News Column

CHEMICAL FINANCIAL CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

February 26, 2014

BUSINESS OF THE CORPORATION Chemical Financial Corporation (Corporation) is a financial holding company headquartered in Midland, Michigan with its business concentrated in a single industry segment - commercial banking. The Corporation, through its wholly-owned subsidiary bank, Chemical Bank, offers a full range of traditional banking and fiduciary products and services. These products and services include business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance and investment products, corporate and personal wealth management services and other banking services. The principal markets for the Corporation's products and services are communities in Michigan where the branches of Chemical Bank are located and the areas immediately surrounding those communities. As of December 31, 2013, Chemical Bank served these markets through 156 banking offices located in 38 counties across Michigan's lower peninsula. In addition to its banking offices, Chemical Bank operated two loan production offices and 173 automated teller machines, both on- and off-bank premises. Chemical Bank operates through an internal organizational structure of four regional banking units. Chemical Bank's regional banking units are collections of branch banking offices organized by geographical regions within the State of Michigan. The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 71% of total revenue in 2013, 73% of total revenue in 2012 and 75% of total revenue in 2011. Interest on investment securities, service charges and fees on deposit accounts and wealth management revenue are also significant sources of revenue, which combined, accounted for 19% of total revenue in 2013, 18% of total revenue in 2012 and 17% of total revenue in 2011. Revenue is influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace. ACQUISITIONS Acquisition of 21 Branches On December 7, 2012, Chemical Bank acquired 21 branches from Independent Bank, a subsidiary of Independent Bank Corporation (branch acquisition transaction). In addition to the branch offices, which are located in the Northeast and Battle Creek regions of Michigan, the acquisition included $404 million in deposits and $44 million in loans. The purchase price of the branch offices, including equipment, was $8.1 million and the Corporation paid a premium on deposits of $11.5 million, or approximately 2.85% of total deposits acquired. The loans were purchased at a discount of 1.75%. In connection with the acquisition of the branches, the Corporation recorded goodwill of $6.8 million, which represented the excess of the purchase price over the fair value of identifiable net assets acquired, and other intangible assets attributable to customer core deposits of $5.6 million. Acquisition-related expenses associated with the acquisition of the branches totaled $2.9 million during 2012, which reduced net income per common share by $0.07 in 2012. Acquisition of O.A.K. Financial Corporation On April 30, 2010, the Corporation acquired O.A.K. Financial Corporation (OAK) for total consideration of $83.7 million. OAK, a bank holding company, owned Byron Bank, which provided traditional banking services and products through 14 banking offices serving communities in Ottawa, Allegan and Kent counties in west Michigan. At April 30, 2010, OAK had total assets of $820 million, including total loans of $627 million, and total deposits of $693 million, including brokered deposits of $193 million. The Corporation operated Byron Bank as a separate subsidiary from the acquisition date until July 23, 2010, the date Byron Bank was consolidated with and into Chemical Bank. In connection with the acquisition of OAK, the Corporation recorded goodwill of $43.5 million. Goodwill recorded was primarily attributable to the synergies and economies of scale expected from combining the operations of the Corporation and OAK. In addition, the Corporation recorded other intangible assets in conjunction with the acquisition of $9.8 million. Acquisition-related expenses associated with the OAK acquisition totaled $4.3 million during 2010, which reduced net income per common share by $0.12 in 2010. Branch Closings During the first quarter of 2013, Chemical Bank closed six branch office locations. These six branch office locations had a combined net book value of $0.4 million. The Corporation recognized less than $0.1 million of expense as a result of closing these branch office locations. The majority of the employees of these six closed branch offices were transferred to other nearby Chemical Bank branch locations or other open positions within Chemical Bank. 23 -------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES The Corporation's consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (GAAP), Securities and Exchange Commission (SEC) rules and interpretive releases and general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions and complex judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the consolidated financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. The Corporation utilizes third-party sources to assist with developing estimates, assumptions and judgments regarding certain amounts reported in the consolidated financial statements and accompanying notes. When third-party sources are utilized, the Corporation's management remains responsible for complying with GAAP. To execute management's responsibilities, the Corporation has processes in place to develop an understanding of the third-party methodologies and to design and implement specific internal controls over valuation. The most significant accounting policies followed by the Corporation are presented in Note 1 to the consolidated financial statements included in Item 8 of this report. These policies, along with the disclosures presented in the other notes to the consolidated financial statements and in "Management's Discussion and Analysis of Financial Condition and Results of Operations," provide information on how significant assets and liabilities are measured in the consolidated financial statements and how those measurements are determined. Based on the techniques used and the sensitivity of financial statement amounts to the methods, estimates and assumptions underlying those amounts, management has identified the determination of the allowance for loan losses, accounting for loans acquired in business combinations, pension plan accounting, income and other taxes, the evaluation of goodwill impairment and fair value measurements to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Management reviews the following critical accounting policies with the Audit Committee of the board of directors at least annually. Allowance for Loan Losses The allowance for loan losses (allowance) is calculated with the objective of maintaining a reserve sufficient to absorb losses inherent in the loan portfolio. Loans represent the Corporation's largest asset type on the consolidated statements of financial position. The determination of the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected cash flows and collateral values on impaired loans, estimated losses on non-impaired loans in the commercial loan portfolio (comprised of commercial, commercial real estate, real estate construction and land development loans) and on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) valuation allowances based upon probable losses identified during the review of impaired loans in the commercial loan portfolio, (ii) reserves established for adversely-rated loans in the commercial loan portfolio and nonaccrual residential mortgage, consumer installment and home equity loans, (iii) reserves, by loan classes, on all other loans based principally on a five-year historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the allowance methodology for loans collectively evaluated for impairment. It is extremely difficult to accurately measure the amount of losses that are inherent in the Corporation's loan portfolio. The Corporation uses a defined methodology to quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the methodology will successfully identify and estimate all of the losses that are inherent in the loan portfolio. As a result, the Corporation could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period ended December 31, 2013. Notes 1 and 4 to the consolidated financial statements further describe the methodology used to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading "Allowance for Loan Losses" in "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Corporation has a loan review function that is independent of the loan origination function. At least annually, the loan review function reviews management's evaluation of the allowance and performs a detailed credit quality review, including analysis of collateral values, of loans in the commercial loan portfolio, particularly focusing on larger balance loans and loans that have deteriorated below certain levels of credit risk. 24 -------------------------------------------------------------------------------- Accounting for Loans Acquired in Business Combinations Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (ASC 310-30), provides the GAAP guidance for accounting for loans acquired in a business combination that have experienced a deterioration in credit quality from origination to acquisition for which it is probable that the investor will be unable to collect all contractually required payments receivable, including both principal and interest. Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be impaired. In the assessment of credit quality deterioration, the Corporation must make numerous assumptions, interpretations and judgments using internal and third-party credit quality information to determine whether or not it is probable that the Corporation will be able to collect all contractually required payments. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved. Evidence of credit quality deterioration as of the acquisition date may include statistics such as past due and nonaccrual status, recent borrower credit scores and loan-to-value percentages. Those loans that qualify under ASC 310-30 are recorded at fair value at acquisition, which involves estimating the expected cash flows to be received. Accordingly, the associated allowance for loan losses related to these loans is not carried over at the acquisition date. ASC 310-30 also allows investors to aggregate acquired loans into loan pools that have common risk characteristics and use a composite interest rate and expectation of cash flows to be collected for the loan pools. The Corporation understands, as outlined in the American Institute of Certified Public Accountants' open letter to the Office of the Chief Accountant of the SEC dated December 18, 2009, and pending further standard setting, that for acquired loans that do not meet the scope criteria of ASC 310-30, a company may elect to account for such acquired loans pursuant to the provisions of either ASC Topic 310-20, Nonrefundable Fees and Other Costs, or ASC 310-30. The Corporation elected to apply ASC 310-30, by analogy, to loans acquired in the OAK acquisition that were determined not to have deteriorated credit quality, and therefore, did not meet the scope criteria of ASC 310-30. Accordingly, the Corporation follows the accounting and disclosure guidance of ASC 310-30 for these loans. Notes 1, 2 and 4 to the consolidated financial statements contain additional information related to loans acquired in the OAK acquisition. The excess of cash flows of a loan, or pool of loans, expected to be collected over the estimated fair value is referred to as the "accretable yield" and is recognized into interest income over the estimated remaining life of the loan, or pool of loans, on a level-yield basis. The difference between the contractually required payments of a loan, or pool of loans, and the cash flows expected to be collected at acquisition, considering the impact of prepayments and estimates of future credit losses expected to be incurred over the life of the loan, or pool of loans, is referred to as the "nonaccretable difference." The Corporation is required to quarterly evaluate its estimates of cash flows expected to be collected from acquired loans. These evaluations require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. Given the current economic environment, the Corporation must apply judgment to develop its estimates of cash flows for acquired loans given the impact of changes in property values, default rates, loss severities and prepayment speeds. Decreases in the estimates of expected cash flows will generally result in a charge to the provision for loan losses and a resulting increase to the allowance for loan losses. Increases in the estimates of expected cash flows will generally result in adjustments to the accretable yield, which will increase amounts recognized in interest income in subsequent periods. Dispositions of acquired loans, which may include sales of loans to third parties, receipt of payments in full or in part by the borrower and foreclosure of the collateral, result in removal of the loan from the acquired loan portfolio at its carrying amount. As a result of the significant amount of judgment involved in estimating future cash flows expected to be collected for acquired loans, the adequacy of the allowance for loan losses could be significantly impacted by changes in expected cash flows resulting from changes in credit quality of acquired loans. Acquired loans that were classified as nonperforming loans prior to being acquired and acquired loans that are not performing in accordance with contractual terms subsequent to acquisition are not classified as nonperforming loans subsequent to acquisition because the loans are recorded in pools at net realizable value based on the principal and interest the Corporation expects to collect on such loans. Judgment is required to estimate the timing and amount of cash flows expected to be collected when the loans are not performing in accordance with the original contractual terms. Pension Plan Accounting The Corporation has a defined benefit pension plan for certain salaried employees. Effective June 30, 2006, benefits under the defined benefit pension plan were frozen for approximately two-thirds of the Corporation's salaried employees as of that date. Pension benefits continued unchanged for the remaining salaried employees. At December 31, 2013, 200 employees, or 12% of total employees on a full-time equivalent basis, were earning pension benefits under the defined benefit pension plan. The Corporation's pension benefit obligations and related costs are calculated using actuarial concepts and measurements. Benefits under the plan are based on years of vested service, age and amount of compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense. 25 -------------------------------------------------------------------------------- The key actuarial assumptions used in the pension plan are the discount rate and long-term rate of return on plan assets. These assumptions have a significant effect on the amounts reported for net periodic pension expense, as well as the respective benefit obligation amounts. The Corporation evaluates these critical assumptions annually. At December 31, 2013, 2012 and 2011, the Corporation calculated a discount rate of 5.00%, 4.08% and 4.90%, respectively, for the pension plan using the results from a bond matching technique, which matched the future estimated annual benefit payments of the pension plan against a portfolio of bonds of Aa quality to determine the discount rate. The assumed long-term rate of return on pension plan assets represents an estimate of long-term returns on an investment portfolio consisting primarily of equity and fixed income investments. When determining the expected long-term return on pension plan assets, the Corporation considers long-term rates of return on the asset classes in which the Corporation expects the pension funds to be invested. The expected long-term rate of return is based on both historical and forecasted returns of the overall stock and bond markets and the actual portfolio. The following rates of return by asset class were considered in setting the assumptions for long-term return on pension plan assets: December 31, 2013 2012 2011 Equity securities 6% - 14% 6% - 10% 6% - 10% Debt securities 3% - 7% 2% - 5% 3% - 6% Other 2% - 4% 2% - 3% 2% - 3% The assumed long-term return on pension plan assets is developed through an analysis of forecasted rates of return on the pension plan's asset allocation as of December 31. It is used to compute the subsequent year's expected return on assets, using the "market-related value" of pension plan assets. The difference between the expected return and the actual return on pension plan assets during the year is either an asset gain or loss, which is deferred and amortized over future periods when determining net periodic pension expense. The Corporation's projection of the long-term return on pension plan assets was 7.0% in 2013, 2012 and 2011, while the actual return on pension plan assets was 18.2%, 8.6% and (0.9)% in 2013, 2012 and 2011, respectively. Other assumptions made in the pension plan calculations involve employee demographic factors, such as retirement patterns, mortality, turnover and the rate of compensation increase. The key actuarial assumptions that will be used to calculate pension expense in 2014 for the defined benefit pension plan are a discount rate of 5.0%, a long-term rate of return on pension plan assets of 7.0% and a rate of compensation increase of 3.5%. The Corporation is not expected to have pension expense in 2014, compared to pension expense of $1.7 million in 2013. The expected decrease in pension expense in 2014, as compared to 2013, is attributable to a combination of an increase in the discount rate and an increase in the actual return on pension plan assets. In 2014, a decrease in the discount rate of 50 basis points and 100 basis points is estimated to increase pension expense by $0.5 million and $1.0 million, respectively, while an increase of 50 basis points and 100 basis points is estimated to decrease pension expense by approximately the same amounts. Although it was not required to do so, in order to mitigate increases in pension expense experienced by the Corporation during the last three years resulting from the lower discount rates, the Corporation made contributions to the pension plan of $15 million in 2013, $12 million in 2012 and $10 million in 2010. There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either or both the results of operations and cash flows (e.g., additional pension expense and/or additional pension plan funding, whether expected or required) from changes in the key actuarial assumptions. If the Corporation were to determine that more conservative assumptions are necessary, pension expense would increase and have a negative impact on results of operations in the period in which the increase occurs. The Corporation accounts for its defined benefit pension and other postretirement plans in accordance with ASC Topic 715, Compensation-Retirement Benefits, which requires companies to recognize the over- or under-funded status of a plan as an asset or liability as measured by the difference between the fair value of the plan assets and the projected benefit obligation and requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income (loss). The impact of pension plan accounting on the statements of financial position at December 31, 2013 and 2012 is further discussed in Note 16 to the consolidated financial statements. 26 -------------------------------------------------------------------------------- Income and Other Taxes The Corporation is subject to the income and other tax laws of the United States, the State of Michigan and other states where nexus has been created. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Corporation's tax returns, management attempts to make reasonable interpretations of applicable tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving regulations and case law. The Corporation and its subsidiaries file a consolidated federal income tax return. The provision for federal income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Corporation's federal income tax return. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. On a quarterly basis, management assesses the reasonableness of its effective federal income tax rate based upon its current best estimate of net income and the applicable taxes expected for the full year, including the impact of any discrete items that have occurred. Deferred tax assets and liabilities are reassessed on a quarterly basis, including the need for a valuation allowance for deferred tax assets. The need for reserves for uncertain tax positions is reviewed quarterly based upon developments in tax law and the status of examinations or audits. As of December 31, 2013 and 2012, there were no federal income tax reserves recorded for uncertain tax positions. Goodwill At December 31, 2013, the Corporation had $120.2 million of goodwill, which was originated through the acquisition of various banks and bank branches, recorded on the consolidated statement of financial position. Goodwill is not amortized, but rather is tested by management annually for impairment, or more frequently if triggering events occur and indicate potential impairment, in accordance with ASC Topic 350-20, Goodwill (ASC 350-20). The Corporation's goodwill impairment assessment utilizes the methodology and guidelines established in GAAP, including assumptions regarding the valuation of Chemical Bank. The Corporation performed its 2013 annual goodwill impairment assessment at October 31, 2013 utilizing the quantitative assessment approach to perform a Step 1 valuation of its goodwill as of that date. The fair value of Chemical Bank as of October 31, 2013 was measured utilizing the income and market approaches as prescribed in ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820). GAAP identifies the cost approach as another acceptable method; however, the cost approach was not deemed an effective method to value a financial institution. The cost approach estimates a company's value by adjusting the reported values of assets and liabilities to their fair values. It is the Corporation's opinion that financial institutions cannot be liquidated in an efficient manner. Estimating the fair value of loans is a very difficult process and subject to a wide margin of error unless done on a loan by loan basis. Voluntary liquidations of financial institutions are not typical. More commonly, if a financial institution is liquidated, it is due to being taken over by the Federal Deposit Insurance Corporation (FDIC). The value of Chemical Bank was based as a going concern and not as a liquidation. The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The income approach includes present value techniques, option-pricing models, such as the Black-Scholes formula and lattice models, and the multi-period excess-earnings method. In the valuation of Chemical Bank, the income approach utilized the discounted cash flow method based upon a forecast of growth and earnings. Cash flows are measured by using projected earnings, projected dividends and dividend paying capacity over a five-year period. In addition to estimating periodic cash flows, an estimate of residual value is determined through the capitalization of earnings. The income approach assumed cost savings and earnings enhancements that a strategic acquiror would likely implement based upon typical participant assumptions of market transactions. The discount rate is critical to the discounted cash flow analysis. The discount rate reflects the risk of uncertainty associated with the cash flows and a rate of return that investors would require from similar investments with similar risks. At the valuation date of October 31, 2013, a discount rate of 14.50% was utilized in the income approach. The market approach uses observable prices and other relevant information that are generated by market transactions involving identical or comparable assets or liabilities. The fair value measure is based on the value that those transactions indicate utilizing both financial and operating characteristics of the acquired companies. The most significant financial ratio analyzed in completed transactions involved the price to tangible book value. The market approach utilized a price to tangible book value of 160% at the valuation date of October 31, 2013. 27 -------------------------------------------------------------------------------- The fair value of Chemical Bank was determined to be slightly above the income approach and within the range of values in the market approach value range. The results of the valuation analysis concluded that the fair value of Chemical Bank was greater than its book value, including goodwill, and thus no goodwill impairment was evident at the valuation date of October 31, 2013. The weighted average of the fair values determined under the income and market approaches resulted in a slight discount from the market capitalization of the Corporation at the valuation date. The Corporation is publicly traded and, therefore, the price per share of its common stock as reported on The NASDAQ Stock MarketŪ establishes the marketable minority value. It is management's opinion that the marketable minority value does not always represent the fair value of the reporting unit as a whole and that an adjustment to the marketable minority value for the acquiror's control is generally considered in the assessment of fair value. The market capitalization of the Corporation was $943 million on December 31, 2013, compared to $872 million on October 31, 2013. The Corporation determined that no triggering events occurred that indicated potential impairment of goodwill from the most recent valuation date through December 31, 2013 and that the Corporation's goodwill was not impaired at December 31, 2013. However, the Corporation could incur impairment charges related to goodwill in the future due to changes in financial results or other matters that could affect the valuation assumptions. Fair Value Measurements The Corporation determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. Estimates, assumptions and judgments may be necessary when assets and liabilities are required to be recorded at fair value or when a decline in the value of an asset not carried at fair value on the financial statements warrants an impairment write-down or a valuation reserve to be established. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when available. When third-party information is not available, valuation adjustments are estimated by management primarily through the use of internal discounted cash flow analyses, and to the extent available, observable market-based inputs. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Corporation's financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP. See Note 13 to the Corporation's consolidated financial statements for more information on fair value measurements. Accounting Standards Updates See Note 1 to the consolidated financial statements included in this report for details of accounting pronouncements adopted by the Corporation during 2013 and recently issued and pending accounting pronouncements and their impact on the Corporation's financial statements. FINANCIAL HIGHLIGHTS The following discussion and analysis is intended to cover significant factors affecting the Corporation's consolidated statements of financial position and income included in this report. It is designed to provide a more comprehensive review of the consolidated operating results and financial position of the Corporation than could be obtained from an examination of the financial statements alone. NET INCOME Net income was $56.8 million, or $2.00 per diluted share, in 2013, compared to net income of $51.0 million, or $1.85 per diluted share, in 2012 and net income of $43.1 million, or $1.57 per diluted share, in 2011. Net income in 2013 represented an 11.4% increase from 2012 net income, with the increase primarily attributable to an increase in net interest income and noninterest income and a decrease in the provision for loan losses, which were partially offset by an increase in operating expenses. Net income in 2012 represented an 18% increase from 2011 net income, with the increase primarily attributable to an increase in net interest income and noninterest income and a decrease in the provision for loan losses. The Corporation's return on average assets was 0.95% in 2013, 0.94% in 2012 and 0.81% in 2011. The Corporation's return on average shareholders' equity was 9.1% in 2013, 8.7% in 2012 and 7.6% in 2011. 28 -------------------------------------------------------------------------------- ASSETS Total assets were $6.18 billion at December 31, 2013, an increase of $267 million, or 4.5%, from total assets at December 31, 2012 of $5.92 billion. The increase in total assets during 2013 was primarily attributable to an increase in customer deposits that were utilized to partially fund loan growth. Average assets were $5.96 billion during 2013, an increase of $523 million, or 9.6%, from average assets during 2012 of $5.44 billion, while average assets during 2012 increased $138 million, or 2.6%, from average assets during 2011 of $5.30 billion. The increase in average assets during 2013, as compared to 2012, was primarily attributable to the branch acquisition transaction on December 7, 2012, which increased assets by approximately $400 million at the acquisition date. The increase in average assets during 2012, as compared to 2011, was attributable to an increase in customer deposits that were utilized to fund loan growth. INVESTMENT SECURITIES Information about the Corporation's investment securities portfolio is summarized in Tables 1 and 2. The following table summarizes the maturities and yields of the carrying value of investment securities by investment category, and fair value by investment category, at December 31, 2013: TABLE 1. MATURITIES AND YIELDS(1) OF INVESTMENT SECURITIES AT DECEMBER 31, 2013 Maturity(2) After One After Five Total Within but Within but Within After Carrying Total One Year Five Years Ten Years Ten Years Value(3) Fair Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Value (Dollars in thousands) Available-for-Sale: Government sponsored agencies $ 12,156 0.86 % $ 75,027 1.05 % $ 6,295 0.75 % $ 285 0.88 % $ 93,763 1.00 % $ 93,763 State and political subdivisions 1,354 4.06 27,827 3.50 14,617 5.65 - - 43,798 4.24 43,798 Residential mortgage-backed securities 49,269 1.49 176,681 1.37 70,785 1.39 2,631 2.84 299,366 1.41 299,366 Collateralized mortgage obligations 60,991 0.85 109,209 0.93 8,945 1.29 1,796 1.66 180,941 0.93 180,941 Corporate bonds 19,992 2.46 45,283 1.66 - - - - 65,275 1.90 65,275 Preferred stock - - - - - - 1,427 6.14 1,427 6.14 1,427 Total investment securities available-for-sale 143,762 1.33 434,027 1.37 100,642 1.96 6,139 3.17 684,570 1.46 684,570 Held-to-Maturity: State and political subdivisions 39,966 2.41 106,380 3.32 74,759 4.35 42,300 4.89 263,405 3.72 262,021 Trust preferred securities - - - - - - 10,500 3.95 10,500 3.95 6,250 Total investment securities held-to-maturity 39,966 2.41 106,380 3.32 74,759 4.35 52,800 4.70 273,905 3.73 268,271 Total investment securities $ 183,728 1.56 % $ 540,407 1.75 % $ 175,401 2.98 % $ 58,939 4.54 % $ 958,475 2.11 % $ 952,841



(1) Yields are weighted by amount and time to contractual maturity, are on a

taxable equivalent basis using a 35% federal income tax rate and are based

on carrying value. Yields disclosed are actual yields based on carrying

value at December 31, 2013. Approximately 25% of the Corporation's

investment securities at December 31, 2013 were variable-rate financial

instruments.

(2) Residential mortgage-backed securities, collateralized mortgage obligations

and certain government sponsored agencies are based on scheduled principal

maturity. All other investment securities are based on final contractual

maturity.

(3) The aggregate book value of securities issued by any single issuer, other

than the U.S. government and government sponsored agencies, did not exceed

10% of the Corporation's shareholders' equity.

The Corporation utilizes third-party pricing services to obtain market value prices for its investment securities portfolio. On a quarterly basis, the Corporation validates the reasonableness of prices received from the third-party pricing services through independent price verification on a sample of investment securities in the portfolio, data integrity validation based upon comparison of current market prices to prior period market prices and analysis of overall expectations of movement in market prices based upon the changes in the related yield curves and other market factors. On a quarterly basis, the Corporation reviews the pricing methodology of the third-party pricing vendors and the results of the vendors' internal control assessments to ensure the integrity of the process that the vendor uses to develop market pricing for the Corporation's investment securities portfolio. 29 -------------------------------------------------------------------------------- The following table summarizes the carrying value of investment securities at December 31, 2013, 2012 and 2011: TABLE 2. SUMMARY OF INVESTMENT SECURITIES December 31, 2013 2012 2011 (In thousands) Available-for-Sale: Government sponsored agencies $ 93,763$ 97,557 $



70,679

State and political subdivisions 43,798 49,965



45,235

Residential mortgage-backed securities 299,366 99,411



120,780

Collateralized mortgage obligations 180,941 263,592 332,400 Corporate bonds 65,275 69,795 96,768 Preferred stock 1,427 6,489 1,414 Total investment securities available-for-sale 684,570 586,809 667,276 Held-to-Maturity: State and political subdivisions 263,405 219,477



172,839

Trust preferred securities 10,500 10,500



10,500

Total investment securities held-to-maturity 273,905 229,977 183,339 Total investment securities

$ 958,475$ 816,786$ 850,615 The carrying value of investment securities totaled $958.5 million at December 31, 2013, an increase of $141.7 million, or 17%, from investment securities of $816.8 million at December 31, 2012. The increase in investment securities during 2013 was primarily attributable to the Corporation deploying a portion of the cash acquired in the branch acquisition transaction into investment securities to obtain a higher yield than the 25 basis points it would have received by maintaining these excess funds at the Federal Reserve Bank (FRB), as the Corporation does not expect short-term interest rates to increase significantly in the near term. A portion of the cash acquired in the branch acquisition transaction, in addition to proceeds received during 2013 from maturing collateralized mortgage obligations, was largely invested in shorter-term fixed-rate residential mortgage-backed securities, as the Corporation does not expect significant increases in market interest rates during 2014. At December 31, 2013, the Corporation's investment securities portfolio consisted of: government sponsored agency (GSA) debt obligations, comprised primarily of variable-rate instruments backed by the Small Business Administration and Student Loan Marketing Corporation, totaling $93.8 million; state and political subdivisions debt obligations, comprised primarily of general debt obligations of issuers primarily located in the State of Michigan, totaling $307.2 million; residential mortgage-backed securities (MBSs), comprised primarily of fixed-rate instruments backed by a U.S. government agency (Government National Mortgage Association) or government sponsored enterprises (Federal Home Loan Mortgage Corporation and Federal National Mortgage Association), totaling $299.4 million; collaterized mortgage obligations (CMOs), comprised of approximately 70% fixed-rate and 30% variable-rate instruments backed by the same U.S. government agency and government sponsored enterprises as the residential MBSs, with average maturities of less than three years, totaling $180.9 million; corporate bonds, comprised primarily of debt obligations of large U.S. global financial organizations, totaling $65.3 million; preferred stock securities, comprised of preferred stock debt instruments of two large regional/national banks, totaling $1.4 million; and trust preferred securities (TRUPs), comprised of a 100% interest in a variable-rate TRUP of a small non-public bank holding company in Michigan totaling $10.0 million and another variable-rate TRUP investment totaling $0.5 million. Variable-rate instruments comprised 25% of the Corporation's investment securities portfolio at December 31, 2013. The Corporation records all investment securities in accordance with ASC Topic 320, Investments-Debt and Equity Securities (ASC 320), under which the Corporation is required to assess equity and debt securities that have fair values below their amortized cost basis to determine whether the decline (impairment) is other-than-temporary. An assessment is performed quarterly by the Corporation to determine whether unrealized losses in its investment securities portfolio are temporary or other-than-temporary by considering all reasonably available information. The Corporation reviews factors such as financial statements, credit ratings, news releases and other pertinent information of the underlying issuer or company to make its determination. In assessing whether a decline is other-than-temporary, management considers, among other things (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the potential for impairments in an entire industry or sub-sector and (iv) the potential for impairments in certain economically depressed geographical locations. 30 -------------------------------------------------------------------------------- The Corporation's investment securities portfolio, with a carrying value of $958.5 million at December 31, 2013, had gross impairment of $18.5 million at that date. Management believed that the unrealized losses on investment securities were temporary in nature and due primarily to changes in interest rates on the investment securities and market illiquidity, and not as a result of credit-related issues. Accordingly, the Corporation believed the impairment in its investment securities portfolio at December 31, 2013 was temporary in nature, and therefore, no impairment loss was recognized in the Corporation's consolidated statement of income in 2013. However, other-than-temporary impairment (OTTI) may occur in the future as a result of material declines in the fair value of investment securities resulting from market, credit, economic or other conditions. A further discussion of the assessment of potential impairment and the Corporation's process that resulted in the conclusion that the impairment was temporary in nature follows. At December 31, 2013, the gross impairment in the Corporation's investment securities portfolio of $18.5 million was comprised as follows: GSA securities, residential MBSs and CMOs, combined, of $7.1 million, state and political subdivisions securities of $6.9 million, corporate bonds of $0.3 million and trust preferred securities of $4.3 million. The amortized costs and fair values of investment securities are disclosed in Note 3 to the consolidated financial statements. GSA securities, residential MBSs and CMOs, included in the available-for-sale investment securities portfolio, had a combined amortized cost of $579.5 million and gross impairment of $7.1 million at December 31, 2013. Virtually all of the impaired investment securities in these categories are backed by the full faith and credit of the U.S. government or a guarantee of a U.S. government agency or government sponsored enterprise. The Corporation determined that the impairment on these investment securities was attributable to current market interest rates being higher than the yields on these investment securities. The Corporation concluded that the impairment of its GSA securities, residential MBSs and CMOs was temporary in nature at December 31, 2013. State and political subdivisions securities, included in both the available-for-sale and held-to-maturity investment securities portfolios, had an amortized cost of $305.9 million and gross impairment of $6.9 million at December 31, 2013. Approximately 90% of the Corporation's state and political subdivisions securities are from issuers located in the State of Michigan and are general obligations of the issuer, meaning that repayment of these obligations is funded by general tax collections of the issuer. The Corporation holds no general debt obligations issued by the City of Detroit, Michigan. The gross impairment was attributable to impaired state and political subdivisions securities with an amortized cost of $152 million that generally mature beyond 2014. It was the Corporation's assessment that the impairment on these investment securities was attributable to a combination of current market interest rates being slightly higher than the yield on these investment securities and illiquidity in the market for these investment securities. The Corporation concluded that the impairment of its state and political subdivisions securities was temporary in nature at December 31, 2013. Corporate bonds, included in the available-for-sale investment securities portfolio, had an amortized cost of $65.0 million and gross impairment of $0.3 million at December 31, 2013. All of the corporate bonds held at December 31, 2013 were of an investment grade. The investment grade ratings of all of the corporate bonds indicated that the obligors' capacities to meet their financial commitments were "strong." It was the Corporation's assessment that the impairment on the corporate bonds was attributable to current market interest rates being slightly higher than the yield on these investment securities and the market perception of issuers, and not due to credit-related issues. The Corporation concluded that the impairment of its corporate bonds was temporary in nature at December 31, 2013. At December 31, 2013, the Corporation held two TRUPs in the held-to-maturity investment securities portfolio, with a combined amortized cost of $10.5 million and gross impairment of $4.3 million. Management reviewed available financial information of the issuers of the TRUPs as of December 31, 2013. One TRUP, with an amortized cost of $10.0 million, represents a 100% interest in a TRUP of a non-public bank holding company in Michigan that was purchased in the second quarter of 2008. At December 31, 2013, the Corporation determined that the fair value of this TRUP was $6.0 million. The second TRUP, with an amortized cost of $0.5 million, represents a 10% interest in the TRUP of another non-public bank holding company in Michigan. At December 31, 2013, the Corporation determined the fair value of this TRUP was $0.2 million. The fair value measurements of the two TRUP investments were developed based upon market pricing observations of much larger banking institutions in an illiquid market adjusted by risk measurements. The fair values of the Corporation's TRUPs were based on calculations of discounted cash flows, and further based upon both observable inputs and appropriate risk adjustments that would be made by market participants. See the additional discussion of the development of the fair values of the TRUPs in Note 3 to the consolidated financial statements. 31 -------------------------------------------------------------------------------- The issuer of the $10.0 million TRUP reported net income in each of the three years ended December 31, 2013 and was categorized as well-capitalized under applicable regulatory requirements during that time. Based on an analysis of financial information provided by the issuer, it was the Corporation's opinion that, as of December 31, 2013, this issuer appeared to be a financially sound financial institution with sufficient liquidity to meet its financial obligations in 2014. There have been no material adverse changes in the issuer's financial performance since the TRUP was issued and purchased by the Corporation and no indication that any material adverse trends were developing that would suggest that the issuer would be unable to make all future principal and interest payments under the TRUP. Quarterly common stock cash dividends have consistently been paid by the issuer and the Corporation understands that the issuer's management anticipates cash dividends to continue to be paid in the future. The principal of $10.0 million of this TRUP matures in 2038, with interest payments of 360 basis points over the three-month London Interbank Offered Rate (LIBOR) due quarterly. All scheduled interest payments on this TRUP have been made on a timely basis. At December 31, 2013, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer or its subsidiaries. In reviewing all reasonably available financial information regarding the issuer, including past performance and its financial and liquidity position, it was the Corporation's opinion that the estimated future cash flows of the issuer supported the carrying value of the TRUP at its original cost of $10.0 million at December 31, 2013. While the total fair value of the TRUP was $4.0 million below the Corporation's amortized cost at December 31, 2013, the Corporation concluded that, based on the overall financial condition of the issuer, the impairment was temporary in nature at December 31, 2013. The Corporation expects the issuer of the $0.5 million TRUP to report a small amount of net income in 2013, compared to a small net loss in 2012 and a small amount of net income in 2011. At December 31, 2013, the issuer was categorized as well-capitalized under applicable regulatory requirements. The principal of $0.5 million of this TRUP matures in 2033, with interest payments due quarterly. All scheduled interest payments on this TRUP have been made on a timely basis. At December 31, 2013, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer of this TRUP or any subsidiary. In reviewing all reasonably available financial information regarding the $0.5 million TRUP, it was the Corporation's opinion that the carrying value of this TRUP at its original cost of $0.5 million was supported by the issuer's financial position at December 31, 2013. While the fair value of the TRUP was $0.3 million below the Corporation's amortized cost at December 31, 2013, the Corporation concluded that the impairment was temporary in nature at December 31, 2013. At December 31, 2013, the Corporation expected to fully recover the entire amortized cost basis of each impaired investment security in its investment securities portfolio at that date. Furthermore, at December 31, 2013, the Corporation did not have the intent to sell any of its impaired investment securities and believed that it was more-likely-than-not that the Corporation would not have to sell any of its impaired investment securities before a full recovery of amortized cost. However, there can be no assurance that OTTI losses will not be recognized on the TRUPs or on any other investment security in the future. LOANS The Corporation's loan portfolio is comprised of commercial, commercial real estate, real estate construction and land development loans, referred to as the Corporation's commercial loan portfolio, and residential mortgage, consumer installment and home equity loans, referred to as the Corporation's consumer loan portfolio. At December 31, 2013, the Corporation's loan portfolio was $4.65 billion and consisted of loans in the commercial loan portfolio totaling $2.52 billion, or 54% of total loans, and loans in the consumer loan portfolio totaling $2.13 billion, or 46% of total loans. Loans at fixed interest rates comprised 76% of the Corporation's total loan portfolio at December 31, 2013, compared to 73% at December 31, 2012 and 71% at December 31, 2011. Chemical Bank is a full-service commercial bank and the acceptance and management of credit risk is an integral part of the Corporation's business. The Corporation maintains loan policies and credit underwriting standards as part of the process of managing credit risk. These standards include making loans generally only within the Corporation's market areas. The Corporation's lending markets generally consist of communities across the lower peninsula of Michigan, except for the southeastern portion of Michigan. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation's lending philosophy is implemented through strong administrative and reporting controls. The Corporation maintains a centralized independent loan review function that monitors the approval process and ongoing asset quality of the loan portfolio. Total loans were $4.65 billion at December 31, 2013, an increase of $480 million, or 11.5%, from total loans of $4.17 billion at December 31, 2012. Total loans increased $336 million, or 8.8%, during 2012, from total loans of $3.83 billion at December 31, 2011. The increases in total loans during 2013 and 2012 generally occurred across all major loan categories and across all of the Corporation's banking markets and were attributable to a combination of improving economic conditions and higher loan demand, as well as the Corporation increasing its market share in both its commercial and consumer loan portfolios. 32 --------------------------------------------------------------------------------



Table 3 includes the composition of the Corporation's loan portfolio, by major loan category, as of December 31 for each of the past five years. TABLE 3. SUMMARY OF LOANS

December 31, 2013 2012 2011 2010 2009 (In thousands) Commercial loan portfolio: Commercial $ 1,176,307$ 1,002,722$ 895,150$ 818,997$ 584,286 Commercial real estate 1,232,658 1,161,861 1,071,999 1,076,971 785,675 Real estate construction 89,795 62,689 73,355 89,234 74,742 Land development 20,066 37,548 44,821 53,386 46,563 Subtotal - commercial loan portfolio 2,518,826 2,264,820 2,085,325 2,038,588 1,491,266 Consumer loan portfolio: Residential mortgage 960,423 883,835 861,716 798,046 739,380 Consumer installment 644,769 546,036 484,058 503,132 485,360 Home equity 523,603 473,044 400,186 341,896 277,154 Subtotal - consumer loan portfolio 2,128,795 1,902,915 1,745,960 1,643,074 1,501,894 Total loans $ 4,647,621$ 4,167,735$ 3,831,285$ 3,681,662$ 2,993,160 A discussion of the Corporation's loan portfolio by category follows. Commercial Loan Portfolio The Corporation's commercial loan portfolio is comprised of commercial loans, commercial real estate loans, real estate construction loans and land development loans. The Corporation's commercial loan portfolio is well diversified across business lines and has no concentration in any one industry. The commercial loan portfolio of $2.52 billion at December 31, 2013 included 80 loan relationships of $5.0 million or greater. These 80 loan relationships totaled $806.2 million and represented 32% of the commercial loan portfolio at December 31, 2013 and included 28 loan relationships that had outstanding balances of $10 million or higher, totaling $374 million, or 14.8% of the commercial loan portfolio, at that date. The Corporation had 10 loan relationships at December 31, 2013 with loan balances greater than $5.0 million and less than $10 million, totaling $75.7 million, that had unfunded credit amounts totaling $54.6 million that, if advanced, could result in a loan relationship of $10 million or more. Table 4 presents the maturity distribution of the Corporation's $2.52 billion commercial loan portfolio at December 31, 2013. The percentage of these loans maturing within one year was 27% at December 31, 2013, while the percentage of these loans maturing beyond five years remained low at 16% at December 31, 2013. At December 31, 2013, loans in the commercial loan portfolio with maturities beyond one year totaled $1.83 billion, with 74% of these loans at fixed interest rates. TABLE 4. COMPARISON OF LOAN MATURITIES AND INTEREST SENSITIVITY December 31, 2013 Due In 1 Year 1 to 5 Over 5 or Less Years Years Total (Dollars in thousands) Loan maturities: Commercial $ 504,552$ 490,587$ 181,168$ 1,176,307 Commercial real estate 157,139 889,089 186,430 1,232,658 Real estate construction and land development 30,287 53,192 26,382 109,861 Total $ 691,978$ 1,432,868$ 393,980$ 2,518,826 Percent of total 27 % 57 % 16 % 100 % Interest sensitivity of above loans: Fixed interest rates $ 208,114$ 1,030,897$ 313,295$ 1,552,306 Variable interest rates 483,864 401,971 80,685 966,520 Total $ 691,978$ 1,432,868$ 393,980$ 2,518,826 33

-------------------------------------------------------------------------------- Commercial loans consist of loans and lines of credit to varying types of businesses, including municipalities, school districts and nonprofit organizations, for the purpose of supporting working capital and operational needs and term financing of equipment. Repayment of such loans is generally provided through operating cash flows of the customer. Commercial loans are generally secured with inventory, accounts receivable, equipment, personal guarantees of the owner or other sources of repayment, although the Corporation may also obtain real estate as collateral. Commercial loans were $1.18 billion at December 31, 2013, an increase of $173.6 million, or 17.3%, from commercial loans of $1.00 billion at December 31, 2012. Commercial loans increased $107.6 million, or 12.0%, during 2012 from commercial loans of $895.2 million at December 31, 2011. The increases in commercial loans during 2013 and 2012 were the result of a combination of increased market share and improving economic conditions in the Corporation's lending markets. Commercial loans represented 25.3% of the Corporation's loan portfolio at December 31, 2013, compared to 24.1% and 23.4% at December 31, 2012 and 2011, respectively. Commercial real estate loans include loans that are secured by real estate occupied by the borrower for ongoing operations, non-owner occupied real estate leased to one or more tenants and vacant land that has been acquired for investment or future land development. Commercial real estate loans were $1.23 billion at December 31, 2013, an increase of $70.8 million, or 6.1%, from commercial real estate loans of $1.16 billion at December 31, 2012. Loans secured by owner occupied properties, non-owner occupied properties and vacant land comprised 59%, 38% and 3%, respectively, of the Corporation's commercial real estate loans outstanding at December 31, 2013. Commercial real estate loans increased $89.9 million, or 8.4%, during 2012 from commercial real estate loans of $1.07 billion at December 31, 2011. Commercial real estate loans represented 26.5% of the Corporation's loan portfolio at December 31, 2013, compared to 27.9% and 28.0% at December 31, 2012 and 2011, respectively. Commercial and commercial real estate lending is generally considered to involve a higher degree of risk than residential mortgage, consumer installment and home equity lending as they typically involve larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties and vacant land loans is typically dependent on the success of the operation of the related project and is typically affected by adverse conditions in the real estate market and in the economy. The Corporation generally attempts to mitigate the risks associated with commercial and commercial real estate lending by, among other things, lending primarily in its market areas, lending across industry lines, not developing a concentration in any one line of business and using prudent loan-to-value ratios in the underwriting process. Michigan's economy has shown signs of improvement over the last three years, resulting in lower loan delinquencies compared to the previous three years. It is management's belief that the loan portfolio is generally well-secured, despite the decline in market values for all types of real estate in the State of Michigan and nationwide that occurred prior to 2013. Real estate construction loans are primarily originated for construction of commercial properties and often convert to a commercial real estate loan at the completion of the construction period. Real estate construction loans were $89.8 million at December 31, 2013, an increase of $27.1 million, or 43%, from real estate construction loans of $62.7 million at December 31, 2012. Real estate construction loans decreased $10.7 million, or 15%, during 2012 from real estate construction loans of $73.4 million at December 31, 2011. Real estate construction loans represented 1.9% of the Corporation's loan portfolio at December 31, 2013, compared to 1.5% and 1.9% at December 31, 2012 and 2011, respectively. Land development loans include loans made to developers for the purpose of infrastructure improvements to vacant land to create finished marketable residential and commercial lots/land. A majority of the Corporation's land development loans consist of loans to develop residential real estate. Land development loans are generally originated with the intention that the loans will be repaid through the sale of finished properties by the developers within twelve months of the completion date. Land development loans were $20.1 million at December 31, 2013, a decrease of $17.5 million, or 47%, from land development loans of $37.5 million at December 31, 2012. The decrease in land development loans during 2013 was largely due to the Corporation receiving payments on loans that existed at December 31, 2012 resulting from the sales of both unimproved land and finished properties by the developers. Land development loans decreased $7.3 million, or 16%, during 2012 from land development loans of $44.8 million at December 31, 2011. Land development loans represented 0.4% of the Corporation's loan portfolio at December 31, 2013, compared to 0.9% and 1.2% at December 31, 2012 and 2011, respectively. Real estate construction and land development lending involves a higher degree of risk than commercial real estate lending and residential mortgage lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates, the need to obtain a tenant or purchaser of the property if it will not be owner-occupied or the need to sell developed properties. The Corporation generally attempts to mitigate the risks associated with real estate construction and land development lending by, among other things, lending primarily in its market areas, using prudent underwriting guidelines and closely monitoring the construction process. The Corporation's risk in this area increased in 2008 due to the weak economic environment within the State of Michigan at that time. While the economy in Michigan began improving in 2011, the sale of lots and units in both residential 34 -------------------------------------------------------------------------------- and commercial development projects has remained low, as customer demand also remains low, resulting in the inventory of unsold lots and housing units remaining higher than historical levels across the State of Michigan and the inability of most developers to sell their finished developed lots and units within their original expected time frames. At December 31, 2013, $7.2 million, or 36%, of the Corporation's $20.1 million of land development loans were impaired, whereby the Corporation determined it was probable that the full amount of principal and interest would not be collected on these loans in accordance with their original contractual terms. Consumer Loan Portfolio The Corporation's consumer loan portfolio is comprised of residential mortgage loans, consumer installment loans and home equity loans and lines of credit. Residential mortgage loans consist primarily of one- to four-family residential loans with fixed interest rates of fifteen years or less, with amortization periods generally from fifteen to thirty years. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with a higher loan-to-value ratio than 80% generally require private mortgage insurance. At December 31, 2013, approximately 70% of the Corporation's residential mortgage loans had an original loan-to-value ratio of 80% or less. Residential mortgage loans were $960.4 million at December 31, 2013, an increase of $76.6 million, or 8.7%, from residential mortgage loans of $883.8 million at December 31, 2012. Residential mortgage loans increased $22.1 million, or 2.6%, during 2012 from residential mortgage loans of $861.7 million at December 31, 2011. Residential mortgage loans have historically involved the least amount of credit risk in the Corporation's loan portfolio, although the risk on these loans has increased with the increase in the unemployment rate and the decrease in real estate property values in the State of Michigan over the last several years. Residential mortgage loans also include loans to consumers for the construction of single family residences that are secured by these properties. Residential mortgage construction loans to consumers were $37.9 million at December 31, 2013, compared to $25.5 million at December 31, 2012 and $21.6 million at December 31, 2011. Residential mortgage loans represented 20.7% of the Corporation's loan portfolio at December 31, 2013, compared to 21.2% and 22.5% at December 31, 2012 and 2011, respectively. During 2013, the Corporation originated $490 million of residential mortgage loans and retained $291 million of these originations in its loan portfolio. The majority of the loans originated were refinancings of existing loans as a result of the continued low interest rate environment for long-term fixed-rate mortgages. The demand for longer-term fixed interest rate residential mortgage loans has been high in recent years due to the historically low level of long-term interest rates. The Corporation generally sells fixed interest rate residential mortgage loans originated with maturities of fifteen years or more in the secondary market. However, the Corporation retained $80 million of fixed interest rate residential mortgage loans originated with terms of fifteen years in its loan portfolio during both 2013 and 2012. At December 31, 2013, the Corporation had residential mortgage loans with maturities beyond five years and that were at fixed interest rates totaling $320 million, or 33% of residential mortgage loans, compared to $290 million, or 33% of residential mortgage loans, at December 31, 2012. The Corporation's consumer installment loans consist of relatively small loan amounts to consumers to finance personal items (primarily automobiles, recreational vehicles and marine vehicles), including direct loans purchased from dealerships. Consumer installment loans were $644.8 million at December 31, 2013, an increase of $98.7 million, or 18.1%, from consumer installment loans of $546.0 million at December 31, 2012. Consumer installment loans increased $61.9 million, or 12.8%, during 2012 from consumer installment loans of $484.1 million at December 31, 2011. At December 31, 2013, collateral securing consumer installment loans was comprised approximately as follows: automobiles - 54%; recreational vehicles - 30%; marine vehicles - 13%; other collateral - 2%; and unsecured - 1%. Consumer installment loans represented 13.9% of the Corporation's loan portfolio at December 31, 2013, compared to 13.1% and 12.6% at December 31, 2012 and 2011, respectively. The Corporation's home equity loans, including home equity lines of credit, are comprised of loans to consumers who utilize equity in their personal residence, including junior lien mortgages, as collateral to secure the loan or line of credit. Home equity loans were $523.6 million at December 31, 2013, an increase of $50.6 million, or 10.7%, from home equity loans of $473.0 million at December 31, 2012. Home equity loans increased $72.8 million, or 18.2%, during 2012 from home equity loans of $400.2 million at December 31, 2011. At December 31, 2013, approximately 55% of the Corporation's home equity loans were first lien mortgages and 45% were junior lien mortgages. Home equity loans represented 11.3% of the Corporation's loan portfolio at December 31, 2013, compared to 11.4% and 10.4% at December 31, 2012 and 2011, respectively. The majority of the Corporation's home equity lines of credit are comprised of loans with payments of interest only until their maturity. Home equity lines of credit have original maturities up to ten years. Home equity lines of credit comprised 35% and 40% of the Corporation's home equity loans at December 31, 2013 and December 31, 2012, respectively. 35 -------------------------------------------------------------------------------- Consumer installment and home equity loans generally have shorter terms than residential mortgage loans, but generally involve more credit risk than residential mortgage lending because of the type and nature of the collateral. The Corporation experienced decreases in losses on consumer installment and home equity loans, with net loan losses totaling 43 basis points of average consumer installment and home equity loans during 2013, compared to 53 basis points of average consumer installment and home equity loans in 2012. Consumer installment and home equity loans are spread across many individual borrowers, which minimizes the risk per loan transaction. The Corporation originates consumer installment and home equity loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. Consumer installment and home equity lending collections are dependent on the borrowers' continuing financial stability and are more likely to be affected by adverse personal situations. Collateral values on properties securing consumer installment and home equity loans are negatively impacted by many factors, including the physical condition of the collateral and property values, although losses on consumer installment and home equity loans are often more significantly impacted by the unemployment rate and other economic conditions. The unemployment rate in the State of Michigan was 8.4% at December 31, 2013, compared to 8.9% at December 31, 2012, although still higher than the national average of 6.7% at December 31, 2013. ASSET QUALITY Nonperforming Assets Nonperforming assets include nonperforming loans, which consist of originated loans for which the accrual of interest has been discontinued (nonaccrual loans), originated loans that are past due as to principal or interest by 90 days or more and still accruing interest and nonperforming loans that have been modified under troubled debt restructurings (TDRs). Nonperforming assets also include assets obtained through foreclosures and repossessions. The Corporation transfers an originated loan that is 90 days or more past due to nonaccrual status (except for loans that are secured by residential real estate, which are transferred at 120 days past due), unless it believes the loan is both well-secured and in the process of collection. For loans classified as nonaccrual, including those with modifications, the Corporation does not expect to receive all principal and interest payments, and therefore, any payments are recognized as principal reductions when received. Conversely, the Corporation expects to receive all principal and interest payments on loans that meet the definition of nonperforming TDR status. TDRs continue to be reported as nonperforming loans until a six-month payment history of principal and interest payments is sustained in accordance with the terms of the loan modification, at which time the loan is no longer considered a nonperforming asset and the Corporation moves the loan to a performing TDR status. Nonperforming assets were $91.8 million at December 31, 2013, a decrease of $17.5 million, or 16%, from $109.3 million at December 31, 2012. Nonperforming assets also decreased $22.5 million, or 17%, during 2012 from $131.8 million at December 31, 2011. Nonperforming assets comprised 1.48%, 1.85% and 2.47% of total assets at December 31, 2013, 2012 and 2011, respectively. The decreases in nonperforming assets during 2013 and 2012 are a sign of improvement in the credit quality of the Corporation's loan portfolio and the improving economic climate in Michigan that began in 2011. However, the Corporation's levels of nonperforming assets have remained elevated, compared to historical levels, due to an unfavorable economic climate within the State of Michigan that has existed for more than five years that has resulted in cash flow difficulties being encountered by an elevated level of commercial and consumer loan customers. The Corporation's nonperforming assets are not concentrated in any one industry or any one geographical area within Michigan, other than $4.7 million in nonperforming land development loans. At December 31, 2013, there were only two commercial loan relationships that exceeded $5.0 million, totaling $12.3 million, that were in a nonperforming status. Based on declines in both residential and commercial real estate appraised values due to the weakness in the Michigan economy over the past several years, management continues to evaluate and, when appropriate, obtain new appraisals or discount appraised values of existing appraisals to compute estimated net realizable values of nonperforming real estate secured loans and other real estate properties. While the economic climate within Michigan has shown signs of improvement, it is management's belief that nonperforming assets will remain at elevated levels during 2014. 36

--------------------------------------------------------------------------------



Table 5 provides a five-year history of nonperforming assets, including the composition of nonperforming loans by major loan category. TABLE 5. NONPERFORMING ASSETS

December 31, 2013 2012 2011 2010 2009 (Dollars in thousands) Nonaccrual loans(1): Commercial $ 18,374$ 14,601$ 10,726$ 16,668$ 19,309 Commercial real estate 28,598 37,660 43,381 55,104 49,419 Real estate construction 371 1,217 1,057 5,454 795 Land development 2,309 4,184 6,190 8,967 14,389 Residential mortgage 8,921 10,164 12,573 12,083 15,508 Consumer installment 676 739 1,707 1,751 4,009 Home equity 2,648 2,733 2,760 2,935 3,160 Total nonaccrual loans 61,897 71,298 78,394 102,962 106,589 Accruing loans contractually past due 90 days or more as to interest or principal payments: Commercial 536 - 1,381 530 1,371 Commercial real estate 190 87 374 1,350 3,971 Real estate construction - - 287 735 1,990 Land development - - - 485 - Residential mortgage 537 1,503 752 3,253 3,614 Consumer installment - - - - - Home equity 734 769 1,023 1,055 787 Total accruing loans contractually past due 90 days or more as to interest or principal payments 1,997 2,359 3,817 7,408 11,733 Nonperforming TDRs(2): Commercial loan portfolio 13,414 13,876 14,675 15,057 - Consumer loan portfolio 4,676 3,321 9,383 22,302 17,433 Total nonperforming TDRs 18,090 17,197 24,058 37,359 17,433 Total nonperforming loans 81,984 90,854 106,269 147,729 135,755 Other real estate and repossessed assets(3) 9,776 18,469 25,484 27,510 17,540 Total nonperforming assets $ 91,760$ 109,323$ 131,753$ 175,239$ 153,295 Nonperforming loans as a percent of total loans 1.76 % 2.18 % 2.77 % 4.01 % 4.54 % Nonperforming assets as a percent of total assets 1.48 % 1.85 % 2.47 % 3.34 % 3.61 %



(1) There was no interest income recognized on nonaccrual loans in 2013 while

they were in nonaccrual status. During 2013, the Corporation received and

recognized $0.9 million of interest income on these loans while they were in

an accruing status. Additional interest income of $3.5 million would have

been recorded in 2013 on nonaccrual loans existing at December 31, 2013 had

they been current in accordance with their original terms.

(2) Interest income of $3.2 million was recorded in 2013 on performing and

nonperforming TDRs. The interest income recognized on residential mortgage

TDRs may include accretion of an identified impairment at the time of modification, which is attributable to a temporary reduction in the borrower's interest rate.



(3) Includes property acquired through foreclosure and by acceptance of a deed in

lieu of foreclosure and other property held for sale.

The Corporation's nonaccrual loans at December 31, 2013, 2012, 2011 and 2010 included $37.3 million, $47.5 million, $41.8 million and $59.4 million, respectively, of loans that meet the definition of a TDR (nonaccrual TDR). These loans have been modified by providing the borrower a financial concession that is intended to improve the Corporation's probability of collection of the amounts due. 37 --------------------------------------------------------------------------------



The following schedule summarizes changes in nonaccrual loans (including nonaccrual TDRs) during 2013 and 2012:

Years Ended December 31, 2013 2012 (In thousands) Balance at beginning of period $ 71,298 $



78,394

Additions during period 49,157



52,265

Principal balances charged off (18,185 ) (17,169 ) Transfers to other real estate/repossessed assets (5,072 ) (12,830 ) Return to accrual status (17,039 ) (10,956 ) Payments received (18,262 ) (18,406 ) Balance at end of period $ 61,897$ 71,298 Nonperforming Loans The following schedule provides the composition of nonperforming loans, by major loan category, as of December 31, 2013 and 2012. December 31, 2013 2012 Percent Percent Amount of Total Amount of Total (Dollars in thousands) Commercial loan portfolio: Commercial $ 22,617 28 % $ 19,763 22 % Commercial real estate 36,082 44 42,472 47 Real estate construction 371 1 1,217 1 Land development 4,722 5 8,173 9



Subtotal - commercial loan portfolio 63,792 78 71,625

79 Consumer loan portfolio: Residential mortgage 14,134 17 14,988 16 Consumer installment 676 1 739 1 Home equity 3,382 4 3,502 4



Subtotal - consumer loan portfolio 18,192 22 19,229

21 Total nonperforming loans $ 81,984 100 % $ 90,854 100 % Total nonperforming loans were $82.0 million at December 31, 2013, a decrease of $8.9 million, or 9.8%, compared to $90.9 million at December 31, 2012. The Corporation's nonperforming loans in the commercial loan portfolio were $63.8 million at December 31, 2013, a decrease of $7.8 million, or 11%, from $71.6 million at December 31, 2012. The decreases in nonperforming loans in the commercial loan portfolio were attributable to a combination of improving economic conditions and net loan charge-offs. Net loan charge-offs in the commercial loan portfolio totaled $9.4 million and $12.7 million during 2013 and 2012, respectively. Nonperforming loans in the commercial loan portfolio comprised 78% of total nonperforming loans at December 31, 2013, compared to 79% at December 31, 2012. The Corporation's nonperforming loans in the consumer loan portfolio were $18.2 million at December 31, 2013, a decrease of $1.0 million, or 5.4%, from $19.2 million at December 31, 2012. The decrease in nonperforming loans in the consumer loan portfolio were primarily attributable to net loan charge-offs, which totaled $7.0 million and $9.6 million during 2013 and 2012, respectively. 38 --------------------------------------------------------------------------------



Nonperforming Loans - Commercial Loan Portfolio The following schedule presents information related to stratification of nonperforming loans in the commercial loan portfolio by dollar amount at December 31, 2013 and 2012.

December 31, 2013 2012 Number of Number of Borrowers Amount Borrowers Amount (Dollars in thousands) $5,000,000 or more 2 $ 12,267 1 $ 6,157$2,500,000 - $4,999,999 - - - - $1,000,000 - $2,499,999 6 9,858 16 27,408 $500,000 - $999,999 27 19,813 21 14,868 $250,000 - $499,999 25 8,318 28 9,521 Under $250,000 181 13,536 173 13,671 Total 241 $ 63,792 239 $ 71,625 Nonperforming commercial loans were $22.6 million at December 31, 2013, an increase of $2.8 million, or 14%, from $19.8 million at December 31, 2012. Nonperforming commercial loans comprised 1.9% of total commercial loans at December 31, 2013, compared to 2.0% at December 31, 2012. The increase in nonperforming commercial loans during 2013 was attributable to the downgrade to nonaccrual status during the fourth quarter of 2013 of one commercial loan relationship with an agricultural grower and processor, which totaled $6.4 million at December 31, 2013. At December 31, 2013, the borrower was experiencing some financial difficulty; however, these loans were believed to be adequately secured by income-producing farmland and other assets and the Corporation did not require a specific impairment reserve on this loan relationship at that date. Nonperforming commercial loans at December 31, 2013 were not concentrated in any single industry. Nonperforming commercial real estate loans were $36.1 million at December 31, 2013, a decrease of $6.4 million, or 15%, from $42.5 million at December 31, 2012. Nonperforming commercial real estate loans comprised 2.9% of total commercial real estate loans at December 31, 2013, compared to 3.7% at December 31, 2012. Nonperforming commercial real estate loans secured by owner occupied real estate, non-owner occupied real estate and vacant land totaled $19.4 million, $9.6 million and $7.1million, respectively, at December 31, 2013, and comprised 2.9%, 2.5% and 22.5%, respectively, of total owner occupied real estate, non-owner occupied real estate and vacant land loans included in the Corporation's originated commercial real estate loans at December 31, 2013. At December 31, 2013, the Corporation's nonperforming commercial real estate loans were comprised of a diverse mix of commercial lines of business and were also geographically disbursed throughout the Corporation's market areas. The largest concentration of nonperforming commercial real estate loans at December 31, 2013 was one customer relationship totaling $5.7 million that was primarily secured by vacant land. This same customer relationship had nonperforming land development loans of $0.2 million and nonperforming residential mortgage loans of $0.4 million. At December 31, 2013, the loans in this relationship were believed to be adequately secured and the Corporation did not require a specific impairment reserve on them at that date. Nonperforming real estate construction loans were $0.4 million at December 31, 2013, a decrease of $0.8 million, or 70%, from $1.2 million at December 31, 2012. Nonperforming real estate construction loans comprised 0.4% of total real estate construction loans at December 31, 2013, compared to 1.9% at December 31, 2012. Nonperforming land development loans were $4.7 million at December 31, 2013, a decrease of $3.5 million, or 42%, from $8.2 million at December 31, 2012, with the decrease primarily attributable to the Corporation receiving payments on its nonperforming land development loans. Nonperforming land development loans comprised 24% of total land development loans at December 31, 2013, compared to 22% at December 31, 2012. At December 31, 2013, nonperforming land development loans were secured primarily by residential real estate improved lots and housing units. At December 31, 2013, the Corporation had nonperforming loans in the commercial loan portfolio of $5.0 million that were secured by real estate and were in various stages of foreclosure, compared to $4.5 million at December 31, 2012. 39 -------------------------------------------------------------------------------- Nonperforming Loans - Consumer Loan Portfolio Nonperforming residential mortgage loans were $14.1 million at December 31, 2013, a decrease of $0.9 million, or 5.7%, from $15.0 million at December 31, 2012. Nonperforming residential mortgage loans comprised 1.5% of total residential mortgage loans at December 31, 2013, compared to 1.7% at December 31, 2012. At December 31, 2013, nonperforming residential mortgage loans totaling $4.0 million were in various stages of foreclosure, compared to $3.2 million at December 31, 2012. Nonperforming consumer installment loans were $0.7 million at both December 31, 2013 and December 31, 2012 and comprised 0.1% of total consumer installment loans at those dates. Nonperforming home equity loans were $3.4 million at December 31, 2013, a decrease of $0.1 million, or 3.4%, from $3.5 million at December 31, 2012. Nonperforming home equity loans comprised 0.6% of total home equity loans at December 31, 2013, compared to 0.7% at December 31, 2012. Troubled Debt Restructurings (TDRs) The unfavorable economic climate in Michigan has resulted in a large number of both business and consumer customers with cash flow difficulties and thus the inability to maintain their loan balances in a performing status. The Corporation determined that it was probable that certain customers who were past due on their loans, if provided a modification of their loan by reducing their monthly payment, would be able to bring their loan relationship to a performing status. The Corporation believes loan modifications will potentially result in a lower level of loan losses and loan collection costs than if the Corporation proceeded immediately through the foreclosure process with these borrowers. The loan modifications involve granting concessions to borrowers who are experiencing financial difficulty and, therefore, these loans meet the criteria to be considered TDRs. The Corporation's performing and nonperforming TDRs continue to accrue interest at the loan's original interest rate as the Corporation expects to collect the remaining principal balance of the loan. A TDR is reported as a nonperforming loan (nonperforming TDR) until a six-month payment history of principal and interest payments is sustained in accordance with the loan modification, at which time the Corporation moves the loan to a performing status (performing TDR). If a performing TDR becomes contractually past due more than 30 days, it is transferred to a nonperforming status. Accordingly, all of the Corporation's performing TDRs at December 31, 2013 were current or less than 30 days past due. The Corporation's nonaccrual loans that meet the definition of a TDR do not accrue interest as the Corporation does not expect to collect the full amount of principal and interest owed from the borrower on these loans. The following summarizes the Corporation's TDRs at December 31, 2013 and 2012: Nonperforming TDRs Performing Past Due Sub- TDRs Current 31-90 Days Total Nonaccrual TDRs Total

December 31, 2013 (In thousands) Commercial loan portfolio $ 26,839$ 10,860$ 2,554$ 13,414 $ 31,961 $ 72,214 Consumer loan portfolio 12,732 3,797 879 4,676 5,321 22,729 Total TDRs $ 39,571$ 14,657$ 3,433$ 18,090 $ 37,282 $ 94,943 December 31, 2012 Commercial loan portfolio $ 15,789$ 13,361$ 515$ 13,876 $ 42,711 $ 72,376 Consumer loan portfolio 15,580 2,688 633 3,321 4,783 23,684 Total TDRs $ 31,369$ 16,049$ 1,148$ 17,197 $ 47,494 $ 96,060 The Corporation's performing and nonperforming TDRs in the commercial loan portfolio generally consist of loans where the Corporation has allowed borrowers to either (i) temporarily defer scheduled principal payments and make interest only payments for a short period of time (generally six months to one year) at the stated interest rate of the original loan agreement, (ii) lower payments due to a modification of the loan's original contractual terms, or (iii) enter into moderate extensions of the loan's original contractual maturity date. These TDRs are individually evaluated for impairment. Based on this evaluation, the Corporation does not expect to incur a loss on these TDRs based on its assessment of the borrowers' expected cash flows, as the pre- and post-modification effective yields are approximately the same for these loans. Accordingly, no additional provision for loan losses has been recognized related to these TDRs. Nonperforming TDRs that have made at least six consecutive months of principal and interest payments under a formal modification agreement are classified by the Corporation as performing TDRs. If a TDR in the commercial loan portfolio becomes 90 days past due as to principal or interest, or if it becomes probable that any remaining principal and interest payments due on the loan will not be collected in accordance with the modified contractual terms, the loan is transferred to nonaccrual TDR status. 40 -------------------------------------------------------------------------------- Due to the borrowers' sustained repayment histories, the Corporation had performing TDRs in the commercial loan portfolio of $26.8 million at December 31, 2013, compared to $15.8 million at December 31, 2012. The Corporation also had nonperforming TDRs in the commercial loan portfolio of $13.4 million at December 31, 2013, compared to $13.9 million at December 31, 2012. The Corporation's nonperforming TDRs in the commercial loan portfolio are categorized as a risk grade 7 (substandard - accrual) under the Corporation's risk rating system, which is further described in Note 4 to the consolidated financial statements. The weighted average contractual interest rate of the Corporation's performing and nonperforming TDRs in the commercial loan portfolio was 5.61% at December 31, 2013, compared to 5.54% at December 31, 2012. At December 31, 2013, the Corporation had $32.0 million of nonaccrual TDRs in the commercial loan portfolio, compared to $42.7 million at December 31, 2012. A summary of changes in the Corporation's performing and nonperforming TDRs in the commercial loan portfolio follows: Years Ended December 31, 2013 2012 Performing Nonperforming Total Performing Nonperforming Total (In thousands) Balance at beginning of period $ 15,789$ 13,876$ 29,665$ 4,765$ 14,675$ 19,440 Additions for modifications - 14,571 14,571 - 19,148 19,148 Transfers to performing TDR status 12,744 (12,744 ) - 15,124 (15,124 ) - Transfers to nonperforming TDR status (2,465 ) 2,465 - (3,696 ) 3,696 - Principal payments and pay-offs (2,517 ) (2,830 ) (5,347 ) (990 ) (310 ) (1,300 ) Transfers from (to) nonaccrual status 3,288 (1,924 ) 1,364 586 (8,209 ) (7,623 ) Balance at end of period $ 26,839$ 13,414$ 40,253$ 15,789$ 13,876$ 29,665 The Corporation's TDRs in the consumer loan portfolio generally consist of loans where the Corporation has reduced a borrower's monthly payments by decreasing the interest rate charged on the loan (generally to a range of 3% to 5%) for a specified period of time (generally 24 months). Once the borrowers have made at least six consecutive months of principal and interest payments under a formal modification agreement, they are classified as performing TDRs. These loans are moved to nonaccrual TDR status if the loan becomes 90 days past due as to principal or interest, or sooner if conditions warrant. The Corporation had performing TDRs in the consumer loan portfolio of $12.7 million at December 31, 2013, compared to $15.6 million at December 31, 2012. The decrease during 2013 was largely attributable to TDRs that had reached the end of their initial modification term being refinanced at market interest rates, and thus no longer meet the definition of a TDR. The Corporation also had nonperforming TDRs in the consumer loan portfolio of $4.7 million at December 31, 2013, compared to $3.3 million at December 31, 2012. The weighted average contractual interest rate on the Corporation's performing and nonperforming TDRs in the consumer loan portfolio was 4.55% at December 31, 2013, compared to 4.54% at December 31, 2012. At December 31, 2013, the Corporation had $5.3 million of nonaccrual TDRs in the consumer loan portfolio, compared to $4.8 million at December 31, 2012. The Corporation's cumulative redefault rate as of December 31, 2013 on its performing and nonperforming TDRs, which represents the percentage of these TDRs that transferred to nonaccrual status since the Corporation began such modifications in 2009, was 21% for performing and nonperforming TDRs in the commercial loan portfolio and 17% for performing and nonperforming TDRs in the consumer loan portfolio. The Corporation's cumulative redefault rate does not include loans that have been modified while in nonaccrual status that remain in nonaccrual status as the Corporation does not expect to collect the full amount of principal and interest owed from the borrower on these loans. 41 -------------------------------------------------------------------------------- Other Real Estate and Repossessed Assets Other real estate and repossessed assets are components of nonperforming assets. These include other real estate (ORE), comprised of residential and commercial real estate and land development properties acquired through foreclosure or by acceptance of a deed in lieu of foreclosure, and repossessed assets, comprised of other personal and commercial assets. ORE totaled $9.5 million at December 31, 2013, a decrease of $8.6 million, or 47%, from $18.1 million at December 31, 2012. The reduction in ORE during 2013 was attributable to a combination of sales of ORE properties and a significant reduction in the level of additions of ORE properties due partially to improving economic conditions. Repossessed assets totaled $0.3 million at December 31, 2013, compared to $0.4 million at December 31, 2012. The following schedule provides the composition of ORE at December 31, 2013 and 2012: December 31, 2013 2012 (In thousands) Composition of ORE: Vacant land $ 2,827$ 3,407



Commercial real estate properties 4,678 8,359 Residential real estate properties 2,013 5,764 Residential land development properties - 527 Total ORE

$ 9,518$ 18,057



The following schedule summarizes ORE activity during 2013 and 2012:

Years Ended December 31, 2013 2012 (In thousands) Balance at beginning of year $ 18,057$ 24,888 Additions 4,134 12,988 Write-downs to fair value (1,308 ) (1,602 ) Dispositions (11,365 ) (18,217 ) Balance at end of year $ 9,518$ 18,057 The Corporation's ORE is carried at the lower of cost or fair value less estimated cost to sell. The historically large inventory of real estate properties for sale across the State of Michigan has resulted in an increase in the Corporation's carrying time and cost of holding ORE. Consequently, the Corporation had $7.5 million in ORE at December 31, 2013 that had been held in excess of one year, of which $3.0 million had been held in excess of three years. Because the redemption period on foreclosures is relatively long in Michigan (six months to one year) and the Corporation had $9.0 million of nonperforming loans that were in the process of foreclosure at December 31, 2013, it is anticipated that the level of the Corporation's ORE will remain at elevated levels. All of the Corporation's ORE properties have been written down to fair value through a charge-off against the allowance for loan losses at the time the loan was transferred to ORE or through a subsequent write-down, recorded as an operating expense, to recognize a further market value decline of the property after the initial transfer date. Accordingly, at December 31, 2013, the carrying value of ORE of $9.5 million was reflective of $21.9 million in charge-offs or write-downs, and represented 30% of the contractual loan balance remaining at the time these loans were classified as nonperforming. During 2013, the Corporation sold 272 ORE properties for total proceeds of $15.6 million. On an average basis, the net proceeds from these sales represented 137% of the carrying value of the property at the time of sale, with the net proceeds representing 49% of the remaining contractual loan balance at the time these loans were classified as nonperforming. Nonperforming assets at December 31, 2013 and 2012 did not include impaired acquired loans totaling $9.8 million and $9.1 million, respectively, even though these loans were not performing in accordance with their original contractual terms. Acquired loans that are not performing in accordance with contractual terms are not reported as nonperforming loans because these loans are recorded in pools at their net realizable value based on the principal and interest the Corporation expects to collect on these loan pools. Acquired loans not performing in accordance with the loan's original contractual terms are included in the Corporation's impaired loan schedule in Note 4 to the consolidated financial statements. 42 -------------------------------------------------------------------------------- Impaired Loans A loan is considered impaired when management determines it is probable that payment of principal and interest due will not be made according to the original contractual terms of the loan agreement. Impaired loans are accounted for at the lower of the present value of expected cash flows discounted at the loan's effective interest rate or the estimated fair value of the collateral, if the loan is collateral dependent. A portion of the allowance for loan losses is specifically allocated to impaired loans. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation. The eventual outcome may differ from amounts estimated. Impaired loans include nonaccrual loans (including nonaccrual TDRs), performing and nonperforming TDRs and acquired loans that were not performing in accordance with their original contractual terms. Impaired loans totaled $129.3 million and $129.0 million at December 31, 2013 and 2012, respectively. A summary of impaired loans at December 31, 2013 and 2012 follows: December 31, 2013 2012 (In thousands) Impaired loans - commercial loan portfolio: Originated commercial loan portfolio: Nonaccrual loans $ 49,652$ 57,662 Nonperforming TDRs 13,414 13,876 Performing TDRs 26,839 15,789 Subtotal 89,905 87,327 Acquired commercial loan portfolio 9,787 9,099



Total impaired loans - commercial loan portfolio 99,692 96,426 Impaired loans - consumer loan portfolio: Nonaccrual loans

12,245 13,636 Nonperforming TDRs 4,676 3,321 Performing TDRs 12,732 15,580



Total impaired loans - consumer loan portfolio 29,653 32,537 Total impaired loans

$ 129,345$ 128,963



The following schedule summarizes impaired loans to commercial borrowers and the related valuation allowance at December 31, 2013 and 2012 and partial loan charge-offs (confirmed losses) taken on these impaired loans:

Cumulative Valuation Confirmed Inherent Amount Allowance Losses Loss Percentage (Dollars in thousands) December 31, 2013 Impaired loans - originated commercial loan portfolio: With valuation allowance and no charge-offs $ 4,534$ 1,020 $ - 22 % With valuation allowance and charge-offs 559 61 528 54 With charge-offs and no valuation allowance 23,759 - 19,643 45 Without valuation allowance or charge-offs 61,053 - - - Total 89,905 $ 1,081$ 20,171 19 % Impaired acquired loans 9,787 Total impaired loans to commercial borrowers $ 99,692 December 31, 2012 Impaired loans - originated commercial loan portfolio: With valuation allowance and no charge-offs $ 16,054$ 4,624 $ - 29 % With valuation allowance and charge-offs 8,006 2,826 790 41 With charge-offs and no valuation allowance 27,634 - 16,525 37 Without valuation allowance or charge-offs 35,633 - - - Total 87,327 $ 7,450$ 17,315 27 % Impaired acquired loans 9,099 Total impaired loans to commercial borrowers $ 96,426 43

-------------------------------------------------------------------------------- After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, the Corporation determined that impaired loans in the commercial loan portfolio totaling $5.1 million at December 31, 2013 required a specific allocation of the allowance for loan losses (valuation allowance) of $1.1 million, compared to $24.1 million of impaired loans in the commercial loan portfolio at December 31, 2012 which required a valuation allowance of $7.5 million. The decrease in the valuation allowance during 2013 was primarily reflective of loan charge-offs of impaired loans during the year. Confirmed losses represent partial loan charge-offs on impaired loans due primarily to the receipt of a recent third-party property appraisal indicating the value of the collateral securing the loan was below the loan balance and management determined that full collection of the loan balance is not likely. The Corporation's performing and nonperforming TDRs in the commercial loan portfolio did not require a valuation allowance as the Corporation expected to collect the full principal and interest owed on each of these loans in accordance with their modified terms. The Corporation generally does not recognize a valuation allowance for impaired loans in the consumer loan portfolio as these loans are comprised of smaller-balance homogeneous loans that are collectively evaluated for impairment. However, the Corporation had a valuation allowance attributable to TDRs in the consumer loan portfolio of $0.5 million at December 31, 2013, compared to $0.7 million at December 31, 2012, related to the reduction in the present value of expected future cash flows for these loans discounted at their original effective interest rate. Impaired loans included acquired loans totaling $9.8 million and $9.1 million at December 31, 2013 and 2012, respectively, that were not performing in accordance with the original contractual terms of the loans. These loans did not require a valuation allowance as they are recorded in pools at their net realizable value based on the principal and interest the Corporation expects to collect on these loan pools. These loans are not included in the Corporation's nonperforming loans. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses (allowance) provides for probable losses in the originated loan portfolio that have been identified with specific customer relationships and for probable losses believed to be inherent in the remainder of the originated loan portfolio but that have not been specifically identified. The allowance is comprised of specific valuation allowances (assessed for originated loans that have known credit weaknesses), pooled allowances based on assigned risk ratings and historical loan loss experience for each loan type, and an unallocated allowance for imprecision in the subjective nature of the specific and pooled allowance methodology. Management evaluates the allowance on a quarterly basis in an effort to ensure the level is adequate to absorb probable losses inherent in the loan portfolio. This evaluation process is inherently subjective as it requires estimates that may be susceptible to significant change and has the potential to affect net income materially. The Corporation's methodology for measuring the adequacy of the allowance is comprised of several key elements, which includes a review of the loan portfolio, both individually and by category, and includes consideration of changes in the mix and volume of the loan portfolio, actual loan loss experience, review of collateral values, the financial condition of the borrowers, industry and geographical exposures within the portfolio, economic conditions and employment levels of the Corporation's local markets and other factors affecting business sectors. Management believes that the allowance is currently maintained at an appropriate level, considering the inherent risk in the loan portfolio. Future significant adjustments to the allowance may be necessary due to changes in economic conditions, delinquencies or the level of loan losses incurred. The following schedule summarizes information related to the allowance for loan losses: December 31, 2013 2012 2011 2010 2009 (Dollars in thousands) Allowance for loan losses: Originated loans $ 78,572$ 83,991$ 86,733$ 89,530$ 80,841 Acquired loans 500 500 1,600 - - Total $ 79,072$ 84,491$ 88,333$ 89,530$ 80,841 Nonperforming loans $ 81,984$ 90,854$ 106,269$ 147,729$ 135,755 Allowance for originated loans as a percent of: Total originated loans 1.81 % 2.22 % 2.60 % 2.86 % 2.60 % Nonperforming loans 96 % 92 % 82 % 61 % 60 % Nonperforming loans, less impaired originated loans for which the expected loss has been charged-off 135 % 132 % 107 % 70 % 70 % 44

-------------------------------------------------------------------------------- The allowance of the acquired loan portfolio was not carried over on the date of acquisition. The acquired loans were recorded at their estimated fair values at the date of acquisition, with the estimated fair values including a component for expected credit losses. Acquired loans are subsequently evaluated for further credit deterioration in loan pools, which consist of loans with similar credit risk characteristics. If an acquired loan pool experiences a decrease in expected cash flows as compared to those expected at the acquisition date, a portion of the allowance is allocated to acquired loans. At December 31, 2013, the allowance on the acquired loan portfolio was $0.5 million and was related to two consumer loan pools performing slightly below original expectations. There were no material changes in expected cash flows for the remaining acquired loan pools at December 31, 2013. A summary of the activity in the allowance for loan losses for the five years ended December 31, 2013 is included in Table 6. TABLE 6. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES Years Ended December 31, 2013 2012 2011 2010 2009 (Dollars in thousands) Allowance for loan losses - beginning of year $ 84,491$ 88,333$ 89,530$ 80,841$ 57,056 Provision for loan losses 11,000 18,500 26,000 45,600 59,000 Loan charge-offs: Commercial (4,104 ) (6,427 ) (6,950 ) (8,430 ) (12,001 ) Commercial real estate (7,363 ) (7,930 ) (13,132 ) (10,811 ) (9,231 ) Real estate construction (37 ) (70 ) (31 ) (755 ) (343 ) Land development (776 ) (1,296 ) (458 ) (1,784 ) (6,626 ) Residential mortgage (2,878 ) (5,438 ) (4,971 ) (8,041 ) (3,694 ) Consumer installment (3,993 ) (4,605 ) (4,308 ) (6,289 ) (5,215 ) Home equity (1,995 ) (1,670 ) (2,258 ) (4,376 ) (1,576 ) Total loan charge-offs (21,146 ) (27,436 ) (32,108 ) (40,486 ) (38,686 ) Recoveries of loans previously charged off: Commercial 1,783 744 1,676 921 904 Commercial real estate 1,086 2,246 856 426 495 Real estate construction - - 3 - 46 Land development 23 2 42 20 261 Residential mortgage 346 562 849 543 614 Consumer installment 1,350 1,396 1,156 1,604 1,116 Home equity 139 144 329 61 35 Total loan recoveries 4,727 5,094 4,911 3,575 3,471 Net loan charge-offs (16,419 ) (22,342 ) (27,197 ) (36,911 ) (35,215 ) Allowance for loan losses - end of year $ 79,072$ 84,491$ 88,333$ 89,530$ 80,841 Net loan charge-offs during the year as a percentage of average loans outstanding during the year 0.38 % 0.57 % 0.73 % 1.07 % 1.18 % The allocation of the allowance for loan losses in Table 7 is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or exactness of the specific amounts. The entire allowance attributable to originated loans is available to absorb future loan losses within the originated loan portfolio without regard to the categories in which the loan losses are classified. The allocation of the allowance is based upon a combination of factors, including historical loss factors, credit-risk grading, past-due experiences, and other factors, as discussed above. 45 --------------------------------------------------------------------------------



TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

December 31, 2013 2012 2011 2010 2009 Percent of Percent of Percent of Percent of Originated Originated Originated Originated Percent Loans Loans Loans Loans of Loans in Each in Each in Each in Each in Each Category Category Category Category Category Allowance to Total Allowance to Total Allowance to Total Allowance to Total Allowance to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans (Dollars in millions)

Originated loans: Commercial $ 18.2 25 % $ 18.8 24 % $ 20.7 23 % $ 22.2 22 % $ 19.1 20 % Commercial real estate 23.8 25 28.4 25 30.0 24 32.6 25 23.9 26 Real estate construction 1.6 2 1.0 1 1.3 2 1.6 2 1.9 2 Land development 0.9 - 1.8 1 2.4 1 3.0 1 3.8 2 Residential mortgage 12.8 22 13.3 23 13.0 25 10.8 25 13.1 25 Consumer installment 8.7 15 8.3 14 9.8 14 10.7 16 11.4 16 Home equity 8.1 11 7.2 12 6.0 11 5.9 9 5.9 9 Unallocated 4.5 - 5.2 - 3.5 - 2.7 - 1.7 - Subtotal - originated loans 78.6 100 % 84.0 100 % 86.7 100 % 89.5 100 % $ 80.8 100 % Acquired loans 0.5 0.5 1.6 - Total $ 79.1$ 84.5$ 88.3$ 89.5 DEPOSITS Total deposits were $5.12 billion at December 31, 2013, an increase of $201 million, or 4.1%, from total deposits at December 31, 2012 of $4.92 billion. The increase in total deposits during 2013 was attributable to organic deposit growth of $255 million, which was partially offset by the payoff of $54 million of maturing brokered deposits acquired in the OAK acquisition. At December 31, 2013, brokered deposits acquired in the OAK acquisition totaled less than $10 million. The organic deposit growth included increases in interest- and noninterest-bearing demand deposits and savings deposits that were partially offset by a decline in certificate of deposit accounts. Interest- and noninterest-bearing demand deposit and savings accounts were $3.79 billion at December 31, 2013 compared to $3.45 billion at December 31, 2012. In comparison, certificates of deposit were $1.33 billion at December 31, 2013 compared to $1.47 billion at December 31, 2012. Total deposits increased $555 million during 2012, with the increase in customer deposits primarily attributable to the $404 million of deposits acquired in the branch acquisition transaction on December 7, 2012. Excluding these acquired deposits, total deposits increased $151 million, or 3.4%, during 2012, with the increase attributable to organic deposit growth of $183 million, which was partially offset by the payoff of $32 million of maturing brokered deposits. Similar to 2013, the organic deposit growth included increases in interest- and noninterest-bearing demand deposits and savings deposits that were partially offset by a decline in certificate of deposit accounts. It is the Corporation's strategy to develop customer relationships that will drive core deposit growth and stability. The Corporation's competitive position within many of its market areas has historically limited its ability to materially increase core deposits without adversely impacting the weighted average cost of the deposit portfolio. While competition for core deposits remained strong throughout the Corporation's markets during 2013 and 2012, the Corporation's efforts to expand its deposit relationships with existing customers, the Corporation's financial strength and a general trend in customers holding more liquid assets have resulted in the Corporation continuing to experience increases in customer deposits. The growth of the Corporation's deposits can be impacted by competition from other investment products, such as mutual funds and various annuity products. These investment products are sold by a wide spectrum of organizations, such as brokerage and insurance companies, as well as by financial institutions. The Corporation also competes with credit unions in most of its markets. These institutions are challenging competitors, as credit unions are exempt from federal income taxes, allowing them to potentially offer higher deposit rates. In response to the competition for other investment products, Chemical Bank, through its Chemical Financial Advisors program, offers a wide array of mutual funds, annuity products and marketable securities through an alliance with an independent, registered broker/dealer. 46 --------------------------------------------------------------------------------



At December 31, 2013, the Corporation's time deposits, which consist of certificates of deposit, totaled $1.33 billion, of which $858 million have stated maturities in 2014, although the Corporation expects the majority of these to be renewed by customers or transferred to another deposit product offered by the Corporation. The following schedule summarizes the scheduled maturities of the Corporation's time deposits:

Weighted Average Maturity Schedule Amount Interest Rate (Dollars in thousands) 2014 maturities: First quarter $ 335,689 0.48 % Second quarter 191,363 0.81 Third quarter 168,863 0.99 Fourth quarter 161,826 0.92 Total 2014 maturities 857,741 0.74 2015 maturities 268,924 1.64 2016 maturities 91,316 1.36 2017 maturities 57,725 1.46 2018 maturities 56,225 1.31 Total time deposits $ 1,331,931 1.02 % Table 8 presents the maturity distribution of time deposits of $100,000 or more at December 31, 2013. Time deposits of $100,000 or more totaled $529 million and represented 10.3% of total deposits at December 31, 2013. TABLE 8. MATURITY DISTRIBUTION OF TIME DEPOSITS OF $100,000OR MORE December 31, 2013 Amount Percent (Dollars in thousands) Maturity: Within 3 months $ 150,269 28.4 % After 3 but within 6 months 84,057 15.9 After 6 but within 12 months 118,280 22.3 After 12 months 176,659 33.4 Total $ 529,265 100.0 % BORROWED FUNDS Borrowed funds include short-term borrowings and FHLB advances. Short-term borrowings are comprised of securities sold under agreements to repurchase with customers. These agreements represent funds deposited by customers, generally on an overnight basis, that are collateralized by investment securities owned by Chemical Bank, as these deposits are not covered by Federal Deposit Insurance Corporation (FDIC) insurance. These funds have been a stable source of liquidity, much like its core deposit base, and are generally only provided to customers that have an established banking relationship with Chemical Bank. The Corporation's securities sold under agreements to repurchase do not qualify as sales for accounting purposes. Short-term borrowings were $327.4 million, $310.5 million and $303.8 million at December 31, 2013, 2012 and 2011, respectively, and were comprised solely of securities sold under agreements to repurchase with customers. Short-term borrowings, which are highly interest rate sensitive, increased $16.9 million, or 5.4%, during 2013 primarily due to additional funds deposited by the Corporation's business and municipal customers. A summary of short-term borrowings for 2013, 2012 and 2011 is included in Note 9 to the consolidated financial statements. FHLB advances are borrowings from the Federal Home Loan Bank of Indianapolis that are secured by both a blanket security agreement of residential mortgage first lien loans with an aggregate book value equal to at least 155% of the advances and FHLB capital stock owned by Chemical Bank. The carrying value of residential mortgage first lien loans eligible as collateral under the blanket security agreement was $894 million at December 31, 2013. 47 -------------------------------------------------------------------------------- FHLB advances are generally used to fund loans and a portion of the Corporation's investment securities portfolio. The Corporation had no FHLB advances outstanding at December 31, 2013, compared to $34.3 million at December 31, 2012. On January 22, 2013, the Corporation paid off early all of its FHLB advances outstanding of $34.3 million, resulting in a prepayment fee of $0.8 million. The Corporation prepaid the FHLB advances to improve its net interest income in 2013. A summary of FHLB advances outstanding at December 31, 2013 and 2012 is included in Note 10 to the consolidated financial statements. CONTRACTUAL OBLIGATIONS AND CREDIT-RELATED COMMITMENTS The Corporation has various financial obligations, including contractual obligations and commitments, which may require future cash payments. Refer to Notes 8, 9, 10 and 19 to the consolidated financial statements for a further discussion of these contractual obligations. Contractual Obligations The following schedule summarizes the Corporation's noncancelable contractual obligations and future required minimum payments at December 31, 2013. December 31, 2013 Minimum Payments Due by Period Less than More than 1 year 1-3 years 3-5 years 5 years Total Contractual Obligations: (In thousands) Deposits with no stated maturity(1) $ 3,790,454 $ - $ - $ - $ 3,790,454 Time deposits with a stated maturity(1) 857,741 360,240 113,950 - 1,331,931 Short-term borrowings(1) 327,428 - - - 327,428 Operating leases and noncancelable contracts 10,889 18,959 8,152 6,867 44,867 Other contractual obligations(2) 2,674 - - - 2,674 Total contractual obligations $ 4,989,186$ 379,199$ 122,102



$ 6,867$ 5,497,354

(1) Deposits and borrowings exclude accrued interest. (2) Includes commitments to fund low income housing partnerships, private equity capital investments and similar types of investments. Credit-Related Commitments The Corporation also has credit-related commitments that may impact liquidity. The following schedule summarizes the Corporation's credit-related commitments and expected expiration dates by period at December 31, 2013. December 31, 2013 Expiration Dates by Period Less than More than 1 year 1-3 years 3-5 years 5 years Total Credit-related commitments: (In thousands) Unused commitments to extend credit: Commercial loans $ 520,104$ 86,827$ 26,877$ 42,359$ 676,167 Home equity lines of credit 31,102 41,612 62,121 16,975 151,810 Unsecured consumer loans 9,560 1,596 5,282 1,860 18,298 Residential mortgage construction loans 31,963 - - - 31,963 Total unused commitments to extend credit 592,729 130,035 94,280 61,194 878,238 Undisbursed loan commitments(1) 197,305 - - - 197,305 Standby letters of credit 38,614 7,924 472 - 47,010 Total credit-related commitments $ 828,648$ 137,959$ 94,752



$ 61,194$ 1,122,553

(1) Includes $11 million of residential mortgage loans that were expected to be sold in the secondary market. Because many of these commitments historically have expired without being drawn upon, the total amount of these commitments does not necessarily represent future cash requirements of the Corporation. Refer to Note 19 to the consolidated financial statements for a further discussion of these obligations. 48 -------------------------------------------------------------------------------- CASH DIVIDENDS The Corporation's annual cash dividends paid per common share over the past five years were as follows: Years Ended December 31, 2013 2012 2011 2010 2009



Annual Cash Dividend (per common share) $ 0.87$ 0.82$ 0.80$ 0.80$ 1.18

The Corporation has paid regular cash dividends every quarter since it began operating as a bank holding company in 1973. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to shareholders. Over the long-term, cash dividends to shareholders are dependent upon earnings, capital requirements, legal and regulatory restraints and other factors affecting Chemical Bank. Refer to Note 20 to the consolidated financial statements for a further discussion of factors affecting cash dividends. CAPITAL Capital supports current operations and provides the foundation for future growth and expansion. Total shareholders' equity was $696.5 million at December 31, 2013, an increase of $100.2 million, or 17%, from total shareholders' equity of $596.3 million at December 31, 2012. The increase in shareholders' equity during 2013 was attributable to the Corporation raising $53.9 million of capital in the third quarter of 2013, the Corporation's net income exceeding cash dividends paid to shareholders by $32.3 million and a $10.6 million decrease in accumulated other comprehensive losses. Shareholders' equity increased $24.6 million in 2012, with the increase attributable to the Corporation's net income exceeding cash dividends paid to shareholders by $28.4 million, which was partially offset by a $5.8 million increase in accumulated other comprehensive losses. Book value per common share at December 31, 2013 and 2012 was $23.38 and $21.69, respectively. On September 18, 2013, the Corporation issued and sold 2,213,750 shares of common stock, including 288,750 shares of common stock that were issued and sold upon the exercise, in full, of the underwriters' over-allotment option, at a public offering price of $26.00 per share. The net proceeds from the issuance and sale of the common stock, after deducting the underwriting discount and issuance related expenses, totaled $53.9 million. The Corporation intends to use the net proceeds for general corporate purposes, which may include funding loan growth and long-term strategic opportunities that may arise in the future. The ratio of shareholders' equity to total assets was 11.3% at December 31, 2013, compared to 10.1% at December 31, 2012. The Corporation's tangible equity, which is defined as total shareholders' equity less goodwill and other acquired intangible assets, totaled $571.0 million and $468.4 million at December 31, 2013 and 2012, respectively. The Corporation's tangible equity to assets ratio was 9.4% and 8.1% at December 31, 2013 and 2012, respectively. The increase in the Corporation's tangible equity to assets ratio during 2013 was largely attributable to the Corporation's capital raise, which increased the Corporation's tangible equity by $53.9 million. Under the regulatory "risk-based" capital guidelines in effect for both banks and bank holding companies, minimum capital levels are based upon perceived risk in the Corporation's and Chemical Bank's various asset categories. These guidelines assign risk weights to on- and off-balance sheet items in arriving at total risk-weighted assets. Regulatory capital is divided by the computed total of risk-weighted assets to arrive at the risk-based capital ratios. Risk-weighted assets at December 31, 2013 totaled $4.64 billion for both the Corporation and Chemical Bank, compared to $4.18 billion and $4.16 billion for the Corporation and Chemical Bank, respectively, at December 31, 2012. The Corporation and Chemical Bank both continue to maintain strong capital positions, which significantly exceeded the minimum levels prescribed by the Federal Reserve at December 31, 2013, as shown in the following schedule: December 31, 2013 Risk-Based Leverage Capital Ratios Ratio Tier 1 Total Actual Capital Ratios: Chemical Financial Corporation 9.9 % 12.7 % 14.0 % Chemical Bank 8.7 11.2



12.5

Minimum required for capital adequacy purposes 4.0 4.0



8.0

Minimum required for "well-capitalized" capital adequacy purposes 5.0 6.0 10.0 49

-------------------------------------------------------------------------------- As of December 31, 2013, Chemical Bank's capital ratios exceeded the minimum required to be categorized as well-capitalized, as defined by applicable regulatory requirements. See Note 20 to the consolidated financial statements for more information regarding the Corporation's and Chemical Bank's regulatory capital ratios. From time to time, the board of directors of the Corporation approves common stock repurchase programs allowing the repurchase of shares of the Corporation's common stock in the open market. The repurchased shares are available for later reissuance in connection with potential future stock dividends, the Corporation's dividend reinvestment plan, employee benefit plans and other general corporate purposes. Under these programs, the timing and actual number of shares subject to repurchase are at the discretion of management and are contingent on a number of factors, including the projected parent company cash flow requirements and the Corporation's share price. In January 2008, the board of directors of the Corporation authorized the repurchase of up to 500,000 shares of the Corporation's common stock under a stock repurchase program. In November 2011, the board of directors of the Corporation reaffirmed the stock buy-back authorization with the qualification that the shares may only be repurchased if the share price is below the tangible book value per share of the Corporation's common stock at the time of the repurchase. Since the January 2008 authorization, no shares have been repurchased. At December 31, 2013, there were 500,000 remaining shares available for repurchase under the Corporation's stock repurchase programs. On April 18, 2011, the shareholders of the Corporation approved an amendment to the restated articles of incorporation to increase the number of authorized shares of common stock from 30,000,000 to 45,000,000. Shelf Registration The Corporation filed a universal shelf registration statement with the SEC on May 23, 2013, which became effective on June 7, 2013, to register up to $100 million in securities. The shelf registration statement provides the Corporation with the ability to raise capital, subject to SEC rules and limitations, if the Corporation's board of directors decides to do so. As previously discussed, on September 18, 2013, the Corporation completed a $57.6 million public stock offering, excluding the underwriting discount and issuance related expenses. As a result of the public stock offering, the Corporation has $42.4 million in securities still available under the shelf registration statement. Basel III On July 2, 2013, the Board of Governors of the Federal Reserve (Reserve Board) approved the final rules implementing the Basel Committee on Banking Supervision's (BCBS) capital guidelines for U.S. banks. Under the final rules, minimum requirements will increase for both the quantity and quality of capital held by the Corporation. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The final rules also raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% and require a minimum leverage ratio of 4.0%. On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Reserve Board. The FDIC's rule is identical in substance to the final rules issued by the Reserve Board. The phase-in period for the final rules will begin for the Corporation and Chemical Bank on January 1, 2015, with full compliance with all of the final rule's requirements phased in over a multi-year schedule. While management is currently evaluating the provisions of the final rules and their expected impact on the Corporation and Chemical Bank, management anticipates that the capital ratios for the Corporation and Chemical Bank under Basel III will continue to exceed the well capitalized minimum capital requirements. NET INTEREST INCOME Net interest income is the difference between interest income on earning assets, such as loans, investment and non-marketable equity securities and interest-bearing deposits with the Federal Reserve Bank (FRB), and interest expense on liabilities, such as deposits and borrowings. Net interest income is the Corporation's largest source of net revenue (net interest income plus noninterest income), representing 76% of net revenue during 2013, compared to 77% in 2012 and 80% in 2011. Net interest income, on a fully taxable equivalent (FTE) basis, is the difference between interest income and interest expense adjusted for the tax benefit received on tax-exempt commercial loans and investment securities. Net interest margin is calculated by dividing net interest income (FTE) by average interest-earning assets. Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Because noninterest-bearing sources of funds, or free funds (principally demand deposits and shareholders' equity), also support earning assets, the net interest margin exceeds the net interest spread. 50 -------------------------------------------------------------------------------- Net interest income (FTE) in 2013, 2012 and 2011 was $202.0 million, $192.6 million and $189.0 million, respectively. The presentation of net interest income on a FTE basis is not in accordance with GAAP, but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine tax equivalent net interest income were $5.36 million, $5.04 million and $5.13 million for 2013, 2012 and 2011, respectively. These adjustments were computed using a 35% federal income tax rate. Table 9 presents the average daily balances of the Corporation's major categories of assets and liabilities, interest income and expense on a FTE basis, average interest rates earned and paid on the assets and liabilities, net interest income (FTE), net interest spread and net interest margin for 2013, 2012 and 2011. TABLE 9. AVERAGE BALANCES, TAX EQUIVALENT INTEREST AND EFFECTIVE YIELDS AND RATES(1) Years Ended December 31, 2013 2012 2011 Effective Effective Effective Average Interest Yield/ Average Interest Yield/ Average Interest Yield/ Balance (FTE) Rate Balance (FTE) Rate Balance (FTE) Rate ASSETS (Dollars in thousands) Interest-Earning Assets: Loans(2) $ 4,366,209$ 197,563 4.52 % $ 3,965,074$ 195,122 4.92 % $ 3,741,850$ 199,982 5.34 % Taxable investment securities 721,932 10,234 1.42 670,766 9,890 1.47 607,921 9,423 1.55 Tax-exempt investment securities 233,965 9,776 4.18 189,796 9,039 4.76 171,971 8,907 5.18 Other interest-earning 25,572 1,105 4.32 assets 25,572 1,041 4.07 26,252 965 3.68 Interest-bearing deposits with FRB 281,291 738 0.26 264,919 703 0.27 423,710 1,097 0.26 Total interest-earning assets 5,628,969 219,416 3.90 % 5,116,127 215,795 4.22 % 4,971,704 220,374 4.43 % Less: Allowance for loan losses (83,264 ) (87,510 ) (91,720 ) Other Assets: Cash and cash due from 121,488 banks 113,582 113,919 Premises and equipment 74,134 67,753 65,344 Interest receivable and other assets 223,265 232,127 244,851 Total Assets $ 5,964,592$ 5,442,079$ 5,304,098 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-Bearing Liabilities: Interest-bearing demand deposits $ 1,093,975$ 1,011 0.09 % $ 890,029$ 971 0.11 % $ 820,996$ 1,366 0.17 % Savings deposits 1,357,317 1,210 0.09 1,174,556 1,367 0.12 1,141,977 2,342 0.21 Time deposits 1,391,045 14,662 1.05 1,451,493 19,444 1.34 1,560,405 25,585 1.64 Short-term borrowings 337,649 484 0.14 312,729 426 0.14 287,176 524 0.18 FHLB advances 1,935 47 2.43 39,301 1,005 2.56 64,257 1,572 2.45 Total interest-bearing liabilities 4,181,921 17,414 0.42 3,868,108 23,213 0.60 3,874,811 31,389 0.81 Noninterest-bearing - - deposits 1,121,745 947,984 - - 826,495 - - Total deposits and 17,414 0.33 23,213 borrowed funds 5,303,666 4,816,092 0.48 4,701,306 31,389 0.67 Interest payable and other liabilities 34,371 38,536 33,271 Shareholders' Equity 626,555 587,451 569,521 Total Liabilities and Shareholders' Equity $ 5,964,592$ 5,442,079$ 5,304,098 Net Interest Spread (Average yield earned minus average rate paid) 3.48 % 3.62 % 3.62 % Net Interest Income (FTE) $ 202,002$ 192,582$ 188,985 Net Interest Margin (Net interest income (FTE)/total average interest-earning assets) 3.59 % 3.76 % 3.80 %



(1) Taxable equivalent basis using a federal income tax rate of 35%. (2) Nonaccrual loans and loans held-for-sale are included in average balances

reported and are included in the calculation of yields. Also, tax equivalent

interest includes net loan fees. 51

-------------------------------------------------------------------------------- Net interest income (FTE) of $202.0 million in 2013 was $9.4 million, or 4.9%, higher than net interest income (FTE) of $192.6 million in 2012. The increase in net interest income (FTE) in 2013, compared to 2012, was primarily attributable to an increase of $401 million in the average volume of loans outstanding and the favorable impact of interest-bearing deposits, primarily certificates of deposit, repricing lower during 2013. The increases attributable to loan growth and deposits repricing were partially offset by the unfavorable impact of interest-earning assets, primarily loans, repricing during 2013. The net interest margin was 3.59% in 2013, compared to 3.76% in 2012. The average yield on interest-earning assets decreased 32 basis points to 3.90% in 2013 from 4.22% in 2012 with the decrease primarily attributable to loans repricing at lower interest rates. The average yield on loans decreased 40 basis points to 4.52% in 2013 from 4.92% in 2012 with declines occurring across all major loan categories. The average cost of interest-bearing liabilities decreased 18 basis points to 0.42% in 2013 from 0.60% in 2012 with the decrease attributable to the repricing of time deposits at lower interest rates as they matured and were renewed in the continued low interest rate environment. Net interest income (FTE) of $192.6 million in 2012 was $3.6 million, or 1.9%, higher than net interest income (FTE) of $189.0 million in 2011. The increase in net interest income (FTE) in 2012, compared to 2011, was primarily attributable to an increase of $223 million in the average volume of loans outstanding and the favorable impact of interest-bearing deposits, primarily certificates of deposit, repricing lower during 2012. The increases attributable to loan growth and deposits repricing were partially offset by the unfavorable impact of interest-earning assets, primarily loans, repricing during 2012. The net interest margin was 3.76% in 2012, compared to 3.80% in 2011. The average yield on interest-earning assets decreased 21 basis points to 4.22% in 2012 from 4.43% in 2011 with the decrease primarily attributable to loans repricing at lower interest rates. The average yield on loans decreased 42 basis points to 4.92% in 2012 from 5.34% in 2011 with declines occurring across all major loan categories. The average cost of interest-bearing liabilities decreased 21 basis points to 0.60% in 2012 from 0.81% in 2011 with the decrease attributable to the repricing of time deposits at lower interest rates as they matured and were renewed in the continued low interest rate environment. Changes in the Corporation's net interest income are influenced by a variety of factors, including changes in the level and mix of interest-earning assets and interest-bearing liabilities, current and prior years' interest rate changes, the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in the Corporation's markets. Risk management plays an important role in the Corporation's level of net interest income. The ineffective management of credit risk, and more significantly interest rate risk, can adversely impact the Corporation's net interest income. Management monitors the Corporation's consolidated statement of financial position to reduce the potential adverse impact on net interest income caused by significant changes in interest rates. The Corporation's policies in this regard are further discussed in the section captioned "Market Risk" in Item 7A of this report. The Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, was 3.25% at the end of 2008 and remained at this historically low rate through December 31, 2013. The prime interest rate has historically been 300 basis points higher than the federal funds rate. The Federal Open Market Committee (FOMC) has indicated that it will potentially keep the federal funds rate between zero and 0.25% at least as long as the unemployment rate remains above 6.5%. The national unemployment rate was 6.7% at December 31, 2013, and therefore, the prime interest rate is expected to remain at or near its current historical low level into 2014. The majority of the Corporation's variable interest rate loans in the commercial loan portfolio are tied to the prime rate. The Corporation is primarily funded by core deposits, which is a lower-cost funding base than wholesale funding and historically has had a positive impact on the Corporation's net interest income and net interest margin. Based on the current historically low level of market interest rates and the Corporation's current low levels of interest rates on its core deposit transaction accounts, further market interest rate reductions would not result in a significant decrease in interest expense. 52 -------------------------------------------------------------------------------- Table 10 allocates the dollar change in net interest income (FTE) between the portion attributable to changes in the average volume of interest-earning assets and interest-bearing liabilities, including changes in the mix of assets and liabilities and changes in average interest rates earned and paid. TABLE 10. VOLUME AND RATE VARIANCE ANALYSIS(1) (In thousands) 2013 Compared to 2012 2012 Compared to 2011 Increase (Decrease) Increase (Decrease) Due to Changes in Combined Due to Changes in Combined Average Average Increase Average Average Increase Volume(2) Yield/ Rate(2) (Decrease) Volume(2) Yield/ Rate(2) (Decrease) Changes in Interest Income on Interest-Earning Assets: Loans $ 18,620$ (16,179 )$ 2,441$ 11,254$ (16,114 )$ (4,860 ) Taxable investment 708 (300 ) 408 securities/other assets 946 (403 ) 543 Tax-exempt investment securities 1,949 (1,212 ) 737 898 (766 ) 132 Interest-bearing deposits with



35

the FRB 55 (20 ) (434 ) 40 (394 ) Total change in interest income on interest-earning assets 21,332 (17,711 ) 3,621 12,664 (17,243 ) (4,579 ) Changes in Interest Expense on Interest-Bearing Liabilities: Interest-bearing demand deposits 213 (173 ) 40 49 (444 ) (395 ) Savings deposits 160 (317 ) (157 ) 10 (985 ) (975 ) Time deposits (664 ) (4,118 ) (4,782 ) (1,659 ) (4,482 ) (6,141 ) Short-term borrowings 58 - 58 38 (136 ) (98 ) FHLB advances (910 ) (48 ) (958 ) (635 ) 68 (567 ) Total change in interest expense on interest-bearing liabilities (1,143 ) (4,656 ) (5,799 ) (2,197 ) (5,979 ) (8,176 ) Total Change in Net Interest Income (FTE) $ 22,475$ (13,055 )$ 9,420$ 14,861$ (11,264 )$ 3,597



(1) Taxable equivalent basis using a federal income tax rate of 35%. (2) The change in interest income and interest expense due to both volume and

rate has been allocated to the volume and rate change in proportion to the

relationship of the absolute dollar amount of the change in each.

PROVISION FOR LOAN LOSSES The provision for loan losses (provision) is an increase to the allowance, as determined by management to provide for probable losses inherent in the originated loan portfolio and for impairment in pools of acquired loans that results from the Corporation experiencing a decrease in the expected cash flows of acquired loans during each reporting period. The provision was $11.0 million in 2013, compared to $18.5 million in 2012 and $26.0 million in 2011. There was no provision in 2013 attributable to the acquired loan portfolio, while the provision in 2012 and 2011 included $1.1 million and $1.6 million, respectively, related to the acquired loan portfolio that was primarily attributable to one acquired loan pool experiencing a decline in expected cash flows. The Corporation experienced net loan charge-offs of $16.4 million in 2013, compared to $22.3 million in 2012 and $27.2 million in 2011. Net loan charge-offs as a percentage of average loans were 0.38% in 2013, compared to 0.57% in 2012 and 0.73% in 2011. Net loan charge-offs in the commercial loan portfolio totaled $9.4 million in 2013, compared to $12.7 million in 2012 and $18.0 million in 2011 and represented 57% of total net loan charge-offs during both 2013 and 2012, compared to 66% in 2011. The commercial loan portfolio's net loan charge-offs in 2013 were not concentrated in any one industry or borrower. Net loan charge-offs in the consumer loan portfolio totaled $7.0 million in 2013, compared to $9.6 million in 2012 and $9.2 million in 2011. The Corporation's provision of $11.0 million in 2013 was $5.4 million lower than 2013 net loan charge-offs and $7.5 million lower than the 2012 provision. The reduction in the provision in 2013, compared to both net loan charge-offs in 2013 and the provision in 2012, was reflective of continued improvement in credit quality of the loan portfolio that included significant decreases in loan charge-offs and nonperforming loans and no significant adverse changes in the risk grade categories of the commercial loan portfolio. 53 -------------------------------------------------------------------------------- NONINTEREST INCOME The following schedule summarizes the major components of noninterest income during the past three years: Years Ended December 31, 2013 2012 2011 (Dollars in thousands)



Service charges and fees on deposit accounts $ 21,939$ 19,581

$ 18,452 Wealth management revenue 13,989 11,763 11,104 Electronic banking fees 12,213 9,793 9,127 Mortgage banking revenue 5,336 6,597 3,881 Other fees for customer services 3,288 2,598



2,451

Insurance commissions 1,650 1,836



1,413

Gain on sale of investment securities 1,133 34 - Gain on sale of merchant card services - 1,280 - Other 861 1,202 462 Total noninterest income $ 60,409$ 54,684$ 46,890 Noninterest income(1) as a percentage of: Net revenue (net interest income plus noninterest income) 23 % 22 % 20 % Average total assets 0.99 % 0.96 % 0.88 % (1) Excludes nonrecurring items such as gain on the sale of investment securities and gain on the sale of merchant card services. See the discussion below for a description and the amounts of these nonrecurring items. Noninterest income was $60.4 million in 2013, $54.7 million in 2012 and $46.9 million in 2011. Noninterest income in 2013 included nonrecurring income of $1.6 million, including $1.1 million attributable to available-for-sale investment securities gains and $0.5 million attributable to gains on the sales of closed branch offices, while 2012 included nonrecurring income of $2.1 million, including $1.3 million attributable to a gain from the sale of the Corporation's merchant card servicing business, $0.6 million from a partial insurance recovery of a 2008 branch cash loss and $0.2 million from a merchant card vendor settlement. Excluding nonrecurring income, noninterest income increased $6.2 million, or 12%, in 2013, compared to 2012, with increases in wealth management revenue, service charges and fees on deposit accounts and other fees for customer services partially offset by a decline in mortgage banking revenue. The increases in charges and fees for customer services were partially driven by growth in the volume of services provided as a result of the branch acquisition transaction. Excluding nonrecurring income, noninterest income increased $5.7 million, or 12%, in 2012, compared to 2011, with the increase primarily attributable to higher service charges on deposit accounts and mortgage banking revenue, although all major components of noninterest income were higher in 2012 than 2011. During 2013, the Corporation sold $32 million of available-for-sale investment securities at a gain of $0.8 million and utilized the proceeds from the sales to pay off the Corporation's FHLB advances. The Corporation incurred prepayment fees of $0.8 million, included in other operating expenses, related to the early payoff of its FHLB advances. The Corporation also had a $4.8 million preferred stock investment security, which was carried at cost, that was redeemed by the issuer during 2013 and which resulted in the Corporation recognizing a gain of $0.3 million. Service charges and fees on deposit accounts, which include overdraft/non-sufficient funds fees, checking account fees and other deposit account charges, were $21.9 million in 2013, $19.6 million in 2012 and $18.5 million in 2011. Service charges and fees on deposit accounts increased $2.3 million, or 12%, in 2013, compared to 2012, due primarily to additional fees earned as a result of the branch acquisition transaction. Service charges and fees on deposit accounts increased $1.1 million, or 6.1%, in 2012, compared to 2011, due to higher overdraft/non-sufficient funds fees and an increase in business checking account fees. During the second quarter of 2012, the Corporation increased certain service fees it charges for business checking accounts, the first such increase in fourteen years. Overdraft/non-sufficient funds fees included in service charges and fees on deposit accounts were $17.6 million in 2013, $15.6 million in 2012 and $14.9 million in 2011. Wealth management revenue is comprised of investment fees that are generally based on the market value of assets within a trust account, custodial account fees and fees from the sale of investment products. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees. Wealth management revenue was $14.0 million in 2013, $11.8 million in 2012 and $11.1 million in 2011. Wealth management revenue increased $2.2 million, or 19%, in 2013, compared to 2012, due to a combination of improving equity market performance that led to increased assets under management, growth in 54 -------------------------------------------------------------------------------- assets under management resulting from new customer accounts and an increase in fees from a higher volume of sales of investment products. Wealth management revenue increased $0.7 million, or 5.9%, in 2012, compared to 2011, due primarily to increases in fees earned resulting from a change in the composition of trust assets under administration, improving equity market performance that led to increased assets under management and growth in assets under management resulting from new customer accounts. Wealth management revenue includes fees from the sale of investment products offered through the Chemical Financial Advisors program. Fees from this program totaled $3.8 million in 2013, compared to $3.0 million in 2012 and $2.7 million in 2011. At December 31, 2013, the estimated fair value of trust assets under administration was $2.51 billion (including discretionary assets of $1.44 billion and nondiscretionary assets of $1.07 billion), compared to $2.07 billion at December 31, 2012 (including discretionary assets of $1.18 billion and nondiscretionary assets of $892 million), and $1.95 billion at December 31, 2011 (including discretionary assets of $1.08 billion and nondiscretionary assets of $867 million). The Corporation also had customer assets within the Chemical Financial Advisors program of $737 million at December 31, 2013, compared to $669 million at December 31, 2012 and $546 million at December 31, 2011. Electronic banking fees, which represent income earned by the Corporation from ATM transactions, debit card activity and internet banking fees, were $12.2 million in 2013, $9.8 million in 2012 and $9.1 million in 2011. Electronic banking fees increased $2.4 million, or 25%, in 2013, compared to 2012, due primarily to increased customer debit card activity that was largely attributable to additional fees earned as a result of the branch acquisition transaction, while the increase of $0.7 million, or 7.3%, in 2012, compared to 2011, was due primarily to increased customer debit card activity. Mortgage banking revenue (MBR) includes revenue from originating, selling and servicing residential mortgage loans for the secondary market. MBR was $5.3 million in 2013, $6.6 million in 2012 and $3.9 million in 2011. MBR decreased $1.3 million, or 19%, in 2013, compared to 2012, due primarily to a lower volume of loans sold in the secondary market. MBR increased $2.7 million, or 70%, in 2012, compared to 2011, due primarily to both higher gains on the sale of loans in the secondary market and a higher volume of loans sold in the secondary market. The Corporation sold $211 million of residential mortgage loans in the secondary market during 2013, compared to $305 million during 2012 and $219 million during 2011. At December 31, 2013, the Corporation was servicing $887 million of residential mortgage loans that had been originated by the Corporation in its market areas and subsequently sold in the secondary market, down slightly from $906 million at December 31, 2012 and $903 million at December 31, 2011. The Corporation sells residential mortgage loans in the secondary market on both a servicing retained and servicing released basis. These sales include the Corporation entering into residential mortgage loan sale agreements with buyers in the normal course of business. The agreements contain provisions that include various representations and warranties regarding the origination, characteristics and underwriting of the mortgage loans. The recourse of the buyer may result in either indemnification of the loss incurred by the buyer or a requirement for the Corporation to repurchase a loan that the buyer believes does not comply with the representations included in the loan sale agreement. Repurchase demands and loss indemnifications received by the Corporation are reviewed by a senior officer on a loan-by-loan basis to validate the claim made by the buyer. The Corporation maintains a reserve for probable losses expected to be incurred from loans previously sold in the secondary market. This contingent liability is based on trends in repurchase and indemnification requests, actual loss experience, information requests, known and inherent risks in the sale of loans in the secondary market and current economic conditions. During 2013, the Corporation incurred loan losses and buyer indemnification expenses totaling $0.2 million related to five residential mortgage loans that had been previously sold in the secondary market. During 2012 and 2011 combined, the Corporation incurred loan losses and buyer indemnification expenses totaling $0.4 million related to five residential mortgage loans that had been previously sold in the secondary market. The Corporation was also required to repurchase ten residential mortgage loans totaling $1.0 million in 2011 and 2012 that had been previously sold in the secondary market as it was determined that these loans did not meet the original qualifications for sale in the secondary market. These ten loans were all performing and their fair values approximated the repurchase price at the repurchase date. Accordingly, the Corporation did not incur a loss at the time of repurchase on any of these ten loans. The Corporation records losses resulting from the repurchase of loans previously sold in the secondary market, as well as adjustments to estimates of future probable losses, as part of its MBR in the period incurred. The Corporation's reserve for probable losses was $1.6 million at December 31, 2013, compared to $0.75 million at December 31, 2012. All other categories of noninterest income, including other fees for customer services, insurance commissions and other noninterest income, excluding the nonrecurring income previously discussed, totaled $5.3 million in 2013, $4.8 million in 2012 and $4.3 million in 2011. Other fees for customer services include revenue from safe deposit boxes, credit card referral fees, wire transfer fees, letter of credit fees and other fees for services. Insurance commissions primarily consist of title insurance commissions received on title insurance policies issued for customers of Chemical Bank. 55 -------------------------------------------------------------------------------- OPERATING EXPENSES The following schedule summarizes the major categories of operating expenses during the past three years: Years Ended December 31, 2013 2012 2011 (Dollars in thousands) Salaries and wages $ 78,014$ 68,668$ 61,301 Employee benefits 18,405 15,715 13,192 Occupancy 13,934 12,413 12,974 Equipment and software 13,734 13,112 11,935 Outside processing and service fees 11,134 10,679 9,583 FDIC insurance premiums 4,362 4,320 5,375 Professional fees 3,771 4,347 4,128 Postage and express mail 3,051 3,149 3,147 Advertising and marketing 2,971 3,106 2,850 Donations 2,829 1,892 1,537 Training, travel and other employee expenses 2,512 2,530



2,246

Telephone 1,940 1,693



1,631

Intangible asset amortization 1,909 1,569 1,860 Supplies 1,670 1,567 1,690 Credit-related expenses 707 3,816 9,535 Other 4,005 3,345 1,509 Total operating expenses $ 164,948$ 151,921$ 144,493 Full-time equivalent staff (at December 31) 1,743 1,859



1,716

Efficiency ratio (1) 63.1 % 60.8 % 61.3 % Total operating expenses as a percentage of total average assets (1) 2.76 % 2.74



% 2.72 %

(1) Excludes nonrecurring items such as expenses incurred in conjunction with acquisitions. Total operating expenses were $164.9 million in 2013, $151.9 million in 2012 and $144.5 million in 2011. Operating expenses included nonrecurring costs in 2012 of $2.9 million related to the branch acquisition transaction. Excluding nonrecurring costs, operating expenses increased $15.9 million, or 11%, in 2013, compared to 2012, due largely to incremental operating costs associated with the branch acquisition transaction. The increase was also attributable to higher employee compensation costs resulting from merit increases that took effect at the beginning of 2013, market-based salary adjustments, higher performance-based compensation and higher group health care costs, all of which were partially offset by lower credit-related expenses. Excluding nonrecurring costs, operating expenses increased $4.5 million, or 3.1%, in 2012, compared to 2011, with the increase primarily due to higher employee compensation costs and equipment and software expenses, which were partially offset by lower credit-related expenses and FDIC insurance premiums. Salaries and wages were $78.0 million in 2013, $68.7 million in 2012 and $61.3 million in 2011. Salaries and wages expense increased $9.3 million, or 14%, in 2013, compared to 2012, due primarily to incremental costs associated with the branch acquisition transaction. The increase was also attributable to merit increases that took effect at the beginning of 2013 and higher performance-based compensation expense. Salaries and wages expense increased $7.4 million, or 12%, in 2012, compared to 2011, due primarily to new positions, merit and market driven salary increases that took effect at the beginning of 2012 and higher performance-based compensation expense. Performance-based compensation expense was $8.9 million in 2013, compared to $7.2 million in 2012 and $5.3 million in 2011. Employee benefits expense was $18.4 million in 2013, $15.7 million in 2012 and $13.2 million in 2011. Employee benefits expense increased $2.7 million, or 17%, in 2013, compared to 2012, due primarily to incremental costs associated with the branch acquisition transaction and higher group health care costs and pension plan expenses. Employee benefits expense increased $2.5 million, or 19%, in 2012, compared to 2011, due primarily to higher group health care costs and pension plan expenses. Pension plan expenses were $1.7 million in 2013, $1.4 million in 2012 and $0.7 million in 2011. The increases in pension plan expenses during 2013 and 2012 were the result of decreases in the discount rate used to value the pension plan's projected benefit obligations. Postretirement plan expenses increased $0.6 million during 2013 due to a change in the plan which provided benefits to certain employees who met age and service requirements. 56 -------------------------------------------------------------------------------- Compensation expenses, which include salaries and wages and employee benefits, as a percentage of total operating expenses were 58.5% in 2013, 55.5% in 2012 and 51.6% in 2011. Occupancy expense was $13.9 million in 2013, $12.4 million in 2012 and $13.0 million in 2011. Occupancy expense increased $1.5 million, or 12%, in 2013, compared to 2012, due primarily to incremental operating costs associated with the branch acquisition transaction. Occupancy expense decreased $0.6 million, or 4.3%, in 2012, compared to 2011, due to lower maintenance, utility and property tax expenses, which were partially offset by higher depreciation expense. Occupancy expense included depreciation expense on buildings of $3.7 million in 2013, $3.3 million in 2012 and $3.1 million in 2011. Equipment and software expense was $13.7 million in 2013, $13.1 million in 2012 and $11.9 million in 2011. Equipment and software expense increased $0.6 million, or 4.7%, in 2013, compared to 2012, due primarily to incremental operating costs associated with the branch acquisition transaction, including higher equipment depreciation and maintenance costs. Equipment and software expense increased $1.2 million, or 9.9%, in 2012, compared to 2011, due primarily to higher software expense where the cost is based on the number of users or is volume-based, both of which were higher in 2012 than 2011. Equipment and software expense included depreciation expense on equipment of $5.0 million in 2013 and $4.8 million in both 2012 and 2011. Outside processing and service fees were $11.1 million in 2013, $10.7 million in 2012 and $9.6 million in 2011. Outside processing and service fees in 2012 included $0.6 million of nonrecurring costs attributable to the branch acquisition transaction. Excluding these nonrecurring costs, outside processing and service fees increased $1.1 million, or 11%, in 2013, compared to 2012, due largely to incremental operating costs associated with the branch acquisition transaction, including increased third-party volume-based costs. Outside processing and service fees increased $0.5 million, or 4.7%, in 2012, compared to 2011, due largely to increased third-party debit card processing costs resulting from increased customer debit card activity. Professional fees were $3.8 million in 2013, $4.3 million in 2012 and $4.1 million in 2011. Professional fees in 2012 included $1.1 million of nonrecurring costs attributable to the branch acquisition transaction. Excluding these nonrecurring costs, professional fees increased $0.6 million, or 17%, in 2013, compared to 2012. Professional fees decreased $0.9 million, or 22%, in 2012, compared to 2011, due partially to 2011 including costs related to the Corporation's business process improvement project, which resulted in the identification of various internal project initiatives with cost saving opportunities which are expected to improve and enhance the overall Chemical Bank customer experience. FDIC insurance premiums were $4.4 million in 2013, $4.3 million in 2012 and $5.4 million in 2011. FDIC insurance premiums increased $0.1 million, or 1.0%, in 2013, compared to 2012, due to an increase in the Corporation's assessment base (defined as average assets less average Tier 1 capital), which was partially offset by a decrease in the Corporation's assessment rate resulting from improvement in the Corporation's earnings and the credit quality of its loan portfolio. FDIC insurance premiums decreased $1.1 million, or 20%, in 2012, compared to 2011, due primarily to a change in the assessment base and a lower assessment rate applicable to the Corporation. Effective April 1, 2011, the Corporation's assessment base changed from average deposits to average consolidated total assets less average Tier 1 capital and its assessment rate declined from approximately 16 basis points to 9 basis points, on an annualized basis. The Corporation's FDIC insurance premiums in 2012 were also lower than 2011 partially due to reductions in its assessment rate resulting from improvement in the Corporation's earnings and the credit quality of its loan portfolio. Credit-related expenses are comprised of other real estate (ORE) net costs and loan collection costs. ORE net costs are comprised of costs to carry ORE, such as property taxes, insurance and maintenance costs, fair value write-downs after a property is transferred to ORE and net gains/losses from the disposition of ORE. Loan collection costs include legal fees, appraisal fees and other costs recognized in the collection of loans with deteriorated credit quality and in the process of foreclosure. Credit-related expenses were $0.7 million in 2013, $3.8 million in 2012 and $9.5 million in 2011. Credit-related expenses decreased $3.1 million, or 82%, in 2013, compared to 2012, due to a combination of higher gains on the sale of ORE properties, lower ORE operating costs and lower loan collection costs on nonperforming and watch loan credits as the credit quality of the Corporation's loan portfolio continued to improve. Credit-related expenses decreased $5.7 million, or 60%, in 2012, compared to 2011, due to a combination of the Corporation recognizing net gains on the sale of ORE properties during 2012, compared to a net expense from write-downs of ORE properties during 2011, and lower ORE operating and loan collection costs. The Corporation recognized net gains on the sale of ORE properties of $2.9 million and $1.5 million in 2013 and 2012, respectively, compared to a net write-down of $2.6 million during 2011. Property taxes on ORE were $0.8 million in 2013, $1.5 million in 2012 and $2.2 million in 2011. Other operating costs on ORE were $1.0 million in 2013, $1.3 million in 2012 and $1.2 million in 2011. Loan collection costs were $1.8 million in 2013, $2.5 million in 2012 and $3.5 million in 2011. Donations were $2.8 million in 2013, $1.9 million in 2012 and $1.5 million in 2011. Donations increased $0.9 million, or 50%, in 2013, compared to 2012. Donations increased $0.4 million, or 23%, in 2012, compared to 2011. The increases in donations during 2013 and 2012 were due to commitments to the Chemical Bank Foundation of $1.4 million and $0.5 million in 2013 and 2012, respectively. The Chemical Bank Foundation was established in 2012 with the intent of building an endowment that will serve to award grants to organizations that improve the quality of life throughout the communities served by the Corporation. 57 -------------------------------------------------------------------------------- All other categories of operating expenses totaled $18.1 million in 2013, $17.0 million in 2012 and $14.9 million in 2011. All other categories of operating expenses in 2012 included nonrecurring costs of $1.2 million attributable to the branch acquisition transaction. Excluding nonrecurring costs, all other categories of operating expenses increased $2.3 million, or 14%, in 2013, compared to 2012, due largely to incremental costs associated with the branch acquisition transaction. Excluding nonrecurring costs, all other categories of operating expenses increased $0.9 million, or 6.0%, in 2012, compared to 2011. The Corporation's efficiency ratio, which measures total operating expenses (excluding nonrecurring costs) divided by the sum of net interest income (FTE) and noninterest income (excluding nonrecurring income), was 63.1% in 2013, 60.8% in 2012 and 61.3% in 2011. INCOME TAXES The Corporation's effective federal income tax rate was 30.0% in 2013, 29.0% in 2012 and 28.5% in 2011. The fluctuations in the Corporation's effective federal income tax rate reflect changes each year in the proportion of interest income exempt from federal taxation, nondeductible interest expense and other nondeductible expenses relative to pretax income and tax credits. The increases in the Corporation's effective federal income tax rate in 2013 and 2012, compared to 2012 and 2011, respectively, were due primarily to increases in the Corporation's pre-tax income. The Corporation had no uncertain tax positions during the three years ended December 31, 2013. Tax-exempt income on a fully tax-equivalent (FTE) basis, net of related nondeductible interest expense, totaled $13.4 million in 2013, $12.5 million in 2012 and $12.8 million in 2011. Tax-exempt income (FTE) as a percentage of total interest income (FTE) was 6.1% in 2013, compared to 5.8% in both 2012 and 2011. Income before income taxes (FTE) was $86.5 million in 2013, $76.8 million in 2012 and $65.4 million in 2011. LIQUIDITY Liquidity measures the ability of the Corporation to meet current and future cash flow needs in a timely manner. Liquidity risk is the adverse impact on net interest income if the Corporation was unable to meet its cash flow needs at a reasonable cost. Liquidity is managed to ensure stable, reliable and cost-effective sources of funds are available to satisfy deposit withdrawals and lending and investment opportunities. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. The Corporation manages its funding needs by maintaining a level of liquid funds through its asset/liability management process. The Corporation's largest sources of liquidity on a consolidated basis are the deposit base that comes from consumer, business and municipal customers within the Corporation's local markets, principal payments on loans, maturing investment securities, cash held at the Federal Reserve Bank (FRB) and unpledged investment securities available-for-sale. Excluding brokered and other deposits acquired in acquisitions, customer deposits increased $255 million during 2013, compared to an increase of $151 million during 2012. The Corporation's loan-to-deposit ratio increased to 90.7% at December 31, 2013 from 84.7% at December 31, 2012 as a result of loans increasing $480 million, or 11.5%, during 2013. At December 31, 2013 and 2012, the Corporation had $180 million and $514 million, respectively, of cash deposits held at the FRB. In addition, at December 31, 2013, the Corporation had unpledged investment securities available-for-sale with an amortized cost of $80 million and available unused wholesale sources of liquidity, including FHLB advances and borrowings from the discount window of the FRB. Chemical Bank is a member of the FHLB and as such has access to short-term and long-term advances from the FHLB that are generally secured by residential mortgage first lien loans. The Corporation considers advances from the FHLB as its primary wholesale source of liquidity. During the first quarter of 2013, the Corporation prepaid all of its FHLB advances outstanding totaling $34.3 million. At December 31, 2013, the Corporation's borrowing availability from the FHLB, based on its FHLB capital stock and subject to certain requirements, was $341 million. Chemical Bank can also borrow from the FRB's discount window to meet short-term liquidity requirements. These borrowings are required to be secured by investment securities and/or certain loan types, with each category of assets carrying various borrowing capacity percentages. At December 31, 2013, Chemical Bank maintained an unused borrowing capacity of $34 million with the FRB's discount window based upon pledged collateral as of that date. It is management's opinion that the Corporation's borrowing capacity could be expanded, if deemed necessary, as Chemical Bank has additional borrowing capacity available at the FHLB that could be used if it increased its investment in FHLB capital stock, and Chemical Bank has a significant amount of additional assets that could be used as collateral at the FRB's discount window. The Corporation manages its liquidity position to provide the cash necessary to pay dividends to shareholders, invest in new subsidiaries, enter new banking markets, pursue investment opportunities and satisfy other operating requirements. The Corporation's primary source of liquidity is dividends from Chemical Bank. 58 -------------------------------------------------------------------------------- Federal and state banking laws place certain restrictions on the amount of dividends that a bank may pay to its parent company. During 2013, Chemical Bank paid $24.5 million in dividends to the Corporation and the Corporation paid cash dividends to shareholders of $24.5 million. During 2012, Chemical Bank paid $27.6 million in dividends to the Corporation and the Corporation paid cash dividends to shareholders of $22.6 million. The Corporation had $65 million in cash at December 31, 2013, which it held in a deposit account at Chemical Bank. The Corporation's cash position increased significantly during 2013 as a result of raising $53.9 million of capital in the third quarter of 2013. The Corporation intends to use the proceeds from the capital raise for general corporate purposes, which may include funding loan growth and long-term strategic opportunities that may arise in the future. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to the Corporation's shareholders. Over the long term, cash dividends to shareholders are dependent upon earnings, capital requirements, regulatory restraints and other factors affecting Chemical Bank. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. MARKET RISK Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due primarily to changes in interest rates. Interest rate risk is the Corporation's primary market risk and results from timing differences in the repricing of interest rate sensitive assets and liabilities and changes in relationships between rate indices due to changes in interest rates. The Corporation's net interest income is largely dependent upon the effective management of interest rate risk. The Corporation's goal is to avoid a significant decrease in net interest income, and thus an adverse impact on the profitability of the Corporation, in periods of changing interest rates. Sensitivity of earnings to interest rate changes arises when yields on assets change differently from the interest costs on liabilities. Interest rate sensitivity is determined by the amount of interest-earning assets and interest-bearing liabilities repricing within a specific time period and the magnitude by which interest rates change on the various types of interest-earning assets and interest-bearing liabilities. The management of interest rate sensitivity includes monitoring the maturities and repricing opportunities of interest-earning assets and interest-bearing liabilities. The Corporation's interest rate risk is managed through policies and risk limits approved by the boards of directors of the Corporation and Chemical Bank and an Asset and Liability Committee (ALCO). The ALCO, which is comprised of executive and senior management from various areas of the Corporation and Chemical Bank, including finance, lending, investments and deposit gathering, meets regularly to execute asset and liability management strategies. The ALCO establishes guidelines and monitors the sensitivity of earnings to changes in interest rates. The goal of the ALCO process is to manage the impact on net interest income and the net present value of future cash flows of probable changes in interest rates within authorized risk limits. The primary technique utilized by the Corporation to measure its interest rate risk is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of the Treasury yield curve, interest rate relationships and the mix of assets and liabilities and loan prepayments. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions and management strategies. The Corporation's interest rate sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of constant market interest rates. The Corporation then compares the results of various simulation analyses to the constant interest rate forecast (base case). At December 31, 2013 and 2012, the Corporation projected the change in net interest income during the next twelve months assuming short-term market interest rates were to uniformly and gradually increase or decrease by up to 200 basis points in a parallel fashion over the entire yield curve during the same time period. Additionally, the Corporation projected the change in net interest income of an immediate 400 basis point increase in market interest rates at December 31, 2013 and 2012. The Corporation did not project an immediate 400 basis point decrease in interest rates as the likelihood of a decrease of this size was considered unlikely given prevailing interest rate levels. These projections were based on the Corporation's assets and liabilities remaining static over the next twelve months, while factoring in probable calls and prepayments of certain investment securities and residential mortgage and consumer loans. The ALCO regularly monitors the Corporation's forecasted net interest income sensitivity to ensure that it remains within established limits. 59 -------------------------------------------------------------------------------- A summary of the Corporation's interest rate sensitivity at December 31, 2013 and 2012 follows: Immediate Gradual Change Change December 31, 2013 Twelve month interest rate change projection (in basis points) -200 -100 0 +100 +200 +400 Percent change in net interest (3.9 )% (1.8 )% - 0.1 % (0.6 )% (2.4)% income vs. constant rates December 31, 2012 Twelve month interest rate change projection (in basis points) -200 -100 0 +100 +200 +400 Percent change in net interest (4.1 )% (2.3 )% - 0.9 % 1.3 % 5.7% income vs. constant rates At December 31, 2013, the Corporation's model simulations projected that a 100 basis point increase in interest rates would result in a positive variance of 0.1%, relative to the base case over the next twelve-month period, while 200 and 400 basis point increases in interest rates would result in negative variances in net interest income of 0.6% and 2.4%, respectively, relative to the base case over the next twelve-month period. At December 31, 2013, the Corporation's model simulations also projected that decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 1.8% and 3.9%, respectively, relative to the base case over the next twelve-month period. At December 31, 2012, the model simulations projected that 100, 200 and 400 basis point increases in interest rates would result in positive variances in net interest income of 0.9%, 1.3% and 5.7%, respectively, relative to the base case over the next twelve-month period, while decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 2.3% and 4.1%, respectively, relative to the base case over the next twelve-month period. The likelihood of a decrease in interest rates beyond 100 basis points at December 31, 2013 and 2012 was considered to be unlikely given prevailing interest rate levels. The Corporation's model simulations at December 31, 2013 for a 200 basis point increase resulted in a negative variance in net interest income, relative to the base case, primarily due to the Corporation deploying excess cash into fixed-rate loans and investment securities during 2013. However, while the model simulations projected a negative variance for a 200 basis point increase, the Corporation's net interest income is still projected to be higher if interest rates were to rise 200 basis points due to the higher yield being earned on the funds deployed into loans and investment securities compared to maintaining these funds at the FRB earning 25 basis points. The Corporation's model simulations for a 100 basis point increase resulted in a slight positive variance in net interest income, relative to the base case, primarily due to the Corporation maintaining excess cash at the FRB. The Corporation's model simulations treat excess cash maintained at the FRB as a variable-rate asset. The Corporation's cash held at the FRB totaled $180 million at December 31, 2013, down from $514 million at December 31, 2012. Future increases in market interest rates are not expected to have a significant immediate favorable impact on the Corporation's net interest income at the time of such increases because of the low percentage of variable interest rate loans in the Corporation's loan portfolio and a large percentage of variable interest rate loans at interest rate floors at December 31, 2013. The percentage of variable interest rate loans, which comprised approximately 24% of the Corporation's loan portfolio at December 31, 2013, has remained relatively consistent during the twelve-month period ended December 31, 2013. Approximately two-thirds of the Corporation's variable interest rate loans were at an interest rate floor with a majority expected to remain at their floor until they mature or market interest rates rise more than 75 basis points. The FOMC has indicated that it will keep the federal funds rate at between zero and 0.25% at least as long as the unemployment rate remains above 6.5%. The national unemployment rate was 6.7% at December 31, 2013 and therefore, corresponding increases in other market interest rates that are generally tied to the federal funds rate, such as the prime interest rate, are not expected to increase significantly during 2014. To reduce the risk of rising interest rates adversely impacting net interest income, the Corporation has positioned its balance sheet to be more asset sensitive by holding some variable rate instruments in its investment securities portfolio. Variable rate investment securities at December 31, 2013 were $238 million, or 25% of total investment securities, compared to $281 million, or 34% of total investment securities, at December 31, 2012. The reduction in the composition of variable rate investment securities during 2013 was primarily attributable to the Corporation investing cash acquired in the branch acquisition transaction in short-term investment securities with primarily fixed interest rates. 60



--------------------------------------------------------------------------------


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools