan Losses: For information regarding our ALLL methodology, the related provision for loan losses, risks related to asset quality and lending activity, see ITEM 1A - Risk Factors, the Allowance for Loan Losses section in ITEM 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 1 - Summary of Significant Accounting Policies and Note 3 - Loans and Allowance for Loan Losses in ITEM 8 - Financial Statements and Supplementary Data of this Form 10‑K.

Other-than-temporary Impairment of Investment Securities: For information regarding our investment securities, investment activity, and related risks, see ITEM 1A - Risk Factors, Note 1 - Summary of Significant Accounting Policies and Note 2 - Investment Securities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

Accounting for Income Taxes: For information on our tax assets and liabilities, and related provision for income taxes, see Note 1 - Summary of Significant Accounting Policies and Note 11 - Income Taxes in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

Fair Value Measurements: For information on our use of fair value measurements and our related valuation methodologies, see Note 1 - Summary of Significant Accounting Policies and Note 9 - Fair Value of Assets and Liabilities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.


Page-23



Executive Summary
 
Annual earnings were $32.6 million in 2018 compared to $16.0 million in 2017. Diluted earnings were $2.33 per share for the year ended December 31, 2018, compared to $1.27 per share in the same period of 2017.

The following are highlights of operating and financial performance for the year ended December 31, 2018:
In 2018, we expanded our footprint in the East Bay and strengthened our team in Sonoma County. We added key people to open a new commercial banking office in Walnut Creek and enhanced our presence in our Santa Rosa market.
The Bank achieved loan growth of $84.9 million, or 5.1% in 2018, to $1,763.9 million at December 31, 2018, from $1,679.0 million at December 31, 2017.
Strong credit quality remains a cornerstone of the Bank’s consistent performance. Non-accrual loans represented 0.04% of the Bank's loan portfolio as of December 31, 2018. There was no provision for loan losses recorded in 2018 due to continuing high credit quality.
Deposits grew by $26.1 million to $2,174.8 million at December 31, 2018, compared to $2,148.7 million at December 31, 2017. Non-interest bearing deposits grew by $51.9 million in 2018 and made up 49% of total deposits at year-end. For the full year 2018, cost of total deposits remained low at 0.10% despite the higher interest rate environment, compared to 0.07% in 2017.
Net interest income totaled $91.5 million and $74.9 million in 2018 and 2017, respectively. The increase of $16.6 million in 2018 was primarily due to a $337.7 million increase in average earning assets. Additionally, higher yields on loans, investment securities and interest-bearing cash positively impacted interest income. The tax-equivalent net interest margin increased to 3.90% in 2018 compared to 3.80% in 2017 for the same reasons, despite the 0.04% negative impact from the early redemption of a subordinated debenture.
Pre-tax net income in 2018 was $43.4 million, up $14.6 million, or 50.6% over 2017 pretax net income of $28.8 million. Higher average balances and yields on both loans and investment securities favorably impacted earnings in the current year.
The efficiency ratio was 57.3% in 2018, down from 64.7% in 2017.

For the year ended December 31, 2018, return on assets was 1.31% and return on equity was 10.73%.

All capital ratios exceed regulatory requirements. The total risk-based capital ratio for Bancorp was 14.9% at both December 31, 2018 and December 31, 2017.

On April 23, 2018, Bancorp announced that its Board of Directors approved a Share Repurchase Program under which Bancorp may repurchase up to $25.0 million of its outstanding common stock through May 1, 2019. During 2018, Bancorp repurchased 171,217 shares for a total amount of $7.0 million.

On October 22, 2018, Bancorp announced a two-for-one stock split, which occurred on November 27, 2018.

The Board of Directors declared a cash dividend of $0.19 per share on January 25, 2019, a $0.015 increase from the prior quarter. This was the 55th consecutive quarterly dividend paid by Bank of Marin Bancorp. Since August 2005, Bancorp's average annual dividend growth rate has been 10.2%. The cash dividend was paid on February 15, 2019 to shareholders of record at the close of business on February 8, 2019.

Looking forward into the new year, with a low cost and stable deposit base, solid opportunities for loan growth, and our unwavering commitment to relationship banking, we are well-positioned to carry our successful performance into 2019. We have ample liquidity and capital to support organic growth and acquisitions in coming years. Acquisitions remain a component of our strategic plan and we will continue to evaluate merger and acquisition opportunities that fit with our culture and add value for our shareholders. Our disciplined credit culture and relationship-focused banking continue to be critical components of our success.


Page-24



RESULTS OF OPERATIONS

Net Interest Income
 
Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is affected by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in net interest income and/or margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. We manage interest rate risk exposure with the goal of minimizing the effect of interest rate volatility on net interest income.
 
Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity.
 
The following table compares interest income, average interest-earning assets, interest expense, and average interest-bearing liabilities for the periods presented. The table also presents net interest income, net interest margin and net interest rate spread for the years indicated.
Table 1 Average Statements of Condition and Analysis of Net Interest Income
 
 
Year ended
 
Year ended
 
 
December 31, 2018
 
December 31, 2017
 
 
 
Interest
 
 
 
Interest
 
 
 
Average
Income/
Yield/
 
Average
Income/
Yield/
(dollars in thousands; unaudited)
Balance
Expense
Rate
 
Balance
Expense
Rate
Assets
 
 
 
 
 
 
 
 
Interest-bearing due from banks 1
$
78,185

$
1,461

1.84
%
 
$
80,351

$
995

1.22
%
 
Investment securities 2, 3
566,883

14,512

2.56
%
 
419,873

9,732

2.32
%
 
Loans 1, 3, 4
1,704,390

80,406

4.65
%
 
1,511,503

68,562

4.47
%
 
   Total interest-earning assets 1
2,349,458

96,379

4.05
%
 
2,011,727

79,289

3.89
%
 
Cash and non-interest-bearing due from banks
41,595

 
 
 
42,511

 
 
 
Bank premises and equipment, net
8,021

 
 
 
8,411

 
 
 
Interest receivable and other assets, net
86,709

 
 
 
63,301

 
 
Total assets
$
2,485,783

 
 
 
$
2,125,950

 
 
Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
Interest-bearing transaction accounts
$
143,706

$
226

0.16
%
 
$
105,544

$
108

0.10
%
 
Savings accounts
178,907

72

0.04
%
 
167,190

66

0.04
%
 
Money market accounts
612,372

1,355

0.22
%
 
542,592

555

0.10
%
 
Time accounts, including CDARS
137,339

542

0.39
%
 
146,069

576

0.39
%
 
FHLB and overnight borrowings 1
105

2

2.03
%
 
1


1.75
%
 
Subordinated debentures 1
5,025

1,339

26.29
%
 
5,664

439

7.65
%
 
   Total interest-bearing liabilities
1,077,454

3,536

0.33
%
 
967,060

1,744

0.18
%
 
Demand accounts
1,085,870

 
 
 
899,289

 
 
 
Interest payable and other liabilities
18,514

 
 
 
13,506

 
 
 
Stockholders' equity
303,945

 
 
 
246,095

 
 
Total liabilities & stockholders' equity
$
2,485,783

 
 
 
$
2,125,950

 
 
Tax-equivalent net interest income/margin 1
 
$
92,843

3.90
%
 
 
$
77,545

3.80
%
Reported net interest income/margin 1
 
$
91,544

3.84
%
 
 
$
74,852

3.67
%
Tax-equivalent net interest rate spread
 

3.72
%
 
 
 
3.71
%
 
1 Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable.
2 Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity. Investment security interest is earned on 30/360 day basis monthly.
3 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the federal statutory rate of 21% in 2018 and 35% in 2017.
4 Average balances on loans outstanding include non-performing loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield.

Page-25



Table 2     Analysis of Changes in Net Interest Income

The following table presents the effects of changes in average balances (volume) or changes in average rates on tax- equivalent net interest income for the years indicated. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates. Rate variances are equal to the increase or decrease in rates multiplied by prior period average balances. Mix variances are attributable to the change in yields or rates multiplied by the change in average balances.
 
2018 compared to 2017
(in thousands, unaudited)
Volume

Yield/Rate

Mix

Total

Interest-bearing due from banks
$
(27
)
$
507

$
(14
)
$
466

Investment securities 1
3,408

1,016

356

4,780

Loans 1
8,749

2,745

350

11,844

Total interest-earning assets
12,130

4,268

692

17,090

Interest-bearing transaction accounts
39

58

21

118

Savings accounts
5

1


6

Money market accounts
71

645

84

800

Time accounts, including CDARS
(34
)
2

(2
)
(34
)
FHLB borrowings and overnight borrowings
2



2

Subordinated debentures
(50
)
1,070

(120
)
900

Total interest-bearing liabilities
33

1,776

(17
)
1,792

 
$
12,097

$
2,492

$
709

$
15,298

1 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the federal statutory rate of 21% in 2018 and 35% in 2017.

2018 Compared to 2017
 
Net interest income totaled $91.5 million and $74.9 million in 2018 and 2017, respectively. The increase of $16.6 million, or 22.2% in 2018 was primarily due to a $337.7 million, or 16.8%, increase in average earning assets and higher average yields across all earning asset categories, partially offset by $916 thousand in accelerated discount accretion from the early redemption of one high-rate subordinated debenture assumed in the NorCal Community Bancorp acquisition. This transaction removed a high cost source of borrowing and the Bank will benefit from reduced interest expense going forward. While we do not plan to redeem the remaining subordinated debenture in the short-term, we may early redeem it in the future depending on changes in rates and our capital position. The tax-equivalent net interest margin increased ten basis points to 3.90% in 2018 compared to 3.80% in 2017 for the same reasons, despite the 0.04% negative impact from the early redemption of a subordinated debenture.

The yield on average interest-earning assets increased sixteen basis points in 2018 compared to 2017. The loan portfolio as a percentage of average interest-earning assets, decreased to 72.5% in 2018, from 75.1% in 2017. Investment securities increased to 24.1% of average interest-earning assets in 2018, compared to 20.9% in 2017.

Market Interest Rates

Market interest rates are, in part, based on the target federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the Federal Reserve Open Market Committee ("FOMC"). Actions by the FOMC to increase the target federal funds rate by 25 basis points in December 2015, December 2016, March 2017, June 2017, December 2017, March 2018, June 2018, September 2018 and December 2018 have positively impacted yields on our rate sensitive interest-earning assets. The increase in December 2018, to the current target range for the federal funds rate of 2.25% to 2.50%, was the ninth rate hike since 2008. If interest rates continue to rise, we anticipate that our net interest income will increase over time. While short-term interest rates have risen and improved the Bank’s yields on prime-rate adjustable assets, the yield curve flattened in 2018 with less movement in longer-term rates that influence pricing for fixed-rate lending activities. In its January 2019 meeting, the FOMC indicated that it will be patient with future rate hikes in light of global economic and financial uncertainties and muted inflation pressures and might plan to stop reducing the Federal Reserve’s asset holdings in late 2019.


Page-26



Impact of Acquired Loans on Net Interest Margin

Early payoffs or prepayments of our acquired loans with significant unamortized purchase discount/premium could result in volatility in our net interest margin. Accretions and gains on payoffs of purchased loans are recorded in interest income. As our acquired loans from prior acquisitions continue to pay off, we expect accretion income from these loans to continue to decline. The positive affect on our net interest margin during the past two years was as follows:
 
Years ended December 31,
 
2018
 
2017
(dollars in thousands; unaudited)
Dollar Amount
Basis point affect on net interest margin
 
Dollar Amount
Basis point affect on net interest margin
Accretion on purchased credit impaired ("PCI") loans
$
320

1 bps
 
$
331

2 bps
Accretion on non-PCI loans
$
487

2 bps
 
$
571

3 bps
Gains on payoffs of PCI loans
$
135

1 bps
 
$
184

1 bps

Provision for Loan Losses
 
Management assesses the adequacy of the allowance for loan losses quarterly based on several factors including growth of the loan portfolio, analysis of probable losses in the portfolio, historical loss experience and the current economic climate.  Actual losses on loans are charged against the allowance, and the allowance is increased by loss recoveries and provisions for loan losses charged to expense.  For further discussion, see Note 1 to the Consolidated Financial Statements in ITEM 8 of this report.

We recorded no provision for loan losses in 2018, compared to $500 thousand in 2017. The allowance for loan losses was 0.90% and 0.94% of loans at December 31, 2018 and 2017, respectively. The lack of a provision for loan losses in 2018 and the decrease in the allowance ratio was primarily due to a $15.3 million decrease in classified loans, resulting from two borrowing relationships whose risk grades were upgraded from substandard to special mention in the second quarter of 2018. This reduction was offset by general allowances resulting from loan growth, refinement of certain loan concentration qualitative factors, and an increase in specific reserves for impaired loans. The allowance for loan losses excluding acquired loans was 0.98% and 1.06% of loans at December 31, 2018 and 2017, respectively. Net recoveries totaled $54 thousand in 2018, compared to net charge-offs of $175 thousand in 2017. The 2017 net charge-offs were primarily related to one unsecured commercial loan. See the section captioned “Allowance for Loan Losses” below for further analysis of the provision for loan losses.

Non-interest Income
 
The table below details the components of non-interest income.
Table 3 Components of Non-Interest Income
 
Years ended
2018 compared to 2017
 
December 31,
Amount
Percent
(dollars in thousands; unaudited)
2018

2017

Increase (Decrease)
Increase (Decrease)
Service charges on deposit accounts
$
1,891

$
1,784

$
107

6.0
 %
Wealth Management and Trust Services
1,919

2,090

(171
)
(8.2
)%
Debit card interchange fees
1,561

1,531

30

2.0
 %
Merchant interchange fees
378

398

(20
)
(5.0
)%
Earnings on bank-owned life insurance
913

845

68

8.0
 %
Dividends on FHLB stock
959

766

193

25.2
 %
Gains (losses) on investment securities, net
876

(185
)
1,061

573.5
 %
Other income
1,642

1,039

603

58.0
 %
Total non-interest income
$
10,139

$
8,268

$
1,871

22.6
 %


Page-27



2018 Compared to 2017

Non-interest income totaled $10.1 million and $8.3 million in 2018 and 2017, respectively. The increase compared to the prior year primarily relates to a $180 thousand Federal Home Loan Bank special dividend, a $442 thousand increase in deposit network income (included in other income) and a $956 thousand pre-tax gain on the sale of 6,500 shares of Visa Inc. Class B restricted common stock, partially offset by $79 thousand in net losses from the sale of available-for-sale investment securities. The Bank sold less than half of its Visa Inc. position to realize recent appreciation in market prices and hedge against market volatility. Currently, we do not intend to sell our remaining shares of Visa Inc. Class B stock, but will consider future sales depending on the resolution of the related Visa litigation (as discussed in Note 12 to the Consolidated Financial Statements in ITEM 8 of this report) and equity market volatility.

Non-interest Expense

The table below details the components of non-interest expense.
Table 4 Components of Non-Interest Expense
 
Years ended
2018 compared to 2017
 
December 31,
Amount
Percent
(dollars in thousands; unaudited)
2018

2017

Increase (Decrease)
Increase (Decrease)
Salaries and related benefits
$
33,335

$
29,958

$
3,377

11.3
 %
Occupancy and equipment
5,976

5,472

504

9.2
 %
Depreciation and amortization
2,143

1,941

202

10.4
 %
FDIC insurance
756

666

90

13.5
 %
Data processing
4,358

4,906

(548
)
(11.2
)%
Professional services
3,317

2,858

459

16.1
 %
Directors' expense
700

720

(20
)
(2.8
)%
Information technology
1,023

769

254

33.0
 %
Provision for losses on off-balance sheet commitments

57

(57
)
(100.0
)%
Other non-interest expense:
 
 
 
 
Advertising
666

567

99

17.5
 %
Amortization of core deposit intangible
921

528

393

74.4
 %
Other expense
5,071

5,340

(269
)
(5.0
)%
Total other non-interest expense
6,658

6,435

223

3.5
 %
Total non-interest expense
$
58,266

$
53,782

$
4,484

8.3
 %

2018 Compared to 2017

In 2018, non-interest expense increased by $4.5 million to $58.3 million. The increase primarily relates to $3.4 million in higher salaries and benefits due to additional personnel (including former Bank of Napa employees), annual merit increases, higher employee insurance and stock based compensation awards reaching retirement eligibility. We expect salaries and benefits to increase in 2019 as we fill certain commercial banking positions. The number of average FTE employees totaled 289 in 2018 and 269 in 2017. The increase in non-interest expense also relates to $1.0 million in consulting expenses related to core processing contract negotiations, higher core deposit intangible amortization and acquisition-related rent. These increases were partially offset by decreases in acquisition-related legal, professional and data processing expenses. Going forward, we expect certain data processing costs to decrease as a result of the contract negotiations. However, these cost savings will be partially offset during the first two quarters of 2019 with additional expenses associated with the implementation of a new mobile banking platform. In addition, for the Bank of Napa acquisition, we do not expect to incur any additional acquisition-related expenses in 2019.

Provision for Income Taxes

The provision for income taxes totaled $10.8 million at an effective tax rate of 24.9% in 2018, compared to $12.9 million at an effective tax rate of 44.6% in 2017. The decrease in both the provision for income taxes and the effective tax rate from the prior year reflects the reduction in the federal corporate income tax rate from 35% to 21% related to the enactment of the Tax Cuts and Jobs Act of 2017 that was signed into law on December 22, 2017 and became effective January 1, 2018. The 2017 provision for income taxes included a $3.0 million write-down of net deferred tax assets which accounted for 10.5 percentage points of the 2017 effective tax rate of 44.6%. In addition, certain acquisition-

Page-28



related expenses incurred in 2017 were not deductible for tax purposes and added 0.8 percentage points to the 2017 effective tax rate. The resulting reduction in the federal statutory rate was partially offset by the effect of the higher level of pre-tax income in 2018 and elimination or reductions to the deductibility of certain meals, entertainment, parking and transportation expenses due to the Tax Cuts and Jobs Act of 2017. Income tax provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income, and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on tax exempt loans and municipal securities, BOLI, and low-income housing tax credits) as well as transactions with discrete tax effects (such as the exercise of non-qualified stock options, the disqualifying dispositions of incentive stock options and vesting of restricted stock awards). Additional fluctuations in the effective rate from period to period are due to the relationship of net permanent differences to income before tax.

The Tax Cuts and Jobs Act of 2017 includes numerous uncertainties, which will likely require the issuance of new regulations or other interpretive guidance for clarification. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws and their interpretation could significantly affect the amounts provided for income taxes in our consolidated financial statements. Going forward, certain provisions of the Tax Cuts and Jobs Act of 2017 may have an unfavorable impact on our tax expenses, including but not limited to 1) the elimination of the exception for performance-based executive compensation resulting in our inability to deduct executive compensation exceeding $1.0 million, and 2) clarification of the definition of a covered employee for excessive employee compensation purposes.

We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal or state income tax examinations at the issuance of this report. At December 31, 2018 and 2017, neither the Bank nor Bancorp had accruals for interest or penalties related to unrecognized tax benefits.

FINANCIAL CONDITION

Our assets increased $52.7 million from December 31, 2017 to December 31, 2018. Deposits increased by $26.1 million and loan growth for 2018 was $84.9 million.

Investment Securities

We maintain an investment securities portfolio to provide liquidity and to generate earnings on funds that have not been loaned to customers. Management determines the maturities and types of securities to be purchased based on liquidity, the interest rate risk position, and the desire to attain a reasonable investment yield balanced with risk exposure. Table 5 shows the composition of the debt securities portfolio by expected maturity at December 31, 2018 and 2017. Expected maturities differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. We estimate and update expected maturity dates regularly based on current and historical prepayment speeds. The weighted average life of the investment portfolio at December 31, 2018 and 2017 was approximately five years.


Page-29



Table 5 Investment Securities
December 31, 2018
Within 1 Year
 
1-5 Years
 
5-10 Years
 
After 10 Years
 
Total
(dollars in thousands; unaudited)
AmortizedCost1

Average Yield2

 
AmortizedCost1

Average Yield2

 
AmortizedCost1

Average Yield2

 
AmortizedCost1

Average Yield2

 
AmortizedCost1

Fair Value

Average Yield2

Held-to-maturity:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and municipal3
$
7,557

3.78
%
 
$
3,554

4.93
%
 
$

%
 
$

%
 
$
11,111

$
11,216

4.14
%
MBS/CMOs issued by U.S. government agencies


 
39,929

2.16

 
83,461

2.53

 
22,705

2.51

 
146,095

142,678

2.43

Total held-to-maturity
7,557

3.78

 
43,483

2.38

 
83,461

2.53

 
22,705

2.51

 
157,206

153,894

2.55

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
MBS/CMOs issued by U.S. government agencies
5,927

1.73

 
135,077

2.51

 
139,882

3.10

 


 
280,886

278,403

2.79

SBA-backed securities


 
2,372

2.77

 
48,351

2.99

 


 
50,723

50,781

2.98

State and municipal3
13,954

1.86

 
26,640

2.46

 
37,080

2.56

 
1,372

4.01

 
79,046

77,960

2.43

Debentures of government sponsored agencies


 
41,460

2.68

 
11,496

3.35

 


 
52,956

53,018

2.82

Privately issued CMOs
193

3.63

 
102

4.43

 


 


 
295

297

3.91

Corporate bonds
501

2.01

 
1,503

3.93

 


 


 
2,004

2,005

3.45

Total available-for-sale
20,575

1.85

 
207,154

2.55

 
236,809

3.01

 
1,372

4.01

 
465,910

462,464

2.76

Total
$
28,132

2.36
%
 
$
250,637

2.52
%
 
$
320,270

2.88
%
 
$
24,077

2.59
%
 
$
623,116

$
616,358

2.70
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
Within 1 Year
 
1-5 Years
 
5-10 Years
 
After 10 Years
 
Total
(dollars in thousands; unaudited)
AmortizedCost1

Average Yield2

 
AmortizedCost1

Average Yield2

 
AmortizedCost1

Average Yield2

 
AmortizedCost1

Average Yield2

 
AmortizedCost1

Fair Value

Average Yield2

Held-to-maturity:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and municipal3
$
7,606

4.64
%
 
$
11,293

4.02
%
 
$
747

5.18
%
 
$

%
 
$
19,646

$
19,998

4.31
%
MBS/CMOs issued by U.S. government agencies


 
26,245

2.18

 
101,291

2.26

 
3,850

2.64

 
131,386

131,034

2.26

Total held-to-maturity
7,606

4.64

 
37,538

2.74

 
102,038

2.28

 
3,850

2.64

 
151,032

151,032

2.52

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
MBS/CMOs issued by U.S. government agencies
800

1.81

 
118,125

2.19

 
45,739

2.54

 
24,702

2.75

 
189,366

188,061

2.34

SBA-backed securities
167

5.23

 
1,759

2.12

 
22,554

2.57

 
1,499

3.09

 
25,979

25,982

2.59

State and municipal3
7,192

1.84

 
51,832

2.09

 
36,984

2.39

 
2,019

4.53

 
98,027

97,491

2.24

Debentures of government sponsored agencies
1,495

1.55

 
11,445

2.06

 


 


 
12,940

12,938

2.00

Privately issued CMOs
121

3.35

 
1,311

2.53

 


 


 
1,432

1,431

2.60

Corporate bonds
4,531

1.94

 
2,010

2.88

 


 


 
6,541

6,564

2.23

Total available-for-sale
14,306

1.89

 
186,482

2.16

 
105,277

2.50

 
28,220

2.90

 
334,285

332,467

2.32

Total
$
21,912

2.84
%
 
$
224,020

2.26
%
 
$
207,315

2.39
%
 
$
32,070

2.87
%
 
$
485,317

$
483,499

2.38
%
1 Book value reflects cost, adjusted for accumulated amortization and accretion.
2 Weighted average calculation is based on amortized cost of securities.
3 Yields on tax-exempt municipal bonds are presented on a taxable equivalent basis, using federal tax rate of 21%.

The amortized cost of our investment securities portfolio increased $137.8 million or 28.4% during 2018. We purchased $237.9 million in securities in 2018, including $2.0 million designated as held-to-maturity and $235.9 million designated as available-for-sale to provide flexibility for liquidity and interest rate risk management. These purchases were partially offset by $80.6 million of paydowns, calls and maturities, and $17.1 million of sales during 2018. Sales of securities were mainly due to changes in tax law resulting in less favorable yields on these tax exempt municipal securities.

During 2018, we purchased $99.1 million in collateralized mortgage obligations ("CMOs"), $55.6 million in mortgage pass-through securities, $41.5 million in debentures of government sponsored agencies, $35.6 million in Small Business Administration ("SBA") backed securities, and $6.0 million in obligations of state and political subdivisions. We consider agency debentures, mortgage-backed securities, and CMOs issued by U.S. government sponsored entities to have low credit risk as they carry the credit support of the U.S. federal government. The debentures, CMOs and MBS issued by U.S. government sponsored agencies, state and municipal securities, SBA-backed securities, and corporate bonds, made up 77%, 14.5%, 8.1% and 0.3% of the portfolio at December 31, 2018, compared to 68.8%, 24.2%, 5.4% and

Page-30



1.4%, respectively at December 31, 2017. See the discussion in the section captioned “Securities May Lose Value due to Credit Quality of the Issuers” in ITEM 1A Risk Factors above.

At December 31, 2018, distribution of our investment in obligations of state and political subdivisions was as follows:
 
December 31, 2018
December 31, 2017
(dollars in thousands; unaudited)
Amortized Cost

Fair Value

% of
state and municipal securities

Amortized Cost

Fair Value

% of
state and municipal securities

Within California:
 
 
 
 
 
 
General obligation bonds
$
14,438

$
14,418

16.0
%
$
19,634

$
19,678

16.7
%
Revenue bonds
7,109

7,108

7.9

11,660

11,776

9.9

Tax allocation bonds
4,541

4,601

5.0

6,099

6,234

5.2

Total within California
26,088

26,127

28.9

37,393

37,688

31.8

Outside California:
 
 
 
 
 
 
General obligation bonds
56,186

55,199

62.3

68,890

68,454

58.5

Revenue bonds
7,883

7,850

8.8

11,390

11,346

9.7

Total outside California
64,069

63,049

71.1

80,280

79,800

68.2

Total obligations of state and political subdivisions
$
90,157

$
89,176

100.0
%
$
117,673

$
117,488

100.0
%

The portion of the portfolio outside the state of California is distributed among 23 states. The largest concentrations outside California are in Texas (18%), Washington (10%), and Minnesota (9%). Revenue bonds, both within and outside California, primarily consisted of bonds issued for essential services (such as transportation, infrastructure, public services, education and utilities).

Investments in states, municipalities and political subdivisions are subject to an initial pre-purchase credit assessment and ongoing monitoring. Key considerations include:
The soundness of a municipality’s budgetary position and stability of its tax revenues
Debt profile and level of unfunded liabilities, diversity of revenue sources, taxing authority of the issuer
Local demographics/economics including unemployment data, largest local taxpayers and employers, income indices and home values
For revenue bonds, the source and strength of revenue for municipal authorities including obligors' financial condition and reserve levels, annual debt service and debt coverage ratio, and credit enhancement (such as insurer’s strength)
Credit ratings by major credit rating agencies

Loans

Table 6 Loans Outstanding by Type at December 31
(in thousands; unaudited)
2018

2017

2016

2015

2014

Commercial loans
$
230,739

$
235,835

$
218,615

$
219,452

$
210,223

Real estate
 
 
 
 
 
  Commercial owner-occupied
313,277

300,963

247,713

242,309

230,605

  Commercial investor
873,410

822,984

724,228

715,879

673,499

  Construction
76,423

63,828

74,809

65,495

48,413

  Home equity
124,696

132,467

117,207

112,300

110,788

  Other residential
117,847

95,526

78,549

73,134

73,035

Installment and other consumer loans
27,472

27,410

25,495

22,639

16,788

Total loans
1,763,864

1,679,013

1,486,616

1,451,208

1,363,351

Allowance for loan losses
(15,821
)
(15,767
)
(15,442
)
(14,999
)
(15,099
)
Total net loans
$
1,748,043

$
1,663,246

$
1,471,174

$
1,436,209

$
1,348,252


New organic loan volume totaled approximately $239.4 million in 2018, compared to approximately $173.1 million in 2017. Loan originations were partially offset by payoffs totaling $157.3 million in 2018 and $132.5 million in 2017.

Page-31



Payoffs to total loans of 8.9% and 7.9% in 2018 and 2017, respectively, were below our anticipated 10% annual payoff rate, but do not change our expectations for future payoffs. Approximately 88% and 87% of our outstanding loans were secured by real estate at December 31, 2018 and 2017, respectively. Also, see ITEM 1A, Risk Factors, regarding our loan concentration risk.

The following table summarizes our commercial real estate loan portfolio by the geographic location in which the property is located as of December 31, 2018 and 2017.

Table 7 Commercial Real Estate Loans Outstanding by Geographic Location
 
December 31, 2018
 
December 31, 2017
(dollars in thousands; unaudited)
Amount
% of Commercial real estate loans
 
Amount
% of Commercial real estate loans

Marin
$
342,163

28.8
%
 
$
341,827

30.4
%
Sonoma
177,087

14.9

 
167,014

14.9

Napa
168,394

14.2

 
151,778

13.5

Alameda
167,170

14.1

 
143,939

12.8

San Francisco
155,863

13.1

 
150,376

13.4

Contra Costa
41,986

3.5

 
42,093

3.7

San Mateo
23,919

2.0

 
20,481

1.8

Solano
17,503

1.5

 
18,071

1.6

El Dorado
13,274

1.1

 
13,860

1.2

Sacramento
10,759

0.9

 
11,030

1.0

Other
68,569

5.9

 
63,478

5.7

Total
$
1,186,687

100.0
%
 
$
1,123,947

100.0
%

Commercial real estate loans increased by $62.7 million in 2018 and $152.0 million in 2017. The increase in 2018 was primarily in Sonoma, Napa, Alameda and San Francisco counties. The increase in 2017 included $92.3 million from the Bank of Napa acquisition, as well as lending activities in Marin and Alameda Counties. Of the commercial real estate loans at December 31, 2018, 74% were non-owner occupied and 26% were owner occupied. Almost the entire commercial real estate loan portfolio is comprised of term loans for which the primary source of repayment is the operating cash flow from the leasing activities of the real estate collateral. Originated loans are subject to our conservative credit underwriting standards and both the acquired and originated loans are actively managed.

We occasionally provide interest-only term loans to borrowers who exhibit strong financial capacity and/or for commercial real estate loans during the occupancy stabilization period. These interest-only term loans must meet our stringent underwriting standards and are generally short-term in nature, usually less than two years. In addition, we may make interest-only concessions in a modified troubled debt restructuring ("TDR"). At December 31, 2018 and 2017, approximately 2.9% and 2.0%, respectively, of our total loans contained an interest-only feature as part of the loan terms. All of these loans were current with their payments as of December 31, 2018. Except for two TDR loans to one borrowing relationship totaling $7.0 million as of December 31, 2018, all were considered to have low credit risk (graded "Pass").


Page-32



The following table shows an analysis of construction loans by type and location as of December 31, 2018 and 2017.

Table 8 Construction Loans Outstanding by Type and Geographic Location
(dollars in thousands; unaudited)
December 31, 2018
 
December 31, 2017
Construction loans by type
Amount

% of Construction Loans

 
Amount

% of Construction Loans

Commercial real estate
$
30,603

40.0
%
 
$
20,935

32.8
%
Apartments and multifamily
23,583

30.9

 
14,878

23.3

1-4 Single family residential
15,760

20.6

 
22,780

35.7

Land - improved
4,046

5.3

 
3,668

5.7

Land - unimproved
2,431

3.2

 
1,567

2.5

Total
$
76,423

100.0
%
 
$
63,828

100.0
%
 
 
 
 
 
 
(dollars in thousands; unaudited)
December 31, 2018
 
December 31, 2017
Construction loans by geographic location
Amount

% of Construction Loans

 
Amount

% of Construction Loans

San Francisco
$
20,764

27.2
%
 
$
21,664

33.9
%
Marin
14,665

19.2

 
9,750

15.3

Sonoma
14,241

18.6

 
4,683

7.3

Alameda
11,411

14.9

 
7,783

12.2

San Mateo
5,110

6.7

 
3,495

5.5

Napa
3,988

5.2

 
12,072

18.9

Riverside
2,688

3.5

 
2,969

4.7

Other
3,556

4.7

 
1,412

2.2

Total
$
76,423

100.0
%
 
$
63,828

100.0
%

Construction loans increased by $12.6 million in 2018 and decreased by $11.0 million in 2017. The increase in 2018 was primarily due to new construction projects, partially offset by payoffs related to completed construction projects. The $8.1 million decrease in Napa construction loans primarily resulted from the successful completion of three projects and one completed project that converted to a commercial real estate term loan. The improving economy resulted in a number of new financing opportunities for existing and new customers who had successfully completed construction projects in the past.

The following table presents the maturity distribution of our commercial and construction loans as of December 31, 2018 based on their contractual maturity dates and does not include scheduled payments or potential prepayments.

Table 9A Commercial and Construction Loan Maturity Distribution
 
Due within

Due after 1 but

Due after

 
(in thousands; unaudited)
1 year

within 5 years

5 years

Total

Maturity distribution:
 
 
 


    Commercial
$
69,335

$
105,464

$
55,940

$
230,739

    Construction
47,427

14,957

14,039

76,423

Total
$
116,762

$
120,421

$
69,979

$
307,162


The following table shows the mix of variable-rate loans to fixed-rate loans for commercial and construction loans. The large majority of the variable-rate loans are tied to independent indices (such as the Wall Street Journal Prime Rate or a Treasury Constant Maturity Rate). Most loans with original terms of more than five years have provisions for the fixed rates to reset, or convert to variable rates, after three, five or seven years. These loans are included in variable-rate balances below.


Page-33



Table 9B Commercial and Construction Loan Interest Rate Sensitivity
(in thousands; unaudited)
Fixed

Variable

Total

Commercial
$
116,796

$
113,943

$
230,739

Construction
20,416

56,007

76,423

Total
$
137,212

$
169,950

$
307,162


Allowance for Loan Losses

Credit risk is inherent in the business of lending. As a result, we maintain an allowance for loan losses to absorb probable losses in our loan portfolio through a provision for loan losses charged against earnings. All specifically identifiable and quantifiable losses are charged off against the allowance. The balance of our allowance for loan losses is Management's best estimate of the remaining probable losses in the portfolio. The ultimate adequacy of the allowance is dependent upon a variety of factors beyond our control, including the real estate market, changes in interest rates and economic and political environments. Based on the current conditions of the loan portfolio, Management believes that the $15.8 million allowance for loan losses at December 31, 2018 is adequate to absorb losses in our loan portfolio, but provides no assurance that adverse economic conditions or other circumstances will not result in increased losses in the portfolio.

The Components of the Allowance for Loan Losses

As stated in Note 1 to the Consolidated Financial Statements in ITEM 8 of this report, the overall allowance consists of 1) specific allowances for individually identified impaired loans ("ASC 310-10") and 2) general allowances for pools of loans ("ASC 450-20"), which incorporate quantitative (e.g., historical loan loss rates) and qualitative risk factors (e.g., portfolio growth and trends, credit concentrations, economic and regulatory factors, etc.).

The first component, specific allowances, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable. Management evaluates these loans individually for impairment. Management considers an originated loan to be impaired when it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. For PCI loans, specific allowances are established to account for credit deterioration subsequent to acquisition if we have probable decreases in cash flows expected to be collected. For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate at origination (for originated loans), based on the loan's observable market price, or based on the fair value of the collateral if the loan is collateral dependent or if foreclosure is imminent. Generally, with problem credits that are collateral dependent, we obtain appraisals of the collateral at least annually. We may obtain appraisals more frequently if we believe the collateral is subject to market volatility, if a specific event has occurred to the collateral, or if we believe foreclosure is imminent. Impaired loan balances decreased to $15.0 million at December 31, 2018 from $16.9 million at December 31, 2017. The specific allowance for impaired loans increased to $778 thousand at December 31, 2018 from $513 thousand at December 31, 2017. The decrease in impaired loan balances primarily relates to $2.2 million in payoffs and paydowns, two loans totaling $247 thousand removed from troubled debt status, partially offset by $611 thousand in loans downgraded to impaired status during 2018. The increase in reserves for impaired loans was primarily due to two unsecured commercial loans that became impaired during 2018.

The second component is an estimate of the probable inherent losses in each loan pool with similar risk characteristics. This analysis encompasses the entire loan portfolio, excluding individually identified impaired loans and acquired loans whose purchase discount has not been fully accreted. Under our allowance model, loans are evaluated on a pool basis by federal regulatory reporting codes ("CALL codes" or "segments"), which are further delineated by assigned credit risk ratings, as described in Note 3 to the Consolidated Financial Statements in ITEM 8 of this report. At December 31, 2018 and 2017, the allowance allocated for the second component totaled $15.0 million and $15.3 million, respectively. The decrease in the general allowance was primarily attributed to reserves for two large non-impaired substandard classified borrowing relationships that were upgraded to special mention, partially offset by allowances related to loan growth and the refinement of certain loan concentration qualitative risk factors, as previously discussed in the section entitled Provision for Loan Losses.


Page-34



Table 10 shows the allocation of the allowance by loan type as well as the percentage of total loans in each of the same loan types.

Table 10 Allocation of Allowance for Loan Losses
 
December 31, 2018
 
December 31, 2017
 
December 31, 2016
 
December 31, 2015
 
December 31, 2014
(dollars in thousands; unaudited)
Allowance balance allocation

Loans as a percent of total loans

 
Allowance balance allocation

Loans as a percent of total loans

 
Allowance balance allocation

Loans as a percent of total loans

 
Allowance balance allocation

Loans as a percent of total loans

 
Allowance balance allocation

Loans as a percent of total loans

Commercial loans
$
2,436

13.1
%
 
$
3,654

14.0
%
 
$
3,248

14.7
%
 
$
3,023

15.1
%
 
$
2,837

15.4
%
Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial, owner-occupied
2,407

17.8

 
2,294

17.9

 
1,753

16.7

 
2,249

16.7

 
1,924

16.9

Commercial, investor
7,703

49.5

 
6,475

49.1

 
6,320

48.7

 
6,178

49.4

 
6,672

49.4

Construction
756

4.3

 
681

3.8

 
781

5.0

 
724

4.5

 
839

3.6

Home Equity
915

7.1

 
1,031

7.9

 
973

7.9

 
910

7.7

 
859

8.1

Other residential
800

6.7

 
536

5.7

 
454

5.3

 
394

5.0

 
433

5.4

Installment and other consumer
310

1.5

 
378

1.6

 
372

1.7

 
425

1.6

 
566

1.2

Unallocated allowance
494

N/A

 
718

N/A

 
1,541

N/A

 
1,096

N/A

 
969

N/A

Total allowance for loan losses
$
15,821

 
 
$
15,767

 
 
$
15,442

 
 
$
14,999

 
 
$
15,099

 
Total percent
 
100.0
%
 
 
100.0
%
 
 
100.0
%
 
 
100.0
%
 
 
100.0
%

Table 11 shows the activity in the allowance for loan losses for each of the years in the five-year period ended December 31, 2018.

Table 11 Allowance for Loan Losses
(dollars in thousands; unaudited)
2018
2017
2016
2015
2014
Beginning balance
$