Annual Report (10-k)

Date : 03/11/2019 @ 8:51PM
Source : Edgar (US Regulatory)
Stock : Pacific Mercantile Bancorp (PMBC)
Quote : 8.23  -0.05 (-0.60%) @ 9:30PM

Annual Report (10-k)


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
 
 
(Mark One)
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2018
OR
¨
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 0-30777
 
PACIFIC MERCANTILE BANCORP
(Exact name of Registrant as specified in its charter)
 
California
 
33-0898238
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
949 South Coast Drive, Suite 300, Costa Mesa, California
 
92626
(Address of principal executive offices)
 
(Zip Code)
(714) 438-2500
(Registrant’s telephone number, including area code)
 
 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class registered
 
Name of each Exchange on which registered
Common Stock without par value
 
Nasdaq Global Select Market
Securities registered pursuant to Section 12(g) of the Act: None
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes   ¨    No   x .
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of 15(d) of the Act.    Yes   ¨     No   x .



Indicate by check mark whether the registrant (1) has filed all reports required 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   ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes   x     No   ¨ .
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 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.    ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See 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
  
Smaller reporting company
 
x
 
 
 
 
Emerging growth company
 
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes   ¨     No   x
The aggregate market value of voting and non-voting common equity held by non-affiliates of registrant as of June 30, 2018, the last business day of the registrant's most recently completed second fiscal quarter, was approximately $150,595,390 .
As of March 7, 2019 , there were 22,019,198 shares of Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Except as otherwise stated therein, Part III of the Form 10-K is incorporated by reference from the Registrant’s Definitive Proxy Statement which is expected to be filed with the Commission on or before April 30, 2019 for its 2019 Annual Meeting of Shareholders.
 




PACIFIC MERCANTILE BANCORP
ANNUAL REPORT ON FORM 10K
FOR THE YEAR ENDED DECEMBER 31, 2018
TABLE OF CONTENTS
 
 
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

i



FORWARD LOOKING STATEMENTS
Statements contained in this Annual Report on Form 10-K (this “Report”) that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” "forecast," or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information available to us and on assumptions that we make about future economic and market conditions and other events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ materially from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares.
In addition to the risk of incurring loan losses and provision for loan losses, which is an inherent risk of the banking business, these risks and uncertainties include, but are not limited to, the following: the risk that the credit quality of our borrowers declines; potential declines in the value of the collateral for secured loans; the risk that steps we have taken to strengthen our overall credit administration are not effective; the risk of a downturn in the United States or local economy, and domestic or international economic conditions, which could cause us to incur additional loan losses and adversely affect our results of operations in the future; the risk that our interest margins and, therefore, our net interest income will be adversely affected by changes in prevailing interest rates; the risk that we will not succeed in further reducing our remaining nonperforming assets, in which event we would face the prospect of further loan charge-offs and write-downs of assets; the risk that we will not be able to manage our interest rate risks effectively, in which event our operating results could be harmed; the prospect of changes in government regulation of banking and other financial services organizations, which could impact our costs of doing business and restrict our ability to take advantage of business and growth opportunities; the risk that our efforts to develop a robust commercial banking platform may not succeed; and the risk that we may be unable to realize our expected level of increasing deposit inflows. See Item 1A “Risk Factors” in this Report for additional information regarding these and other risks and uncertainties to which our business is subject.
Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report as a result of new information, future events or otherwise, except as may otherwise be required by law.


1


PART I
 
ITEM 1.     BUSINESS
Background
Pacific Mercantile Bancorp is a California corporation that owns 100% of the stock of Pacific Mercantile Bank, a California state chartered commercial bank (which, for convenience, will sometimes be referred to in this Report as the “Bank”). The capital stock of the Bank is our principal asset and substantially all of our business operations are conducted and substantially all of our assets are owned by the Bank which, as a result, accounts for substantially all of our revenues, expenses and income. As the owner of a commercial bank, Pacific Mercantile Bancorp is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and, as such, our operations are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or the “FRB”) and the Federal Reserve Bank of San Francisco (“FRBSF”) under delegated authority from the FRB. See “Supervision and Regulation” below in this Item 1 of this Report. PM Asset Resolution, Inc. (“PMAR”) was a wholly owned subsidiary of Pacific Mercantile Bancorp, which existed for the purpose of purchasing certain non-performing loans and other real estate from the Bank and thereafter collecting on or disposing of those assets. During the year PMBC liquidated all assets at PMAR and during the third quarter of 2018, the entity was dissolved. For ease of reference, we will sometimes use the terms “Company,” “we,” “our,” or “us” in this Report to refer to Pacific Mercantile Bancorp on a consolidated basis and “PM Bancorp,” “Bancorp” or “PMBC” to refer to Pacific Mercantile Bancorp on a “stand-alone” or unconsolidated basis.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (the “FDIC”).
The Bank commenced business in March 1999, with the opening of its first financial center, located in Newport Beach, California, and in April 1999 it launched its online banking site at www.pmbank.com.
The Bank's commercial lending solutions include working capital lines of credit and asset based lending, 7(a) and 504 Small Business Administration ("SBA") loans, commercial real estate loans, growth capital loans, equipment financing, letters of credit and corporate credit cards. The Bank's depository and corporate banking services include cash and treasury management solutions, interest-bearing term deposit accounts, checking accounts, automated clearinghouse (“ACH”) payment and wire solutions, fraud protection, remote deposit capture, courier services, and online banking. Additionally, the Bank serves clients operating in the global marketplace through services including letters of credit and import/export financing.
The Bank attracts the majority of its loan and deposit business from the numerous small and middle market companies located in the Southern California region. The Bank reserves the right to change its business plan at any time, and no assurance can be given that, if the Bank's proposed business plan is followed, it will prove successful.
Our Business Strategy
We plan to expand our business by adhering to a business plan that is focused on building and growing a banking organization offering our customers the best attributes of a community bank, which are personalized and responsive service, while also offering the more sophisticated services of the big banks.
We will continue to focus our services and offer products primarily to small to mid-size businesses and professional firms in order to achieve internal growth of our banking franchise. We believe this focus will enable us to grow our loan portfolio and other earning assets and increase our core deposits (consisting of non-interest bearing demand, and lower-cost savings and money market deposits), with a goal to increase our net interest margin and improve our profitability. We also believe that, with our existing technology systems, we have the capability to increase the volume of our banking transactions without having to incur the cost or disruption of a major computer enhancement program.
Following our transition to a commercial banking model, it has become clear that our current client base is well served through our treasury management tools and rarely makes use of full-service branches. We reduced the size of several branches during 2016 and 2017. The resultant cost savings from the branch reorganization was redeployed to expand our business development team and more actively promote our online banking. We will continue to explore opportunities to create efficiencies in our office locations and redeploy those cost savings. As we add more relationship managers, we believe we can better penetrate our core markets and accelerate the growth of our commercial customer base.

2


Our Commercial Banking Operations
We seek to meet the banking needs of small and mid-size businesses and professional firms by providing our customers with:
A broad range of loan and deposit products and banking and financial services, more typically offered by larger banks, in order to gain a competitive advantage over independent or community banks that do not provide the same range or breadth of services that we are able to provide to our customers; and
A high level of personal service and responsiveness, more typical of independent and community banks, which we believe gives us a competitive advantage over large out-of-state and other large multi-regional banks that may be unable, or unwilling, due to the expense involved, to provide that same level of personal service to this segment of the banking market.
Deposit Products
Deposits are a bank’s principal source of funds for making loans and acquiring other interest earning assets. Additionally, the interest expense that a bank must incur to attract and maintain deposits has a significant impact on its operating results. A bank’s interest expense, in turn, will be determined in large measure by the types of deposits that it offers to, and is able to attract from, its customers. Generally, banks seek to attract “core deposits” which consist of demand deposits that bear no interest and low cost interest-bearing checking, savings and money market deposits. By comparison, time deposits (also sometimes referred to as “certificates of deposit”), including those in denominations of $100,000 or more, usually bear much higher interest rates and are more interest-rate sensitive and volatile than core deposits. A bank that is not able to attract significant amounts of core deposits must rely on more expensive time deposits or alternative sources of cash, such as Federal Home Loan Bank (“FHLB”) borrowings, to fund interest-earning assets, which means that its cost of funds are likely to be higher and, as a result, its net interest margin is likely to be lower than a bank with a higher proportion of core deposits. See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — Results of Operations- Net Interest Income ” in Item 7 of this Report.
The following table sets forth information regarding the composition, by type of deposits, maintained by our customers during the year ended and as of December 31, 2018 :
 
Average Balance
During the Year Ended
December 31, 2018
 
Balance at December 31, 2018
 
(Dollars in thousands)
Type of Deposit
 
 
 
Noninterest-bearing checking accounts (1)
$
348,923

 
$
340,406

Interest-bearing checking accounts
69,841

 
64,144

Money market and savings deposits
412,366

 
460,355

Certificates of deposit (2)
315,189

 
271,097

Totals
$
1,146,319

 
$
1,136,002

 
(1)
Excludes noninterest bearing deposits maintained at the Bank by the Company with an annual average balance of $15.4 million for the year ended December 31, 2018 and a balance of $16.5 million at December 31, 2018 .
(2)
Comprised of time certificates of deposit in varying denominations under and over $100,000. Excludes certificates of deposit maintained by the Company at the Bank with an average balance of $248,000 for the year ended December 31, 2018 and a balance at December 31, 2018 of $250,000 . Excludes certificates of deposit maintained by PMAR at the Bank with an average balance of $75,000 for the year ended December 31, 2018 . There were no certificates of deposit maintained by PMAR at December 31, 2018.
Loan Products
We offer our customers a number of different loan products, including commercial loans and credit lines, accounts receivable and inventory financing, SBA guaranteed business loans, and owner-occupied commercial real estate loans. The following table sets forth the types and the amounts of our loans that were outstanding as of December 31, 2018 :

3


 
At December 31, 2018
 
Amount
 
Percent of Total
 
(Dollars in thousands)
Commercial loans
$
444,441

 
40.6
%
Commercial real estate loans – owner occupied
211,645

 
19.3
%
Commercial real estate loans – all other
226,441

 
20.7
%
Residential mortgage loans – multi-family
97,173

 
8.9
%
Residential mortgage loans – single family (1)
21,176

 
1.9
%
Land development loans
38,496

 
3.5
%
Consumer loans
54,514

 
5.0
%
Gross loans
$
1,093,886

 
100.0
%
 
(1)
These loans originated prior to March 2014 and our subsequent exit from the mortgage business and are retained in our loan portfolio as a loan diversification strategy.

Commercial Loans
The commercial loans we offer generally include short-term secured and unsecured business and commercial loans with maturities ranging from 12 to 24 months, accounts receivable financing for terms of up to 24 months, equipment loans which generally amortize over a period of up to 7 years, and SBA guaranteed business loans with terms of up to 10 years. The interest rates on these loans generally are adjustable and usually are indexed to The Wall Street Journal’s prime rate and will vary based on market conditions and credit risk. In order to mitigate the risk of borrower default, we generally require collateral to support the credit or, in the case of loans made to businesses, we often require personal guarantees from their owners, or both. In addition, all such loans must have well-defined primary and secondary sources of repayment.
We also offer asset-based lending products made to businesses that are growing rapidly, but cannot internally fund their growth without borrowings. These loans are collateralized by a security interest in all business assets with specific advance rates made against the borrower's accounts receivable and inventory. We control our risk by monitoring borrower cash flow, financial performance and accounts receivable and inventory reports. In 2016, we centralized our loan monitoring function as a means to achieve improved portfolio risk monitoring of substantially all commercial loans, including asset-based loans.
Commercial loan growth is important to the growth and profitability of our banking franchise because commercial loan borrowers typically establish noninterest-bearing (demand) and interest-bearing transaction deposit accounts and banking services relationships with us. Those deposit accounts help us to reduce our overall cost of funds and those banking services relationships provide us with a source of non-interest income.
Commercial Real Estate Loans
The majority of our commercial real estate loans are secured by first trust deeds on nonresidential real property. Loans secured by nonresidential real estate often involve loan balances to single borrowers or groups of related borrowers. Payments on these loans depend to a large degree on the rental income stream from the properties and the global cash flows of the borrowers, which are generated from a wide variety of businesses and industries. As a result, repayment of these loans can be affected adversely by changes in the economy in general or by the real estate market more specifically. Accordingly, the nature of this type of loan makes it more difficult to monitor and evaluate. Consequently, we typically require personal guarantees from the owners of the businesses to which we make such loans.
Business Banking Services
We offer an array of banking and financial services designed to support the needs of our business banking clients. Those services include:
Our online business banking portal allows our clients to conduct online transactions and access account information; features include the ability to:
View account balances and activity, including statements
Transfer funds between accounts
Access wires, ACH and bill pay capabilities
View check images
Setup account alerts
Prepare customizable reports and dashboards views

4


Download activity into Intuit QuickBooks and Quicken

Our mobile banking platform allows our clients to conduct transactions and access account information from their mobile device; features include the ability to:
View available balances, transactions and transaction details
Create one time balance transfers
Create bill payments for existing payees
Schedule future dated bill payments
Cancel scheduled bill payments
View recent payments
Approve wires, ACH, and balance transfer transactions
Deposit checks
Find bank locations
Collection services such as remote deposit capture services (PMB xPress Deposit), remittance payments (Lockbox), and incoming ACH and wire reporting and notification.
Payable services such as checks, wire transfer and ACH origination, business bill pay service, and business credit cards. We also provide courier and onsite vault services for those clients with cash needs.
Fraud prevention services such as Positive Pay, ACH Positive Pay, and transactional alerts.
Security Measures
Our ability to provide customers with secure and uninterrupted financial services is of paramount importance to our business. We believe our computer banking systems, services and software meet the highest standards of bank and electronic systems security. The following are among the security measures that we have implemented:
Bank-Wide Security Measures
Service Continuity. In order to better ensure continuity of service, we have located our critical servers and telecommunications systems at an offsite hardened and secure data center. This center provides the physical environment necessary to keep servers up and running 24 hours a day, 7 days a week. This data center has raised floors, temperature control systems with separate cooling zones, seismically braced racks, and generators to keep the system operating during power outages and has been designed to withstand fires and major earthquakes. The center also has a wide range of physical security features, including smoke detection and fire suppression systems, motion sensors, and 24/7 secured access, as well as video camera surveillance and security breach alarms. The center is connected to the Internet by redundant high speed data circuits with advanced capacity monitoring.
Physical Security. All servers and network computers reside in secure facilities. Only employees with proper identification may enter the primary server areas.
Monitoring. Customer transactions on online servers and internal computer systems produce one or more entries into transactional logs. Our personnel routinely review these logs as a means of identifying and taking appropriate action with respect to any abnormal or unusual activity.
Internet Security Measures
We maintain electronic and procedural safeguards that comply with federal regulations to guard nonpublic personal information. We regularly assess and update our systems to improve our technology for protecting information. Our security measures include:
Transport Layer Security;
digital certificates;
multi-factor authentication;
data loss prevention systems;
anti-virus, anti-malware, and patch management systems;
intrusion detection/prevention systems;
vulnerability management systems; and
firewall protection.

5


We believe the risk of fraud presented by online banking is not materially different from the risk of fraud inherent in any banking relationship. Potential security breaches can arise from any of the following circumstances:
misappropriation of a customer’s account number or password;
compromise of the customer’s computer system;
penetration of our servers by an outside “hacker;”
fraud committed by a new customer in completing his or her loan application or opening a deposit account with us; and
fraud committed by employees or service providers.
Both traditional banks and internet banks are vulnerable to these types of fraud. By establishing the security measures described above, we believe we can minimize, to the extent practicable, our vulnerability to the first three types of fraud. To counteract fraud by new customers, employees and service providers, we have established internal procedures and policies designed to ensure that, as in any bank, proper control and supervision is exercised over new customers, employees and service providers. We also maintain insurance to protect us from losses due to fraud committed by employees or through breaches in our cyber security.
Additionally, the adequacy of our security measures is reviewed periodically by the FRBSF and the California Department of Business Oversight (“CDBO”), which are the federal and state government agencies, respectively, with primary supervisory authority over the Bank. We also retain the services of third party computer security firms to conduct periodic tests of our computer and online banking systems to identify potential threats to the security of our systems and to recommend additional actions that we can take to improve our security measures.
Competition
Competitive Conditions in the Traditional Banking Environment
The banking business in California generally, and in our service area in particular, is highly competitive and is dominated by a relatively small number of large multi-state and California - based banks that have numerous banking offices operating over wide geographic areas. We compete for deposits and loans with those banks, with community banks that are based or have branch offices in our market areas, and with savings banks (also sometimes referred to as “thrifts”), credit unions, money market and other mutual funds, stock brokerage firms, insurance companies, and other traditional and nontraditional financial service organizations. We also compete for customers’ funds with governmental and private entities issuing debt or equity securities or other forms of investments which may offer different and potentially higher yields than those available through bank deposits.
Major financial institutions that operate throughout California and that have offices in our service areas include Bank of America, Wells Fargo Bank, JPMorgan Chase, Union Bank of California, Bank of the West, U. S. Bancorp, Comerica Bank and Citibank. Larger independent banks and other financial institutions with offices in our service areas include, among others, OneWest Bank, City National Bank, Citizens Business Bank, Manufacturers Bank, and California Bank and Trust.
These banks, as well as many other financial institutions in our service areas, have the financial capability to conduct extensive advertising campaigns and to shift their resources to regions or activities of greater potential profitability. Many of them also offer diversified financial services which we do not presently offer directly. The larger banks and financial institutions also have substantially more capital and higher lending limits than our Bank.
In order to compete with the banks and other financial institutions operating in our service areas, we rely on our ability to provide flexible, more convenient and more personalized service to customers, including online banking services and financial tools. At the same time, we:
emphasize personal contacts with existing and potential new customers by our directors, officers and other employees;
develop and participate in local promotional activities; and
seek to develop specialized or streamlined services for customers.
To the extent customers desire loans in excess of our lending limits or services not offered by us, we attempt to assist them in obtaining such loans or other services through participations with other banks or assistance from our correspondent banks or third party vendors.

6


Competitive Conditions in Online Banking
There are a number of banks that offer services exclusively over the internet, such as E*TRADE Bank, and other banks, such as Bank of America and Wells Fargo Bank, that market their internet banking services to their customers nationwide. We believe that only the larger of the commercial banks with which we compete offer the comprehensive set of online banking tools and services that we offer to our customers. However, most community banks do offer varying levels of internet banking services to their customers by relying on third party vendors to provide the functionality they need to provide such services. Additionally, many of the larger banks have greater market presence and greater financial resources to market their internet banking services than do we. Moreover, new competitors (including non-bank fintech start-ups) and other competitive factors have emerged over the past few years as part of the rapid development of internet commerce. We believe that these findings support our strategic decision, made at the outset of our business, to offer customers the benefits of both traditional and online banking services. However, utilization trends continue to show that our clients largely favor online banking services over traditional branch services. Thus, we have reduced and expect to continue to reduce the size of our branches and are redeploying the cost savings to expand our business development team and to more actively promote our online banking. We believe that this strategy has been an important factor in our recent growth in core deposits and will contribute to our growth in the future. See “BUSINESS — Our Business Strategy” earlier in this Item 1 of this Report.
Impact of Economic Conditions, Government Policies and Legislation on our Business
Government Monetary Policies . Our profitability, like that of most financial institutions, is affected to a significant extent by our net interest income, which is the difference between the interest income we generate on interest-earning assets, such as loans and investment securities, and the interest we pay on deposits and other interest-bearing liabilities, such as borrowings. Our interest income and interest expense, and hence our net interest income, depends to a great extent on prevailing market rates of interest, which are highly sensitive to many factors that are beyond our control, including inflation, recession and unemployment. Moreover, it is often difficult to predict with any assurance how changes in economic conditions of this nature will affect our future financial performance.
Our net interest income and operating results also are affected by monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies to curb inflation, or to stimulate borrowing and spending in response to economic downturns, through its open-market operations by adjusting the required level of reserves that banks and other depository institutions must maintain, and by varying the target federal funds and discount rates on borrowings by banks and other depository institutions. These actions affect the growth of bank loans, investments and deposits and the interest earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact of any future changes in monetary and fiscal policies on us cannot be predicted with any assurance.
Legislation Generally . From time to time, federal and state legislation is enacted which can affect our operations and our operating results by materially changing the costs of doing business, limiting or expanding the activities in which banks and other financial institutions may engage, or altering the competitive balance between banks and other financial services providers.
Economic Conditions and Recent Legislation and Other Government Actions.
The last economic recession, which is reported to have begun at the end of 2007 and ended in the middle of 2009, created wide ranging consequences and difficulties for the banking and financial services industry, in particular, and the economy in general. The recession led to significant write-downs of the assets and an erosion of the capital of a large number of banks and other lending and financial institutions which, in turn, significantly and adversely affected the operating results of banking and other financial institutions and led to steep declines in their stock prices. In addition, bank regulatory agencies have been very aggressive in responding to concerns and trends identified in their bank examinations, which has resulted in the increased issuance of enforcement orders requiring banks to take actions to address credit quality, liquidity and risk management and capital adequacy, as well as other safety and soundness concerns. All of these conditions, moreover, led the U.S. Congress, the U.S. Treasury Department and the federal banking regulators, including the FDIC, to take broad actions, to address systemic risks and volatility in the U.S. banking system. A description of some of the regulatory and other actions taken, and their impact on the Company, are described below under “Supervision and Regulation.”

Supervision and Regulation
Both federal and state laws extensively regulate bank holding companies and banks. Such regulation is intended primarily for the protection of depositors, the FDIC’s deposit insurance fund and customers, and is not for the benefit of shareholders. Set forth below is a summary description of the material laws and regulations that affect or bear on our operations. The description does not purport to be complete and is qualified in its entirety by reference to the laws and regulations that are summarized below.

7


Pacific Mercantile Bancorp
PM Bancorp is a registered bank holding company subject to regulation under the Bank Holding Company Act. Pursuant to the Bank Holding Company Act, PM Bancorp is subject to supervision and periodic examination by, and is required to file periodic reports with, the Federal Reserve Board. PM Bancorp is also a bank holding company within the meaning of the California Financial Code. As such, PM Bancorp and its subsidiaries are subject to supervision and periodic examination by, and may be required to file reports with, the CDBO.
As a bank holding company, PM Bancorp is allowed to engage, directly or indirectly, only in banking and other activities that the Federal Reserve Board deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Bank holding companies that meet certain eligibility requirements prescribed by the Bank Holding Company Act and elect and retain "financial holding company" status may engage in broader securities, insurance, merchant banking and other activities that are determined to be "financial in nature" or are incidental or complementary to activities that are financial in nature without prior FRB approval. PM Bancorp has not elected financial holding company status and neither PM Bancorp nor the Bank has engaged in any activities for which financial holding company status is required.
As a bank holding company, PM Bancorp is also required to obtain the prior approval of the Federal Reserve Board for the acquisition of more than 5% of the outstanding shares of any class of voting securities, or of substantially all of the assets, by merger with or purchase of (i) any bank or other bank holding company and (ii) any other entities engaged in banking-related businesses or that provide banking-related services.
The Dodd-Frank Act requires PM Bancorp to act as a source of financial strength to the Bank including committing resources to support the Bank even at times when PM Bancorp may not be in a financial position or believe that it is in the best interest of our shareholders to do so. It is the Federal Reserve Board’s policy that, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. For these reasons, among others, the Federal Reserve Board requires all bank holding companies to maintain capital at or above certain prescribed levels. A bank holding company’s failure to meet these requirements will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board’s regulations or both, which could lead to the imposition of restrictions on the offending bank holding company, including restrictions on its further growth. See the discussion below under the caption “Prompt Corrective Action.” In addition, under the cross‑guarantee provisions of the Federal Deposit Insurance Act (“FDIA”), the FDIC can hold any FDIC‑insured depository institution liable for any loss suffered or anticipated by the FDIC in connection with (i) the default of a commonly controlled FDIC‑insured depository institution or (ii) any assistance provided by the FDIC to such a commonly controlled institution.
Additionally, the Federal Reserve Board may require any bank holding company to terminate an activity or terminate control of, or liquidate or divest itself of, any subsidiary or affiliated company that the Federal Reserve Board determines constitutes a significant risk to the financial safety, soundness or stability of the bank holding company or any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate aspects of a bank holding company’s debt. Subject to certain exceptions, bank holding companies also are required to file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming their common stock or other equity securities. A bank holding company and its non-banking subsidiaries also are prohibited from implementing so-called tying arrangements whereby customers may be required to use or purchase services or products from the bank holding company or any of its non-bank subsidiaries in order to obtain a loan or other services from any of the holding company’s subsidiary banks.
Pacific Mercantile Bank
General . The Bank is subject to primary supervision, periodic examination and regulation by (i) the Federal Reserve Board, which is its primary federal banking regulator, because the Bank is a member of the Federal Reserve System and (ii) the CDBO, because the Bank is a California state chartered bank. The Bank also is subject to certain of the regulations promulgated by the FDIC, because its deposits are insured by the FDIC.
Various requirements and restrictions under the Federal and California banking laws affect the operations of the Bank. These laws and the implementing regulations cover most aspects of a bank’s operations, including the reserves a bank must maintain against deposits and for possible loan losses and other contingencies; the types of deposits it obtains and the interest it is permitted to pay on certain deposit accounts; the loans and investments that a bank may make; the borrowings that a bank may incur; the number and location of banking offices that a bank may establish; the rate at which it may grow its assets; the acquisition and merger activities of a bank; the amount of dividends that a bank may pay; and the capital requirements that a bank must satisfy, which can determine the extent of supervisory control to which a bank will be subject by its federal and state bank regulators. A more detailed discussion regarding capital requirements that are applicable to us and the Bank is set forth below under the caption “ Prompt Corrective Action.

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Permissible Activities and Subsidiaries . California law permits state chartered commercial banks to engage in any activity permissible for national banks. Those permissible activities include conducting many so-called “closely related to banking” or “nonbanking” activities either directly or through their operating subsidiaries.
Federal Home Loan Bank System . The Bank is a member of the FHLB of San Francisco. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region and makes available loans or advances to its member banks. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. As an FHLB member, the Bank is required to own a certain amount of capital stock in the FHLB. At December 31, 2018 , the Bank was in compliance with the FHLB’s stock ownership requirement. Historically, the FHLB has paid dividends on its capital stock to its members.
FRB Deposit Reserve Requirements . The Federal Reserve Board requires all federally-insured depository institutions to maintain noninterest bearing reserves at specified levels against their transaction accounts. At December 31, 2018 , the Bank was in compliance with these requirements.
Single Borrower Loan Limitations. With certain limited exceptions, the maximum amount that a California state bank may lend to any borrower (including certain related entities) at any one time may not exceed 15% of the sum of the shareholders’ equity, allowance for loan and lease losses, capital notes and debentures of the bank if unsecured. The combined unsecured and secured obligations of any borrower may not exceed 25% of the sum of the shareholders’ equity, allowance for loan and lease losses, capital notes and debentures of the bank.
Restrictions on Transactions between the Bank and the Company and its other Affiliates . The Bank is subject to restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, the Company or any of its other subsidiaries; the purchase of, or investments in, Company stock or other Company securities and the taking of such securities as collateral for loans; and the purchase of assets from the Company or any of its other subsidiaries. These restrictions prevent the Company and any of its subsidiaries from borrowing from the Bank unless the loans are secured by marketable obligations in designated amounts, and such secured loans and investments by the Bank in the Company or any of its subsidiaries are limited, individually, to 10% of the Bank’s capital and surplus (as defined by federal regulations) and, in the aggregate, for all loans made to and investments made in the Company and its other subsidiaries, to 20% of the Bank’s capital and surplus. California law also imposes restrictions with respect to transactions involving the Company and other persons deemed under that law to control the Bank. It is the policy of the federal banking agencies that tax sharing agreements between a bank holding company and subsidiary bank that file consolidated tax returns must provide that any refund received by the holding company be allocated between the holding company and the bank in proportion to their respective income, losses and other tax characteristics as if they had filed on a stand-alone basis and, until the bank’s share is paid to it (which should be done promptly upon receipt), its share must be held in trust or as agent for the benefit of the bank, and not merely owed by the holding company as a debt to the bank.
Enforcement. If, as a result of an examination of a bank, its primary federal bank regulatory agency were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of a bank’s operations had become unsatisfactory or that the bank or its management was in violation of any law or regulation, that agency has the authority to take a number of different remedial actions as it deems appropriate under the circumstances. These actions include the power to enjoin “unsafe or unsound” banking practices; to require that affirmative action be taken to correct any conditions resulting from any violation or practice; to issue an administrative order that can be judicially enforced; to require the bank to increase its capital; to restrict the bank’s growth; to assess civil monetary penalties against the bank or its officers or directors; to remove officers and directors of the bank; and, if the federal agency concludes that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate a bank’s deposit insurance, which in the case of a California chartered bank would result in revocation of its charter and require it to cease its banking operations. Additionally, under California law the CDBO has many of the same remedial powers with respect to the Bank, because it is a California state chartered bank.

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Dividends
Cash dividends from the Bank constitute the primary source of cash available to PM Bancorp for its operations and to fund any cash dividends that the board of directors might declare in the future. PM Bancorp is a legal entity separate and distinct from the Bank and the Bank is subject to various statutory and regulatory restrictions on its ability to pay cash dividends to PM Bancorp. Those restrictions would prohibit the Bank, subject to certain limited exceptions, from paying cash dividends in amounts that would cause the Bank to become undercapitalized. Additionally, the Federal Reserve Board and the CDBO have the authority to prohibit the Bank from paying dividends, if either of those authorities deems the payment of dividends by the Bank to be an unsafe or unsound practice. We have agreed that the Bank will not, without the FRB and the CDBO's prior written approval, pay any dividends to PM Bancorp. See “ Dividend Policy and Restrictions on the Payment of Dividends ” in Item 5 of this Report.
Additionally, it is FRB policy that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. It is also an FRB policy that bank holding companies should not maintain dividend levels that undermine their ability to be a source of strength to their banking subsidiaries. Additionally, the FRB has indicated that bank holding companies should carefully review their dividend policies and has discouraged dividend payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong. We have committed to obtaining approval from the FRB and the CDBO prior to paying any dividends. There can be no assurance that our regulators will approve such payments or dividends in the future.
Safety and Soundness Standards
Banking institutions may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices or for violating any law, rule, regulation, or any condition imposed in writing by its primary federal banking regulatory agency or any written agreement with that agency. The federal banking agencies have adopted guidelines designed to identify and address potential safety and soundness concerns that could, if not corrected, lead to deterioration in the quality of a bank’s assets, liquidity or capital. Those guidelines set forth operational and managerial standards relating to such matters as:
internal controls, information systems and internal audit systems;
loan documentation;
credit underwriting;
asset growth;
earnings; and
compensation, fees and benefits.
In addition, federal banking agencies have adopted safety and soundness guidelines with respect to asset quality. These guidelines provide standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. Under these standards, an FDIC-insured depository institution is expected to:
conduct periodic asset quality reviews to identify problem assets, estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb those estimated losses;
compare problem asset totals to capital;
take appropriate corrective action to resolve problem assets;
consider the size and potential risks of material asset concentrations; and
provide periodic asset quality reports with adequate information for the Bank's management and the board of directors to assess the level of asset risk.
These guidelines also establish standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.
Capital Requirements
The Company and the Bank are subject to the regulatory capital requirements administered by the federal banking agencies. The federal banking agencies’ current risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the Basel Committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. The requirements are intended to ensure that banking organizations

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have adequate capital given the risk levels of assets and off-balance sheet financial instruments. Under the requirements, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A bank’s or bank holding company’s capital, in turn, is classified in one of two tiers, depending on type:
Core Capital (Tier 1). Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, minority interests in equity accounts of consolidated subsidiaries (and, under existing standards, a limited amount of qualifying trust preferred securities and qualifying cumulative perpetual preferred stock at the holding company level), less goodwill, most intangible assets and certain other assets.
Supplementary Capital (Tier 2) . Tier 2 capital includes, among other things, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for loan and lease losses, subject to limitations.
These capital requirements were modified effective as of January 1, 2015 in connection with commencement of Basel III Capital Rules described below. Through 2014, we were required to maintain Tier 1 capital and “total capital” (the sum of Tier 1 and Tier 2 capital) equal to at least 4.0% and 8.0%, respectively, of our total risk-weighted assets (including various off-balance-sheet items, such as letters of credit). The Bank, like other depository institutions, was required to maintain similar capital levels under capital adequacy guidelines. In addition, for a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its Tier 1 and total capital ratios must have been at least 6.0% and 10.0% on a risk-adjusted basis, respectively.
Bank holding companies and banks are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its total adjusted quarterly average assets (as defined for regulatory purposes). Through 2014, the requirements necessitated a minimum leverage ratio of 3.0% for bank holding companies and banks that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk. All other bank holding companies and banks are required to maintain a minimum leverage ratio of 4.0%, unless a different minimum is specified by an appropriate regulatory authority. In addition, for a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its leverage ratio must be at least 5.0%.
Basel III Capital Rules. As of January 1, 2015, the Basel III Capital Rules establishing a new comprehensive capital framework for U.S. banking organizations took effect. The rules implement the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Company and the Bank, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach, which was derived from the Basel I capital accords of the Basel Committee, with a more risk-sensitive approach based, in part, on the standardized approach in the Basel Committee’s 2004 “Basel II” capital accords. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules. The Basel III Capital Rules were effective for the Company and the Bank on January 1, 2015 subject to a phase-in period ending on January 1, 2019. Under a Federal Reserve Board policy amended in 2018, qualifying bank holding companies with consolidated assets of less than $3.0 billion, such as the Company, are exempt from the requirements of the Basel III Capital Rules. The Bank, however, is subject to these rules.
The Basel III Capital Rules, among other things, (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions/adjustments as compared to existing regulations.
The Basel III capital Rules also include a capital conservation buffer designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased in over a three-year period (increasing by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019).
As fully phased in as of January 1, 2019, the Basel III Capital Rules require the Bank to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus the 2.5% “capital conservation buffer” effectively resulting in a minimum ratio

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of CET1 to risk-weighted assets of at least 7%, (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer effectively resulting in a minimum Tier 1 capital ratio of 8.5%, (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (resulting in a minimum total capital ratio of 10.5%), and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets .
The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain larger, covered institutions and is not expected to have any current applicability to the Company or the Bank.
The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1 for mortgage servicing rights, certain deferred tax assets, significant investments in non-consolidated financial entities and the effects of accumulated other comprehensive income. The Basel III Capital Rules also preclude certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies, subject to phase-out, but institutions with less than $15 billion in assets are exempted from this new rule.
With respect to the Bank, the Basel III Capital Rules also revise the “prompt corrective action” regulations as discussed below under “ Prompt Corrective Action .”
The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories.
In addition, the Basel III Capital Rules provide more advantageous risk weights for derivatives and repurchase-style transactions cleared through a qualifying central counterparty and increase the scope of eligible guarantors and eligible collateral for purposes of credit risk mitigation.
As of December 31, 2018 , the capital levels of the Bank exceed the minimums necessary to be categorized as well capitalized under the Basel III Capital Rules, including the applicable capital conservation buffers. See “See “Item 7. — MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — Capital Resources — Regulatory Capital Requirements Applicable to Banking Institutions.”
Liquidity Requirements
Historically, the regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures. In September 2013, the federal banking agencies adopted rules to impose quantitative liquidity requirements consistent with the liquidity coverage ratio standard established by the Basel Committee. These rules apply to larger (over $250 billion in assets, with less stringent requirements for institutions over $50 billion in assets) and internationally active institutions but, as adopted, do not apply to the Company or the Bank.
Prompt Corrective Action
The FDIA, requires among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDIA includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio. The Basel III Capital Rules affect the capital requirements for prompt corrective action purposes also.
A bank is (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a CET1 ratio of 6.5% or greater and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, a CET1 ratio of 4.5% or greater and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0%, a CET1 ratio of less than 4.5% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0%, a CET1 ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose

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of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.
The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”
“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.
The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.
At December 31, 2018 , the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios applicable to it, under the capital adequacy guidelines described above.
FDIC Deposit Insurance
The FDIC is an independent federal agency that insures customer deposits of federally insured banks and savings institutions in order to safeguard the safety and soundness of the banking and savings industries through the Deposit Insurance Fund (the “DIF”) up to prescribed limits, currently $250,000 per depositor. The DIF is funded primarily by FDIC assessments paid by each DIF member institution. The amount of each DIF member’s assessment is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.50% of estimated insured deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. The Dodd-Frank Act increased the minimum reserve ratio (the ratio of the net worth of the DIF to estimated insured deposits) from 1.15% of estimated deposits to 1.35% of estimated deposits (or a comparable percentage of the asset-based assessment base described above). The Dodd-Frank Act requires the FDIC to offset the effect of the increase in the minimum reserve ratio when setting assessments for insured depository institutions with less than $10 billion in total consolidated assets, such as the Bank. The FDIC has until September 30, 2020 to achieve the new minimum reserve ratio of 1.35%.
Additionally, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the predecessor to the DIF. The FICO assessment rates, which are determined quarterly, averaged approximately 0.00305% of insured deposits in fiscal 2018. These assessments will continue until the FICO bonds mature through 2019.
The FDIC may terminate a depository institution’s deposit insurance upon a finding that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices that pose a risk to the DIF or that may prejudice the interest of the bank’s depositors. Pursuant to California law, the termination of a California state chartered bank’s FDIC deposit insurance would result in the revocation of the bank’s charter, forcing it to cease conducting banking operations.
Community Reinvestment Act and Fair Lending Laws
The Bank is subject to fair lending requirements and the evaluation of its small business operations under the Community Reinvestment Act (“CRA”). The CRA generally requires the federal banking agencies to evaluate the record of a bank in meeting the credit needs of its local communities, including those of low- and moderate-income neighborhoods in its service area. A bank’s compliance with its CRA obligations is based on a performance-based evaluation system which determines the bank’s CRA ratings on the basis of its community lending and community development performance. When a bank holding company files an application for approval to acquire a bank or another bank holding company, the Federal Reserve Board will review the CRA assessment of

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each of the subsidiary banks of the applicant bank holding company, and a low CRA rating may be the basis for denying the application.
A bank may be subject to substantial penalties and corrective measures for a violation of fair lending laws. Federal banking agencies also may take compliance with fair lending laws into account when determining a bank's CRA rating and when regulating and supervising other activities of a bank or its bank holding company.
USA Patriot Act of 2001
In October 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (“USA Patriot Act”) of 2001 was enacted into law in response to the September 11, 2001 terrorist attacks. The USA Patriot Act was adopted to strengthen the ability of U.S. law enforcement and intelligence agencies to work cohesively to combat terrorism on a variety of fronts.
Of particular relevance to banks and other federally insured depository institutions are the USA Patriot Act’s sweeping anti-money laundering and financial transparency provisions and various related implementing regulations that:
establish due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts and foreign correspondent accounts;
prohibit U.S. institutions from providing correspondent accounts to foreign shell banks;
establish standards for verifying customer identification at account opening; and
set rules to promote cooperation among financial institutions, regulatory agencies and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
Under implementing regulations issued by the U.S. Treasury Department, banking institutions are required to incorporate a customer identification program into their written money laundering plans that includes procedures for:
verifying the identity of any person seeking to open an account, to the extent reasonable and practicable;
maintaining records of the information used to verify the person’s identity; and
determining whether the person appears on any list of known or suspected terrorists or terrorist organizations.
Consumer Laws
The Company and the Bank are subject to a broad range of federal and state consumer protection laws and regulations prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition. Those laws and regulations include:
The Home Ownership and Equity Protection Act of 1994, which requires additional disclosures and consumer protections to borrowers designed to protect them against certain lending practices, such as practices deemed to constitute “predatory lending.”
Laws and regulations requiring banks to establish privacy policies which limit the disclosure of nonpublic information about consumers to nonaffiliated third parties.
The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act, which requires banking institutions and financial services businesses to adopt practices and procedures designed to help deter identity theft, including developing appropriate fraud response programs, and provides consumers with greater control of their credit data.
The Truth in Lending Act, which requires that credit terms be disclosed in a meaningful and consistent way so that consumers may compare credit terms more readily and knowledgeably.
The Equal Credit Opportunity Act, which generally prohibits, in connection with any consumer or business credit transaction, discrimination on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), or the fact that a borrower is receiving income from public assistance programs.
The Fair Housing Act, which regulates many lending practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status.

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The Home Mortgage Disclosure Act, which includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes.
The Real Estate Settlement Procedures Act, which requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibits certain abusive practices, such as kickbacks.
The National Flood Insurance Act, which requires homes in flood-prone areas with mortgages from a federally regulated lender to have flood insurance.
The Secure and Fair Enforcement for Mortgage Licensing Act of 2008, which requires mortgage loan originator employees of federally insured institutions to register with the Nationwide Mortgage Licensing System and Registry, a database created by the states to support the licensing of mortgage loan originators, prior to originating residential mortgage loans.
Regulation W
The FRB has adopted Regulation W to comprehensively implement Sections 23A and 23B of the Federal Reserve Act.
Sections 23A and 23B and Regulation W limit transactions between a bank and its affiliates (which include its holding company) and limit a bank’s ability to transfer to its affiliates the benefits arising from the bank’s access to insured deposits, the payment system and the discount window and other benefits of the Federal Reserve system. The statute and regulation impose quantitative and qualitative limits on the ability of a bank to extend credit to, or engage in certain other transactions with, an affiliate (and a non-affiliate if an affiliate benefits from the transaction). However, certain transactions that generally do not expose a bank to undue risk or abuse the safety net are exempted from coverage under Regulation W.
Historically, a subsidiary of a bank was not considered an affiliate for purposes of Sections 23A and 23B, since their activities were limited to activities permissible for the bank itself. However, the Gramm-Leach-Bliley Act of 1999 authorized “financial subsidiaries” that may engage in activities not permissible for a bank. These financial subsidiaries are now considered affiliates. Certain transactions between a financial subsidiary and another affiliate of a bank are also covered by Sections 23A and 23B and under Regulation W.     
Privacy
The Gramm-Leach-Bliley Act of 1999 and the California Financial Information Privacy Act require financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to non-affiliated third parties. In general, the statutes require explanations to consumers on policies and procedures regarding the disclosure of such nonpublic personal information and, except as otherwise required by law, prohibit disclosing such information except as provided in the Bank's policies and procedures. We have implemented privacy policies addressing these restrictions which are distributed regularly to all existing and new customers of the Bank.
Customer Information Security
The FRB and other bank regulatory agencies have adopted guidelines for safeguarding confidential, personal customer information. These guidelines require each financial institution, under the supervision and ongoing oversight of its board of directors or an appropriate committee thereof, to create, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazard to the security or integrity of such information and protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. We have adopted a customer information security program to comply with such requirements.
Incentive Compensation
In June 2010, the FRB and the FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. These three principles are incorporated into proposed joint compensation regulations under the Dodd-Frank Act that would prohibit incentive-based payment arrangements at specified regulated entities having at least $1 billion in total

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assets that encourage inappropriate risks. The FRB will review, as part of its regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not "large, complex banking organizations." These reviews will be tailored to 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 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 deficiency.
Legislative and Regulatory Initiatives
From time to time, various legislative and regulatory initiatives are introduced in the U.S. Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on our financial condition, results of operations or cash flows. A change in statutes, regulations or regulatory policies applicable to the Company or any of its subsidiaries could have a material effect on our business.
Employees
As of December 31, 2018 , we employed 160 persons on a full-time equivalent basis and 0 persons on a part-time basis for a total of 160 persons. None of our employees are covered by a collective bargaining agreement. We believe relations with our employees are good.
Information Available on our Website
Our Internet address is www.pmbank.com. We make available on our website, free of charge, our filings made with the SEC electronically, including those on Form 10-K, Form 10-Q, and Form 8-K, and any amendments to those filings. Copies of these filings are available as soon as reasonably practicable after we have filed or furnished these documents to the SEC (at www.sec.gov).

ITEM 1A.     RISK FACTORS
Our business is subject to a number of risks and uncertainties, including those described below, that could cause our financial condition or operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in the forward looking statements contained in this Report. The risks discussed below are not the only ones facing our business but do represent those risks that we believe are material to us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business.
Our business may be adversely affected by conditions in the financial markets and economic conditions generally.
Our business, earnings and profitability are affected by the financial markets and economic conditions in the United States generally and, more specifically, in Southern California where a substantial portion of our business is generated, including factors such as the level and volatility of short-term and long-term interest rates, inflation, real estate values, unemployment and under-employment levels, bankruptcies, household income, consumer spending, fluctuations in both debt and equity capital markets, liquidity of the global financial markets, the availability and cost of capital and credit, investor sentiment and confidence in the financial markets and the sustainability of economic growth both in the United States and globally. The deterioration of any of these conditions could adversely affect the financial performance and/or condition of our borrowers, the demand for credit and other banking products, the ability of borrowers to pay interest on and repay principal on outstanding loans and the value of collateral securing those loans, which could lead to decreased loan utilization rates, increased delinquencies and defaults and changes to our customers’ ability to meet certain credit obligations. If any of these events occur, we could experience one or more of the following adverse effects on our business:
a decline in the demand for loans, which would cause a decline in interest income and our net interest margin;
a decline in the value of our loans or other assets secured by residential or commercial real estate or by trading assets of our borrowers;
a decrease in deposit balances due to overall reductions in the accounts of customers, which would adversely impact our liquidity position;
an impairment of our investment securities and other real estate owned (“OREO”); and

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an increase in the volume of loans that become delinquent or the number of borrowers that file for protection under bankruptcy laws or default on their home loans or commercial loan obligations to us, either of which could result in a higher level of non-performing assets and cause us to increase our allowance for loan and lease losses (“ALLL”), thereby reducing our earnings.
In addition, because the substantial majority of our customers and the assets securing a large proportion of our loans are located in Southern California, any regional or local economic downturn that affects Southern California, including the financial condition of our existing or prospective borrowers or property values in Southern California, may affect us and our profitability more significantly and more adversely than our competitors whose operations are less geographically focused.
We could incur losses on the loans we make and underwriting practices may not protect us against losses in our loan portfolio.
Loan defaults and the incurrence of losses on the loans we make are an inherent risk of the banking business. We seek to mitigate the risks inherent in our loan portfolio by adhering to specific underwriting practices, including: analyzing a borrower's credit history, financial statements, tax returns and cash flow projections; valuing collateral based on reports of independent appraisers; and verifying liquid assets. Although we believe that our underwriting criteria are, and historically have been, appropriate for the various kinds of loans we make, we have incurred losses on loans that have met these criteria, and may continue to experience higher than expected losses depending on economic factors and consumer behavior. In addition, our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future behaviors.
Lending risks have historically been exacerbated by cyclical slowdowns in the real estate markets in Los Angeles, Orange, Riverside, San Bernardino and San Diego counties of California where most of our customers are based. During the economic recession that began in 2007, for example, these markets experienced declining real estate prices, excess inventories of unsold homes, high vacancy rates at commercial properties and increases in unemployment and a resulting loss of confidence about the future among businesses and consumers that had combined to adversely affect business and consumer spending. These conditions led to increases in our non-performing assets in prior periods, which required us to record loan charge-offs and write-downs in the carrying values of real properties that we acquired by or in lieu of foreclosure and caused us to incur losses in those periods. While economic conditions in our markets have improved, as measured by increased real estate prices, lower vacancy rates at commercial properties and continued improvement in unemployment, future weakness in economic conditions could result in loan charge-offs and asset write-downs that would require us to increase the provisions we make for loan losses and losses on real estate owned that could have a material adverse effect on our future operating results, financial condition and capital.
A portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market could adversely affect asset quality and profitability for our loans secured by real property.
Many of the loans in our portfolio are secured by real estate. For instance, the majority of our commercial real estate loans, which represented approximately 40.0% of our total loans outstanding as of December 31, 2018 , are secured by first trust deeds on nonresidential real property. Payments on these loans depend to a large degree on the rental income stream from the properties and the global cash flows of the borrowers. A downturn in the economy, generally, or in the real estate market where the collateral for a real estate loan is located, specifically, could negatively affect the borrower's ability to repay the loan and the value of the collateral securing the loan, which, in turn, could have an adverse effect on our profitability and asset quality. In addition, unexpected decreases in commercial real estate prices coupled with slow economic growth and elevated levels of unemployment could drive losses beyond that provided for in our ALLL, which could adversely affect our operating results and financial condition.
We may be required to increase our ALLL which would adversely affect our financial performance in the future.
On a quarterly basis we evaluate and conduct an analysis to determine the probable and estimable losses inherent in our loan portfolio. This evaluation requires us to make a number of estimates and judgments regarding the financial condition and creditworthiness of a significant number of our borrowers, the sufficiency of the collateral securing our loans, including the fair value of the properties collateralizing our outstanding loans, which may depreciate over time, be difficult to appraise and fluctuate in value, and economic trends that could affect the ability of borrowers to meet their payment obligations to us. Based on those estimates and judgments, we make determinations, which are necessarily subjective, with respect to (i) the adequacy of our ALLL to provide for write-downs in the carrying values and charge-offs of loans that may be required in the future and (ii) the need to increase the ALLL by means of a charge to income (commonly referred to as the provision for loan and lease losses). If those estimates or judgments prove to have been incorrect due to circumstances outside our control, the ineffectiveness of our credit administration or for other reasons or the Bank’s regulators come to a different conclusion regarding the adequacy of the Bank’s ALLL, we could have to increase the provisions we make for loan losses, which could reduce our income or could cause us to incur operating losses in the future. Moreover, additions to the allowance may be necessary based on changes in economic and

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real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control. These additions may require increased provision expense, which could negatively impact our results of operations.
In June 2016, the Financial Accounting Standards Board issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires banking organizations to determine the adequacy of their ALLL with an expected loss model, which is referred to as the current expected credit loss (“CECL”) model. Under the CECL model, banking organizations will be required to present certain financial assets carried at amortized cost, such as loans held-for-investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current GAAP, which delays recognition until it is probable a loss has been incurred. ASU 2016-13 is expected to be effective for public business entities for fiscal years after December 15, 2019. CECL will change the manner in which we determine the adequacy of our ALLL. We are evaluating the impact the CECL model will have on our accounting, but we may recognize a one-time cumulative-effect adjustment to the ALLL as of the beginning of the first reporting period in which the new standard is effective. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations. The federal banking regulators, including the Federal Reserve Board, have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital.
Our underwriting practices may not protect us against losses in our loan portfolio.
We maintain a comprehensive credit policy that includes specific underwriting guidelines as well as standards for loan origination and reporting and portfolio management. Our underwriting guidelines outline specific standards and risk management criteria for each lending product offered. We seek to mitigate the risks inherent in our loan portfolio by adhering to these specific underwriting guidelines. Although we believe that our underwriting criteria are, and historically have been, appropriate for the various kinds of loans we make, we have incurred losses on loans that have met these criteria, and may continue to experience higher than expected losses depending on economic factors and consumer behavior. Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future behaviors. Further, we may have higher credit risk, or experience higher credit losses, to the extent our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral.
Current loan concentrations or strategic and tactical changes in loan types, geographic locations and loan concentrations may expose us to increased risks.
From 2008 to present, in light of the industry-wide real estate loan losses prevalent in our markets, and in order to transition from a transaction based approach to a long-term relationship based approach, the bank strategically exited the residential mortgage business and purposely increased non-real estate lending activity such as commercial and industrial and asset-based lending.  Since 2008, our real estate loans as a percentage of the overall portfolio have generally declined. At the same time, the commercial and industrial and asset-based loans as a percentage of the entire loan portfolio have generally increased.  Relative to other banks in our market, we may at any given time have loan concentrations in real estate, commercial and industrial or asset-based, that are higher or lower than other banks with which we compete.  Since commercial and industrial and asset-based business loans generally have shorter term durations and variable rates, we believe this positions us well in a rising interest rate environment, reduces real estate risk exposures and better positions us for future profits.   However, this current strategy and any subsequent periodic changes in strategic or tactical direction that affects our loan portfolio mix, loan types, geographic locations and concentrations could also have the effect of increasing our overall risk exposure.  To manage these risks, we continuously monitor our loan concentration risk exposures relative to expenses, anticipated returns, forecast and actual losses and competitive outlook, and this proactive risk management could result in us temporarily or permanently changing/updating our strategy, tactics, loan types, geographic locations and concentrations, including possible changes implemented without or prior to public disclosure.
Our focus on lending to small to mid-sized businesses and professional firms may increase our credit risk.

Most of our commercial business and commercial real estate loans are made to small or midsize businesses and professional firms. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the markets in which we operate negatively impact this important customer sector, our results of operations and financial condition and the value of our common stock may be adversely affected. Moreover, a portion of these loans have been made by us in recent years following our transition to a commercial banking model and the borrowers may not have experienced a complete business or economic cycle. Furthermore,

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the deterioration of our borrowers’ businesses may hinder their ability to repay their loans with us, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Liquidity risk could adversely affect our ability to fund operations and hurt our financial condition.
Liquidity is essential to our business, as we use cash to fund loans, investments, other interest-earning assets, and deposit withdrawals that occur in the ordinary course of our business. Our principal sources of liquidity include deposits, FHLB borrowings, sales of loans or investment securities held for sale, repayments to the Bank of loans it makes to borrowers and sales of equity securities by us. If our ability to obtain funds from these sources becomes limited or the costs to us of those funds increases, whether due to factors that affect us specifically, including our financial performance or the imposition of regulatory restrictions on us, or due to factors that affect the financial services industry generally, including weakening economic conditions or negative views and expectations about the prospects for the financial services industry as a whole, then, our ability to grow our banking business would be adversely affected and our financial condition and results of operations could be harmed.
We have a significant deferred tax asset that may or may not be fully realized.
We have a significant deferred tax asset. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between the carrying amounts and the tax basis of assets and liabilities computed using enacted tax rates. We periodically assess available positive and negative evidence to determine whether it is more likely than not that our net deferred tax asset will be realized. Realization of a deferred tax asset requires us to apply significant judgment and is inherently speculative because it requires estimates that cannot be made with certainty. We have determined that it is more likely than not that we will be able to utilize our deferred tax asset to offset or reduce future taxes, and, as a result, we have released the previously established full valuation allowance on our deferred tax asset. This determination required us to incur a benefit to operations in the period in which we released or decreased the valuation allowance. If, in the future, we conclude that it is more-likely-than-not that all or a portion of our deferred tax asset would not be realized, we would be required to establish a valuation allowance against that portion of our deferred tax asset. If, in the future, we are able to conclude that it is more likely, than not, that we will not be able to utilize our deferred tax asset, any future determination that a valuation allowance is again necessary will require us to incur a charge to operations that could have, a material impact on our financial condition, results of operations and regulatory capital condition. In addition, certain of our deferred tax assets, including our tax credit carryforwards and net operating loss carryforwards, are subject to expiration if we are unable to utilize them during their respective terms. We cannot assure you that we will be able to fully realize our deferred tax asset.
Changes in tax laws and regulations could affect our future taxable income.
A change in tax laws or regulations, or their interpretation, could materially affect us if we generate taxable income in a future period. For example, on December 22, 2017, the United States enacted H.R.1., known as the Tax Cuts and Jobs Act (the “2017 Tax Act”). The legislation significantly changes U.S. tax law by, among other things, reducing the U.S. federal corporate tax rate from 35% to 21%, implementing a territorial tax system and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. As a result of the 2017 Tax Act, we recorded a decrease related to our deferred tax assets and liabilities of $5.8 million with a corresponding adjustment to our valuation allowance as of December 31, 2017. We currently do not expect the 2017 Tax Act to have a material impact on our financial statements. However, we are still in the process of evaluating the new law and do not know the full effect it will have on our business, including our financial statements. The 2017 Tax Act is unclear in many respects and could be subject to potential amendments and technical corrections, as well as interpretations and implementing regulations by the U.S. Treasury Department and IRS, any of which could lessen or increase the impact of the 2017 Tax Act on our business and financial statements. In addition, it is unclear how these U.S. federal income tax changes will affect state and local taxation, which often uses federal taxable income as a starting point for computing state and local tax liabilities.
We face intense competition from other banks, financial institutions and non-banking institutions that could hurt our business.
We conduct our business operations in Southern California, where the banking business is highly competitive and is dominated by large multi-state and in-state banks with operations and offices covering wide geographic areas. We also compete with other financial service businesses, mutual fund companies, and securities brokerage and investment banking firms that offer competitive banking and financial products and services, including online and mobile banking services, as well as products and services that we do not offer. The larger banks and many of those other financial institutions have greater financial and other resources than we do, which enables them to conduct extensive advertising campaigns and to allocate resources to regions or activities of greater potential profitability. They also have substantially more capital and higher lending limits than we do, which enable them to attract larger customers and offer financial products and services that we are unable to offer, putting us at a disadvantage in competing with them for loans and deposits. Increased competition may prevent us from (i) achieving increases,

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or could even result in decreases, in our loan volume or deposit balances, or (ii) increasing interest rates on the loans we make or reducing the interest rates we pay to attract or retain deposits, either or both of which could cause a decline in our interest income or an increase in our interest expense and, therefore, lead to reductions in our net interest income and earnings. In addition, technology and other changes are allowing parties to complete financial transactions, which historically have involved banks, through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits, which could have a material impact on our financial condition and results of operations.
A higher risk of severe weather and natural disasters in Southern California could disproportionately harm our business.
Historically, California, in which a substantial portion of our business is located, has been susceptible to natural disasters such as earthquakes, floods, droughts and wild fires. The nature and level of natural disasters cannot be predicted and may be exacerbated by global climate change. In the event of a major natural disaster, many of our borrowers may suffer uninsured property damage, experience interruption of their businesses or lose their jobs, which may negatively impact the ability of these borrowers to make deposits with us or repay their loans or negatively impact the values of collateral securing our loans, any of which could result in losses and increased provisions for credit losses. Additionally, the occurrence of natural disasters could harm our operations through interference with communications, including the interruption or loss of our computer systems, which could prevent or impede us from gathering deposits, originating loans and processing and controlling our business flow, as well as through the destruction of facilities and our operational, financial and management information systems. Although we have established disaster recovery plans and procedures, and we monitor the effects of any such events on our loans, properties and investments, the occurrence of any such event could have a material adverse effect on us or our financial condition and results of operations.
Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.
A substantial portion of our income is derived from the differential or “spread” between the interest we earn on loans, securities and other interest-earning assets, and the interest we pay on deposits, borrowings and other interest-bearing liabilities. Due to the differences in the maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread and, in turn, our profitability. In addition, as a general rule, loan origination volumes are affected by market interest rates. Rising interest rates, generally, are associated with a lower volume of loan originations while lower interest rates are usually associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates may decline and in falling interest rate environments, loan repayment rates may increase. Also, in a rising interest rate environment, we may accelerate the pace of rate increases on our deposit accounts as compared to the pace of increases in short-term market rates. Accordingly, changes in market interest rates could materially and adversely affect our net interest spread, asset quality and loan origination volume.
We have adopted an interest rate risk management strategy for the purpose of protecting us against interest rate changes. Developing an effective interest rate risk management strategy, however, is complex, and no risk management strategy can completely insulate us from risks associated with interest rate changes.
Government regulations may impair our operations, restrict our growth or increase our operating costs.
We are subject to extensive supervision, examination, and regulation by federal and state bank regulatory agencies, including the FRB and the FRBSF, and the CDBO. The primary objective of these agencies is to protect bank depositors and other customers and consumers, and not shareholders, whose respective interests often differ. Congress and these federal and state regulators continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations, or regulatory policies, including changes in interpretation or implementation of statutes, regulations, or policies, could affect the Company in substantial and unpredictable ways. If, as a result of an examination, the CDBO or the Federal Reserve should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its management is violating or has violated any law or regulation, the CDBO and the Federal Reserve, and separately the FDIC as insurer of the Bank’s deposits, have residual authority to, among other things, require affirmative action to correct any conditions resulting from any violation or practice and to impose restrictions that they believe are needed to protect depositors and customers of banking organizations. In addition, due to the complex and technical nature of many of the government regulations to which banking organizations are subject, inadvertent violations of those regulations may and sometimes do occur. In such an event, we would be required to correct or implement measures to prevent a recurrence of such violations. If more serious violations were to occur, the regulatory agencies could limit our activities or growth, impose fines on us, or ultimately require us to cease operations in the event we were to encounter severe liquidity problems or a

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significant erosion of our capital below the minimum amounts required under applicable bank regulatory guidelines or if we engage in unsafe or unsound practices that could lead to termination of our deposit insurance or banking charter.
The Dodd-Frank Act poses uncertainties for our business and has increased, and is likely to continue to increase, our costs of doing business.
The 2010 Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, established the Consumer Financial Protection Bureau (the “CFPB”) and requires the CFPB and other federal agencies to implement many new and significant rules and regulations. Certain provisions of the Dodd-Frank Act were made effective immediately. However, much of the Dodd-Frank Act is subject to further rulemaking and/or studies and the Trump Administration may ultimately roll back or modify certain of the regulations adopted under the Dodd-Frank Act. As a result, the enactment of the Dodd-Frank Act poses uncertainties for our business and has increased, and is likely to continue to increase, our costs of doing business. However, due to uncertainties concerning the timing and extent of future rulemaking, it is difficult to assess the extent to which the Dodd-Frank Act, or the resulting rules and regulations, will further impact our business and financial performance. Compliance with these new laws and regulations will result in additional costs, which could be significant, and may have a material and adverse effect on our results of operations. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level. We cannot predict whether California state agencies will adopt consumer protection laws and standards that are more stringent than those adopted at the federal level or, if any are adopted, what impact they may have on us, our business or our results of operations.
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act, other anti‐money laundering and anti‐bribery statutes and regulations, and U.S. economic and trade sanctions.

The Bank Secrecy Act, the USA PATRIOT Act of 2001, and other laws and regulations require financial institutions to, among other things, institute and maintain an effective anti‐money laundering program and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network is authorized to impose significant civil monetary penalties for violations of those requirements and has engaged in coordinated enforcement efforts with state and federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration, and Internal Revenue Service. We also must comply with U.S. economic and trade sanctions administered by the U.S. Treasury Department's Office of Foreign Assets Control and the Foreign Corrupt Practices Act, and we, like other financial institutions, are subject to increased scrutiny for compliance with these requirements. We maintain policies, procedures and systems designed to detect and deter prohibited financing activities. If these controls were deemed deficient, we could be subject to liability, including civil fines and regulatory actions, which may include restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan. In addition, any failure to effectively maintain and implement adequate programs to combat money laundering and terrorist financing could have serious reputational consequences for us. Any of these results could materially and adversely affect our business, financial condition or results of operations.
Potential changes in U.S. accounting standards may adversely affect our financial statements.
We prepare our financial statements in accordance with generally accepted accounting principles in the United States (“GAAP”). From time to time we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board. It is possible that future accounting standards that we are required to adopt could change the current accounting treatment that we apply to our consolidated financial statements and that such changes could have a materially adverse effect on our results of operations and financial condition. For example, as described above, we are evaluating the impact the new CECL model will have on our accounting, but our implementation of CECL could cause us to recognize a one-time cumulative-effect adjustment to the ALLL as of the beginning of the first reporting period in which the new standard is effective. For information regarding new accounting pronouncements and the expected impact, if any, on our financial position or results of operations, see Note 2 to the Notes to the consolidated financial statements in this Report.

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Premiums for federal deposit insurance may increase in the future.
The Dodd-Frank Act broadens the base for FDIC insurance assessments. The FDIC insures deposits at FDIC-insured financial institutions, including the Bank. The FDIC charges insured financial institutions premiums to maintain the DIF at a specific level. In addition, the Dodd-Frank Act increased the minimum target DIF ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits and the FDIC must seek to achieve the 1.35% ratio by September 30, 2020. The FDIC has issued regulations to implement these provisions of the Dodd-Frank Act, and although it recently reduced deposit insurance premiums for the overwhelming majority of banks whose assets are less than $10 billion, it has, in addition, established a higher reserve ratio of 2% as a long-term goal beyond what is required by statute, although there is no implementation deadline for the 2% ratio. The FDIC may increase the assessment rates or impose additional special assessments in the future to keep the DIF at the statutory target level. The Bank’s FDIC insurance premiums increased substantially beginning in 2009, and have returned to more normal levels with the improved condition of the Bank. Any increase in our FDIC premiums could have a material adverse effect on the Bank’s financial condition and results of operations.
The loss of key personnel could hurt our financial performance.
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the communities that we serve. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a great extent on the continued availability of our existing management and, in particular, on Thomas M. Vertin our President and Chief Executive Officer, Curt A. Christianssen our Chief Financial Officer, Thomas J. Inserra our Chief Risk Officer, and Robert Anderson our Chief Banking Officer. In addition to their skills and experience as bankers, our executive officers have extensive community ties upon which our competitive strategy is partially based. As a result, the loss of the services of any of these officers could harm our ability to implement our business strategy or our future operating results.
We rely on communications, information, operating and financial control systems technology from third-party service providers, and we may suffer an interruption in those systems.
We rely heavily on third-party service providers for much of our communications, information, operating, and financial control systems technology, including our online banking services and data processing systems. Any failure or interruption, or breaches in security, of these systems could result in failures or interruptions in our customer relationship management, general ledger, deposit, servicing and/or loan origination systems and, therefore, could harm our business, operating results and financial condition. Additionally, interruptions in service and security breaches could lead existing customers to terminate their banking relationships with us and could make it more difficult for us to attract new banking customers.
A breach in the security of our systems could disrupt our business, result in the disclosure of confidential information, damage our reputation and create significant financial and legal exposure to us.
We rely heavily on communications and information systems to conduct our business. Although we devote significant resources to maintain and regularly upgrade our systems and processes that are designed to protect the security of our computer systems, software, networks and other technology assets and the confidentiality, integrity and availability of information belonging to us and our customers, there is no assurance that all of our security measures will provide absolute security. Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, foreign governments, terrorists or other external parties. Those parties may also attempt to fraudulently induce employees, customers or other users of our systems to disclose sensitive information in order to gain access to our data or that of our customers. For example, other financial services institutions and companies engaged in data processing have reported breaches in the security of their websites or other systems, some of which have involved sophisticated and targeted attacks intended to obtain unauthorized access to confidential information, destroy data, disrupt or degrade service, sabotage systems or cause other damage, often through the introduction of computer viruses, malware, worms, cyberattacks, phishing attacks, and other means.
Despite our efforts to ensure the integrity of our systems, it is possible that we may not be able to anticipate or to implement effective preventive measures against all security breaches of these types, especially because the techniques used change frequently or are not recognized until launched. These risks may increase in the future as we continue to increase our internet-based product offerings and expand our internal usage of web-based products and applications. A successful penetration or circumvention of the security of our systems could cause serious negative consequences for us, including significant disruption of our operations, misappropriation of our confidential information or that of our customers, or damage to our computers or systems and those of our customers and counterparties, and could result in violations of applicable privacy and other laws, financial loss to us or our

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customers, loss of confidence in our security measures, customer dissatisfaction, significant litigation exposure, and harm to our reputation, all of which could have a material adverse effect on us.
We are exposed to risk of environmental liabilities with respect to real properties which we may acquire.
If borrowers are unable to meet their loan repayment obligations, we will initiate foreclosure proceedings with respect to, and may take actions to acquire title to the personal and real property that collateralized their loans. As an owner of such properties, we could become subject to environmental liabilities and incur substantial costs for any property damage, personal injury, investigation and clean-up that may be required due to any environmental contamination that may be found to exist at any of those properties, even though we did not engage in the activities that led to such contamination. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties seeking damages for environmental contamination emanating from the site. If we were to become subject to significant environmental liabilities or costs, our business, financial condition, results of operations and prospects could be adversely affected.
Managing reputational risk is important to attracting and maintaining customers, investors and employees.
Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies and questionable or fraudulent activities of our customers. We have policies and procedures in place to promote ethical conduct and protect our reputation. However, these policies and procedures may not be fully effective. Negative publicity regarding our business, employees, or customers, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.
We may be adversely affected by changes in the actual or perceived soundness or condition of other financial institutions.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial and financial soundness of other financial institutions. Financial institutions are closely related as a result of trading, investment, liquidity management, clearing, counterparty and other relationships. Loss of public confidence in any one institution, including through default, could lead to liquidity and credit problems, losses, or defaults for other institutions. Even the perceived lack of creditworthiness of, or questions about, a counterparty may lead to market-wide liquidity and credit problems, losses, or defaults by various institutions. This systemic risk may adversely affect financial intermediaries, such as clearing agencies, banks and exchanges we interact with on a daily basis or key funding providers, any of which could have a material adverse effect on our access to liquidity or otherwise have a material adverse effect on our business, financial condition, or results of operations.
The price of our common stock may be volatile or may decline, which may make it more difficult to realize a profit on your investment in our shares of common stock.
The trading prices of our common stock may fluctuate widely as a result of a number of factors, many of which are outside our control. Our stock price in the future could be adversely affected by other factors including:
quarterly fluctuations in our operating results or financial condition;
failure to meet analysts’ revenue or earnings estimates;
the restrictions on our ability to pay cash dividends on our common stock as described below;
the imposition of additional regulatory restrictions on our business and operations or an inability to meet regulatory requirements;
an inability to successfully implement our growth strategy;
strategic actions by us or our competitors, such as acquisitions or restructurings;
fluctuations in the stock prices and operating results of our competitors;
general market conditions and, in particular, developments related to market conditions for financial services industry stocks;
proposed or newly adopted legislative or regulatory changes or developments aimed at the financial services industry; and
any future proceedings or litigation that may involve or affect us.
As a bank holding company that conducts substantially all of our operations through our subsidiaries, primarily the Bank, our ability to pay dividends, repurchase shares of our common stock or to repay our indebtedness depends upon liquid assets held by the holding company and the results of operations of our subsidiaries.

23


We are a separate and distinct legal entity from our subsidiaries and we receive substantially all of our revenue from dividends paid to us by the Bank. There are legal limitations on the Bank's ability to extend credit, pay dividends or otherwise supply funds to, or engage in transactions with, us. We have agreed that the Bank will not, without the FRB and the CDBO's prior written approval, pay any dividends to us. Our inability to receive dividends from the Bank could adversely affect our business, financial condition, results of operations and prospects.
Various statutory provisions restrict the amount of dividends the Bank can pay to us without regulatory approval. The Bank may not pay cash dividends if that payment could reduce the amount of its capital below that amount which is necessary to meet the “adequately capitalized” standard under regulatory capital requirements. It is also possible that, depending upon the financial condition of the Bank and other factors, regulatory authorities could conclude that payment of dividends or other payments, including payments to us, is an unsafe or unsound practice, and as a result, and could impose restrictions on or prohibit such payments. The FRB has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the FRB’s view that a bank holding company should pay cash dividends only to the extent that its net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition. We have committed to obtaining approval from the FRB and the CDBO prior to paying any dividends, or making any distributions representing interest, principal or other sums on subordinated debentures or trust preferred securities. There can be no assurance that our regulators will approve such payments or dividends in the future.
If we sell additional shares of our common stock in the future, our shareholders could suffer dilution in their share ownership and voting power.
Subject to market conditions and other factors, we may determine from time to time to issue additional shares of our common stock or pursue other equity financings to meet capital requirements or support the growth of our business. Further issuance of any shares of our common stock and/or preferred stock would dilute the ownership interests of any holders of our common stock at the time of such issuance. In addition, we have issued, and may continue to issue, stock options, warrants, or other stock grants under our equity incentive plan. It is probable that such options will be exercised during their respective terms if the stock price exceeds the exercise price of the particular option, in which case existing shareholders' share ownership and voting power will be diluted.
Certain banking laws and provisions of our articles of incorporation could discourage a third party from making a takeover offer that may be beneficial to our shareholders.
Provisions of federal banking laws, including regulatory approval requirements, could make it difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The acquisition of 10% or more of any class of voting stock of a bank holding company or depository institution, including shares of our common stock, generally creates a rebuttable presumption that the acquirer “controls” the bank holding company or depository institution. Also, a bank holding company must obtain the prior approval of the FRB before, among other things, acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank, including us.
Additionally, our Board of Directors has the power, under our articles of incorporation, to create and authorize the sale of one or more new series of preferred stock without having to obtain shareholder approval for such action. As a result, the Board could authorize the issuance of and issue shares of a new series of preferred stock to implement a shareholders rights plan (often referred to as a “poison pill”) or could sell and issue preferred shares with special voting rights or conversion rights that could deter or delay attempts by our shareholders to remove or replace management, and attempts of third parties to engage in proxy contests and effectuate a change in control of us.

ITEM 1B.     UNRESOLVED STAFF COMMENTS
None.

ITEM 2.     PROPERTIES
We lease office space in various locations throughout Southern California, including Costa Mesa, Newport Beach, Irvine, Century City, San Diego, La Habra and Ontario. We believe our leased facilities are adequate for us to conduct our business.

ITEM 3.     LEGAL PROCEEDINGS
We are subject to legal actions that arise from time to time in the ordinary course of our business. Currently, neither we nor any of our subsidiaries is a party to, and none of our or our subsidiaries' property is the subject of, any material legal proceeding.

ITEM 4.     MINE SAFETY DISCLOSURES

24


Not applicable.

25


PART II
 
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Trading Market for the Company’s Shares
Our common stock is traded on the Nasdaq Global Select Market under the symbol “PMBC.” As of March 7, 2019 , there were approximately 60 holders of record of our common stock.
Stock Performance Graph
The following graph compares the percentage change in our cumulative total shareholder return on our common stock, in each of the years in the five year period ended December 31, 2018 , with the cumulative total return of: (i) the Russell 2000 Index, which measures the performance of the smallest 2,000 members, by market capitalization, of the Russell 3,000 Index, and (ii) an index published by SNL Securities L.C. (“SNL”) and known as the SNL Western Bank Index, which is comprised of 51 banks and bank holding companies (including the Company), the shares of which are listed on Nasdaq or the New York Stock Exchange and most of which are based in California and the remainder of which are based in nine other western states.
The stock performance graph assumes that $100 was invested at the close of market on the last trading day for the year ended December 31, 2013 in Company common stock and in the Russell 2000 Index and the SNL Western Bank Index and that any dividends paid in the indicated periods were reinvested. Shareholder returns shown in the stock performance graph are not necessarily indicative of future stock price performance.
PMBCPERFORMANCEGRAPH2018.JPG
 
 
(1)
The source of the above graph and chart is SNL.
 
Period Ending
Index
12/31/13
 
12/31/14
 
12/31/15
 
12/31/16
 
12/31/17
 
12/31/18
Pacific Mercantile Bancorp
100.00

 
113.18

 
114.63

 
117.36

 
140.68

 
114.95

Russell 2000 Index
100.00

 
104.89

 
100.26

 
121.63

 
139.44

 
124.09

SNL Western Bank Index
100.00

 
120.01

 
124.35

 
137.85

 
153.70

 
121.69


26


The above performance graph shall not be deemed “filed” for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities under that section and shall not be deemed to be incorporated by reference into any of our filings under the Securities Act or the Exchange Act.
Dividend Policy and Restrictions on the Payment of Dividends
We have not declared or paid any cash dividends on our common stock since 2008.
Cash dividends from the Bank represent the principal source of funds available to Bancorp to pay cash dividends to shareholders. Therefore, government regulations, including the laws of the State of California, as they pertain to the payment of cash dividends by California state chartered banks, limit the amount of funds that the Bank would be permitted to dividend to Bancorp. As a result, those laws also affect our ability to pay cash dividends to our shareholders. In particular, under California law, cash dividends by a California state chartered bank may not exceed, in any calendar year, the lesser of (i) the sum of its net income for the year and its retained net income from the preceding two years (after deducting all dividends paid during the period), or (ii) the amount of its retained earnings. We have agreed that the Bank will not, without the FRB and CDBO's prior written approval, pay any dividends to Bancorp.
Additionally, because the payment of cash dividends has the effect of reducing capital, the capital requirements imposed on bank holding companies and commercial banks often operate, as a practical matter, to preclude the payment, or limit the amount of, cash dividends that might otherwise be permitted by California law; and the federal bank regulatory agencies, as part of their supervisory powers, generally require insured banks to adopt dividend policies which limit the payment of cash dividends much more strictly than do applicable state laws. Refer to “Supervision and Regulation” above in Item 1 and Note 14, Shareholders' Equity in the notes to our consolidated financial statements for more detail regarding the regulatory restrictions on our and the Bank's ability to pay dividends. We have committed to obtaining approval from the FRB and the CDBO prior to Bancorp paying any dividends, or making any distributions representing interest, principal or other sums on subordinated debentures or trust preferred securities. There can be no assurance that our regulators will approve such payments or dividends in the future.
Even if legal or regulatory restrictions do not prevent us from paying dividends to our shareholders, our Board of Directors follows a policy of retaining earnings to maintain capital, enhance the Bank's liquidity and support the growth of our banking franchise. Accordingly, we do not expect to pay cash dividends for the foreseeable future.
Restrictions on Inter-Company Transactions
Section 23(a) of the Federal Reserve Act limits the amounts that a bank may loan to its bank holding company to an aggregate of no more than 10% of the bank subsidiary’s capital surplus and retained earnings and requires that such loans be secured by specified assets of the bank holding company—See “BUSINESS—Supervision and Regulation– Restrictions on Transactions between the Bank and the Company and its other Affiliates” in Item 1 of this Report. We do not have any present intention to obtain any borrowings from the Bank.


27


ITEM 6.     SELECTED FINANCIAL DATA
The selected statement of operations data for the fiscal years ended December 31, 2018 , 2017 and 2016 , the selected balance sheet data as of December 31, 2018 and 2017 , and the selected financial ratios (other than book value per share), that follow below were derived from our audited consolidated financial statements included in Item 8 of this Report and should be read in conjunction with those audited consolidated financial statements, together with the notes thereto, and with “MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ” set forth in Item 7 of this Report. The selected statement of operations data for the years ended December 31, 2015 and 2014 , the selected balance sheet data as of December 31, 2016 , 2015 and 2014 , and the selected financial ratios (other than book value per share) for the periods prior to January 1, 2016 are derived from audited consolidated financial statements that are not included in this Report.
 
Year Ended December 31,
 
2018
 
2017
 
2016
 
2015
 
2014
 
(Dollars in thousands except per share data)
Selected Statement of Operations Data:
 
 
 
 
 
 
 
 
 
Total interest income
$
62,542

 
$
51,573

 
$
41,000

 
$
38,797

 
$
38,290

Total interest expense
13,620

 
7,831

 
5,477

 
5,269

 
5,829

Net interest income
48,922

 
43,742

 
35,523

 
33,528

 
32,461

Provision for loan and lease losses

 

 
19,870

 

 
1,500

Net interest income after provision for loan and lease losses
48,922

 
43,742

 
15,653

 
33,528

 
30,961

Total noninterest income
4,635

 
4,374

 
2,937

 
2,686

 
4,370

Total noninterest expense
36,970

 
37,758

 
36,401

 
35,324

 
36,808

Income before income taxes
16,587

 
10,358

 
(17,811
)
 
890

 
(1,477
)
Income tax (benefit) provision
(10,752
)
 
(91
)
 
16,832

 
(11,551
)
 
(608
)
Net income (loss) from continuing operations
27,339

 
10,449

 
(34,643
)
 
12,441

 
(869
)
Net income from discontinued operations

 

 

 

 
1,226

Accumulated declared dividends on preferred stock

 

 

 

 
(547
)
Accumulated undeclared dividends on preferred stock

 

 

 

 
(616
)
Dividends on preferred stock

 

 

 
(927
)
 

Inducements for exchange of the preferred stock

 

 

 
(512
)
 

Net income (loss) allocable to common shareholders
$
27,339

 
$
10,449

 
$
(34,643
)
 
$
11,002

 
$
(806
)
Per share data-basic:
 
 
 
 
 
 
 
 
 
Net income (loss) from continuing operations
$
1.17

 
$
0.45

 
$
(1.51
)
 
$
0.54

 
$
(0.11
)
Net income (loss) allocable to common shareholders
$
1.17

 
$
0.45

 
$
(1.51
)
 
$
0.54

 
$
(0.04
)
Per share data-diluted:
 
 
 
 
 
 
 
 
 
Net income (loss) from continuing operations
$
1.16

 
$
0.45

 
$
(1.51
)
 
$
0.53

 
$
(0.11
)
Net income (loss) allocable to common shareholders
$
1.16

 
$
0.45

 
$
(1.51
)
 
$
0.53

 
$
(0.04
)
Weighted average shares outstanding
 
 
 
 
 
 
 
 
 
Basic
22,788,164

 
23,071,671

 
22,802,439

 
20,516,575

 
19,230,913

Diluted
23,527,183

 
23,312,292

 
22,958,644

 
20,675,279

 
19,230,913

Dividends per common share

 

 

 

 

Dividends per Series A non-voting preferred share

 

 

 

 

 
December 31,
 
2018
 
2017
 
2016
 
2015
 
2014
 
(Dollars in thousands except for per share information)
Selected Balance Sheet Data:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
187,718

 
$
198,208

 
$
138,845

 
$
113,921

 
$
177,135

Total loans, net
1,083,240

 
1,053,201

 
931,525

 
849,733

 
824,197

Total assets
1,349,338

 
1,322,604

 
1,140,689

 
1,062,389

 
1,099,610

Total deposits
1,136,002

 
1,139,393

 
1,001,300

 
893,840

 
916,309

Junior subordinated debentures
17,527

 
17,527

 
17,527

 
17,527

 
17,527

Total shareholders’ equity
141,374

 
112,876

 
99,719

 
133,916

 
119,281

Book value per share
$
6.06

 
$
4.86

 
$
4.33

 
$
5.87

 
$
5.53

 
(1)
Cash and cash equivalents include cash and due from banks and federal funds sold.

28


 
For the Year Ended December 31,
 
2018
 
2017
 
2016
 
2015
 
2014
 
(unaudited)
Selected Financial Ratios:
 
 
 
 
 
 
 
 
 
Return on average assets
2.04
%
 
0.88
%
 
(3.13
)%
 
1.17
%
 
(0.08
)%
Return on average equity
21.40
%
 
9.78
%
 
(27.56
)%
 
10.23
%
 
(0.74
)%
Ratio of average equity to average assets
9.54
%
 
9.03
%
 
11.35
 %
 
11.48
%
 
11.30
 %

29


ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview
The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 8 of this Report.
Our principal operating subsidiary is Pacific Mercantile Bank (the “Bank”), which is a California state chartered bank. The Bank accounts for substantially all of our consolidated revenues, expenses and income and our consolidated assets and liabilities. Accordingly, the following discussion focuses primarily on the Bank’s results of operations and financial condition.
As of December 31, 2018 , our total assets, net loans and total deposits were $1.3 billion , $1.1 billion and $1.1 billion , respectively.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (the “FDIC”). For the years ended December 31, 2018 , 2017 and 2016 , we operated as one reportable segment, Commercial Banking.
Unless the context otherwise requires, the “Company,” “we,” “our,” “ours,” and “us” refer to Pacific Mercantile Bancorp and its consolidated subsidiaries.

Results of Operations
Operating Results for the Years Ended December 31, 2018 , 2017 , and 2016     
Our operating results for the year ended December 31, 2018 , compared to December 31, 2017 , and for the year ended December 31, 2017 , compared to December 31, 2016 , were as follows:
 
Year Ended December 31,
 
 
 
 
 
2018
 
2017
 
2016
 
2018 vs. 2017
% Change
 
2017 vs. 2016
% Change
 
(Dollars in thousands)
 
 
 
 
Interest income
$
62,542

 
$
51,573

 
$
41,000

 
21.3
 %
 
25.8
 %
Interest expense
13,620

 
7,831

 
5,477

 
73.9
 %
 
43.0
 %
Provision for loan and lease losses

 

 
19,870

 
 %
 
(100.0
)%
Non-interest income
4,635

 
4,374

 
2,937

 
6.0
 %
 
48.9
 %
Non-interest expense
36,970

 
37,758

 
36,401

 
(2.1
)%
 
3.7
 %
Income tax provision (benefit)
(10,752
)
 
(91
)
 
16,832

 
11,715.4
 %
 
(100.5
)%
Net (loss) income allocable to common shareholders
$
27,339

 
$
10,449

 
$
(34,643
)
 
161.6
 %
 
(130.2
)%
Interest Income
2018 vs. 2017 .
Total interest income increased 21.3% to $62.5 million for the year ended December 31, 2018 from $51.6 million for the year ended December 31, 2017 . This increase is primarily due to an increase in interest income on loans during the year ended December 31, 2018 compared to the prior year due to an increase in average loan balances, as well as an increase in the average yield on loans. During the year ended December 31, 2018 and 2017 , interest income on loans was $57.6 million and $49.0 million , respectively, yielding 5.38% and 4.91% on average loan balances of $1.1 billion and $996.7 million , respectively. The increase in the average loan balances is attributable to an increase in loan demand. The increase in the average yield on loans was primarily the result of the rising interest rate environment and the recovery of $1.6 million in interest income on two loans that had been on nonaccrual status but were paid in full during the year ended December 31, 2018 as compared to $1.1 million recovered on one loan relationship during the year ended December 31, 2017. The average yield on interest-earning assets was 4.78% for the year ended December 31, 2018 compared to 4.41% for the year ended December 31, 2017 .

30


During the year s ended December 31, 2018 and 2017 , interest income from our securities available-for-sale and stock, was $1.2 million and $1.2 million , yielding 2.92% and 2.49% on average balances of $39.7 million and $49.7 million , respectively. The average securities balances decreased as a result of sales and maturities of, and payments on, securities throughout the year ended December 31, 2018, which was partially offset by purchases during the second half of the year. The increase in the average yield is attributable to the rising interest rate environment and the result of a Federal Home Loan Bank (“FHLB”) special dividend of $83 thousand received during December 2018. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $3.8 million and $1.4 million for the year ended December 31, 2018 and 2017 , respectively, yielding 1.92% and 1.11% on average balances of $195.7 million and $123.8 million , respectively. The increase in the average yield is a result of the rising interest rate environment. As a result, total interest income on investments increased for the year ended December 31, 2018 .
2017 vs. 2016 .
Total interest income increased 25.8% to $51.6 million for the year ended December 31, 2017 from $41.0 million for the year ended December 31, 2016 . This increase is primarily due to an increase in interest income on loans during the year ended December 31, 2017 compared to the prior year due to an increase in average loan balances, as well as an increase in the average yield on loans and the recovery of $1.1 million in interest income on a single loan relationship that had been on nonaccrual status but was paid in full during the third quarter of 2017. During the years ended December 31, 2017 and 2016 , interest income on loans was $49.0 million and $38.6 million , respectively, yielding 4.91% and 4.50% on average loan balances of $996.7 million and $857.7 million , respectively. The increase in the average loan balances is attributable to an increase in loan demand. The increase in loan yield is primarily attributable to the actions of the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) to raise short-term interest rates by 100 basis points since the fourth quarter of 2016. The average yield on interest-earning assets was 4.41% for the year ended December 31, 2017 compared to 3.81% for the year ended December 31, 2016 .
During the years ended December 31, 2017 and 2016 , interest income from our securities available-for-sale and stock, was $1.2 million and $1.6 million , respectively, yielding 2.49% and 2.76% on average balances of $49.7 million and $57.1 million , respectively. The average securities balances decreased as a result of maturities of, and payments on, securities which we did not fully replace due to liquidity needs. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $1.4 million and $842 thousand for the years ended December 31, 2017 and 2016 , respectively, yielding 1.11% and 0.52% on average balances of $123.8 million and $162.6 million , respectively. The increase in the average yield is attributable to the Federal Reserve Board raising interest rates by 100 basis points since the fourth quarter of 2016. As a result, total interest income on investments increased for the year ended December 31, 2017 .
Interest Expense
2018 vs. 2017 .
Total interest expense increased 73.9% to $13.6 million for the year ended December 31, 2018 from $7.8 million for the year ended December 31, 2017 . The increase was primarily due to an increase in the volume of and average cost of funds of our interest-bearing liabilities to 1.60% at December 31, 2018 from 1.05% at December 31, 2017 , which consisted of deposits, borrowings and junior subordinated debentures, which was primarily the result of new client acquisition, our decision to increase the rate of interest paid on our certificates of deposit resulting from the rising interest rate environment, and an increase in our FHLB borrowings. Interest expense on our certificates of deposit for the years ended December 31, 2018 and 2017 was $5.3 million and $3.8 million , respectively, with a cost of funds of 1.70% and 1.26% on average balances of $315.2 million and $298.5 million , respectively.
2017 vs. 2016 .
Total interest expense increased 43.0% to $7.8 million for the year ended December 31, 2017 from $5.5 million for the year ended December 31, 2016 . The increase was primarily due to an increase in the volume of and average cost of funds of our interest-bearing liabilities to 1.05% at December 31, 2017 from 0.81% at December 31, 2016 , which consisted of deposits, borrowings and junior subordinated debentures, which was primarily the result of new client acquisition, our decision to increase the rate of interest paid on our certificates of deposit resulting from the rising interest rate environment, and an increase in our FHLB borrowings. Interest expense on our certificates of deposit for the years ended December 31, 2017 and 2016 was $3.8 million and $2.6 million , respectively, with a cost of funds of 1.26% and 0.99% , on average balances of $298.5 million and $263.6 million , respectively.
Net Interest Margin
One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference

31


or “spread” between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or “spread” will generally result in a decline in our net income.
A bank’s interest income and interest expense are affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”
As a result of the Federal Reserve Board raising interest rates by 175 basis points since 2016, we experienced expansion in our net interest margin. The favorable impact of higher prevailing interest rates on our asset-sensitive balance sheet was evidenced in the year ended December 31, 2018 as compared to the year ended December 31, 2016. While we are unable to acertain whether the Federal Reserve Board will continue to increase short-term interest rates in the future, we expect the favorable impact on our net interest margin to remain in the event that interest rates continue to rise. However, we believe that the competition for deposits is increasing and could lead to increases in the cost of interest-bearing deposit liabilities that may partially offset the contractual increase in the yield on earning assets.
The following tables set forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the years ended December 31, 2018 , 2017 and 2016 . Average balances are calculated based on average daily balances.
 
 
Year Ended December 31,
 
2018
 
2017
 
2016
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest earning assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Short-term investments (1)
$
195,736

 
$
3,756

 
1.92
%
 
$
123,761

 
$
1,379

 
1.11
%
 
$
162,585

 
$
842

 
0.52
%
Securities available for sale and stock (2)
39,744

 
1,160

 
2.92
%
 
49,745

 
1,237

 
2.49
%
 
57,135

 
1,578

 
2.76
%
Loans (3)
1,071,874

 
57,626

 
5.38
%
 
996,696

 
48,957

 
4.91
%
 
857,666

 
38,580

 
4.50
%
Total interest-earning assets
1,307,354

 
62,542

 
4.78
%
 
1,170,202

 
51,573

 
4.41
%
 
1,077,386

 
41,000

 
3.81
%
Noninterest-earning assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
16,785

 
 
 
 
 
14,482

 
 
 
 
 
15,533

 
 
 
 
All other assets (3)
14,577

 
 
 
 
 
(1,116
)
 
 
 
 
 
14,550

 
 
 
 
Total assets
$
1,338,716

 
 
 
 
 
$
1,183,568

 
 
 
 
 
$
1,107,469

 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
69,841

 
$
363

 
0.52
%
 
$
87,771

 
$
347

 
0.40
%
 
$
60,024

 
162

 
0.27
%
Money market and savings accounts
412,366

 
6,358

 
1.54
%
 
334,703

 
2,859

 
0.85
%
 
327,401

 
2,048

 
0.63
%
Certificates of deposit
315,189

 
5,349

 
1.70
%
 
298,531

 
3,752

 
1.26
%
 
263,569

 
2,610

 
0.99
%
Other borrowings
36,209

 
705

 
1.95
%
 
4,538

 
203

 
4.47
%
 
7,407

 
75

 
1.01
%
Junior subordinated debentures
17,527

 
845

 
4.82
%
 
17,527

 
670

 
3.82
%
 
17,527

 
582

 
3.32
%
Total interest bearing liabilities
851,132

 
13,620

 
1.60
%
 
743,070

 
7,831

 
1.05
%
 
675,928

 
5,477

 
0.81
%
Noninterest-bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
348,923

 
 
 
 
 
326,105

 
 
 
 
 
299,447

 
 
 
 
Accrued expenses and other liabilities
10,931

 
 
 
 
 
7,566

 
 
 
 
 
6,380

 
 
 
 
Shareholders' equity
127,730

 
 
 
 
 
106,827

 
 
 
 
 
125,714

 
 
 
 
Total liabilities and shareholders' equity
$
1,338,716

 
 
 
 
 
$
1,183,568

 
 
 
 
 
$
1,107,469

 
 
 
 
Net interest income
 
 
$
48,922

 
 
 
 
 
$
43,742

 
 
 
 
 
$
35,523

 
 
Net interest income/spread
 
 
 
 
3.18
%
 
 
 
 
 
3.36
%
 
 
 
 
 
3.00
%
Net interest margin
 
 
 
 
3.74
%
 
 
 
 
 
3.74
%
 
 
 
 
 
3.30
%
 

32


(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of FHLB stock and Federal Reserve Bank stock.
(3)
Loans include the average balance of nonaccrual loans and loan fees. The allowance for loan and lease losses is included within the "All other assets" line item.
The following table sets forth changes in interest income, including loan fees, and interest paid in each of the years ended December 31, 2018 , 2017 and 2016 and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or the rates of interest paid on our interest-bearing liabilities.
 
 
2018 Compared to 2017
Increase (Decrease) due to Changes in
 
2017 Compared to 2016
Increase (Decrease) due to Changes in
 
Volume
 
Rates
 
Total
Increase
(Decrease)
 
Volume
 
Rates
 
Total
Increase
(Decrease)
 
(Dollars in thousands)
Interest income
 
 
 
 
 
 
 
 
 
 
 
Short-term investments (1)
$
1,060

 
$
1,317

 
$
2,377

 
$
(241
)
 
$
778

 
$
537

Securities available for sale and stock (2)
(272
)
 
195

 
(77
)
 
(193
)
 
(148
)
 
(341
)
Loans
3,848

 
4,821

 
8,669

 
6,621

 
3,756

 
10,377

Total earning assets
4,636

 
6,333

 
10,969

 
6,187

 
4,386

 
10,573

Interest expense
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
(80
)
 
96

 
16

 
92

 
93

 
185

Money market and savings accounts
783

 
2,716

 
3,499

 
47

 
764

 
811

Certificates of deposit
219

 
1,378

 
1,597

 
377

 
765

 
1,142

Borrowings
677

 
(175
)
 
502

 
(38
)
 
166

 
128

Junior subordinated debentures

 
175

 
175

 

 
88

 
88

Total interest-bearing liabilities
1,599

 
4,190

 
5,789

 
478

 
1,876

 
2,354

Net interest income
$
3,037

 
$
2,143

 
$
5,180

 
$
5,709

 
$
2,510

 
$
8,219

 
(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at financial institutions.
(2)
Stock consists of FHLB stock and Federal Reserve Bank stock.
Provision for Loan and Lease Losses
We maintain reserves to provide for loan losses that occur in the ordinary course of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced (“written down”) to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan “charge-off”). Loan charge-offs and write-downs are charged against our allowance for loan and lease losses (“ALLL”). The amount of the ALLL is increased periodically to replenish the ALLL after it has been reduced due to loan write-downs or charge-offs. The ALLL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans and to take account of changes in the risk of probable loan losses due to financial performance of borrowers, the value of collateral securing non-performing loans or changing economic conditions. Increases in the ALLL are made through a “provision for loan and lease losses” that is recorded as an expense in the statement of operations. Increases in the ALLL are also recognized through the recovery of charged-off loans which are added back to the ALLL. As such, recoveries are a direct offset for a provision for loan and lease losses that would otherwise be needed to replenish or increase the ALLL.
We employ economic models and data that conform to bank regulatory guidelines and reflect sound industry practices as well as our own historical loan loss experience to determine the sufficiency of the ALLL and any provisions needed to increase or replenish the ALLL. Those determinations involve judgments and assumptions about current economic conditions and external events that can impact the ability of borrowers to meet their loan obligations. However, the duration and impact of these factors cannot be determined with any certainty. As such, unanticipated changes in economic or market conditions, bank regulatory guidelines or the sound practices that are used to determine the sufficiency of the ALLL, could require us to record additional, and possibly significant, provisions to increase the ALLL. This would have the effect of reducing reportable income or, in the most extreme circumstance, creating a reportable loss. In addition, the Federal Reserve Bank and the California Department of Business Oversight (“CDBO”), as an integral part of their regulatory oversight, periodically review the adequacy of our ALLL. These agencies may require us to make additional provisions for perceived potential loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur.

33


We recorded no provision for loan and lease losses during either the year ended December 31, 2018 or December 31, 2017 primarily as a result of reserves for new loan growth being offset by a decline in the level of classified assets. We recorded a $19.9 million provision for loan and lease losses for the year ended December 31, 2016 primarily as a result of new loan growth and downgrades and charge offs on loans that exceeded recoveries. Approximately 60%, or $12.0 million, of the $19.9 million provision for loan and lease losses was attributable to the full charge-off of one large shared national credit.
See "— Financial Condition—Nonperforming Loans and the Allowance for Loan and Lease Losses " below in this Item 7 for additional information regarding the ALLL.
Noninterest Income
The following table identifies the components of and the percentage changes in noninterest income in the years ended December 31, 2018 , 2017 and 2016 :  
 
Year Ended December 31,
 
Amount
 
Amount
 
Amount
 
Percentage
Change
 
Percentage
Change
 
2018
 
2017
 
2016
 
2018 vs. 2017
 
2017 vs. 2016
 
(Dollars in thousands)
Service fees on deposits and other banking services
$
1,549

 
$
1,347

 
$
1,093

 
15.0
 %
 
23.2
 %
Net gain (loss) on sale of securities available for sale
48

 
(4
)
 

 
(1,300.0
)%
 
(100.0
)%
Net loss on sale of other assets
(4
)
 
(37
)
 
(527
)
 
(89.2
)%
 
(93.0
)%
Net gain on sale of small business administration loans

 

 
40

 
 %
 
(100.0
)%
Other noninterest income
3,042

 
3,068

 
2,331

 
(0.8
)%
 
31.6
 %
Total noninterest income
$
4,635

 
$
4,374

 
$
2,937

 
6.0
 %
 
48.9
 %
2018 vs. 2017 .
Noninterest income increased $261 thousand , or 6.0% , for the year ended December 31, 2018 as compared to the year ended December 31, 2017 , primarily as a result of:
An increase in loan servicing and referral fees during the year ended December 31, 2018 as compared to the same period in 2017 ; and
An increase of $52 thousand in gain on the sale of securities available-for-sale during the year ended December 31, 2018 as compared to the same period in 2017; partially offset by
A decrease in other noninterest income attributable to recoveries of fees on previously charged off loans during the second quarter of 2017 for which a similar level of recoveries did not occur during the year ended December 31, 2018.
2017 vs. 2016 .
During the year ended December 31, 2017 , noninterest income increased by $1.4 million , or 48.9% , to $4.4 million from $2.9 million for the year ended December 31, 2016 , primarily as a result of:
An increase in loan servicing and referral fees during the year ended December 31, 2017 as compared to the same period in 2016; and
A loss of $37 thousand on the sale of other assets during the year ended December 31, 2017 as compared to a loss of $527 thousand during the same period in 2016; partially offset by
A decrease of $40 thousand in net on sale of small business administration (“SBA”) loans for the year ended December 31, 2017 as compared to the same period in 2017.
Noninterest Expense
The following table sets forth the principal components and the amounts of, and the percentage changes in, noninterest expense in the years ended December 31, 2018 , 2017 and 2016 .

34


 
Year Ended December 31,
 
2018
 
2017
 
2016
 
2018 vs. 2017
 
2017 vs. 2016
 
Amount
 
Amount
 
Amount
 
Percent Change
 
Percent Change
 
(Dollars in thousands)
Salaries and employee benefits
$
23,749

 
$
22,977

 
$
21,817

 
3.4
 %
 
5.3
 %
Occupancy
2,388

 
2,605

 
3,061

 
(8.3
)%
 
(14.9
)%
Equipment and depreciation
1,802

 
1,687

 
1,802

 
6.8
 %
 
(6.4
)%
Data processing
1,681

 
1,479

 
1,271

 
13.7
 %
 
16.4
 %
FDIC expense
927

 
1,073

 
950

 
(13.6
)%
 
12.9
 %
Other real estate owned expense, net
123

 

 
(70
)
 
100.0
 %
 
(100.0
)%
Professional fees
2,468

 
4,215

 
4,046

 
(41.4
)%
 
4.2
 %
Business development
946

 
729

 
795

 
29.8
 %
 
(8.3
)%
Loan related expense
769

 
456

 
375

 
68.6
 %
 
21.6
 %
Insurance
248

 
221

 
291

 
12.2
 %
 
(24.1
)%
Other operating expenses (1)
1,869

 
2,316

 
2,063

 
(19.3
)%
 
12.3
 %
Total noninterest expense
$
36,970

 
$
37,758

 
$
36,401

 
(2.1
)%
 
3.7
 %
 
(1)
Other operating expenses primarily consist of telephone, investor relations, promotional, regulatory expenses, and correspondent bank fees.
2018 vs. 2017 .
Noninterest expense decreased $788 thousand , or 2.1% , for the year ended December 31, 2018 as compared to the year ended December 31, 2017 , primarily as a result of:
A decrease of $1.7 million in our professional fees primarily related to lower legal fees in the first quarter of 2018, the recovery of legal fees attributable to the payoff of a loan relationship in the second quarter of 2018 that was previously on nonaccrual status and the recovery of legal fees in the third quarter of 2018 related to a loan relationship that was fully charged off in previous years; partially offset by
An increase of $772 thousand in salaries and employee benefits primarily related to an increase in employee compensation expense;
An increase of $123 thousand in other real estate owned expense during the year ended December 31, 2018 as compared to the same period in 2017; and
An increase in various expense accounts related to the normal course of operating, including expenses related to loan production and business development during the year ended December 31, 2018 as compared to the year ended December 31, 2017.
2017 vs. 2016 .
During the year ended December 31, 2017 , noninterest expense increased by $1.4 million , or 3.7% , to $37.8 million from $36.4 million for the year ended December 31, 2016 , primarily as a result of: 
An increase of $1.2 million in salaries and employee benefits primarily related to our incentive compensation accrual for the year ended December 31, 2017 and the reversal of our incentive compensation accrual during the fourth quarter of 2016 due to the losses experienced in 2016; and
An increase of $169 thousand in our professional fees attributable to an increase in accounting and legal fees during the year ended December 31, 2017.
Provision for (Benefit from) Income Tax
During the year ended December 31, 2018 , we had an income tax benefit of $10.8 million . The income tax benefit during the year ended December 31, 2018 is as a result of our net income during the year and the release of our full valuation allowance of $11.1 million on our net deferred tax asset during the second quarter of 2018, discussed further below. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. The tax code allows net operating losses incurred prior to December 31, 2017 to be carried forward for 20 years from the date of the loss, and based on its evaluation, management believes that the Company will be able to realize the deferred tax asset within the period that our net operating losses may be carried forward. Due to the hierarchy of evidence that the accounting rules specify, management determined that there continued to be enough positive evidence to support no valuation allowance on our deferred tax asset at December 31, 2018 . Significant positive evidence included our three-year cumulative income position, continued improvement in asset quality, and the expectation that we will continue to have positive earnings based on nine trailing quarters

35


of positive income and our forecast. Negative evidence included our accumulated deficit. Due to the hierarchy of evidence that the accounting rules specify, management determined that there continued to be enough positive evidence to support no valuation allowance on our deferred tax asset at December 31, 2018 .
During the year ended December 31, 2017 , we had an income tax benefit of $91 thousand . The income tax benefit for the year ended December 31, 2017 represents the reclassification of the alternative minimum tax credit carryforward from a deferred tax asset to an income tax receivable as required by the Tax Cuts and Jobs Act signed into law on December 22, 2017. This was partially offset by the payment to the State of California for the cost of doing business within the state. No additional income tax expense was recorded as a result of our full valuation allowance, discussed further below. The year ended December 31, 2017 results reflect the estimated impact of the enactment of the new tax law, which resulted in a minimal increase in net income due to the elimination of the corporate alternative minimum tax. Additionally, as part of the newly enacted tax law, the decrease in our deferred tax asset and corresponding valuation allowance as of December 31, 2017 is primarily attributable to the Federal corporate tax rate decreasing from 35% to 21%, which caused us to decrease our gross deferred tax asset and the related valuation allowance to $15.9 million from $21.7 million as of September 30, 2017. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. The tax code allows net operating losses to be carried forward for 20 years from the date of the loss, and while management believes that the Company will be able to realize the deferred tax asset within the period that our net operating losses may be carried forward, we are unable to assert the timing as to when that realization will occur. Due to the hierarchy of evidence that the accounting rules specify, management determined that a full valuation allowance that was previously established on the balance of our deferred tax asset was still required at December 31, 2017.
During the year ended December 31, 2016 , we had income tax expense of $16.8 million as a result of the establishment of a full valuation allowance during 2016 on the balance of our deferred tax asset, which includes current and historical losses that may be used to offset taxes on future profits. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. Negative evidence included the significant losses incurred during the second and third quarters of 2016, an increase in our nonperforming assets from December 31, 2015, and our accumulated deficit. Positive evidence included our forecast of our taxable income, the time period in which we have to utilize our deferred tax asset and the current economic conditions. The tax code allows net operating losses to be carried forward for 20 years from the date of the loss, and while management believed that the Company would be able to realize the deferred tax asset within that period, we were unable to assert the timing as to when that realization would occur. As a result of this conclusion and due to the hierarchy of evidence that the accounting rules specify, a valuation allowance had been recorded as of December 31, 2016 to offset the deferred tax asset.
See "– Critical Accounting Policies - Utilization and Valuation of Deferred Income Tax Benefits ” below for additional information regarding our deferred tax asset.

Financial Condition
Assets
Our total consolidated assets increased by $27 million at December 31, 2018 from $1.3 billion at December 31, 2017 . The following table sets forth the composition of our interest earning assets at:
 
December 31, 2018
 
December 31, 2017
 
(Dollars in thousands)
Interest-bearing deposits with financial institutions (1)
$
174,468

 
$
186,010

Interest-bearing time deposits with financial institutions
2,420

 
2,920

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
8,822

 
8,107

Securities available for sale, at fair value
31,231

 
39,738

Loans (net of allowances of $13,506 and $14,196, respectively)
1,083,240

 
1,053,201

 
(1)
Includes interest-earning balances maintained at the Federal Reserve Bank of San Francisco (“FRBSF”).

Securities Available for Sale
Securities Available for Sale . Securities that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, interest rates, or prepayment risks or other similar factors, are classified as “securities

36


available for sale”. Such securities are recorded on our balance sheet at their respective fair values and increases or decreases in those values are recorded as unrealized gains or losses, respectively, and are reported as Other Comprehensive Income (Loss) on our accompanying consolidated balance sheet, rather than included in or deducted from our earnings.
The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and the gross unrealized gains and losses attributable to those securities, as of December 31, 2018 , 2017 and 2016 :
(Dollars in thousands)
Amortized Cost
 
Gross
Unrealized Gain
 
Gross
Unrealized Loss
 
Estimated
Fair Value
Securities available for sale at December 31, 2018:
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,999

 
$

 
$
(19
)
 
$
2,980

Residential mortgage backed securities issued by U.S. Agencies
24,739

 
1

 
(1,023
)
 
23,717

Commercial mortgage backed securities issued by U.S. Agencies
4,495

 
40

 
(1
)
 
4,534

Total securities available for sale
$
32,233

 
$
41

 
$
(1,043
)
 
$
31,231

Securities available for sale at December 31, 2017:
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,996

 
$

 
$
(25
)
 
$
2,971

Residential mortgage backed securities issued by U.S. Agencies
30,894

 
5

 
(777
)
 
30,122

Asset backed security
1,992

 

 
(251
)
 
1,741

Mutual funds
5,000

 
11

 
(107
)
 
4,904

Total securities available for sale
$
40,882

 
$
16

 
$
(1,160
)
 
$
39,738

Securities available for sale at December 31, 2016:
 
 
 
 
 
 
 
Residential mortgage backed securities issued by U.S. Agencies
$
37,813

 
$
6

 
$
(1,144
)
 
$
36,675

Residential collateralized mortgage obligations issued by non agencies
484

 

 
(16
)
 
468

Asset backed security
2,025

 

 
(592
)
 
1,433

Mutual funds
5,000

 
11

 
(107
)
 
4,904

Total securities available for sale
$
45,322

 
$
17

 
$
(1,859
)
 
$
43,480

At December 31, 2018 , 2017 and 2016 , U.S. agency mortgage backed securities and collateralized mortgage obligations with an aggregate fair market value of $18.2 million , $22.7 million and $21.1 million , respectively, were pledged to secure FHLB borrowings, repurchase agreements, local agency deposits and treasury, tax and loan accounts.
The amortized cost of securities available for sale at December 31, 2018 is shown in the table below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.

37


 
December 31, 2018
Maturing in
 
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years