KBRA Affirms Ratings for Old Second Bancorp, Inc.

KBRA affirms the senior unsecured debt rating of BBB, the subordinated debt rating of BBB-, and the short-term debt rating of K3 for Aurora, Illinois-based Old Second Bancorp, Inc. (NASDAQ: OSBC) ("Old Second" or "the company"). Additionally, KBRA affirms the deposit and senior unsecured debt ratings of BBB+, the subordinated debt rating of BBB, and the short-term deposit and debt ratings of K2 for its main subsidiary, Old Second National Bank. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

The ratings are supported by OSBC’s best-in-class funding profile, anchored by a coveted low-cost deposit franchise that is reinforced by the overall granularity and robust noninterest-bearing component at 38% of total deposits. Moreover, the company maintains a conservative liquidity position, including a below average loan-to-deposit ratio, that offers the flexibility to allow more price sensitive depositors to leave the bank, if necessary, and maintain its very low deposit costs (82 bps for 2Q24). As it currently stands, Old Second's deposit costs are the lowest in the KBRA rated universe, and, combined with a historically largely floating rate loan portfolio and shorter duration asset mix, support a very strong NIM, and, in turn, favorable bottom line returns despite rising credit costs. Additionally, NIM has been relatively stable over the last year given less pricing pressure on the funding side. Supplementing earnings are solid and relatively balanced noninterest verticals, including meaningful contributions from wealth management, service charges, and card fees. Moving forward, profitability is expected to remain healthy due to the expectation of improvement on the credit quality front (ROA of +1.50% during 1H24). With that said, if and when the Fed reduces short-term rates, the company is likely to experience headwinds due to its asset sensitivity, though management has been implementing more fixed rate assets to partially offset the impact. As such, we anticipate that Old Second's NIM and earnings should remain above peer in this scenario. A reduction in assets and strong earnings retention, which has been assisted by a pause in share buybacks and a below average dividend payout has lifted capital ratios significantly higher since YE22. Given this, OSBC’s core capital ratios currently track higher than the rated peer average (CET1 ratio of 12.4% as of 2Q24). Moreover, capital is likely to continue to build in coming quarters, though, over the longer-term, will likely be deployed on opportunistic M&A or a resumption in share buybacks. OSBC’s ratings also recognize the credit challenges, which have stemmed from acquired portfolios and headwinds in the investor CRE space, notably, the healthcare and office sectors following the pandemic (combined accounts for 13% of total loans). With that said, we acknowledge that the issues have been isolated, that the investor CRE portfolio is lower than average at ~225% of total risk-based capital, and that the remainder of the portfolio continues to perform well. However, the NPA, NCO, and classified loan ratios have all tracked well above peer, though appear to have reached an inflexion point during 4Q23 and trended positively since that time. Moreover, management is confident in continued improvement with more muted NCO activity compared to recent quarters prospectively. It is also worth noting that despite the credit problems that have required a higher level of provision for credit losses, the company's profitability has remained peer leading, which demonstrates its durable business model and appropriate risk-adjusted pricing.

Rating Sensitivities

A rating upgrade is unlikely at this time, though over the medium term, continued diversification and scaling of the franchise while maintaining peer-leading returns and strong capital could support positive rating momentum. Conversely, negative rating action is not expected, though continued credit issues or any degradation in the funding/liquidity profile, or a more aggressive capital stance could pressure the ratings.

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