KBRA Affirms Ratings for Financial Institutions, 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 Financial Institutions, Inc. (NASDAQ: FISI) (“the company”). In addition, 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 bank subsidiary, Five Star Bank. The Outlook for all long-term ratings is Negative.

Key Credit Considerations

The ratings are supported by a seasoned management team with extensive market knowledge and a continued focus on strategic initiatives to enhance its earnings and capital profiles. However, the Negative Outlook reflects the continued challenges FISI faces to sustain peer like earnings and rebuild the capital position consistent with the company's risk profile following a $23.0 million auto loan litigation settlement ($17.1 million after-tax) charge disclosed on March 10, 2025 (estimated ~35 bps of risk-based capital or ~30% of 2024 core earnings). In 2024, the company had proactively raised approximately $120 million collectively in an common equity issuance ($108.5 million) and from the sale of its insurance agency (~$10 million) in 2Q24. However, the benefit of the additional capital has been partially offset by the $650 million restructuring of the investment portfolio which included reinvestment into higher yielding assets (portfolio yield jumps from 1.74% to 4.25% post-sale), but generated an after-tax loss of ~$75 million and the aforementioned $17.1 million after-tax settlement charge. KBRA expects FISI to build its capital ratios to be more in line with peer averages considering the higher risk density of its balance sheet of 85% relative to 79% for peers. Despite 100 bps of improvement in the CET1 ratio to 10.5% as of 4Q24 versus 4Q23, FISI's capital ratios continue to remain weaker relative to peers with CET1 and total risk-based capital ratios at 110 bps and 130 bps, respectively, below peer averages. In addition, total risk-based capital could be impacted as management evaluates call options of its $40 million of subordinated debt which becomes callable on April 15, 2025. The company expects to rebuild the CET1 ratio to ~11.0% in FY25 primarily from its enhanced earnings profile post-balance sheet restructuring driven by an improved NIM, which also has benefited from stabilization in the company's funding costs. With that said, the company's high concentration in public funds has limited FISI's ability to fully realize the benefit of the 100 bps of interest rate cuts. Historically, FISI has reflected strong asset quality with average NCOs of 20-25 bps. However, negative credit migration seen in the recent quarter with NPAs at ~1.0% and NCOs at ~0.20% is largely due to the headwinds in the commercial portfolio with certain isolated credits and seasonality in the indirect auto portfolio. That said, strong sponsors in the loan relationships, low LTVs, and proactive risk management have supported minimal loss content underscoring a disciplined and strong credit culture.

Rating Sensitivities

A return to Stable Outlook would require core capital metrics to be consistent with peer levels and manageable credit costs that support core profitability which facilitates the rebuilding of capital. The inability to rebuild capital closer to peer averages over the intermediate term and any material shift in risk profile, marked by credit deterioration beyond expectations resulting in elevated credit costs, which adversely impact core profitability and regulatory capital levels, could lead to a downgrade.

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Methodologies