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

Old Second’s ratings are underpinned by its strong funding profile, which ranks as best-in-class among KBRA-rated and other local peers. Driven by its conservative approach to liquidity management and the successful execution of strategic acquisitions, OSBC has maintained a granular and retail-focused deposit base. We also recognize that some of these transactions occurred during periods of industry-wide excess liquidity when deposit growth was less imperative, which reflect a disciplined and long-term approach to balance sheet management. The deposit franchise is further strengthened by a high proportion of core deposits (95% of total funding as of 1Q25) and a favorable mix, with 36% in noninterest-bearing accounts as of 2Q25. These factors have contributed to Old Second maintaining some of the lowest deposit costs among all banks, with a cost of deposits at just 84 basis points in 2Q25. This has positioned the company advantageously in a higher-rate environment and supported a favorable NIM (comfortably above 4.0% in recent years; 4.85% in 2Q25 on a tax-equivalent basis), and, in turn, healthy returns despite some credit challenges in recent years.

Looking ahead, profitability is projected to remain strong and become more durable following the acquisition of Bancorp Financial, Inc. (closed in 3Q25), which is expected to reduce asset sensitivity and better position OSBC in the event of a more pronounced rate-cutting cycle. Moreover, when combined with the expected cost-savings and the deployment of excess liquidity to replace the target bank’s higher-cost, wholesale-oriented funding base, this should help maintain the company’s ROA around the 1.5% level (1.5% in 2Q25). Old Second reflects healthy and relatively balanced noninterest revenue streams, which have helped generate fee income between 15%-20% of total revenues in recent periods, which is an impressive level, particularly in light of the company’s significantly above-peer net interest income generation.

The ratings also reflect recent credit challenges, primarily tied to acquired loan portfolios and broader headwinds in the investor CRE sector, particularly in the healthcare and office segments following the pandemic. With that said, we acknowledge that the issues have been isolated, that the investor CRE portfolio is lower than the rated peer average at 217% of total risk-based capital as of 1Q25, and that the remainder of the portfolio continues to perform well. However, these pressures have contributed to elevated NPA, NCO, and classified loan ratios relative to peers. The company's credit quality metrics have shown consistent improvement since late 2023, and management has largely addressed the issues within the office and healthcare portfolios, though the NPA and NCO ratios remain above similarly rated peer levels in recent quarters. Moreover, NCO activity is expected to rise post-acquisition given the target bank’s historical NCO ratio of near or above 1%. Although, in our view, the acquired loan portfolio offers attractive yields that support favorable risk-adjusted returns.

The capital and liquidity positions are viewed favorably, although both are expected to moderate slightly following the acquisition. That said, pro forma levels remain sound, including a CET1 ratio of 11.7% and a loan-to-deposit ratio of 86%. Looking ahead, we expect capital ratios to rebuild relatively quickly, as demonstrated following prior acquisitions, supported by Old Second’s strong internal capital generation, which reflects both its robust earnings power and disciplined capital allocation. While the liquidity position remains healthy, we anticipate that any modest pressure on the combined funding profile could be offset through strategic acquisitions of deposit-rich institutions - an approach that management has both pursued successfully in the past and expressed continued interest in going forward.

Rating Sensitivities

Given the Stable Outlook, a rating upgrade is not expected in the near-term, though positive momentum could occur over time if OSBC successfully integrates its recent acquisition all while maintaining its high-quality earnings, funding, liquidity, and capital positions. Conversely, a rating downgrade is not anticipated; however, negative rating action could occur if additional material credit issues emerge from the core bank or recent acquisition, or if there is any deterioration in other key financial metrics.

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