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EX-32.01 - EXHIBIT 32.01 - Bank of Marin Bancorpbmrc-ex3201_20171231.htm
EX-31.02 - EXHIBIT 31.02 - Bank of Marin Bancorpbmrc-ex3102_20171231.htm
EX-31.01 - EXHIBIT 31.01 - Bank of Marin Bancorpbmrc-ex3101_20171231.htm
EX-23.01 - EXHIBIT 23.01 - Bank of Marin Bancorpbmrc-ex2301_20171231.htm
 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, 2017
 
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 o
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 30, 2017, 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 $396 million. For the purpose of this response, directors and certain officers of the Registrant are considered the affiliates at that date.

As of February 28, 2018, there were 6,970,446 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 22, 2018 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
 
Executive Summary
 
Critical Accounting Policies
 
 
 
 
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
 
Selected Quarterly Financial Data
 
 
 
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 
 
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
 
 

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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
 
 

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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, and the successful integration of acquisitions 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 cyber-security 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”). On July 1, 2007 (the “Effective Date”), a bank holding company reorganization was completed whereby Bank of Marin Bancorp (“Bancorp”) became the parent holding company for the Bank, the sole and wholly-owned subsidiary of Bancorp. On the Effective Date, each outstanding share of Bank of Marin common stock was converted into one share of Bank of Marin Bancorp common stock. Bancorp is listed at NASDAQ under the ticker symbol BMRC, which was formerly used by the Bank. Prior to the Effective Date, the Bank filed reports and proxy statements with the FDIC pursuant to Section 12 of the 1934 Act. 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.
 

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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 business customers. Through third party vendors, we offer a consumer Visa® credit card product combined with a rewards program to our customers, a Business Visa® program, an American Express® credit card program, a leasing program for commercial equipment financing, and cash management sweep 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, 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 services (“ACH”), 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®, Android Pay®, SurePayroll®, Positive Pay fraud detection tool, and cash management solutions including 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, with the exception of the words "Bank of Marin Bancorp" which is registered on the United States Patent & Trademark Office Supplemental 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. As a result, Bank of Marin is the largest community bank in Napa County based on deposit share1.

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,

_________________________________________________________________________________________
1 We obtained the FDIC deposit market share data from S&P Global Market Intelligence of New York, New York.


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2017, approximately 67% of our deposits are in Marin County and southern Sonoma County, and approximately 55% of our deposits are from businesses and 45% 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 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 and technology infrastructure to achieve economies of scale. 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.

In order to compete with the numerous, and often larger, financial institutions in our primary market area, we use, to the fullest extent possible, the flexibility and rapid response capabilities that derive from our local leadership and decision making. Our competitive advantages also include an emphasis on personalized service, extensive community involvement, philanthropic giving, local promotional activities and strong relationships with our customers.

In Marin County, we have the third largest market share of total deposits at 10.4%, based upon FDIC deposit market share data as of June 30, 20172. A significant driver of our franchise value is the growth and stability of our checking deposits, a low-cost funding source for our loan portfolio.

Employees

At December 31, 2017, we employed 291 full-time equivalent (“FTE”) staff. The actual number of employees, including part-time employees, at year-end 2017 included seven executive officers, 123 other corporate officers and 183 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 and as a "Top Corporate Philanthropist” by the San Francisco Business Times.

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 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.


_________________________________________________________________________________________
2 Source: S&P Global Market Intelligence of New York, New York

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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.

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.

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 quarterly average consolidated total assets minus average tangible equity, defined as Common Equity Tier 1 Capital. The FDIC has reduced the deposit insurance assessment rates since the Deposit Insurance Fund Reserve Ratio reached its target level as of June 30, 2016. 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 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 May 2015, which was performed under the large bank requirements. The FDIC completed a performance examination in January 2018, the report of which is pending.

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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.

Privacy and Data Security

The Gramm-Leach Bliley Act (“GLBA”) of 1999 imposes requirements on financial institutions with respect to consumer privacy. The GLBA generally prohibits disclosure of consumer information to non-affiliated 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 annually. 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, 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.

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. The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds. We became subject to the new rule on January 1,

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2015 and certain provisions of the new rule will be phased in over the period of 2015 through 2019. In August 2017, the federal banking regulators published a final rule, halting the phase-in of certain Basel III capital rules. The rule extends the regulatory capital treatment applicable during 2017 under the regulatory capital rules for certain items. This effectively pauses the full transition to the Basel III treatment of certain assets until the federal banking regulators pursue more extensive rulemaking to simplify the treatment of those assets. We have modeled our ratios under the finalized Basel III rules and we do not expect that we will be required to raise additional capital when the new rules fully phase in. For further information on our risk-based capital positions and the effect of the new Basel III rules, see Note 15 to the Consolidated Financial Statements in ITEM 8 of this report.

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. At this time, no details on the proposed reforms have been published and we are uncertain whether the intended deregulation will have a significant impact on us.

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 2011. If the agencies adopt the regulations in the form initially proposed, they will impose limitations on the manner in which we may structure compensation for our executives.

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as us, that are not “large, complex banking organizations.” The Federal Reserve will tailor 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 will be included in reports of examination. Deficiencies will be 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

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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.

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

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 includes but is 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. While labor market conditions continue to strengthen, real gross domestic product rose at a solid pace during the second half of 2017, and household spending had been expanding at a moderate pace, there is no assurance that these improvements are sustainable. Economic pressure on consumers and uncertainty regarding the sustainability of the economic improvements may result in changes in consumer and business spending, borrowing and savings habits, which may affect the demand for loans and other products and services we offer. Our success also depends on the general economic conditions of the State of California, particularly the local markets in which we operate within the San Francisco Bay Area. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers in the greater Bay Area. The local economic conditions in these areas 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 deposit funding sources. In addition, oil price volatility, the level of U.S. debt and global economic conditions could destabilize financial markets. Lastly, the pro-growth fiscal policy could cause the inflation rate to rise faster than expected, compelling the Federal Open Market Committee ("FOMC") of the Federal Reserve to raise interest rates rapidly to combat inflation and causing stock market volatility, which we observed in early 2018.

In general, weakness in commercial and residential real estate values and home sale volumes, financial stress on borrowers, increases in unemployment rates1, and customers' inability to pay debt could adversely affect our financial condition and results of operations in the following ways:
____________________________________________________________________________________________
1 According to the California Employment Development Department's December 2017 labor reports, the unemployment rates in Marin, San Francisco, Sonoma, Alameda and Napa counties were 2.3%, 2.4%, 2.8%, 3.0% and 3.6%, respectively, compared to the state of California record low of 4.3%, which was down from 5.2% at the end of 2016.

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Demand for our products and services may decline;
Low cost or non-interest bearing deposits may decrease;
Collateral for our loans, especially real estate, may decline in value;
Loan delinquencies, problem assets and foreclosures may increase as a result of a deterioration of our borrowers' creditworthiness; and
Investment securities may become impaired.

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 average duration of our securities and loan portfolios. Our portfolio of loans 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.

The FOMC increased the federal funds target rate by 25 basis points (basis points are equal to one hundredth of a percentage point) each in March, June and December 2017 to a current range of 1.25% to 1.50%. While there was no interest rate action in the first meeting of 2018, the FOMC indicated that it may consider further gradual adjustments in 2018 in light of strong labor markets and expectations that inflation will reach the targeted two percent inflation rate over the medium term. Additionally, other factors such as productivity, oil prices, the strength of the U.S. dollar, and global demand play a role in the FOMC's consideration of future rate hikes. Our net interest income is vulnerable to a falling or flat rate environment and will benefit if the prevailing market interest rates increase.

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 and dividend policy, and compliance costs among other things. Future legislative changes or interpretations may also alter the structure and competitive relationship among financial institutions.

Disruptions in the financial marketplace have led to additional regulations in an attempt to reform financial markets. This reform included, among other things, regulations over consumer financial products, capital adequacy, and the creation of a regime for regulating systemic risk across all types of financial service firms. Further restrictions on financial service companies may adversely affect our results of operations and financial condition, as well as increase our compliance risk. While regulations for higher capital requirements have been postponed and there are discussions to deregulate further the financial industry under the current Administration, the nature and extent of future legislative and regulatory changes from both the federal and California legislatures affecting us are unpredictable at this time.

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

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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.

For further information on supervision and regulation, see the section captioned “Supervision and Regulation” in ITEM 1 above.

Intense 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, saving 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 legislature, 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 may lag 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.

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. We experienced loan payoffs of $133 million and $158 million in 2017 and 2016, respectively. These payoffs approximated nine and eleven percent annual turnover of our loan portfolio in 2017 and 2016, respectively. 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 account for approximately nine percent of our total deposit balances. 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. Approximately 87% of our loans were secured by real estate at December 31, 2017, of which 70% were secured by CRE and the remaining 17% 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.

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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. The FDIC applies two criteria for identifying institutions that are potentially exposed to significant CRE concentration risk. The first criterion looks at whether non-owner occupied commercial real estate loans, as defined by the guidelines, exceed 300% of the Bank's total capital. As of December 31, 2017, our non-owner occupied CRE loans represented 317% of the Bank's capital, which declined from 332% as of December 31, 2016. The second criterion measures whether the non-owner occupied CRE growth rate during the prior thirty six months exceeds 50%. Since December 31, 2014, our non-owner occupied CRE portfolio has grown by 22%, below the 50% growth rate per the regulatory guideline. We maintain heightened review and analyses of our concentrations and have regular conversations with regulators to avoid unexpected regulatory risk.

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, 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.

In October 2017, much of the North Bay region of Northern California was struck by widespread and destructive wildfires. Fortunately, there was no damage to bank facilities and no significant impairment to services. Management has assessed the impact of the fires on our loan and investment portfolios; including mapping client addresses and locations of municipal bond issuers to areas affected by the fires and evaluating any known damage to collateral and businesses. Based on our assessment, the loss to properties and businesses located in the affected areas that are pledged as collateral to our loans or bonds is minimal. However, the long-term impact to the Napa and Sonoma regional economies is uncertain. Management is monitoring the situation and will continue to respond to the needs of customers and employees during the rebuilding process.

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.

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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. Early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We have formed an internal Current Expected Credit Loss ("CECL") committee and are working with our third party vendor to determine the appropriate methodologies and resources to utilize in preparation for transition to the new accounting standards. Refer to Note 1 to the Consolidated Financial Statements in ITEM 8 for further discussion.

Non-performing Assets Take Significant Time to Resolve and Adversely Affect Results of Operations and Financial Condition.

While our non-performing assets are currently at a low level, there can be no assurance that we will not experience increases in non-performing assets in the future. Generally, interest income is not recognized on non-performing loans and the administrative costs on these loans are higher than performing loans. We might incur losses if the creditworthiness of our borrowers deteriorates to a point when we need to take collateral in foreclosures and similar proceedings, resulting in possible mark down of the loans to the fair value of the collateral. While we have managed our problem assets through workouts, restructurings and other proactive credit management practices that mitigate credit losses, decreases in the value of the underlying collateral, or deterioration in borrowers' performance or financial conditions, whether or not due to economic and market conditions beyond our control, could adversely affect our business, results of operations and financial condition. In addition, the resolution of non-performing assets can distract Management from other responsibilities.

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 Bank. We also hold mortgage-backed securities (“MBS”) securities issued by FNMA and FHLMC. While we consider these securities to have low credit risk as they carry the backing of the U.S. Government, they are not direct obligations of the U.S. Government. GSE debt is sponsored but not guaranteed by the federal government, 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 United States.

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. In October 2017, the FOMC initiated the balance sheet normalization program, in which it intends to reduce the Federal Reserve's holdings of Treasury and agency securities by gradually decreasing its reinvestment of the principal payments it receives from securities. If the U.S. Government stops reinvesting or starts selling their holdings in U.S. Treasury or MBS issued by the GSE; if the government support is phased-out or completely withdrawn; or if either FNMA or FHLMC comes under financial stress or suffers creditworthiness deterioration, the value of our investments may be significantly impacted.

We also invest in tax exempt obligations of state and political subdivisions whose value have been affected by tax rate reductions from the Tax Cuts and Jobs Act of 2017. Additionally, 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.

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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.

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

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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, 2017, we had goodwill totaling $30.1 million and a core deposit intangible asset totaling $6.5 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 Cyber Security 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 cyber security 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, 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.


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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.

Failure of Correspondent Banks May Affect Liquidity

Financial services institutions are highly interrelated because of clearing and exchange, counterparty, and other business relationships. In particular, the financial services industry in general was materially and adversely affected by the recent credit crisis, including the failure and consolidation of banks in the industry in recent years. While we regularly monitor the financial health of our correspondent banks and we have diverse sources of liquidity, should any one of our correspondent banks become financially impaired, our available credit may decline and/or they may be unable to honor their commitments.

Deterioration of Credit Quality or Insolvency of Insurance Companies May Impede Our Ability to Recover Losses

We have property, casualty and financial institution risk coverage underwritten by several insurance companies, who may not avoid insolvency risk inherent in the insurance industry. In addition, some of our investments in obligations of state and political subdivisions are insured by insurance companies. While we closely monitor the credit ratings of our insurers and the insurers of our municipal securities and we are poised to make quick changes if needed, we cannot predict an unexpected inability to honor commitments. We also invest in bank-owned life insurance policies on certain members of Management, which may lose value in the event of a carrier's insolvency. In the event that a bank-owned life insurance policy carrier's credit ratings fall below investment grade, we may exchange policies to other carriers at a cost charged by the original carrier, or we may terminate the policies, which may result in adverse tax consequences.

Our loan portfolio is secured primarily by properties located in earthquake or fire-prone zones. In the event of a disaster that causes pervasive damage to the region in which we operate, not only the Bank, but also the loan collateral may suffer losses not recoverable by insurance.

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

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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.

We may need to Raise Additional Capital in the Future, and if we Fail to Maintain Sufficient Capital, Whether due to Losses, an Inability to Raise Additional Capital or Otherwise, our Financial Condition, Liquidity and Results of Operations, as well as our Ability to Maintain Regulatory Compliance, Could be Adversely Affected

We face significant capital and other regulatory requirements as a financial institution. We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs, which could include the possibility of financing acquisitions. In addition, Bancorp, on a consolidated basis, and the Bank, on a stand-alone basis, must meet certain regulatory capital requirements and maintain sufficient liquidity. Importantly, as discussed below, regulatory capital requirements could increase from current levels, which could require us to raise additional capital or contract our operations. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions and governmental activities, and on our financial condition and performance. Accordingly, we cannot assure that we will be able to raise additional capital if needed or on terms acceptable to us. If we fail to maintain capital to meet regulatory requirements, our liquidity, business, financial condition and results of operations could be materially and adversely affected.

We may be Subject to more Stringent Capital Requirements in the Future

We are subject to regulatory requirements specifying minimum amounts and types of capital that we must maintain. From time to time, the regulators change these regulatory capital adequacy guidelines. If we fail to meet these minimum capital guidelines and other regulatory requirements, Bancorp or the Bank may be restricted in the types of activities we may conduct and we may be prohibited from taking certain capital actions, such as paying dividends and repurchasing or redeeming capital securities. If we become subject to annual stress testing requirements, our stress test results may have the effect of requiring us to comply with even greater capital requirements. While we currently meet the requirements of the Basel III-based capital rules on a fully implemented basis, we may eventually fail to do so. In addition, these requirements could negatively affect our ability to lend, grow deposit balances, make acquisitions or make capital distributions in the form of dividends or share repurchases. Higher capital levels could also lower our return on equity.

We may be Subject to Environmental Liabilities in Connection with the Foreclosure on Real Estate Assets Securing our Loan Portfolio

Hazardous or toxic substances or other environmental hazards may be located on the properties that secure our loans. If we acquire such properties as a result of foreclosure or otherwise, we could become subject to various environmental liabilities. For example, we could be held liable for the cost of cleaning up or otherwise addressing contamination at or from these properties. We could also be held liable to a governmental entity or third party for property damage, personal injury or other claims relating to any environmental contamination at or from these properties. In addition, we own and operate certain properties that may be subject to similar environmental liability risks. Although we have policies and procedures that are designed to mitigate against certain environmental risks, we may not detect all environmental hazards associated with these properties. If we ever became subject to significant environmental liabilities, our business, financial condition and results of operations could be adversely affected.

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

Page-18



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.

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 tradeoff. 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

Regulators and law-enforcement agencies from a number of governments, including entities in the United States, Japan, Canada and the United Kingdom, have been conducting civil and criminal investigations into whether the banks that contributed to the British Bankers’ Association (the “BBA”) in connection with the calculation of daily LIBOR may have underreported or otherwise manipulated or attempted to manipulate LIBOR. Based on a review conducted by the Financial Conduct Authority of the United Kingdom (the “FCA”) and a consultation conducted by the European Commission, proposals have been made for governance and institutional reform, regulation, technical changes and contingency planning. In particular: (a) new legislation has been enacted in the United Kingdom pursuant to which LIBOR submissions and administration are now “regulated activities” and manipulation of LIBOR has been brought within the scope of the market abuse regime; (b) legislation has been proposed which if implemented would, among other things, alter the manner in which LIBOR is determined, compel more banks to provide LIBOR submissions, and require these submissions to be based on actual transaction data; and (c) LIBOR rates for certain currencies and maturities are no longer published daily. In addition, pursuant to authorization from the FCA, the ICE Benchmark Administration Limited (the “IBA”) took over the administration of LIBOR from the BBA on February 1, 2014.

In a speech on July 27, 2017, Andrew Bailey, the Chief Executive of the FCA, announced the FCA’s intention to cease sustaining LIBOR after 2021. The FCA has statutory powers to require panel banks to contribute to LIBOR where necessary. The FCA has decided not to ask, or to require, that panel banks continue to submit contributions to LIBOR beyond the end of 2021. The FCA has indicated that it expects that the current panel banks will voluntarily sustain LIBOR until the end of 2021. The FCA’s intention is that after 2021, it will no longer be necessary for the FCA to ask,

Page-19



or to require, banks to submit contributions to LIBOR. The FCA does not intend to sustain LIBOR through using its influence or legal powers beyond that date. While it is possible that the IBA and the panel banks could continue to produce LIBOR on the current basis after 2021, there is no assurance that LIBOR will survive in its current form, or at all.

We have floating rate loans and investment securities, interest rate swap agreements and subordinated debentures whose interest rates are indexed to LIBOR. We cannot predict the effect of the FCA’s decision not to sustain LIBOR or, if changes are ultimately made to LIBOR, the effect of those changes. In addition, we cannot predict what alternative index would be chosen, should this occur. If LIBOR in its current form does not survive or if an alternative index is chosen, the market value and/or liquidity of our financial instruments currently indexed to LIBOR could be adversely affected.

ITEM 1B      UNRESOLVED STAFF COMMENTS

None

ITEM 2     PROPERTIES

We lease our corporate headquarters building in Novato, California, which houses substantial loan production, operations and administration.  We also lease other branch or 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 and Oakland.  We consider our properties to be suitable and adequate for our needs. 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
 
We may be party to legal actions that arise from time to time as part of the normal course of our business.  We believe, after consultation with legal counsel, that we have meritorious defenses in these actions, and that litigation contingent liability, if any, will not have a material adverse effect on our financial position, results of operations, or cash flows.
 
We are responsible for our 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. 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-20



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

Bancorp common stock trades on the NASDAQ Capital Market under the symbol BMRC. At February 28, 2018, 6,970,446 shares of Bancorp's common stock, no par value, were outstanding and held by approximately 2,900 holders of record and beneficial owners. The following table sets forth, for the periods indicated, the range of high and low intra-day sales prices of Bancorp's common stock.
Calendar
2017
2016
 Quarter
High

Low

High

Low

1st Quarter
$
72.50

$
63.25

$
54.50

$
45.65

2nd Quarter
$
69.95

$
59.05

$
51.61

$
47.16

3rd Quarter
$
70.75

$
60.95

$
52.47

$
47.25

4th Quarter
$
77.90

$
63.90

$
75.05

$
49.25


The table below shows cash dividends paid to common shareholders on a quarterly basis in the last two fiscal years.
Calendar
2017
2016
 Quarter
Per Share

Dollars

Per Share

Dollars

1st Quarter
$
0.27

$
1,655

$
0.25

$
1,518

2nd Quarter
$
0.27

$
1,661

$
0.25

$
1,526

3rd Quarter
$
0.29

$
1,788

$
0.25

$
1,528

4th Quarter
$
0.29

$
1,792

$
0.27

$
1,651

 
$
1.12

$
6,896

$
1.02

$
6,223


On January 19, 2018, the Board of Directors declared a cash dividend of $0.29 per share, payable on February 9, 2018 to shareholders of record at the close of business on February 2, 2018. For additional information regarding our ability to pay dividends, see discussion in Note 8 to the Consolidated Financial Statements, under the heading “Dividends,” in ITEM 8 of this report.

There were no purchases made by or on behalf of Bancorp or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) of the Bancorp's common stock during the fourth quarter of 2017.

On July 6, 2017, Bancorp executed a shareholder rights agreement (“Rights Agreement”), which expires July 23, 2022, 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, 2017, 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
258,968

$
40.84

219,414
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 258,968 shares to be issued upon exercise of outstanding options and 192,453 shares available to be issued under the Employee Stock Purchase Plan.


Page-21



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, 2017 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, 2012 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.
 
bmrcreturnperformance.jpg
 
2012

2013

2014

2015

2016

2017

Bank of Marin Bancorp (BMRC)
100.00

117.90

145.42

150.33

200.41

198.70

Russell 2000 Index
100.00

138.82

145.62

139.19

168.85

193.58

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

145.41

152.04

170.20

244.85

261.04

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-22



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)
2017
2016
2015
2014
2013
Selected financial condition data:
 
 
 
 
 
Total assets
$
2,468,154

$
2,023,493

$
2,031,134

$
1,787,130

$
1,805,194

Loans, net
1,663,246

1,471,174

1,436,299

1,348,252

1,255,098

Deposits
2,148,670

1,772,700

1,728,226

1,551,619

1,587,102

Borrowings
5,739

5,586

72,395

20,185

19,969

Stockholders' equity
297,025

230,563

214,473

200,026

180,887

 
For the Years Ended December 31,
(dollars in thousands, except per share data)
2017
2016
2015
2014
2013
Selected operating data:
 
 
 
 
 
Net interest income
$
74,852

$
73,161

$
67,187

$
70,441

$
58,775

Provision for (reversal of) loan losses
500

(1,850
)
500

750

540

Non-interest income
8,268

9,161

9,193

9,041

8,066

Non-interest expense 1
53,782

47,692

46,949

47,263

44,092

Net income 1
15,976

23,134

18,441

19,771

14,270

Net income per common share:
 
 
 
 
 
Basic
$
2.58

$
3.81

$
3.09

$
3.35

$
2.62

Diluted
$
2.55

$
3.78

$
3.04

$
3.29

$
2.57

 
At or for the Years Ended December 31,
 
2017
2016
2015
2014
2013
Performance and other financial ratios:
 
 
 
 
 
Return on average assets
0.75
%
1.15
%
0.98
%
1.08
%
0.96
%
Return on average equity
6.49
%
10.23
%
8.84
%
10.31
%
8.86
%
Tax-equivalent net interest margin
3.80
%
3.91
%
3.83
%
4.13
%
4.20
%
Efficiency ratio
64.70
%
57.93
%
61.47
%
59.46
%
65.97
%
Loan-to-deposit ratio
78.14
%
83.86
%
83.97
%
87.87
%
79.98
%
Cash dividend payout ratio on common stock 2
43.41
%
26.77
%
29.10
%
23.90
%
27.90
%
Cash dividends per common share
$
1.12

$
1.02

$
0.90

$
0.80

$
0.73

Asset quality ratios:
 
 
 
 
 
Allowance for loan losses to total loans
0.94
%
1.04
%
1.03
%
1.11
%
1.12
%
Allowance for loan losses to non-performing loans 3
38.88x

106.5x

6.88x

1.61x

1.22x

Non-performing loans to total loans 3
0.02
%
0.01
%
0.15
%
0.69
%
0.92
%
Capital ratios:
 
 
 
 
 
Equity to total assets ratio
12.03
%
11.39
%
10.60
%
11.20
%
10.00
%
Total capital (to risk-weighted assets)
14.91
%
14.32
%
13.37
%
13.94
%
13.21
%
Tier 1 capital (to risk-weighted assets)
14.04
%
13.37
%
12.44
%
12.87
%
12.18
%
Tier 1 capital (to average assets)
12.13
%
11.39
%
10.67
%
10.62
%
10.78
%
Common equity Tier 1 capital (to risk-weighted assets)
13.75
%
13.07
%
12.16
%
N/A

N/A

Other data:
 
 
 
 
 
Number of full service offices
23

20

20

21

21

Full time equivalent employees
291

262

259

260

281

1 2017, 2014 and 2013 included $2.2 million, $746 thousand and $3.7 million, respectively, in merger-related expenses.
2 Calculated as dividends on common shares divided by basic net income per common share.
3 Non-performing loans include loans on non-accrual status and loans past due 90 days or more and still accruing interest.

Page-23



ITEM 7     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of financial condition as of December 31, 2017 and 2016 and results of operations for each of the years in the three-year period ended December 31, 2017 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.
 
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, 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, ITEM 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, 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-24



Executive Summary
 
Annual earnings were $16.0 million in 2017 compared to $23.1 million in 2016. Diluted earnings were $2.55 per share for the year ended December 31, 2017, compared to $3.78 per share in the same period of 2016.

The following are highlights of operating and financial performance for the year ended December 31, 2017:
In 2017, Bank of Marin acquired Bank of Napa. As a result, Bank of Marin is the largest community bank in Napa County by deposit share. This is the third acquisition in the past six years that strengthens the Bank’s presence in the San Francisco Bay Area. Additionally, we expanded our presence in Sonoma County by opening our Healdsburg office.
Earnings in 2017 included a $3.0 million one-time deferred tax asset write-down due to the enactment of the new federal tax law on December 22, 2017, and expenses related to the acquisition of Bank of Napa. Without these expenses, diluted earnings per share ("EPS") would have been $3.28 for the full year, and net income would have been $20.5 million for the year ended December 31, 2017. Refer to table on the following page for a detailed reconciliation of these financial measures presented according to the Generally Accepted Accounting Principles (“GAAP”) vs. non-GAAP. Additionally, annual earnings in 2016 were higher than 2017 due to loan recoveries and early payoff of several acquired loans purchased at a discount, which positively impacted the 2016 EPS by $0.47.
The Bank achieved organic loan growth of $59.5 million, or 4.0% in 2017. Including loans acquired from Bank of Napa, the total loan portfolio grew 12.9% from $1,486.6 million at December 31, 2016 to $1,679.0 million at December 31, 2017. In early 2018, we are funding loans carried over from the prior year as we continue to rebuild our pipeline.
Organic deposit growth was $144.5 million, or 8.2% for the year. Combined organic growth and deposits acquired from Bank of Napa resulted in 21.2% total deposit growth to $2,148.7 million at December 31, 2017, compared to $1,772.7 million at December 31, 2016. Non-interest bearing deposits, including those acquired, grew by $197.1 million in 2017 and made up 47% of total deposits at year end. Cost of total deposits remained low at 0.07% despite three short-term interest rate increases by the Federal Reserve Open Market Committee in 2017.
Strong credit quality remains a cornerstone of the Bank’s consistent performance. Non-accrual loans represent 0.02% of the Bank's loan portfolio as of December 31, 2017. A $500 thousand provision for loan losses was recorded in the fourth quarter due to continuing loan growth and elevated risk factors associated with the unknown long-term impacts of the 2017 North Bay wildfires and effects of the Bank of Napa acquisition.
While the long-term impact of the October 2017 wildfires on the North Bay economy is still unknown, the immediate impact to our loan portfolio and to our customer base was minimal. Bank of Marin is committed to helping our customers and our communities recover and rebuild.
Net interest income totaled $74.9 million and $73.2 million in 2017 and 2016, respectively. The increase of $1.7 million in 2017 is primarily due to an increase in earning assets of $114.4 million, partially offset by a decrease in gains on payoffs and accretion on purchased loans, and a $1.4 million interest recovery in 2016. The tax equivalent net interest margin decreased to 3.80% in 2017 compared to 3.91% in 2016 for the same reasons. Refer to the Net Interest Income section below for information on the tax equivalent net interest margin and the reported net interest margin.
The effective tax rate of 44.6% for the year was elevated by 10.5 percentage points due to the deferred tax asset write-down. Without this charge, the effective tax rate would have been slightly lower than the previous years.
 
The efficiency ratio was 64.7% for the full year, up from 57.9% in 2016. Acquisition expenses increased the efficiency ratio by 2.7 percentage points for the year. We expect approximately $1.0 million in additional acquisition-related expenses in 2018.


Page-25



For the year ended December 31, 2017, return on assets ("ROA") was 0.75% and return on equity ("ROE") was 6.49%. Acquisition expenses and the deferred tax asset write-down reduced ROA by 0.22 percentage points and ROE by 1.86 percentage points.

All capital ratios are well above regulatory requirements for a well-capitalized institution. The total risk-based capital ratio for Bancorp was 14.9% at December 31, 2017, compared to 14.3% at December 31, 2016.

Looking forward into the new year, the investments we made in both organic growth and the Bank of Napa acquisition in 2017 should position us very well for 2018.
The reduced tax rate resulting from the Tax Cuts and Jobs Act of 2017 presents an opportunity for the Bank to consider or accelerate certain strategies, including potential value-added investments, changes to our dividend policy or other capital actions.   Additionally, in January 2018, the Bank awarded special bonuses to staff in recognition of their consistent contributions to the Bank's ongoing success.
We have ample liquidity and capital to support organic growth and acquisitions in coming years.
As part of its organic growth plan, the Bank expanded its executive and lending teams with several strategic hires in 2017, including a Chief Operating Officer and a Commercial Banking Regional Manager for the Bank’s Napa and Sonoma markets.
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.
Statement regarding use of non-GAAP financial measures

Management believes that presentation of operating results using non-GAAP financial measures provides useful supplemental information to investors and facilitates the analysis of Bancorp's core operating results and comparison of operating results across reporting periods. Management also uses non-GAAP financial measures to establish budgets and manage Bancorp's business. A reconciliation of the GAAP financial results to non-GAAP financial results is included in the following table.
Reconciliation of GAAP and Non-GAAP Financial Measures
 
 
Years ended
(in thousands, unaudited)
December 31, 2017
December 31, 2016
December 31, 2015
Net income (GAAP)
$
15,976

$
23,134

$
18,441

Acquisition-related expenses
2,209



Tax effect associated with acquisition-related expenses
               (657)



Deferred tax asset write-down
              3,017



Comparable net income (Non-GAAP)
$
20,545

$
23,134

$
18,441

Diluted earnings per share (GAAP)
$
2.55

$
3.78

$
3.04

Acquisition-related expenses
                0.35



Tax effect associated with acquisition-related expenses
              (0.10)



Deferred tax asset write-down
                0.48



Comparable diluted earnings per share (Non-GAAP)
$
3.28

$
3.78

$
3.04


Following is a description of the adjustments made to GAAP financial measures:

Acquisition-related costs: Costs related to closing and integration of the acquired bank.

Tax expense associated with write-down of the net deferred tax assets due to the Tax Cuts and Jobs Act of 2017 discussed earlier.

Page-26



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, Average Statements of Condition and Analysis of Net Interest Income, 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
 
Year ended
 
 
December 31, 2017
 
December 31, 2016
 
December 31, 2015
 
 
 
Interest
 
 
 
Interest
 
 
 
Interest
 
 
 
Average
Income/
Yield/
 
Average
Income/
Yield/
 
Average
Income/
Yield/
(dollars in thousands; unaudited)
Balance
Expense
Rate
 
Balance
Expense
Rate
 
Balance
Expense
Rate
Assets
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing due from banks 1
$
80,351

$
995

1.22
%
 
$
38,314

$
209

0.54
%
 
$
52,004

$
135

0.26
%
 
Investment securities 2, 3
419,873

9,732

2.32
%
 
406,640

8,671

2.13
%
 
370,730

8,255

2.23
%
 
Loans 1, 3, 4
1,511,503

68,562

4.47
%
 
1,452,357

68,794

4.66
%
 
1,354,564

62,953

4.58
%
 
   Total interest-earning assets 1
2,011,727

79,289

3.89
%
 
1,897,311

77,674

4.03
%
 
1,777,298

71,343

3.96
%
 
Cash and non-interest-bearing due from banks
42,511

 
 
 
42,150

 
 
 
44,543

 
 
 
Bank premises and equipment, net
8,411

 
 
 
8,836

 
 
 
9,705

 
 
 
Interest receivable and other assets, net
63,301

 
 
 
59,989

 
 
 
58,201

 
 
Total assets
$
2,125,950

 
 
 
$
2,008,286

 
 
 
$
1,889,747

 
 
Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing transaction accounts
$
105,544

$
108

0.10
%
 
$
94,252

$
109

0.12
%
 
$
95,662

$
115

0.12
%
 
Savings accounts
167,190

66

0.04
%
 
151,214

58

0.04
%
 
134,997

50

0.04
%
 
Money market accounts
542,592

555

0.10
%
 
524,989

445

0.08
%
 
505,280

495

0.10
%
 
Time accounts, including CDARS
146,069

576

0.39
%
 
158,878

742

0.47
%
 
156,316

853

0.55
%
 
Overnight borrowings 1
1


1.75
%
 
5,383

23

0.42
%
 
784

3

0.38
%
 
FHLB fixed-rate advances 1


%
 
6,803

456

6.59
%
 
15,000

315

2.07
%
 
Subordinated debentures 1
5,664

439

7.65
%
 
5,493

436

7.80
%
 
5,288

420

7.94
%
 
   Total interest-bearing liabilities
967,060

1,744

0.18
%
 
947,012

2,269

0.24
%
 
913,327

2,251

0.25
%
 
Demand accounts
899,289

 
 
 
819,916

 
 
 
753,038

 
 
 
Interest payable and other liabilities
13,506

 
 
 
15,142

 
 
 
14,856

 
 
 
Stockholders' equity
246,095

 
 
 
226,216

 
 
 
208,526

 
 
Total liabilities & stockholders' equity
$
2,125,950

 
 
 
$
2,008,286

 
 
 
$
1,889,747

 
 
Tax-equivalent net interest income/margin 1
 
$
77,545

3.80
%
 
 
$
75,405

3.91
%
 
 
$
69,092

3.83
%
Reported net interest income/margin 1
 
$
74,852

3.67
%
 
 
$
73,161

3.79
%
 
 
$
67,187

3.73
%
Tax-equivalent net interest rate spread
 

3.71
%
 
 
 
3.79
%
 
 
 
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 35 percent.
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-27



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 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.
 
2017 compared to 2016
2016 compared to 2015
(in thousands, unaudited)
Volume

Yield/Rate

Mix

Total

Volume

Yield/Rate

Mix

Total

Interest-bearing due from banks
$
229

$
266

$
291

$
786

$
(36
)
$
149

$
(39
)
$
74

Investment securities 1
282

754

25

1,061

800

(350
)
(34
)
416

Loans 1
2,802

(2,915
)
(119
)
(232
)
4,545

1,209

87

5,841

Total interest-earning assets
3,313

(1,895
)
197

1,615

5,309

1,008

14

6,331

Interest-bearing transaction accounts
13

(13
)
(1
)
(1
)
(2
)
(4
)

(6
)
Savings accounts
6

2


8

6

2


8

Money market accounts
15

91

4

110

19

(67
)
(3
)
(51
)
Time accounts, including CDARS
(60
)
(115
)
9

(166
)
14

(123
)
(2
)
(111
)
FHLB borrowings and overnight borrowings
(479
)


(479
)
(155
)
690

(374
)
161

Subordinated debentures
14

(10
)
(1
)
3

17



17

Total interest-bearing liabilities
(491
)
(45
)
11

(525
)
(101
)
498

(379
)
18

 
$
3,804

$
(1,850
)
$
186

$
2,140

$
5,410

$
510

$
393

$
6,313

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

2017 Compared with 2016
 
Net interest income totaled $74.9 million and $73.2 million in 2017 and 2016, respectively. The increase of $1.7 million in 2017 is primarily due to an increase in earning assets of $114.4 million, partially offset by a decrease in gains on payoffs and accretion on purchased loans, and a $1.4 million interest recovery in 2016. The tax-equivalent net interest margin was 3.80% in 2017, compared to 3.91% in 2016.  The decrease of eleven basis points was primarily due to a $1.4 million interest recovery upon payoff of a problem credit in 2016. Other factors that affected the net interest margin during 2017 included a decline in gains on payoffs and accretion on purchased loans and a shift in the mix of earning assets. These factors were partially offset by higher average yields on investment securities and cash in 2017, and prepayment fees of $312 thousand on FHLB borrowings in 2016. The net interest spread decreased eight basis points over the same period for the same reasons.

The yield on average interest-earning assets decreased fourteen basis points in 2017 compared to 2016 for the reasons listed above. The loan portfolio as a percentage of average interest-earning assets, decreased to 75.1% in 2017, from 76.6% in 2016. Cash was 4.0% and 2.0% of average interest-earning assets in 2017 and 2016, respectively. Total average interest-earning assets increased $114.4 million, or 6.0%, in 2017 compared to 2016.

2016 Compared with 2015
 
The tax-equivalent net interest margin was 3.91% in 2016, compared to 3.83% in 2015.  The increase of eight basis points was primarily due to a $1.4 million interest recovery upon payoff of a problem credit in 2016. Other factors that affected the net interest margin during 2016 included greater gains on payoffs and accretion on purchased loans and a shift to higher yielding earning assets, partially offset by lower average rates on loans and investment securities and prepayment fees of $312 thousand on FHLB borrowings. The net interest spread increased eight basis points over the same period for the same reasons.

The yield on average interest-earning assets increased seven basis points in 2016 compared to 2015 for the reasons listed above. The loan portfolio as a percentage of average interest-earning assets, increased to 76.6% in 2016, from 76.2% in 2015. The investment securities were 21.4% and 20.9% of average interest-earning assets in 2016 and 2015, respectively. Total average interest-earning assets increased $120.0 million, or 6.8%, in 2016 compared to 2015.

Page-28




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 and December 2017, have positively impacted yields on our rate sensitive interest-earning assets. The increase in June 2017, to the current target range for the federal funds rate of 1.25% to 1.50%, was the fifth rate hike since 2008. If interest rates continue to rise, we anticipate that our net interest income will increase. While short-term interest rates have risen and improved the Bank’s yields on prime-rate adjustable assets, there has been little movement in longer-term rates that influence competitive pricing for fixed-rate lending activities.

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. The loans acquired from Bank of Napa are not expected to significantly increase the accretion of purchased loans. 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 three years was as follows:
 
Years ended December 31,
 
2017
 
2016
 
2015
(dollars in thousands; unaudited)
Dollar Amount
Basis point affect on net interest margin
 
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
$
331

2 bps
 
$
364

2 bps
 
$
495

3 bps
Accretion on non-PCI loans
$
571

3 bps
 
$
1,411

7 bps
 
$
1,389

8 bps
Gains on payoffs of PCI loans
$
184

1 bps
 
$
1,027

5 bps
 
$
44

0 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 a $500 thousand provision for loan losses in 2017, consistent with our organic loan growth and changing risk factors, compared to a reversal of loan losses of $1.9 million in 2016 due to the resolution and payoff of a problem commercial real estate credit. The provision for loan losses totaled $500 thousand in 2015. The allowance for loan losses was 0.94%, 1.04% and 1.03% of loans at December 31, 2017, 2016 and 2015, respectively. The decline in ratio compared to the prior year was primarily due to loans acquired from Bank of Napa in November 2017 that were recorded at fair value upon acquisition requiring no allowance as of December 31, 2017. The allowance for loan losses, excluding acquired loans, was 1.06%, 1.10% and 1.12% of loans at December 31, 2017, 2016 and 2015, respectively. Net charge-offs totaled $175 thousand in 2017, compared to net recoveries of $2.3 million in 2016, primarily related to the resolution of the problem commercial real estate credit. Net charge-offs totaled $600 thousand in 2015, primarily relating to a land development loan sold in 2015. See the section captioned “Allowance for Loan Losses” below for further analysis of the provision for loan losses.


Page-29



Non-interest Income
 
The table below details the components of non-interest income.
Table 3 Components of Non-Interest Income
 
Years ended
2017 compared to 2016
 
2016 compared to 2015
 
December 31,
Amount
Percent
 
Amount
Percent
(dollars in thousands; unaudited)
2017

2016

2015

Increase (Decrease)
Increase (Decrease)
 
Increase (Decrease)
Increase (Decrease)
Service charges on deposit accounts
$
1,784

$
1,789

$
1,979

$
(5
)
(0.3
)%
 
$
(190
)
(9.6
)%
Wealth Management and Trust Services
2,090

2,090

2,391


 %
 
(301
)
(12.6
)%
Debit card interchange fees
1,531

1,503

1,445

28

1.9
 %
 
58

4.0
 %
Merchant interchange fees
398

449

545

(51
)
(11.4
)%
 
(96
)
(17.6
)%
Earnings on bank-owned life insurance
845

844

814

1

0.1
 %
 
30

3.7
 %
Dividends on FHLB stock
766

1,153

1,003

(387
)
(33.6
)%
 
150

15.0
 %
Gains on investment securities, net
(185
)
425

79

(610
)
(143.5
)%
 
346

438.0
 %
Other income
1,039

908

937

131

14.4
 %
 
(29
)
(3.1
)%
Total non-interest income
$
8,268

$
9,161

$
9,193

$
(893
)
(9.7
)%
 
$
(32
)
(0.3
)%

2017 Compared with 2016

Non-interest income totaled $8.3 million and $9.2 million in 2017 and 2016, respectively. The decrease compared to the prior year primarily relates to a special FHLB dividend of $347 thousand and $425 thousand net gains on the sale of investment securities recorded in 2016. Additionally, merchant interchange fees continue to trend down as we transitioned our merchant customers to a new service provider with different contract arrangements in 2016 and 2017.

2016 Compared with 2015

Non-interest income totaled $9.2 million in both 2016 and 2015, respectively. Non-interest income in 2016 included higher gains on the sale of investment securities, higher dividends on FHLB stock as we purchased $1.8 million in capital stock due to an increase in the total asset base used to calculate our membership stock requirement, and received a $347 thousand special dividend, compared to a $305 thousand special dividend in 2015. These increases were offset by lower service charges on business analysis accounts due to higher average deposit balances and lower wealth management and trust related fees due to the settlement of several large estates in 2015 and early 2016. Additionally, merchant interchange fees continue to trend down as we transition our merchant customers to a new service provider with different contract arrangements.


Page-30



Non-interest Expense

The table below details the components of non-interest expense.
Table 4 Components of Non-Interest Expense
 
Years ended
2017 compared to 2016
2016 compared to 2015
 
December 31,
Amount
Percent
Amount
Percent
(dollars in thousands; unaudited)
2017

2016

2015

Increase (Decrease)
Increase (Decrease)
Increase (Decrease)
Increase (Decrease)
Salaries and related benefits
$
29,958

$
26,663

$
25,764

$
3,295

12.4
 %
$
899

3.5
 %
Occupancy and equipment
5,472

5,081

5,498

391

7.7
 %
(417
)
(7.6
)%
Depreciation and amortization
1,941

1,822

1,968

119

6.5
 %
(146
)
(7.4
)%
FDIC insurance
666

825

997

(159
)
(19.3
)%
(172
)
(17.3
)%
Data processing
4,906

3,625

3,318

1,281

35.3
 %
307

9.3
 %
Professional services
2,858

2,044

2,121

814

39.8
 %
(77
)
(3.6
)%
Directors' expense
720

553

826

167

30.2
 %
(273
)
(33.1
)%
Information technology
769

862

736

(93
)
(10.8
)%
126

17.1
 %
Provision for (reversal of) losses on off-balance sheet commitments
57

150

(263
)
(93
)
(62.0
)%
413

(157.0
)%
Other non-interest expense:
 
 
 
 
 
 
 
Advertising
567

565

334

2

0.4
 %
231

69.2
 %
Amortization of core deposit intangible
528

533

619

(5
)
(0.9
)%
(86
)
(13.9
)%
Other expense
5,340

4,969

5,031

371

7.5
 %
(62
)
(1.2
)%
Total other non-interest expense
6,435

6,067

5,984

368

6.1
 %
83

1.4
 %
Total non-interest expense
$
53,782

$
47,692

$
46,949

$
6,090

12.8
 %
$
743

1.6
 %

2017 Compared with 2016

In 2017, non-interest expense increased by $6.1 million to $53.8 million. The increase primarily relates to higher salaries and benefits due to additional full-time equivalent personnel, annual merit increases, and higher employee insurance. The number of average FTE employees totaled 269 in 2017 and 258 in 2016. The increase also relates to $2.2 million in acquisition expenses ($1.1 million in data processing, $952 thousand in professional services, $35 thousand in personnel severance and $114 thousand in other expense), as well as higher occupancy and equipment expenses related to rent increases, new branches and higher maintenance costs.

These increases were partially offset by lower FDIC assessments due to lower assessment rates. For additional information on the acquisition related expenses, see Note 18 to the Consolidated Financial Statements in ITEM 8 of this report.

2016 Compared with 2015

In 2016, non-interest expense increased by $743 thousand to $47.7 million. The increase primarily relates to higher salaries and benefits due to annual merit increases, higher employee insurance and stock-based compensation expense, partially offset by the effect of job vacancies during the year. The number of average FTE employees totaled 258 in 2016 and 260 in 2015. The increase also relates to a higher reserve for losses on off-balance sheet commitments, as unused commitments increased in 2016, and 2015 included a one-time adjustment (reversal) related to a refinement in methodology (see discussion below). Data processing costs also increased due to higher transaction volume and the addition of new products and services.

These increases were partially offset by a decrease in occupancy and equipment expenses from cost savings related to the relocation of offices in 2016 and lease accounting adjustments recorded in 2015, lower director expense resulting from fewer board members, as well as lower FDIC assessment expense due to lower assessment rates.


Page-31



Provision for Income Taxes

The provision for income taxes totaled $12.9 million at an effective tax rate of 44.6% in 2017, compared to $13.3 million at an effective tax rate of 36.6% in 2016 and $10.5 million at an effective tax rate of 36.3% in 2015. The 2017 provision for income taxes included a $3.0 million write-down of net deferred tax assets related to the enactment of the Tax Cuts and Jobs Act of 2017 on December 22, 2017, which reduced the federal corporate income tax rate to 21% at which the temporary difference of tax items are expected to reverse in the future. The deferred tax write-down in 2017 raised the effective tax rate by 10.5%. We incurred non-deductible acquisition related expenses in 2017, which also increased our effective tax rate by 0.8% compared to the prior year. Additionally, discrete tax benefits from the exercise of stock options and vesting of restricted stock increased in 2017 as a result of the adoption of FASB Accounting Standards Codification ("ASU") No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"), as discussed in Note 1 to the Consolidated Financial Statements in ITEM 8 of this report. 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, bank owned life insurance ("BOLI") and low income housing credits). Additional fluctuations in the effective rate from period to period are due to the relationship of net permanent differences to income before tax.

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. In June 2015, the State of California completed its examination of the 2011 and 2012 corporate income tax returns, resulting in a minor adjustment. At December 31, 2017 and 2016, neither the Bank nor Bancorp had accruals for interest or penalties related to unrecognized tax benefits.

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. We estimate that the reduction in the federal statutory tax rate for corporations like us effective January 1, 2018 from 35% to 21% will reduce our effective tax rate for 2018 to approximately 24%. However, there can be no assurance as to the actual amount because the provision for income taxes is dependent upon the nature and amount of future income and expenses as well as transactions with discrete tax effects such as the exercise of stock options. The Tax Cuts and Jobs Act of 2017 has provisions that will have an unfavorable impact to our tax expenses, including but not limited to 1) elimination or reductions to the deductibility of certain meals, entertainment, parking and transportation expenses, 2) elimination of the exception for performance-based executive compensation resulting in our inability to deduct executive compensation exceeding $1.0 million, and 3) clarification of the definition of a covered employee for excessive employee compensation purposes.

FINANCIAL CONDITION

Our assets increased $445 million from December 31, 2016 to December 31, 2017. Increases of $376 million in deposits and $192 million in loans reflected both organic growth and the acquisition of Bank of Napa. The influx of deposits also raised our cash level by $155 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, 2017 and 2016. 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, 2017 and 2016 was approximately five years and four years, respectively.


Page-32



Table 5 Investment Securities
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
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
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
$
9,954

3.18
%
 
$
18,925

5.33
%
 
$
1,977

6.85
%
 
$

%
 
$
30,856

$
31,544

4.73
%
Corporate bonds
3,519

1.07

 


 


 


 
3,519

3,518

1.07

MBS/CMOs issued by U.S. government agencies


 
4,051

3.50

 
6,012

3.32

 


 
10,063

10,035

3.39

Total held-to-maturity
13,473

2.63

 
22,976

5.01

 
7,989

4.19

 


 
44,438

45,097

4.14

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
MBS/CMOs issued by U.S. government agencies
11,609

1.65

 
142,602

2.03

 
103,260

1.92

 


 
257,471

253,434

1.97

SBA backed securities


 
614

5.21

 


 


 
614

607

5.21

State and municipal3
4,027

1.93

 
31,929

2.35

 
41,980

3.07

 
1,369

5.46

 
79,305

77,701

2.76

Debentures of government sponsored agencies
5,000

1.00

 
30,486

1.13

 


 


 
35,486

35,403

1.11

Privately issued CMOs
265

1.62

 
154

3.01

 


 


 
419

419

2.13

Corporate bonds


 
3,965

1.97

 
994

1.99

 


 
4,959

5,016

1.97

Total available-for-sale
20,901

1.55

 
209,750

1.96

 
146,234

2.25

 
1,369

5.46

 
378,254

372,580

2.06

Total
$
34,374

1.97
%
 
$
232,726

2.26
%
 
$
154,223

2.35
%
 
$
1,369

5.46
%
 
$
422,692

$
417,677

2.28
%
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% for 2017 data and 35% for
2016 data.

The amortized cost of our investment securities portfolio increased $62.6 million or 14.8% during 2017. We purchased $123.2 million in securities in 2017, including $4.5 million designated as held-to-maturity and $118.7 million designated as available-for-sale to provide flexibility for liquidity and interest rate risk management. In addition, we acquired $75.5 million of investment securities from the Bank of Napa acquisition. These purchases were partially offset by $74.9 million of paydowns, calls and maturities, and $56 million of sales during 2017. Sales of securities were mainly due to changes in credit and tax law implications.

During 2017, we purchased $10 million in agency debentures issued by FHLMC, $4.5 million in mortgage pass-through securities, $88 million in collateralized mortgage obligations ("CMOs"), and $20.7 million in Small Business Administration backed securities ("SBAs"). 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 and MBS issued by the U.S. government sponsored agencies, state and municipal

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securities, SBAs and corporate bonds, made up 68.8%, 24.2%, 5.4% and 1.4% of the portfolio at December 31, 2017, compared to 71.7%, 26.1%, 0.2% and 2.0%, respectively at December 31, 2016. 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, 2017, distribution of our investment in obligations of state and political subdivisions was as follows:
 
December 31, 2017
December 31, 2016
(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
$
19,634

$
19,678

16.7
%
$
15,777

$
15,660

14.3
%
Revenue bonds
11,660

11,776

9.9

10,895

11,127

9.9

Tax allocation bonds
6,099

6,234

5.2

4,043

4,178

3.7

Total within California
37,393

37,688

31.8

30,715

30,965

27.9

Outside California:
 
 
 
 
 
 
General obligation bonds
68,890

68,454

58.5

71,534

70,376

64.9

Revenue bonds
11,390

11,346

9.7

7,913

7,904

7.2

Total outside California
80,280

79,800

68.2

79,447

78,280

72.1

Total obligations of state and political subdivisions
$
117,673

$
117,488

100.0
%
$
110,162

$
109,245

100.0
%

The portion of the portfolio outside the state of California is distributed among 28 states. The largest concentrations outside California are in Washington (12.1%), Texas (11.4%), and Minnesota (7.7%). Revenue bonds, both within and outside California, primarily consisted of bonds relating to 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.
    


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Loans

Table 6 Loans Outstanding by Type at December 31
(in thousands; unaudited)
2017

2016

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