News Column

MACKINAC FINANCIAL CORP /MI/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

May 15, 2014

FINANCIAL OVERVIEW

The Corporation recorded a first quarter 2014 net income available to common shareholders of $.660 million or $.12 per share compared to net income of $.676 million, or $.12 per share for the first quarter of 2013. Operating results for the first quarter of 2014 included a provision for loan losses of $.183 million compared to $.375 million for the same period of 2013.



Weighted average shares outstanding totaled 5,530,908 for the first quarter of 2014 and 5,559,570 for the same period in 2013.

The net interest margin for the first quarter of 2014 increased to $5.593 million, or 4.25%, compared to $5.156 million, of 4.18% in the first quarter of 2013.

Total assets of the Corporation at March 31, 2014 were $583.592 million, up by $41.696 million, or 7.69% from the $541.896 million in total assets reported at March 31, 2013 and up by $10.792 million, or 1.88%, from total assets of $572.800 million at year-end 2013. The loan portfolio increased $2.030 million in the first quarter of 2014, from December 31, 2013 balances of $483.832 million. Deposits totaled $475.710 million at March 31, 2014, an increase of $9.411 million from the $466.299 million at December 31, 2013. FINANCIAL CONDITION Cash and Cash Equivalents Cash and cash equivalents increased $6.532 million during the first quarter of 2014. See further discussion of the change in cash and cash equivalents in the Liquidity section. Investment Securities



Securities available for sale increased $3.023 million, or 6.81%, from December 31, 2013 to March 31, 2014, with the balance on March 31, 2014, totaling $47.411 million. Investment securities are utilized in an effort to manage interest rate risk and liquidity. As of March 31, 2014, investment securities with an estimated fair value of $4.758 million were pledged.

Loans Through the first quarter of 2014, loan balances increased by $2.030 million, or .42%, from December 31, 2013 balances of $483.832 million. During the first three months of 2014, the Bank had total loan production of $31.166 million, which included $4.987 million of secondary market loan production. This loan production, however, was offset by loan principal runoff, paydowns and amortization, totaling $30.535 million, and nonperforming loans transferred to other real estate owned ("OREO") amounting to $.282 million. Management continues to actively manage the loan portfolio, seeking to identify and resolve problem assets at an early stage. Management believes a properly positioned loan portfolio provides the most attractive earning asset yield available to the Corporation and, with a diligent loan approval process and exception reporting, management can effectively manage the risk in the loan portfolio. Management intends to continue loan growth within its markets for mortgage, consumer, and commercial loan products while concentrating on loan quality, industry concentration issues, and competitive pricing. 28 --------------------------------------------------------------------------------



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Following is a summary of the loan portfolio at March 31, 2014, December 31, 2013 and March 31, 2013 (dollars in thousands):

March 31, Percent of December 31, Percent of March 31, Percent of 2014 Total 2013 Total 2013 Total Commercial real estate $ 267,153 54.99 % $ 268,809 55.56 % $ 246,207 54.22 % Commercial, financial, and agricultural 83,461 17.18 79,655 16.46 82,530 18.18 One to four family residential real estate 104,376 21.48 103,768 21.45 89,629 19.74 Construction: Consumer 6,383 1.31 6,895 1.43 7,587 1.67 Commercial 10,685 2.20 10,904 2.25 16,295 3.59 Consumer 13,804 2.84 13,801 2.85 11,803 2.60 Total loans $ 485,862 100.00 % $ 483,832 100.00 % $ 454,051 100.00 %



Following is a table showing the significant industry types in the commercial loan portfolio as of March 31, 2014, December 31, 2013 and March 31, 2013 (dollars in thousands):

March 31, 2014 December 31, 2013 March 31, 2013 Outstanding Percent of Percent of Outstanding Percent of Percent of Outstanding Percent of Percent of Balance Loans Capital Balance Loans Capital Balance Loans Capital

Real estate - operators of nonres bldgs $ 97,153 26.89 % 147.81 % $ 100,333 27.92 % 153.77 % $ 94,828 27.48 % 129.83 % Hospitality and tourism 44,243 12.24 67.31 45,360 12.62 69.01 42,733 12.39 58.51 Lessors of nonresidential buildings 13,649 3.78 20.77 14,191 3.95 21.75 13,162 3.81 18.02 Gasoline stations and convenience stores 11,980 3.32 18.23 11,534 3.21 17.68 11,201 3.25 15.33 Commercial construction 10,685 2.96 16.26 10,904 3.03 16.71 16,295 4.72 22.31 Insurance agencies and brokerages 10,331 2.86 15.72 10,097 2.81 15.47 11,854 3.44 16.23 Other 173,258 47.95 263.59 166,949 46.46 255.86 154,959 44.91 212.16 Total Commercial Loans $ 361,299 100.00 % $ 359,368 100.00 % $ 345,032 100.00 % Management recognizes the additional risk presented by the concentration in certain segments of the portfolio. On a historical basis, the Corporation's highest concentration of credit risk was the hospitality and tourism industry. Management does not consider the current loan concentrations in hospitality and tourism to be problematic, and has no intention of further reducing loans to this industry segment. Management does not believe that its current portfolio composition has increased exposure related to any specific industry concentration as of March 31, 2014. The current concentration of real estate related loans represents a broad customer base composed of a high percentage of owner occupied developments. Our residential real estate portfolio predominantly includes one to four family adjustable rate mortgages that have repricing terms generally from one to three years, construction loans to individuals and bridge financing loans for qualifying customers. As of March 31, 2014, our residential loan portfolio totaled $110.759 million, or 22.80% of our total outstanding loans. The Corporation has also extended credit to governmental units, including Native American organizations. Tax-exempt loans and leases decreased from $1.526 million at the end of December 31, 2013 to $1.514 million at March 31, 2014. The Corporation has elected to reduce its tax-exempt portfolio, since it provides no current tax benefit, due to tax net operating loss carryforwards. Due to the seasonal nature of many of the Corporation's commercial loan customers, loan payment terms provide flexibility by structuring payments to coincide with the customer's business cycle. The lending staff evaluates the collectability of the past due loans based on documented collateral values and payment history. The Corporation discontinues the accrual of interest on loans when, in the opinion of management, there is an indication that the borrower may be unable to meet the payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. 29 --------------------------------------------------------------------------------

Table of Contents Credit Quality Management analyzes the allowance for loan losses in detail on a monthly basis to determine whether the losses inherent in the portfolio are properly reserved for. Net recoveries for the three months ended March 31, 2014 amounted to $39,000, compared to $.566 million, or .50% of average loans outstanding, for the same period in 2013. The current reserve balance is representative of the relevant risk inherent within the Corporation's loan portfolio. Additions or reductions to the reserve in future periods will be dependent upon a combination of future loan growth, nonperforming loan balances and charge-off activity. The table below shows period end balances of nonperforming assets (dollars in thousands): March 31, December 31, March 31, 2014 2013 2013 Nonperforming Assets: Nonaccrual Loans $ 983$ 1,410$ 3,833 Loans past due 90 days or more - - - Restructured loans 508 614 - Total nonperforming loans 1,491 2,024 3,833 Other real estate owned 2,166 1,884 3,825 Total nonperforming assets $ 3,657$ 3,908$ 7,658 Nonperforming loans as a % of loans .31 % .42 % .84 % Nonperforming assets as a % of assets .63 % .68 % 1.41 % Reserve for Loan Losses: At period end $ 4,883$ 4,661 $



5,037

As a % of loans 1.01 % .96 % 1.11 % As a % of nonperforming loans 327.50 % 230.29 % 131.41 % As a % of nonaccrual loans 497.74 % 330.27 % 131.41 % Texas ratio* 5.18 % 5.59 % 9.90 %



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*calculated by taking total nonperforming assets divided by total tangible equity plus reserve for loan losses

Nonperforming assets at $3.657 million have been reduced in 2014 by $.251 million from the $3.908 million at 2013 year end. This reduction in nonperforming assets reflects management's continued efforts in the remediation of problem credits and disposition of OREO properties. The current low level of nonperforming assets is also representative of the overall quality of the Corporation's loan portfolio. The following provides additional information relative to the Corporation's credit quality: At Period End March 31, 2014 December 31, 2013 March 31, 2013 Total loans, at period end $ 485,862 $ 483,832 $ 454,051 Average loans for the period $ 486,354 $ 462,500 $ 449,065 For the Period Ended Three Months Ended Twelve



Months Ended Three Months Ended

March 31, 2014 December



31, 2013 March 31, 2013

Net charge-offs during the period $ (39 ) $ 2,232 $ 556 Net charge-offs to average loans N/M % .48 % .50 % Net charge-offs to beginning allowance balance N/M % 42.78 % 10.66 % Management continues to address market issues impacting its loan customer base. In conjunction with the Corporation's senior lending staff and the bank regulatory examinations, management reviews the Corporation's loans, related collateral evaluations, and the overall lending process. The Corporation also utilizes an outside loan review consultant to perform a review of the loan portfolio. Historically, this independent review has provided findings similar to management as to the overall adequacy of the loan loss reserve and has substantiated the Corporation's loan rating system. In 2014, the Corporation will again utilize a consultant for loan review. 30 --------------------------------------------------------------------------------



Table of Contents

As of March 31, 2014, the allowance for loan losses represented 1.01% of total loans. At March 31, 2014, the allowance included specific reserves in the amount of $1.406 million, as compared to $1.111 million at December 31, 2013 and $1.922 million at March 31, 2013. In management's opinion, the allowance for loan losses is adequate to cover probable losses related to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio. As part of the process of resolving problem credits, the Corporation may acquire ownership of collateral which secured such credits. The Corporation carries this collateral in other real estate on the balance sheet.



The following table represents the activity in other real estate for the periods indicated (dollars in thousands):

Three Months Ended Year Ended Three Months Ended March 31, 2014 December 31, 2013 March 31, 2013 Balance at beginning of period $ 1,884 $ 3,212 $ 3,212 Other real estate transferred from loans due to foreclosure 282 932 649 Other real estate sold - (1,996 ) (34 ) Writedowns on other real estate held for sale - (231 ) - Loss on sale of other real estate held for sale - (33 ) (2 ) Balance at end of period $ 2,166 $ 1,884 $ 3,825 During the first quarter of 2014, the Corporation received real estate in lieu of loan payments of $.282 million. Other real estate is initially valued at the lower of cost or the fair value less selling costs. After the initial receipt, management periodically re-evaluates the recorded balances and any additional reductions in the fair value result in a write-down of other real estate. Deposits The Corporation had an increase in deposits in the first quarter of 2014. Total deposits increased by $9.411 million, or 2.02%, in the first quarter of 2014. The increase in deposits for the first quarter of 2014 is composed of an increase in noncore deposits of $.158 million and an increase in core deposits of $9.253 million. In recent years, the Corporation strategically emphasized the growth of core deposits. This strategic initiative is supported with an individual incentive plan, along with the introduction of several new deposit products and competitive deposit pricing. The core deposit balances increased primarily in transactional account deposits, our lowest cost of funds. Most recently, we have experienced some declines in core deposits. A portion of these decreases can be attributed to individual customer deposit reductions due to various business related needs. In an effort to stem some runoff from core deposit CDs, management recently increased some offering rates on CD products.



Management continues to monitor existing deposit products in order to stay competitive as to both terms and pricing. It is the intent of management to be aggressive in its markets to grow core deposits with an emphasis placed on transactional deposits.

The following table represents detail of deposits at the end of the periods indicated (dollars in thousands):

March 31, December 31, March 31, 2014 % of Total 2013 % of Total 2013 % of Total Noninterest bearing $ 68,027 14.30 % $ 72,936 15.64 % $ 57,547 13.53 % NOW, money market, checking 148,023 31.12 149,123 31.98 161,445 37.97 Savings 14,425 3.03 13,039 2.80 13,273 3.12 Certificates of Deposit $100,000 154,371 32.45 140,495 30.13 130,646 30.72 Total core deposits 384,846 80.90 375,593 80.55 362,911 85.34 Certificates of Deposit >$100,000 23,317 4.90 23,159 4.97 24,619 5.79 Brokered CDs 67,547 14.20 67,547 14.48 37,706 8.87 Total non-core deposits 90,864 19.10 90,706 19.45 62,325 14.66 Total deposits $ 475,710 100.00 % $ 466,299 100.00 % $ 425,236 100.00 % 31

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Table of Contents Borrowings The Corporation also utilizes FHLB borrowings as a source of funding. At March 31, 2014, this source of funding totaled $35 million and the Corporation secured this funding by pledging loans and investments. The $35 million of FHLB borrowings has a weighted average maturity of 2.21 years and a weighted average rate of 1.79% at March 31, 2014. The Corporation also has a USDA Rural Development loan held by its wholly owned subsidiary, First Rural Relending that has a fixed interest rate of 1% and matures in August 2024. In addition to the above, the Corporation maintains a relationship with a correspondent bank, which consists of a line of credit and a term note. The line of credit bears interest at 90-day LIBOR plus 2.75% with a floor rate of 4.00% and has an initial term that expires on March 22, 2015. The term note bears the same interest and matures on March 22, 2017. Shareholders' Equity Total shareholders' equity increased $.481 million from December 31, 2013 to March 31, 2014. Contributing to the increase in shareholders' equity was net income available to common shareholders of $.660 million, a reduction for dividends on common stock of $.276 million, increases due to stock compensation of $.112 million, an increase in the market value of securities of $.128 million and a decrease due to the repurchase of common stock of $.143 million. RESULTS OF OPERATIONS Summary The Corporation reported net income available to common shareholders of $.660 million, or $.12 per share, in the first quarter of 2014, compared to $.676 million or $.12 per share for the first quarter of 2013. The first quarter results include a provision for loan losses of $.183 million. Operating results for the same period in 2013 include a provision for loan losses of $.375 million. Net Interest Income Net interest income is the Corporation's primary source of core earnings. Net interest income represents the difference between the average yield earned on interest earning assets and the average rate paid on interest bearing obligations. The net interest income is impacted by economic and competitive factors that influence rates, loan demand, and the availability of funding. Net interest margin on a fully taxable equivalent basis amounted to $5.608 million, 4.26% of average earning assets, in the first quarter of 2014, compared to $5.174 million, and 4.20% of average earning assets, in the first quarter of 2013. Margin improvement in 2014 was primarily due to a reduction in funding costs between periods. 32

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Table of Contents The following table presents the amount of interest income from average interest-earning assets and the yields earned on those assets, as well as the interest expense on average interest-bearing obligations and the rates paid on those obligations. All average balances are daily average balances. Three Months Ended 2014-2013 Average Balances Average Rates Interest Income/ Rate/ March 31, Increase/ March 31, March 31, Expense Volume Rate Volume (dollars in thousands) 2014 2013 (Decrease) 2014 2013 2014 2013 Variance Variance Variance Variance Loans (1,2,3) $ 486,354$ 448,925$ 37,429 5.27 %



5.36 % $ 6,315$ 5,930$ 385$ 495$ (101 )$ (9 ) Taxable securities

43,257 46,704 (3,447 ) 2.22 2.08 237 240 (3 ) (18 ) 16 (1 ) Nontaxable securities (2) 1,505 843 662 4.85 4.81 18 10 8 8 - - Federal funds sold 3 3 - - - - - - - - - Other interest-earning assets 3,070 3,070 - 6.21 4.10 47 31 16 - 16 -



Total earning assets 534,189 499,545 34,644 5.02

5.04 6,617 6,211 406 485 (69 ) (10 ) Reserve for loan losses (4,852 ) (5,086 ) 234 Cash and due from banks 23,847 18,562 5,285 Fixed Assets 10,288 10,633 (345 ) Other Real Estate 2,058 3,294 (1,236 ) Other assets 15,186 14,212 974 Total assets $ 580,716$ 541,160$ 39,556 NOW and money market deposits $ 116,847$ 126,149$ (9,302 ) .21 % .25 % $ 61$ 79$ (18 )$ (6 )$ (13 )$ 1 Interest checking 33,090 36,071 (2,981 ) .18 .31 15 28 (13 ) (2 ) (12 ) 1 Savings deposits 13,569 14,997 (1,428 ) .09 .11 3 4 (1 ) - (1 ) - CDs $100,000 151,317 131,641 19,676 1.23 1.64 460 533 (73 ) 80 (133 ) (20 ) CDs >$100,000 23,205 24,630 (1,425 ) 1.40 1.66 80 101 (21 ) (6 ) (16 ) 1 Brokered deposits 67,557 37,706 29,851 1.22 1.43 203 133 70 104 (19 ) (15 ) Borrowings 38,808 35,755 3,053 1.95 1.80 187 159 28 14 13 1 Total interest-bearing liabilities 444,393 406,949 37,444 .92 1.03 1,009 1,037 (28 ) 184 (181 ) (31 ) Demand deposits 68,366 71,376 (3,010 ) Other liabilities 2,495 2,545 (50 ) Shareholders' equity 65,462 60,290 5,172 Total liabilities and shareholders' equity $ 580,716$ 541,160$ 39,556 Rate spread 4.10 % 4.01 % Net interest margin/revenue 4.26 % 4.20 % $ 5,608$ 5,174$ 434$ 301$ 112$ 21



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(1) For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.

(2) The amount of interest income on loans and nontaxable securities has been adjusted to a tax euivalent basis, using a 34% tax rate

In the past several years of a low interest rate environment, the Corporation, repriced all of its brokered deposits along with the majority of its bank time deposits. This repricing of liabilities is the primary reason for the increased interest margin, on a fully taxable equivalent basis in recent reported periods. During this relatively low interest environment, the Corporation has also repriced a significant portion of its loan portfolio. Management has been diligent when repricing maturing or new loans in establishing interest rate floors in order to maintain our improved interest rate spread. The Corporation is anticipating some margin pressure in future periods as we continue to see extremely competitive pricing on new and renewable loans. Provision for Loan Losses The Corporation records a provision for loan losses when it believes it is necessary to adjust the allowance for loan losses to maintain an adequate level after considering factors such as loan charge-offs and recoveries, changes in identified levels of risk in the loan portfolio, changes in the mix of loans in the portfolio, loan growth, and other economic factors. During the first quarter of 2014, the Corporation determined through this analysis that a $.183 million provision for loan loss was required, compared to $.375 required in the first quarter of 2013. There were net recoveries of $39,000 in the first quarter of 2014 and net charge-offs of $.556 million in the same period of 2013. Other Income Other income decreased by $.067 million for the three months ended March 31, 2014, compared to the three months ended March 31, 2013. Included in first quarter of 2014 is income from loans sold on the secondary market of $.103 million and income from SBA/USDA loan sales of $.382 million, compared to $.299 million for secondary market loans and $.109 million from SBA/USDA loans sales in the first quarter of 2013. Management continues to evaluate deposit products and services for ways to better serve its customer base and also enhance service fee income through a broad array of products that price services based on income contribution and cost attributes. 33

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Table of Contents

The following table details other income for the three months ended March 31, 2014 and 2013 (dollars in thousands):

Three Months Ended March 31, Increase/(Decrease) 2014 2013 Dollars Percent Deposit service fees $ 157$ 162$ (5 ) (3.09 )% Income from secondary market loans sold 103 299 (196 ) (65.55 ) SBA/USDA loan sale gains 382 109 273 100.00 Mortgage servicing income 13 103 (90 ) (87.38 ) Other noninterest income 36 85 (49 ) (57.65 ) Total other income $ 691$ 758$ (67 ) (8.84 )% Other Expense For the first quarter of 2014, the Corporation recorded other expense of $5.107 million compared to $4.311 million in 2013, an increase of $.796 million. Included in other expense for the quarter is an increase in salaries and employee benefits of $.235 million, reflective of the compensation packages for the staff up of our asset based lending subsidiary formed in the third quarter of 2013. We also had increased occupancy costs between periods due primarily to our new branch office in Marquette, which we moved into late in 2013. Also included in the increase in the first quarter of 2014 were legal costs incurred for the exploration of an acquisition and additional SEC work needed this year.



The following table details other expense for the three months ended March 31, 2014 and 2013 (dollars in thousands):

Three Months Ended March 31, Increase/(Decrease) 2014 2013 Dollars Percentage



Salaries and employee benefits $ 2,541$ 2,306$ 235

10.19 % Occupancy 538 382 156 40.84 Furniture and equipment 319 270 49 18.15 Data processing 286 265 21 7.92 Advertising 107 104 3 2.88 Professional service fees 331 225 106 47.11 Loan and deposit 79 73 6 8.22 Writedowns and losses on other real estate held for sale - 2 (2 ) (100.00 ) FDIC insurance premiums 85 105 (20 ) (19.05 ) Telephone 82 82 - - Other 739 497 242 48.69 Total other expense $ 5,107$ 4,311$ 796 18.46 % Federal Income Taxes A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized. The Corporation, as of March 31, 2014 had a net operating loss and tax credit carryforwards for tax purposes of approximately $19.2 million, and $2.1 million, respectively. The net operating loss carryforwards expire twenty years from the date they originated. These carryforwards, if not utilized, will begin to expire in the year 2023. A portion of the NOL, approximately $12.8 million, and all of the credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code. The annual limitation is $1.400 million for the NOL and the equivalent value of tax credits, which is approximately $.476 million. These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004. The Corporation has reported deferred tax assets of $9.533 million at March 31, 2014, which is net of a valuation allowance of $.760 million. Management evaluated the deferred tax valuation allowance as of March 31, 2014 and determined that no adjustment to the valuation was warranted. The remaining valuation allowance pertains to the existing tax credit carryovers, which will only be utilized after all net operating loss carryforwards. Since a portion of these tax credits may expire before that occurs, a valuation allowance for these has been established. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted. 34 --------------------------------------------------------------------------------

Table of Contents LIQUIDITY Liquidity is defined as the ability to generate cash at a reasonable cost to fulfill lending commitments and support asset growth, while satisfying the withdrawal demands of customers and make payments on existing borrowing commitments. The Bank's principal sources of liquidity are core deposits and loan and investment payments and prepayments. Providing a secondary source of liquidity is the available for sale investment portfolio. As a final source of liquidity, the Bank can exercise existing credit arrangements. Current balance sheet liquidity consists of $24.751 million in cash and due from balances, negligible federal funds sold and $42.653 million of unpledged investment securities. Although current liquidity is deemed adequate, management will increase on hand liquidity in the near term by issuing brokered CDs in order to fund anticipated loan growth. During the first quarter of 2014, the Corporation increased cash and cash equivalents by $6.532 million. As shown on the Corporation's condensed consolidated statement of cash flows, liquidity was impacted by cash used in investing activities, with a net increase in investment securities of $2.878 million and a net increase in loans of $2.272 million. The management of bank liquidity for funding of loans and deposit maturities and withdrawals includes monitoring projected loan fundings and scheduled prepayments and deposit maturities within a 30 day period, a 30 to 90 day period and from 90 days until the end of the year. This funding forecast model is completed weekly.



The Corporation's primary source of liquidity on a stand-alone basis is dividends from the Bank. At this time, the Corporation does not have any definitive plans for payments of dividends by the Bank however may consider doing so in future periods.

Liquidity is managed by the Corporation through its Asset and Liability Committee ("ALCO"). The ALCO Committee meets monthly to discuss asset and liability management in order to address liquidity and funding needs to provide a process to seek the best alternatives for investments of assets, funding costs, and risk management. The liquidity position of the Bank is managed daily, thus enabling the Bank to adapt its position according to market fluctuations. Core deposits are important in maintaining a strong liquidity position as they represent a stable and relatively low cost source of funds. The Bank's liquidity is best illustrated by the mix in the Bank's core and noncore funding dependence ratio, which explains the degree of reliance on noncore liabilities to fund long-term assets. Core deposits are herein defined as demand deposits, NOW (negotiable order withdrawals), money markets, savings and certificates of deposit under $100,000. Noncore funding consists of certificates of deposit greater than $100,000, brokered deposits, and FHLB and Farmers' Home Administration borrowings. At March 31, 2014, the Bank's core deposits in relation to total funding were 74.79% compared to 77.85% at March 31, 2013. These ratios indicated at March 31, 2014, that the Bank has increased its reliance on noncore deposits and borrowings to fund the Bank's long-term assets, namely loans and investments. The bank believes that by maintaining adequate volumes of short-term investments and implementing competitive pricing strategies on deposits, it can ensure adequate liquidity to support future growth. The Bank also has correspondent lines of credit available to meet unanticipated short-term liquidity needs.



As

of March 31, 2014, the Bank had $28.375 million of unsecured lines available and additional funding sources available if secured. The bank believes that its liquidity position remains strong to meet both present and future financial obligations and commitments, events or uncertainties that have resulted or are reasonably likely to result in material changes with respect to the Bank's liquidity. From a long-term perspective, the Corporation's strategy is to increase core deposits in the Corporation's local markets. Management continually evaluates deposit products offered in order to remain competitive in its goal of increasing core deposits. The Corporation will and has the ability to augment local deposit growth efforts with wholesale CD funding. 35 --------------------------------------------------------------------------------

Table of Contents CAPITAL AND REGULATORY As a bank holding company, the Corporation is required to maintain certain levels of capital under government regulation. There are several measurements of regulatory capital and the Corporation is required to meet minimum requirements under each measurement. The federal banking regulators have also established capital classifications beyond the minimum requirements in order to risk-rate deposit insurance premiums and to provide trigger points for prompt corrective action in the event an institution becomes financially troubled.



As

of March 31, 2014, the Corporation and Bank were well capitalized. During the first quarter of 2014, total capitalization increased by $.481 million.

The following table details sources of capital for the periods indicated (dollars in thousands): March 31, December 31, March 31, 2014 2013 2013 Capital Structure Shareholders' equity $ 65,730$ 65,249$ 62,039 Preferred stock - - 11,000 Total shareholders' equity $ 65,730$ 65,249$ 73,039 Total capitalization $ 65,730$ 65,249$ 73,039 Tangible capital $ 65,730$ 65,249$ 72,314 Intangible Assets Core deposit premium $ - $ - $ - Other identifiable intangibles 1,057 1,129 725 Total intangibles $ 1,057$ 1,129 $ 725 Regulatory capital Tier 1 capital: Shareholders' equity $ 65,730$ 65,249$ 73,039 Net unrealized (gains) on available for sale securities (344 ) (216 ) (970 ) Less: disallowed deferred tax asset (6,500 ) (7,000 ) (6,800 ) Less: intangibles (106 ) (113 ) (73 ) Total Tier 1 capital $ 58,780$ 57,920$ 65,196 Tier 2 Capital: Allowable reserve for loan losses $ 4,883$ 4,661$ 5,037 Qualifying long-term debt - - - Total Tier 2 capital 4,883 4,661 5,037 Total capital $ 63,663$ 62,581$ 70,233 Risk-adjusted assets $ 492,356$ 489,407$ 466,377 Capital ratios: Tier 1 Capital to average assets 10.24 % 10.31 % 12.23 % Tier 1 Capital to risk weighted assets 11.94 % 11.83 % 13.98 % Total Capital to risk weighted assets 12.93 % 12.79 % 15.06 % Regulatory capital is not the same as shareholders' equity reported in the accompanying condensed consolidated financial statements. Certain assets cannot be considered assets for regulatory purposes, such as acquisition intangibles and noncurrent deferred tax benefits.



Presented below is a summary of the capital position in comparison to generally applicable regulatory requirements:

Shareholders' Tangible Tier 1 Tier 1 Total Equity to Equity to Capital to Capital to Capital to Quarter-end Quarter-end Average Risk-Weighted Risk-Weighted Assets Assets Assets Assets Assets Regulatory minumum for capital adequacy purposes N/A N/A 4.00 % 4.00 % 8.00 % Regulatory defined well capitalized guideline N/A N/A 5.00 % 6.00 % 10.00 % The Corporation: March 31, 2014 11.26 % 11.26 % 10.24 % 11.94 % 12.93 % March 31, 2013 13.48 % 13.36 % 12.23 % 13.98 % 15.06 % The Bank: March 31, 2014 11.13 % 11.13 % 10.10 % 11.76 % 12.74 % March 31, 2013 11.24 % 11.12 % 9.95 % 11.37 % 12.44 % 36

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