News Column

HAWTHORN BANCSHARES, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition

May 15, 2014

And Results of Operations Forward-Looking Statements



This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company, Hawthorn Bancshares, Inc., and its subsidiaries, including, without limitation:

statements that are not historical in nature, and



statements preceded by, followed by or that include the words believes, expects, may, will, should, could, anticipates, estimates, intends or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:



competitive pressures among financial services companies may increase significantly,

changes in the interest rate environment may reduce interest margins, general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of our loans and other assets, increases in non-performing assets in the Company's loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,



costs or difficulties related to the integration of the business of the Company and its acquisition targets may be greater than expected,

legislative or regulatory changes may adversely affect the business in which the Company and its subsidiaries are engaged, and

changes may occur in the securities markets.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, was enacted on July 21, 2010. Provisions of the Act address many issues including, but not limited to, capital, interchange fees, compliance and risk management, debit card overdraft fees, the establishment of a new consumer regulator, healthcare, incentive compensation, expanded disclosures and corporate governance. While many of the new regulations under the Act are expected to primarily impact financial institutions with assets greater than $10 billion, the Company expects these new regulations could reduce revenues and increase expenses in the future. Management is currently assessing the impact of the Act and of the regulations anticipated to be promulgated under the Act. We have described under the caption Risk Factors in the Company's Annual Report on Form 10-K for the year ended December 31, 2013, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made. Overview Through the branch network of its subsidiary bank, the Company, with $1.2 billion in assets at March 31, 2014, provides a broad range of commercial and personal banking services, including certificates of deposit, individual retirement and other time deposit accounts, checking and other demand deposit accounts, interest checking accounts, savings accounts, and money market accounts. The Company also provides a wide range of lending services, including real estate, commercial, installment, and other consumer loans. Other financial services that the Company provides include automated teller machines, trust services, credit-related insurance, and safe-deposit boxes. The geographic areas in which the Company provides products and services include the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson, and Lee's Summit, Missouri. The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. A secondary source of revenue is investment income. The Company also derives income from trust, brokerage, credit card and mortgage banking activities and service charge income. 34 -------------------------------------------------------------------------------- Much of the Company's business is commercial, commercial real estate development, and mortgage lending. The Company has experienced soft loan demand in the communities within which we operate during the current economic slowdown. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings. The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control. The Company's subsidiary bank, Hawthorn Bank (Bank), is a full-service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services. The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the by the Board of Governors of the Federal Reserve System. CRITICAL ACCOUNTING POLICIES The following accounting policies are considered most critical to the understanding of the Company's financial condition and results of operations. These critical accounting policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the critical accounting policies on the business operations are discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results. Allowance for Loan Losses Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the Company's results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company's business operations is provided in note 1 to the Company's unaudited consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company. Income Taxes Income taxes are accounted for under the asset/liability method by recognizing the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Judgment is required in addressing the Company's future tax consequences of events that have been recognized in the consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forwards and changes in tax laws or interpretations thereof. A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, the Company would adjust the recorded value of the deferred tax asset, which would result in a direct charge to income tax expense and earnings in the period that the determination was made. Likewise, the Company would reverse the valuation allowance when it is expected to realize the deferred tax asset. Critical to the assessment is the Company's estimates and judgments related to future taxable income which is based on historical financial performance and 35

-------------------------------------------------------------------------------- assumptions related to the forecasts of future performance. In addition, the Company is subject to the continuous examination of its tax returns by the Internal Revenue Service and other taxing authorities. The Company accrues for penalties and interest related to income taxes in income tax expense. As of March 31, 2014, the Company has not recognized any tax liabilities or any interest or penalties in income tax expense related to uncertain tax positions.



Other Real Estate Owned and Repossessed Assets

Other real estate owned and repossessed assets consist of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are initially recorded as held for sale at the fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. The write-downs are recorded as other real estate expense, net. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the cost of the property. 36

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SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for the Company as of and for each of the three months ended March 31, 2014 and 2013, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein. Selected Financial Data Three Months Ended March 31, (In thousands, except per share data) 2014 2013



Per Share Data Basic earnings (loss) per common share $ 0.39$ (0.09 ) Diluted earnings (loss) per common share

0.39 (0.09 ) Dividends paid on preferred stock - 228 Accretion of discount on preferred stock - 72 Dividends paid on common stock 252 242 Book value per common share 15.24 14.48 Market price per common share 13.23 11.08 Selected Ratios (Based on average balance sheets) Return on total assets 0.70 % (0.05 )% Return on common stockholders' equity 10.67 % (2.33 )%



Common stockholders' equity to total assets 6.57 % 7.85 % Efficiency ratio (1)

74.17 % 93.70 % Efficiency ratio (2) 73.10 % 73.20 % (Based on end-of-period data) Common stockholders' equity to assets 6.58 % 7.66 % Stockholders' equity to assets 6.58 % 6.14 % Total risk-based capital ratio 15.51 % 16.84 % Tier 1 risk-based capital ratio 11.67 % 13.55 % Leverage ratio (3) 8.87 % 10.09 %



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(1) Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue includes net interest income and non-interest income.

(2) Does not include other real estate expense or gain on sale of investment securities.

(3) Leverage ratio is calculated by dividing Tier 1 capital ratio by average total consolidated assets.

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RESULTS OF OPERATIONS ANALYSIS

The Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates. Three Months Ended March 31, (In thousands) 2014 2013 $ Change % Change Net interest income $ 9,654$ 9,729$ (75 ) (0.8 )% Provision for loan losses - 1,000 (1,000 ) (100.0 ) Noninterest income 2,085 3,007 (922 ) (30.7 ) Noninterest expense 8,707 11,934 (3,227 ) (27.0 ) Income (loss) before income taxes 3,032 (198 ) 3,230 1,631.3 Income tax expense (benefit) 1,045 (62 ) 1,107



1,785.5

Net income (loss) $ 1,987$ (136 )$ 2,123 1,561.0 % Preferred stock dividends and accretion of discount - 295 (295 ) (100.0 ) Net income (loss) available to common shareholders $ 1,987$ (431 )$ 2,418 561.0 % Business Events On December 19, 2008, the Company announced its participation in the U.S. Treasury Department's Capital Purchase Program (CPP), a voluntary program that provides capital to financially healthy banks. Participation in this program included the Company's issuance of 30,255 shares of senior preferred stock (with a par value of $1,000 per share) and a ten year warrant to purchase approximately 287,133 shares of common stock. On May 9, 2012, the Company redeemed 12,000 of the 30,255 shares of preferred stock issued under the U.S. Treasury's CPP program, and on May 15, 2013, the remaining 18,255 shares were redeemed. On June 11, 2013, the common stock warrant issued under the U.S. Treasury Department's CPP program was repurchased by the Company pursuant to a letter agreement between the Treasury and the Company for a total repurchase price of $540,000, or $1.88 per warrant share. The repurchase price was based on the fair value of the warrant as agreed upon by the Company and the Treasury. The repurchase of the warrant ends the Company's participation in the U.S. Treasury Department's CPP. For the fifth consecutive year, on July 1, 2013, the Company distributed a four percent stock dividend to shareholders of record at the close of business on June 15, 2013. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect the stock dividend. Consolidated net income of $2.0 million for the three months ended March 31, 2014 increased $2.1million compared to a consolidated net loss of $136,000 for the three months ended March 31, 2013. Net income available to common shareholders for the three months ended March 31, 2014 was $2.0 million, or $0.39 per diluted common share, compared to a net loss available to common shareholders of $431,000, or $(0.09) per diluted common share for the three months ended March 31, 2013. For the quarter ended March 31, 2014, the return on average assets was 0.70%, the return on average common stockholders' equity was 10.67%, and the efficiency ratio was 74.17%. Net interest income was $9.7 million for both the three months ended March 31, 2014 and 2013. The net interest margin increased to 3.72% for the three months ended March 31, 2014, compared to 3.65% for the three months ended March 31, 2013 primarily resulting from a decrease in the Company's cost of certificate of deposits. During the third quarter of 2013, $23.0 million from a 58 month 6.05% certificate of deposit special matured and approximately $5.7 million was reinvested at current market rates. The lower provision for loan losses for the three months ended March 31, 2014 compared to the three months ended March 31, 2013 was primarily a result of the improving credit quality in the Company's historical loss analysis and reduced levels of nonperforming loans. Net charge-offs for the three months ended March 31, 2014, were $874,000, or 0.10% of average loans compared to $3.2 million, or 0.15% of average loans for the three months ended March 31, 2013. Non-performing loans totaled $36.2 million, or 4.29% of total loans, at March 31, 2014 compared to $35.3 million, or 4.21% of total loans, at December 31, 2013, and $38.6 million, or 4.63%of total loan, at March 31, 2013. 38

-------------------------------------------------------------------------------- Non-interest income decreased $922,000, or 30.7%, for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. These changes are discussed in greater detail below under Non-interest Income.



Non-interest expense decreased $3.2 million, or 27.0%, for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. These changes are discussed in greater detail below under Non-interest Expense.

Average Balance Sheets Net interest income is the largest source of revenue resulting from the Company's lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended March 31, 2014 and 2013, respectively. 39 -------------------------------------------------------------------------------- Three Months Ended March 31, 2014 2013 Interest Rate Interest Rate Average Income/ Earned/ Average Income/ Earned/ (In thousands) Balance Expense(1) Paid(1) Balance Expense(1) Paid(1) ASSETS Loans: (2) (4) Commercial $ 129,845$ 1,502 4.69 % $ 126,969$ 1,559 4.98 % Real estate construction - residential 22,962 238 4.20 22,746 252 4.49 Real estate construction - commercial 56,768 606 4.33 44,681 514 4.67 Real estate mortgage - residential 228,530 2,753 4.89 219,843 2,781 5.13 Real estate mortgage - commercial 383,157 4,468 4.73 400,681 4,928 4.99 Consumer 20,364 332 6.61 25,069 378 6.12 Total loans $ 841,626$ 9,899 4.77 % $ 839,989$ 10,412 5.03 % Investment securities: (3) U.S. Treasury $ 1,003 $ 3 1.21 % $ 2,029 $ 8 1.60 % Government sponsored enterprises 66,822 217 1.32 71,949 216 1.22 Asset backed securities 108,941 649 2.42 117,396 670 2.31 State and municipal 33,221 295 3.60 35,157 334 3.85 Total investment securities $ 209,987$ 1,164 2.25 % $ 226,531$ 1,228 2.20 % Restricted investments 4,046 20 2.00 3,924 22 2.27 Federal funds sold and interest bearing deposits in other financial institutions 10,658 8 0.30 24,661 14 0.23 Total interest earning assets $ 1,066,317$ 11,091 4.22 % $ 1,095,105$ 11,676 4.32 % All other assets 96,718 105,301 Allowance for loan losses (13,682 ) (15,271 ) Total assets $ 1,149,353$ 1,185,135 LIABILITIES AND STOCKHOLDERS' EQUITY NOW accounts $ 209,669$ 150 0.29 % $ 203,709$ 147 0.29 % Savings 79,595 20 0.10 71,535 19 0.11 Money market 161,473 97 0.24 159,549 95 0.24 Time deposits of $100,000 and over 110,648 190 0.70 119,511 248 0.84 Other time deposits 235,353 432 0.74 271,682 884 1.32 Total time deposits $ 796,738$ 889 0.45 % $ 825,986$ 1,393 0.68 % Federal funds purchased and securities sold under agreements to repurchase 19,397 4 0.08 18,544 5 0.11 Subordinated notes 49,486 312 2.56 49,486 320 2.62 Federal Home Loan Bank Advances 25,167 104 1.68 20,104 99 2.00 Total borrowings $ 94,050$ 420 1.81 % $ 88,134$ 424 1.95 % Total interest bearing liabilities $ 890,788$ 1,309 0.60 % $ 914,120$ 1,817 0.81 % Demand deposits 176,860 171,398 Other liabilities 6,220 6,595 Total liabilities 1,073,868 1,092,113 Stockholders' equity 75,485 93,022 Total liabilities and stockholders' equity $ 1,149,353$ 1,185,135 Net interest income (FTE) 9,782 9,859 Net interest spread 3.62 % 3.51 % Net interest margin 3.72 % 3.65 %

-------------------------------------------------------------------------------- (1) Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $128,000 and $131,000 for the three months ended March 31, 2014 and 2013, respectively. (2) Non-accruing loans are included in the average amounts outstanding. (3) Average balances based on amortized cost. (4) Fees and costs on loans are included in interest income. 40

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Rate and Volume Analysis The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the three months ended March 31, 2014 compared to March 31, 2013. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each. Three Months Ended March 31, 2014 vs. 2013 Change due to Total Average Average (In thousands) Change Volume Rate Interest income on a fully taxable equivalent basis: (1) Loans: (2) (4) Commercial $ (57 ) $ 34 $ (91 ) Real estate construction - residential (14 ) 2 (16 ) Real estate construction - commercial 92 131 (39 ) Real estate mortgage - residential (28 ) 108 (136 ) Real estate mortgage - commercial (460 ) (211 ) (249 ) Consumer (46 ) (75 ) 29 Investment securities: (3) 0 0 U.S. Treasury (5 ) (3 ) (2 ) Government sponsored entities 1 (16 ) 17 Asset backed securities (21 ) (49 ) 28 State and municipal (39 ) (17 ) (22 ) Restricted investments (2 ) 1 (3 ) Federal funds sold and interest bearing deposits in other financial institutions (6 ) (10 ) 4 Total interest income (585 ) (105 ) (480 ) Interest expense: NOW accounts 3 4 (1 ) Savings 1 2 (1 ) Money market 2 1 1 Time deposits of $100,000 and over (58 ) (17 ) (41 ) Other time deposits (451 ) (106 ) (345 ) Federal funds purchased and securities sold under agreements to repurchase (1 ) 0 (1 ) Subordinated notes (8 ) 0 (8 ) Federal Home Loan Bank advances 5 23 (18 ) Total interest expense (507 ) (93 ) (414 ) Net interest income on a fully taxable equivalent basis $ (78 )$ (12 )$ (66 )

-------------------------------------------------------------------------------- (1) Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $128,000 and $131,000 for the three months ended March 31, 2014 and 2013, respectively. (2) Non-accruing loans are included in the average amounts outstanding. (3) Average balances based on amortized cost. (4) Fees and costs on loans are included in interest income. Financial results for the three months ended March 31, 2014 compared to the three months ended March 31, 2013, reflected a decrease in net interest income, on a tax equivalent basis, of $78,000, or 0.79%. The decrease in net interest income is primarily due to lower average earning asset levels. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased to 3.72% for the three months ended March 31, 2014, compared to 3.65% for the three months ended March 31, 2013. Although the volume and yield on average earning assets decreased for the three months ending March 31, 2014 compared to the three months ended March 31, 2013, the increase in the net interest margin was primarily due to lower costs of certificates of deposit. See Interest expense on deposits below for further discussion. 41

-------------------------------------------------------------------------------- Average interest-earning assets decreased $28.8 million, or 2.6%, to $1.1 billion for the three months ended March 31, 2014 compared to the three months ended March 31, 2013, and average interest bearing liabilities decreased $23.3 million, or 2.6%, to $890.8 million for the three months ended March 31, 2014 compared to $914.1 million for the three months ended March 31, 2013. Total interest income (expressed on a fully taxable equivalent basis) decreased to $11.1 million for the three months ended March 31, 2014 compared to $11.7 million for the three months ended March 31, 2013. The Company's rates earned on interest earning assets were 4.22% for the three months ended March 3, 2014 compared to 4.32% for the three months ended March 31, 2013. Interest income on loans decreased to $9.9 million for the three months ended March 31, 2014 compared to $10.4 million for the three months ended March 31, 2014. Average loans outstanding increased $1.6 million, or 0.19%, to $841.6 million for the three months ended March 31, 2014 compared to $840.0 million for the three months ended March 31, 2013. The average yield on loans receivable decreased to 4.77% during the three months ended March 31, 2014 compared to 5.03% for the three months ended March 31, 2013 primarily as a result of decreasing market interest rates. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio. Total interest expense decreased to $1.3 million for the three months ended March 31, 2014, compared to $1.8 million for the three months ended March 31, 2013. The Company's rates paid on interest bearing liabilities was 0.60% for the three months ended March 31, 2014 compared to 0.81% for the three months ended March 31, 2013. See the Liquidity Management section for further discussion. Interest expense on deposits decreased to $889,000 for the three months ended March 31, 2014 compared to $1.4 million for the three months ended March 31, 2013. Average time deposits decreased $29.2 million, or 3.5%, to $796.7 million for the three months ended March 31, 2014 compared to $826.0 million for the three months ended March 31, 2013. The average cost of deposits decreased to 0.45% during the three months ended March 31, 2014 compared to 0.68% for the three months ended March 31, 2013 primarily as a result of lower market interest rates and the maturity of $23.0 million from a 58 month 6.05% certificate of deposit special during the third quarter of 2013. Interest expense on borrowings decreased to $420,000 for the three months ended March 31, 2014 compared to $424,000 for the three months ended March 31, 2013. Average borrowings increased $5.9 million to $94.0 million for the three months ended March 31, 2014 compared to $88.1 million for the three months ended March 31, 2013. See the Liquidity Management section for further discussion. 42

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Non-interest Income and Expense

Non-interest income for the periods indicated is as follows:

Three Months Ended March 31, (In thousands) 2014 2013 $ Change % Change Non-interest Income Service charges on deposit accounts $ 1,230$ 1,359$ (129 ) (9.5 )% Trust department income 203 210 (7 ) (3.3 ) Real estate servicing fees, net 177 159 18 11.3 Gain on sales of mortgage loans, net 191 720 (529 ) (73.5 ) Gain on sale of investment securities 0 294 (294 ) NM Other 284 265 19 7.2 Total non-interest income $ 2,085$ 3,007$ (922 ) (30.7 )% Non-interest income as a % of total revenue * 17.8 % 23.6 % Total revenue per full time equivalent employee $ 33.5$ 37.6



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* Total revenue is calculated as net interest income plus non-interest income.

NM - not meaningful Total non-interest income decreased $922,000, or 30.7%, to $2.1 million for the three months ended March 31, 2014 compared to $3.0 million for the three months ended March 31, 2013. Real estate servicing fees, net increased $18,000 to $177,000 for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. Net real estate servicing fees include mortgage loan servicing fees and the gains or losses due to the change in fair value of MSRs arising from inputs and assumptions. Mortgage loan servicing fees earned on loans sold were $223,000 for the three months ended March 31, 2014 compared to $217,000 for the three months ended March 31, 2013. Total net losses recognized related to MSRs due to the change in fair value were $46,000 for the three months ended March 31, 2014 compared to total net losses of $57,000 for the three months ended March 31, 2013. The Company was servicing $319.3 million of mortgage loans at March 31, 2014 compared to $322.5 million and $318.9 million at December 31, 2013 and March 31, 2013, respectively. Gain on sales of mortgage loans decreased $529,000 to $191,000 for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. The Company sold loans of $6.0 million for the three months ended March 31, 2014 compared to $29.3 million for the three months ended March 31, 2013. Refinancing activity impacting both the volume of loans sold and gains recognized continued to be slow during 2014 primarily due to rising interest rates. 43 --------------------------------------------------------------------------------



Non-interest expense for the periods indicated was as follows:

Three Months Ended March 31, (In thousands) 2014 2013 $ Change % Change Non-interest Expense Salaries $ 3,819$ 3,707$ 112 3.0 % Employee benefits 1,211 1,203 8 0.7 Occupancy expense, net 620 635 (15 ) (2.4 ) Furniture and equipment expense 444 435 9 2.1 FDIC insurance assessment 238 243 (5 ) (2.1 ) Legal, examination, and professional fees 226 226 0 0.0 Advertising and promotion 291 281 10 3.6 Postage, printing, and supplies 265 256 9 3.5 Processing expense 759 1,275 (516 ) (40.5 ) Other real estate expense 124 2,821 (2,697 ) (95.6 ) Other 710 852 (142 ) (16.7 ) Total non-interest expense $ 8,707$ 11,934$ (3,227 ) (27.0 )% Efficiency ratio * 74.2 % 93.7 % Efficiency ratio *** 73.1 73.2 Salaries and benefits as a % of total non-interest expense 57.8 % 41.1 % Number of full-time equivalent employees 350 339



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* Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue includes net interest income and non-interest income.

*** Does not include other real estate expense or gain on sale of investment securities

Total non-interest expense decreased $3.2 million, or 27.0%, to $8.7 million for the three months ended March 31, 2014 compared to the three months ended March 31, 2013.

Processing expense decreased $516,000, or 40.5%, for the three months ended March 31, 2014 compared to the three months ended March 31, 2013 primarily due to contract savings resulting in lower core processing expenses. In 2013 a one time consulting fee was incurred to negotiate reduced future core processing expenses. A portion of this fee is being amortized over the new contract period with the Company's core processing vendor. Other real estate (ORE) expense decreased $2.7 million, or 95.6%, to $124,000 for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. The expense provision for valuation write-downs taken on ORE was $123,000 for the three months ended March 31, 2014 compared to $2.3 million for the three months ended March 31, 2013. The significant expense provision during 2013 primarily related to two hotels located in the Branson area that were sold at auction during the second quarter of 2013. Expenses incurred to maintain foreclosed properties were $147,000 for the three months ended March 31, 2014 compared to $490,000 for the three months ended March 31, 2013. Overall operating costs began to decrease during the third quarter of 2013 due to the sale of the hotels. Other non-interest expense decreased $142,000, or 16.7%, for the three months ended March 31, 2014 compared to the three months ended March 31, 2013. The decrease for the three months ended March 31, 2014 was primarily due to a $101,000 decrease in core deposit intangible asset amortization and a $50,000 decrease in commercial and real estate loan expense. Income taxes



Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.5% for the three months ended March 31, 2014 compared to 31.3% for the three months ended March 31, 2013.

Lending and Credit Management Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 71.5% of total assets as of March 31, 2014 compared to 72.4% as of December 31, 2013. Lending activities are conducted pursuant to an established loan policy approved by the Bank's Board of Directors. The Bank's credit review process is overseen by regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank. 44 --------------------------------------------------------------------------------



A summary of loans, by major class within the Company's loan portfolio as of the dates indicated is as follows:

March 31, December 31, (In thousands) 2014 2013



Commercial, financial, and agricultural $ 133,346$ 133,717 Real estate construction - residential 22,060

21,008 Real estate construction - commercial 57,340 55,076 Real estate mortgage - residential 230,310 225,541 Real estate mortgage - commercial 384,130 382,550 Installment loans to individuals 19,121 21,655 Total loans $ 846,307$ 839,547 Percent of categories to total loans: Commercial, financial, and agricultural 15.7 % 15.9 % Real estate construction - residential 2.6 2.5 Real estate construction - commercial 6.8 6.6 Real estate mortgage - residential 27.2 26.9 Real estate mortgage - commercial 45.4 45.6 Installment loans to individuals 2.3 2.5 Total 100.0 % 100.0 % The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as "highly leveraged" by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in nonaccrual, past due, or restructured loans if such assets were loans. The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. For the three months ended March 31, 2014, the Company sold approximately $6.0 million of loans to investors compared to $29.3 million for the three months ended March 31, 2013. At March 31, 2014, the Company was servicing approximately $322.5 million of loans sold to the secondary market compared to $322.5 million at December 31, 2013, and $318.9 million at March 31, 2013.



Risk Elements of the Loan Portfolio

Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The senior loan committee reviews and reports to the board of directors, on a monthly basis, past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB's ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered adequate by management to provide for probable losses inherent in the loan portfolio. 45 --------------------------------------------------------------------------------

Nonperforming Assets



The following table summarizes nonperforming assets at the dates indicated:

March 31, December 31, (In thousands) 2014 2013 Nonaccrual loans: Commercial, financial, and agricultural $ 2,632 $



1,684

Real estate construction - residential 2,143



2,204

Real estate construction - commercial 5,936



6,251

Real estate mortgage - residential 3,939



4,165

Real estate mortgage - commercial 9,838



9,074

Installment loans to individuals 316



302

Total $ 24,804 $



23,680

Loans contractually past - due 90 days or more and still accruing: Commercial, financial, and agricultural

$ 0 $ 0 Real estate construction - residential 0 0 Real estate construction - commercial 1 0 Real estate mortgage - residential 194



129

Real estate mortgage - commercial 0



100

Installment loans to individuals 9



14

Total $ 204 $



243

Troubled debt restructurings - accruing 11,234 11,395 Total nonperforming loans 36,242 35,318 Other real estate owned 14,031 14,826 Foreclosed assets 23 41 Total nonperforming assets $ 50,296$ 50,185 Loans $ 845,307$ 839,547 Allowance for loan losses to loans 1.52 % 1.63 % Nonperforming loans to loans 4.29 % 4.21 % Allowance for loan losses to nonperforming loans 35.44 % 38.84 % Nonperforming assets to loans, other real estate owned and foreclosed assets 5.85 % 5.87 % Total nonperforming assets totaled $50.3 million at March 31, 2014 compared to $50.2 million at December 31, 2013. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $36.2 million, or 4.29%, of total loans at March 31, 2014 compared to $35.3 million, or 4.21%, of total loans at December 31, 2013. See further discussion below. It is the Company's policy to discontinue the accrual of interest income on loans when management believes that the borrower's financial condition, after consideration of business conditions and collection efforts, is such that the collection of interest is doubtful, or upon which principal or interest due has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis. Interest on nonaccrual loans, which would have been recorded under the original terms of the loans, was approximately $289,000 and $350,000 for the three months ended March 31, 2014 and 2013, respectively. As of March 31, 2014 and December 31, 2013, approximately $15.9 million and $21.0 million, respectively, of loans classified as substandard, not included in the nonperforming asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Even though borrowers are experiencing moderate cash flow problems as well as some deterioration in collateral value, management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at March 31, 2014 and December 31, 2013, respectively. Total non-accrual loans at March 31, 2014 increased $1.1 million to $24.8 million from December 31, 2013. This increase primarily consisted of a $948,000 increase in commercial, financial and agricultural non-accrual loans and a $764,000 increase in real estate mortgage - commercial non-accrual loans. This increase was partially offset by a $376,000 decrease in real estate construction non-accrual loans and a $226,000 decrease in real estate mortgage - residential non-accrual loans. At March 31, 2014 and December 31, 2013, real estate mortgage - commercial non-accrual loans made up 40% and 38%, respectively, of total non-accrual loans. Loans past due 90 days and still accruing interest at March 31, 2014 were $204,000 compared to $243,000 at December 31, 2013. Other real estate owned and repossessed assets at March 31, 2014 were $14.0 million compared to $14.9 million at December 31, 2013. During the three months ended March 31, 2014, $259,000 of nonaccrual loans, net of charge-offs taken, 46 -------------------------------------------------------------------------------- moved to other real estate owned and repossessed assets, and a net $123,000 additional provision to the valuation allowance was recorded to reflect current fair values. This is compared to a net $2.3 million provision during the three months ended March 31, 2013. The provision during 2013 primarily related to two hotels located in the Branson area that were sold during the second quarter.



The following table summarizes the Company's TDRs at the dates indicated:

March 31, 2014 December 31, 2013 Number of Recorded Specific Number of Recorded Specific (In thousands) Contracts Investment Reserves Contracts Investment Reserves TDRs - Accrual Commercial, financial and agricultural 9 $ 2,287$ 99 9 $ 2,331$ 101 Real estate construction - commercial 0 0 0 1 364 0 Real estate mortgage - residential 7 3,533 1,039 6 2,352 529 Real estate mortgage - commercial 6 5,414 0 6 6,348 885 Total TDRs - Accrual 22 $ 11,234$ 1,138 22 $ 11,395$ 1,515 TDRs - Non-accrual Commercial, financial and agricultural 4 $ 327$ 250 2 $ 88 $ 8 Real estate construction - commercial 1 3,742 0 1 3,742 0 Real estate mortgage - residential 5 631 240 5 639 229 Real estate mortgage - commercial 7 6,242 801 7 5,572 424 Consumer 2 43 16 2 43 15 Total TDRs - Non-accrual 19 $ 10,985$ 1,307 17 $ 10,084$ 676 Total TDRs 41 $ 22,219$ 2,445 39 $ 21,479$ 2,191 At March 31, 2014, loans classified as TDRs totaled $22.2 million, of which $11.0 million were on non-accrual status and $11.2 million were on accrual status. At December 31, 2013, loans classified as TDRs totaled $21.5 million, of which $10.1 million were on non-accrual status and $11.4 million were on accrual status. The net increase in total TDRs from December 31, 2013 was primarily due to $1.5 million additions to TDRs, partially offset by $314,000 charged off, and approximately $446,000 of payments received. The increase in TDRs classified as real estate mortgage - residential accruing loans primarily relates to one new loan relationship modified to interest only payments. The increase in real estate mortgage - commercial non-accrual TDRs is primarily related to one loan relationship that was placed on non-accrual TDR status during the first quarter of 2014.



Provision and Allowance for Loan Losses

As mentioned above, the Company is continuing to recover from the deterioration of collateral values during the prior and current economic conditions. Current appraisals are being obtained and management has adjusted the provision to reflect the amounts determined necessary to maintain the allowance for loan losses at a level necessary to cover probable losses in the loan portfolio. The allowance for loan losses was $12.8 million, or 1.52%, of loans outstanding at Mach 31, 2014 compared to $13.7 million, or 1.63%, of loans outstanding at December 31, 2013, and $14.5 million, or 1.74%, of loans outstanding at March 31, 2013. 47

-------------------------------------------------------------------------------- The following table summarizes loan loss experience for the periods indicated: Three Months Ended March 31, (In thousands) 2014 2013 Analysis of allowance for loan losses: Balance beginning of period $ 13,719$ 14,842



Charge-offs:

Commercial, financial, and agricultural 131 61 Real estate construction - residential 60 120 Real estate construction - commercial 414 - Real estate mortgage - residential 120 292 Real estate mortgage - commercial 367 999 Installment loans to individuals 84 109 Total charge-offs 1,176 1,581



Recoveries:

Commercial, financial, and agricultural $ 116$ 42 Real estate construction - residential

- - Real estate construction - commercial - - Real estate mortgage - residential 112 15 Real estate mortgage - commercial 16 161 Installment loans to individuals 58 66 Total recoveries 302 284 Net charge-offs 874 1,297 Provision for loan losses - 1,000 Balance end of period $ 12,845$ 14,545 Loan Charge-offs The Company's net loan charge-offs were $874,000, or 0.10% of average loans, for the three moths ended March 31, 2014 compared to net loan charge-offs of $1.3 million, or 0.15% of average loans, for the three months ended March 31, 2013. Real estate mortgage charge-offs represented 41% of total charge-offs during the three months ended March 31, 2014 compared to 81% of total charge-offs during the three months ended March 31, 2013. Real estate construction charge-offs represented 40% of total charge-offs during the three months ended March 31, 2014 compared to 8% of total charge-offs during the three months ended March 31, 2013. Provision There was no provision for loan losses during the three months ended March 31, 2014 compared to $1.0 million for the three months ended March 31, 2013. Due to decreases in historical loss rates based on the Company's last thirty-six months of charge-off experience, decreases in average loans and reduced levels of nonperforming loans, no provision was required during the first quarter of 2014. Allowance for Loan Losses The following table is a summary of the allocation of the allowance for loan losses: March 31, December 31, (In thousands) 2014 2013



Allocation of allowance for loan losses at end of year: Commercial, financial, and agricultural

$ 2,452$ 2,374 Real estate construction - residential 479



931

Real estate construction - commercial 550



631

Real estate mortgage - residential 3,090



2,959

Real estate mortgage - commercial 6,019



6,523

Installment loans to individuals 255 294 Unallocated 0 7 Total $ 12,845$ 13,719 48

-------------------------------------------------------------------------------- The Company's allowance for loan losses decreased to $12.8 million at March 31, 2014 compared to $13.7 million at December 31, 2013. The decrease from December 31, 2013 primarily consisted of a $452,000 decrease in the allocation for real estate construction - residential loans, and a $504,000 decrease in real estate mortgage - commercial loans, partially offset by a $131,000 increase in real estate mortgage - residential loans. The ratio of the allowance for loan losses to nonperforming loans was 35.4% at March 31, 2014, compared to 38.8% at December 31, 2013. The following table is a summary of the general and specific allocations of the allowance for loan losses: March 31, December 31, (In thousands) 2014 2013 Allocation of allowance for loan losses: Individually evaluated for impairment - specific reserves $ 4,753$ 4,796 Collectively evaluated for impairment - general reserves 8,092 8,923 Total $ 12,845$ 13,719 The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At March 31, 2014, $4.8 million of the Company's allowance for loan losses was allocated to impaired loans totaling approximately $36.0 million compared to $4.8 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $35.1 million at December 31, 2013. Management determined that $21.3 million, or 59%, of total impaired loans required no reserve allocation at March 31, 2014 compared to $18.8 million, or 54%, at December 31, 2013 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability. The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying percentages to pools of loans by asset type. Loans not individually evaluated are aggregated based on similar risk characteristics. Historical loss rates for each risk group, which is updated quarterly, are quantified using all recorded loan charge-offs. Management determined that the previous twelve quarters were reflective of the loss characteristics of the Company's loan portfolio during the recent economic environment. These historical loss rates for each risk group are used as the starting point to determine allowance provisions. The Company's methodology includes factors that allow management to adjust its estimates of losses based on the most recent information available. The rates are then adjusted through the use of qualitative risk factors to reflect actual changes and anticipated changes such as changes in specific allowances on loans and real estate acquired through foreclosure, any gains and losses on final disposition of real estate acquired through foreclosure, changes in national and local economic conditions and developments, including general economic and business conditions affecting the Company's key lending areas, credit quality trends, specific industry conditions within portfolio segments, bank regulatory examination results, and findings of the internal loan review department. These qualitative risk factors are generally reviewed and updated quarterly, as appropriate.



The specific and general reserve allocations represent management's best estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

Liquidity and Capital Resources

Liquidity Management The role of liquidity management is to ensure funds are available to meet depositors' withdrawal and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers. The Company's Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity. 49

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



The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company's most liquid assets are comprised of available for sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve.

March 31, December 31, (In thousands) 2014 2013



Federal funds sold and other overnight interest-bearing deposits

$ 16,920$ 1,360 Available-for-sale investment securities 213,227 205,985 Total $ 230,147$ 207,345 Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $213.2 million at March 31, 2014 and included an unrealized net loss of $1.5 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $8.0 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company's deposit base. The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At March 31, 2014 and December 31, 2013, the Company's unpledged securities in the available for sale portfolio totaled approximately $27.0 million and $60.2 million, respectively.



Total investment securities pledged for these purposes were as follows:

March 31, December 31, (In thousands) 2014 2013 Investment securities pledged for the purpose of securing: Federal Reserve Bank borrowings $ 3,213$ 3,360 Federal funds purchased and securities sold under agreements to repurchase 32,598 25,149 Other deposits 150,353 117,283 Total pledged, at fair value $ 186,164$ 145,792 Liquidity is available from the Company's base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At March 31, 2014, such deposits totaled $643.6 million and represented 65.2% of the Company's total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $344.1 million at March 31, 2014. These accounts are normally considered more volatile and higher costing representing 34.8% of total deposits at March 31, 2014.



Core deposits at March 31, 2014 and December 31, 2013 were as follows:

March 31, December 31, (In thousands) 2014 2013 Core deposit base: Non-interest bearing demand $ 189,925$ 187,382 Interest checking 210,848 182,103 Savings and money market 242,876 236,982 Total $ 643,649$ 606,467 Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company's outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of March 31, 2014, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $4.7 million on a secured basis. There was no federal funds purchased outstanding at March 31, 2014. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company's investment portfolio. At March 31, 2014, there was $20.8 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at March 31, 2014. The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of March 31, 2014, the Bank had $24.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts. 50

-------------------------------------------------------------------------------- Borrowings outstanding at March 31, 2014 and December 31, 2013 were as follows: March 31, December 31, (In thousands) 2014 2013 Borrowings:



Securities sold under agreements to repurchase $ 20,761$ 31,084Federal Home Loan Bank advances

24,000 24,000 Subordinated notes 49,486 49,486 Total $ 94,247$ 104,570 The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the Company may draw advances against this collateral.



The following table reflects the advance equivalent of the assets pledged, borrowings, and letters of credit outstanding in addition to the estimated future funding capacity available to the Company as follows:

March 31, December 31, 2014 2013 Federal Federal Federal Funds Federal Funds Reserve Purchased Reserve Purchased (In thousands) FHLB Bank Lines Total FHLB Bank Lines Total Advance equivalent $ 259,604$ 3,134$ 41,540$ 304,278$ 259,221$ 3,286$ 41,430$ 303,937 Advances outstanding (24,000 ) 0 0 (24,000 )



(24,000 ) 0 (13,504 ) (37,504 ) Total available $ 235,604$ 3,134$ 41,540$ 280,278$ 235,221$ 3,286$ 27,926$ 266,433

At March 31, 2014, loans with a market value of $370.1 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At March 31, 2014, investments with a market value of $5.3 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank. Sources and Uses of Funds Cash and cash equivalents were $41.2 million at March 31, 2014 compared to $28.4 million at December 31, 2013. The $12.8 million increase resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the three months ended March 31, 2014. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $4.9 million for the three months ended March 31, 2014. Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio, used total cash of $12.8 million. The cash outflow primarily consisted of $24.0 million purchases of investment securities and a $6.9 million increase the loan portfolio, partially offset by $17.4 million proceeds from maturities, calls, and pay-downs of investment securities. Financing activities provided cash of $20.7 million, resulting primarily from a $34.6 million increase in interest bearing transaction accounts, partially offset by a $10.3 million decrease in federal funds purchased and securities sold under agreements to repurchase. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2014. In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had $124.6 million in unused loan commitments and standby letters of credit as of March 31, 2014. Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low. The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company's ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its common and preferred shareholders. The Company paid cash dividends to its common and preferred shareholders totaling approximately $252,000 and $470,000 for the three months ended March 31, 2014 and 2013, respectively. A large portion of the Company's liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $250,000 in dividends to the Company during the three months ended March 31, 2014. At March 31, 2014 and December 31, 2013, the Company had cash and cash equivalents totaling $332,000 and $450,000, respectively. 51 --------------------------------------------------------------------------------

Capital Management The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. Quantitative measures established by regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted-average assets. Management believes, as of March 31, 2014 and December 31, 2013, the Company and the Bank each met all capital adequacy requirements. In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations begins January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) must begin compliance on January 1, 2014. The final rules call for the following capital requirements: A minimum ratio of common tier 1 capital to risk-weighted assets of 4.5%. A minimum ratio of tier 1 capital to risk-weighted assets of 6%. A minimum leverage ratio of 4%. In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organizations will begin on January 1, 2016. Under the proposed rules previously issued by the federal banking agencies, accumulated other comprehensive income (AOCI) would have been included in a banking organization's common equity tier 1 capital. The final rules allow community banks to make a one-time election not to include these new AOCI components in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. The opt-out election must be made in the first call report or FR Y-9 series report that is filed after the financial institution becomes subject to the final rule. The final rules permanently grandfather non-qualifying capital instruments (such as trust preferred securities and cumulative perpetual preferred stock) issued before May 19, 2010 for inclusion in the tier 1 capital of banking organizations with total consolidated assets less than $15 billion as of December 31, 2009 and banking organizations that were mutual holding companies as of May 19, 2010.



The Company has assessed the impact of these changes and it does not expect there to be a material impact on the regulatory ratios of the Company and the Bank and on the capital, operations and earnings of the Company and the Bank.

The Company exceeded all capital adequacy requirements as of March 31, 2014 and December 31, 2013.

52 -------------------------------------------------------------------------------- Minimum Well-Capitalized Actual Capital Requirements Capital Requirements (in thousands) Amount Ratio Amount Ratio Amount Ratio March 31, 2014 Total capital (to risk-weighted assets): Company $ 135,389 15.51 % $ 69,855 8.00 % N.A. N.A. % Bank 125,164 14.52 68,973 8.00 $ 86,217 10.00 Tier I capital (to risk-weighted assets): Company $ 101,902 11.67 % $ 34,928 4.00 % N.A. N.A. % Bank 114,361 13.26 34,487 4.00 $ 51,730 6.00 Tier I capital (to adjusted average assets): Company $ 101,902 8.87 % $ 34,482 3.00 % $ N.A. N.A. % Bank 114,361 10.04 34,178 3.00 56,964 5.00 (in thousands) December 31, 2013 Total capital (to risk-weighted assets): Company $ 133,638 15.33 % $ 69,728 8.00 % N.A. N.A. % Bank 122,959 14.29 68,842 8.00 $ 86,052 10.00 Tier I capital (to risk-weighted assets): Company $ 99,398 11.40 % $ 34,864 4.00 % N.A. N.A. % Bank 112,166 13.03 34,421 4.00 $ 51,631 6.00 Tier I capital (to adjusted average assets): Company $ 99,398 8.80 % $ 33,876 3.00 % $ N.A. N.A. % Bank 112,166 10.04 33,517 3.00



55,862 5.00


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