PROSPERITY BANCSHARES INC

Net Interest Income

The Company’s operating results depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, including securities and loans, and interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

2023 versus 2022. Net interest income before the provision for credit losses for 2023 was $956.4 million compared with $1.01 billion for 2022, a decrease of $48.8 million or 4.9%. The change was primarily due to an increase in the average balances and average rates on other borrowings and an increase in the average rates on interest-bearing deposits, partially offset by increases in the average balances and average rates on loans. Interest income was $1.44 billion in 2023, an increase of $349.7 million or 31.9% compared with 2022. Interest income on loans was $1.15 billion for 2023, an increase of $317.8 million or 38.2% compared with 2022, primarily due an increase in the average balances and average rates on loans. The Company had $27.9 million of total outstanding accretable discounts on Non-PCD loans and PCD loans at December 31, 2023. Interest income on securities was $283.3 million during 2023, an increase of $22.9 million or 8.8% compared with 2022 due primarily to an increase the average rates on investment securities, partially offset by a decrease in the average balances on investment securities. Average interest-bearing liabilities increased $1.50 billion or 7.5% during 2023 compared with 2022. The average rate on interest-bearing liabilities increased from 0.45% to 2.27% during the same time period, resulting in an increase in interest expense of $398.5 million. The total cost of funds increased to 1.54% during 2023 compared to 0.29% during 2022.

Net interest margin, defined as net interest income divided by average interest-earning assets, was 2.78% on a tax equivalent basis for 2023, a decrease of 22 basis points compared with 3.00% for 2022.

2022 versus 2021. Net interest income before the provision for credit losses for 2022 was $1.01 billion compared with $993.3 million for 2021, an increase of $11.9 million or 1.2%. The change was primarily due to an increase in average balances and average rates on investment securities, partially offset by a decrease in PPP fees and interest income of $44.6 million, a decrease in loan discount accretion of $31.9 million and an increase in the average rates on interest-bearing liabilities. Interest income was $1.09 billion in 2022, an increase of $47.9 million or 4.6% compared with 2021. Interest income on loans was $831.2 million for 2022, a decrease of $38.7 million or 4.5% compared with 2021, primarily due to a decrease in PPP fees and interest income of $44.6 million and a decrease in loan discount accretion of $31.9 million, partially offset by an increase in loan interest income for loans held for investment. The Company had $5.6 million of total outstanding accretable discounts on Non-PCD loans and PCD loans at December 31, 2022. Interest income on securities was $260.4 million during 2022, an increase of $85.0 million or 48.4% compared with 2021 due primarily to an increase in average balances and average rates on investment securities. Average interest-bearing liabilities increased $625.4 million or 3.2% during 2022 compared with 2021. The average rate on interest-bearing liabilities increased from 0.28% to 0.45% during the same time period, resulting in an increase in interest expense of $36.0 million. The total cost of funds increased to 0.29% during 2022 compared to 0.18% during 2021.

Net interest margin was 3.00% on a tax equivalent basis for 2022, a decrease of 14 basis points compared with 3.14% for 2021.

The following table presents, for the periods indicated, the total dollar amount of average balances, interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.

(1)

The net interest margin is equal to net interest income divided by average interest-earning assets.

(2)

In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax equivalent adjustment has been computed using a federal income tax rate of 21% and other applicable effective tax rates for the years ended December 31, 2023, 2022 and 2021.

The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes in interest rates. For purposes of this table, changes in interest income and interest expense related to purchase accounting adjustments and changes attributable to both rate and volume which cannot be segregated have been allocated to rate.

Provision for Credit Losses

The Company’s provision for credit losses is established through charges to income to bring the Company’s allowance for credit losses on loans and off-balance sheets credit exposures to a level deemed appropriate by management based on the factors discussed under “Financial Condition—Allowance for Credit Losses” and “Financial Condition—Allowance for Credit Losses on Off-Balance Sheet Credit Exposures” The allowance for credit losses on loans at December 31, 2023 was $332.4 million, or 1.57% of total loans and 1.63% of total loans excluding Warehouse Purchase Program loans. The allowance for credit losses on loans at December 31, 2022 was $281.6 million, or 1.49% of total loans and 1.56% of total loans excluding Warehouse Purchase Program loans. Acquired loans were recorded at fair value based on a discounted cash flow valuation methodology that considers, among other things, interest rates, projected default rates, loss given defaults and recovery rates, with no carryover of any existing allowance for credit losses. The allowance for credit losses on off-balance sheet credit exposures was $36.5 million at December 31, 2023, compared to $29.9 million at December 31, 2022. The provision for credit losses was $18.5 million for the year ended December 31, 2023, compared to no provision for credit losses for the years ended December 31, 2022 and 2021. The $18.5 million provision was due to loans acquired in the Merger and included a $12.0 million provision for credit losses on loans and a $6.5 million provision for credit losses on off-balance sheet credit exposures.

Net charge-offs for the years ended December 31, 2023, 2022 and 2021 were $38.0 million, $4.8 million and $29.7 million, respectively. Net charge-offs for the year ended December 31, 2023 included $16.6 million related to resolved PCD loans and $15.0 million related to one commercial real estate loan acquired in a previous merger. The PCD loans had reserves of $16.3 million assigned as of the acquisition date. Additionally, reserves on PCD loans increased by $76.8 million due to the Merger and $23.5 million of reserves on resolved PCD loans was released to the general reserve.

Noninterest Income

The Company’s primary sources of recurring noninterest income are credit, debit and ATM card income, nonsufficient funds (“NSF”) fees, and service charges on deposit accounts. Additionally, the Company generates recurring noninterest income from its various additional products and services, including trust services, mortgage lending, brokerage and independent sales organization sponsorship operations. Noninterest income does not include loan origination fees, which are recognized over the life of the related loan as an adjustment to yield using the interest method. For the year ended December 31, 2023, noninterest income totaled $153.3 million, an increase of $8.1 million or 5.6% compared with 2022. This increase was primarily due to the Merger, partially offset by lower net gain on the sale or write-down of assets.

For the year ended December 31, 2022, noninterest income totaled $145.1 million, an increase of $5.2 million or 3.7% compared with 2021. This increase was primarily due to an increase in NSF income, a net gain on the sale or write-down of assets, an increase in trust income and an increase in other noninterest income, partially offset by a decrease in mortgage income.

The following table presents, for the periods indicated, the major categories of noninterest income:

Noninterest Expense

For the year ended December 31, 2023, noninterest expense totaled $556.7 million, an increase of $72.5 million or 15.0% compared with 2022. The change was primarily due to the FDIC special assessment of $19.9 million, merger related expenses of $15.1 million and additional expenses related to the Merger.

For the year ended December 31, 2022, noninterest expense totaled $484.2 million, an increase of $10.6 million or 2.2% compared with 2021. The change was primarily due to an increase in salaries and benefits, an increase in credit and debit card and data processing expense and lower net gains on sale of other real estate.

The following table presents, for the periods indicated, the major categories of noninterest expense:

(1)

Total salaries and employee benefits include $12.2 million, $11.8 million and $12.6 million in 2023, 2022 and 2021, respectively, in stock-based compensation expense.

(2)

Communications expense includes telephone, data circuits, postage, and courier expenses.

(3)

Other real estate expense is net of rental income and gains and losses on sales of real estate.

Salaries and Employee Benefits. Salaries and employee benefits were $328.4 million for the year ended December 31, 2023, an increase of $13.7 million or 4.4% compared with 2022, as a result of the Merger. Salaries and employee benefits were $314.7 million for the year ended December 31, 2022, an increase of $4.2 million or 1.3% compared with 2021. The number of full-time equivalent associates employed by the Company was 3,850, 3,633 and 3,704 at December 31, 2023, 2022 and 2021, respectively. Total salaries and benefits for the year ended December 31, 2023 included $12.2 million in stock‑based compensation expense compared with $11.8 million and $12.6 million recorded for each of the years ended December 31, 2022 and 2021, respectively.

Net Occupancy and Equipment: Net occupancy and equipment expense was $35.5 million for the year ended December 31, 2023, an increase of $3.1 million or 9.5% compared with 2022, primarily due to the Merger. Net occupancy and equipment expense was $32.4 million for the year ended December 31, 2022, an increase of $262 thousand compared with 2021.

Credit and Debit Card, Data Processing and Software Amortization. Credit and debit card, data processing and software amortization expenses were $41.6 million for the year ended December 31, 2023, an increase of $4.2 million or 11.4% compared with 2022, primarily due to an increase in data processing costs and the Merger. Credit and debit card, data processing and software amortization expenses were $37.3 million for the year ended December 31, 2022, an increase of $2.2 million or 6.3% compared with 2021, as a result of increase in debit card interchange fees and software maintenance expense.

Regulatory Assessments and FDIC Insurance. Regulatory assessments and FDIC insurance assessments were $40.2 million for the year ended December 31, 2023, an increase of $28.8 million, compared with $11.4 million for the year ended December 31, 2022, as a result of the FDIC special assessment of $19.9 million and the Merger. During the fourth quarter of 2023, Prosperity accrued for the FDIC special assessment of $19.9 million, which was imposed by the FDIC to recover the cost associated with protecting uninsured depositors following the closures of Silicon Valley Bank and Signature Bank in early 2023. Regulatory assessments and FDIC insurance assessments were $11.4 million for the year ended December 31, 2022, an increase of $743 thousand or 7.0%, compared with $10.6 million for the year ended December 31, 2021.

Core Deposit Intangibles Amortization. Core deposit intangibles (“CDI”) amortization was $12.7 million for the year ended December 31, 2023, an increase of $2.3 million or 22.6% compared with $10.3 million for the year ended December 31, 2022. CDI amortization was $10.3 million for the year ended December 31, 2022, a decrease of $1.2 million or 10.5% compared with $11.6 million for the year ended December 31, 2021.

Other Real Estate. Other real estate (income) expense was $(834) thousand for the year ended December 31, 2023, a change of $712 thousand compared with $(122) thousand for the year ended December 31, 2022. Other real estate (income) expense was $(122) thousand for the year ended December 31, 2022, a change of $2.1 million compared with $(2.2) million for the year ended December 31, 2021, primarily due to a decrease in sales of other real estate in 2022.

Merger Related Expenses. Merger related expenses were $15.1 million for the year ended December 31, 2023, due to the Merger and the pending merger of Lone Star. Merger related expenses were $272 thousand for the year ended December 31, 2022, due to the pending acquisitions of First Bancshares and Lone Star announced in October 2022.

Efficiency Ratio

The Company’s efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of the Company and is not calculated based on GAAP. A GAAP-based efficiency ratio is calculated by dividing total noninterest expense, excluding credit loss provisions, by net interest income plus total noninterest income, as shown in the Consolidated Statements of Income. The Company’s efficiency ratio, as calculated and used by the Company, excludes from noninterest income the net gains and losses on the sale of securities and assets, which can vary widely from period to period. Taxes are not included in either calculation. The Company believes this non-GAAP financial measure provides information useful to investors by excluding certain items that may not be indicative of its core net operating earnings and business outlook. This non-GAAP financial measure should not be considered a substitute for, nor of greater importance than, the GAAP basis financial measure. Because a non-GAAP financial measure is not standardized, it may not be possible to compare this financial measure with other companies’ non-GAAP financial measures having the same or a similar name. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources. The Company’s efficiency ratio calculated pursuant to GAAP was 50.17% for the year ended December 31, 2023 compared with 42.09% for the year ended December 31, 2022 and 41.79% for the year ended December 31, 2021. The efficiency ratio, excluding net gains and losses on the sale or write down of assets and taxes, was 50.26% for the year ended December 31, 2023, compared with 42.23% for the year ended December 31, 2022 and 41.83% for the year ended December 31, 2021.

Income Taxes

The amount of federal and state income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income and the amount of nondeductible expenses. Income tax expense was $115.1 million for the year ended December 31, 2023, a decrease of $26.5 million or 18.7% compared with $141.7 million for the year ended December 31, 2022. Income tax expense was $141.7 million for the year ended December 31, 2022, an increase of $1.3 million or 0.9% compared with $140.4 million for the year ended December 31, 2021. The effective tax rate for the years ended December 31, 2023, 2022 and 2021 was 21.5%, 21.3% and 18.0%, respectively. The effective income tax rates differed from the U.S. statutory rate of 21% during 2023, 2022 and 2021 primarily due to the effect of tax-exempt income from loans and securities.

Impact of Inflation

The Company’s consolidated financial statements and related notes included in this Annual Report on Form 10-K have been prepared in accordance with GAAP. These require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.

Unlike many industrial companies, substantially all of the Company’s assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Company’s performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, noninterest expenses do reflect general levels of inflation.