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MIDDLEFIELD BANC CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 12, 2014

The following discussion and analysis provides further detail to the financial condition and results of operations of the Company. The MD&A should be read in conjunction with the notes and financial statements presented in this report.



CHANGES IN FINANCIAL CONDITION

General. The Company's total assets ended the June 30, 2014 quarter at $668.3 million, an increase of $21.2 million or 3.3% from December 31, 2013. For the same time period, cash and cash equivalents decreased $0.6 million, or 2.4% while loans increased $14.3 million, or 3.3%. Total liabilities increased $15.5 million, or 2.6% while stockholders' equity grew $5.7 million, or 10.7%. Cash on hand and due from banks. Cash and due from banks and Federal funds sold represent cash and cash equivalents. Cash and cash equivalents decreased $0.6 million at June 30, 2014 from $26.2 million at December 31, 2013. Deposits from customers into savings and checking accounts, loan and securities repayments and proceeds from borrowed funds typically increase these accounts. Decreases result from customer withdrawals, new loan originations, purchases of investment securities and repayments of borrowed funds. Investment securities. Investment securities available for sale on June 30, 2014 totaled $165.5 million, an increase of $8.4 million or 5.3% from $157.1 million at December 31, 2013. During this period the Company recorded repayments, calls, and maturities of $6.8 million. Sales of securities were $1.5 million with a net realized gain of $58,000. Purchases for the period were $12.3 million. Loans receivable. The loans receivable category consists primarily of single-family mortgage loans used to purchase or refinance personal residences located within the Company's market area and commercial real estate loans used to finance properties that are used in the borrowers' businesses or to finance investor-owned rental properties, and to a lesser extent, construction and consumer loans. Net loans receivable increased $14.3 million or 3.3% to $443.0 million as of June 30, 2014 from $428.7 million at December 31, 2013. Included in this amount were increases in the residential real estate and consumer installment portfolios of $8.9 million, or 4.2%, and $2.0 million, or 49.4%, respectively. The commercial real estate, commercial and industrial, and real estate construction portfolios also increased by $1.3 million, $1.1 million, and $1.0 million, respectively. Allowance for loan and lease losses and Asset Quality. The Company increased the allowance for loan and lease losses to $7.1 million, or 1.6% of total loans, at June 30, 2014. For the three months ended June 30, 2014, net loan charge-offs totaled $6,000, or 0.01% of average loans, compared to $283,000, or 0.3%, for the second quarter of 2013. To maintain the adequacy of the allowance for loan and lease losses, the Company recorded a provision for loan losses of $120,000, versus $300,000 for the first half of 2014. For the six months ended June 30, 2014, net loan charge-offs totaled $217,000, or 0.1% of average loans, compared to $643,000, or 0.3%, for the second quarter of 2013. To maintain the adequacy of the allowance for loan and lease losses, the Company recorded a provision for loan losses of $300,000, versus $613,000 for the first half of 2013. Management analyzes the adequacy of the allowance for loan and lease losses regularly through reviews of the performance of the loan portfolio considering economic conditions, changes in interest rates and the effect of such changes on real estate values and changes in the amount and composition of the loan portfolio. The allowance for loan and lease losses is a significant estimate that is particularly susceptible to significant changes in the near term. Such evaluation, which includes a review of all loans for which full collectability may not be reasonably assured, considers among other matters, historical loan loss experience, the estimated fair value of the underlying collateral, economic conditions, current interest rates, trends in the borrower's industry and other factors that management believes warrant recognition in providing for an appropriate allowance for loan and lease losses. Future additions to the allowance for loan and lease losses will be dependent on these factors. Additionally, the Company uses an outside party to conduct an independent review of commercial and commercial real estate loans. The Company uses the results of this review to help determine the effectiveness of the existing policies and procedures, and to provide an independent assessment of the allowance for loan and lease losses allocated to these types of loans. Management believes the allowance for loan and lease losses is appropriately stated at June 30, 2014. Based on the variables involved and management's judgments about uncertain outcomes, the determination of the allowance for loan and lease losses is considered a critical accounting policy. 28 -------------------------------------------------------------------------------- Nonperforming assets. Nonperforming assets includes nonaccrual loans, troubled debt restructurings (TDRs), loans 90 days or more past due, EMORECO assets, other real estate, and repossessed assets. Real estate owned is written down to fair value at its initial recording and continually monitored for changes in fair value. A loan is classified as nonaccrual when, in the opinion of management, there are serious doubts about collectability of interest and principal. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower's financial condition is such that collection of principal and interest is doubtful. Payments received on nonaccrual loans are applied against principal until doubt about collectability ceases. TDRs are those loans which the Company, for economic or legal reasons related to a borrower's financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. The Company has 29 TDRs with a total balance of $3.3 million as of June 30, 2014. Nonperforming loans amounted to $10.5 million, or 2.3% of total loans, and $12.3 million, or 2.8% of total loans, at June 30, 2014 and December 31, 2013, respectively. A TDR that yields market interest rate at the time of restructuring and is in compliance with its modified terms is no longer reported as TDR in calendar years after the year in which the restructuring took place. To be in compliance with its modified terms, a loan that is a TDR must not be in nonaccrual status and must be current or less than 30 days past due on its contractual principal and interest payments under the modified repayment terms. Nonperforming loans secured by real estate totaled $9.7 million as of June 30, 2014, down $1.7 million from $11.4 million at December 31, 2013. Asset Quality History (Dollar amounts in thousands) 6/30/2014 3/31/2014 12/31/2013



9/30/20136/30/2013

Nonperforming loans $ 10,506$ 10,741$ 12,290$ 13,607$ 12,869 Real estate owned 2,392 2,656 2,698 2,719 2,361 Nonperforming assets 12,898 13,397 14,988



16,326 15,230

Allowance for loan and lease losses 7,129 7,015 7,046 7,821 7,749 Ratios Nonperforming loans to total loans 2.33 % 2.42 % 2.82 % 3.25 % 3.12 % Nonperforming assets to total assets 1.93 % 2.00 % 2.32 % 2.48 % 2.32 % Allowance for loan and lease losses to total loans 1.58 % 1.58 % 1.62 % 1.87 % 1.88 % Allowance for loan and lease losses to nonperforming loans 67.85 % 65.31 % 57.33 % 57.48 % 60.21 % A major factor in determining the appropriateness of the allowance for loan and lease losses is the type of collateral which secures the loans. Of the total nonperforming loans at June 30, 2014, 92.6% were secured by real estate. Although this does not insure against all losses, the real estate typically provides for at least partial recovery, even in a distressed-sale and declining-value environment. In response to the performance of the Company's loan portfolio after the Great Recession, additional resources have been allocated to the loan workout process. The Company's objective is to minimize the future loss exposure to the Company. Deposits. The Company considers various sources when evaluating funding needs, including but not limited to deposits, which are a significant source of funds totaling $588.8 million or 97.0% of the Company's total funding sources at June 30, 2014. Total deposits increased $20.0 million or 3.5% at June 30, 2014 from $568.8 million at December 31, 2013. The increase in deposits is primarily related to the increase in noninterest-bearing demand, time, and interest-bearing demand deposit accounts of $10.3 million or 12.0%, $7.6 million or 4.3%, and $4.6 million or 8.6%, respectively, at June 30, 2014. These increases were partially offset by a decrease in money market accounts of $3.9 million, or 5.0%, respectively, during the six months ended June 30, 2014. Borrowed funds. The Company uses short and long-term borrowings as another source of funding used for asset growth and liquidity needs. These borrowings primarily include FHLB advances, junior subordinated debt, short-term borrowings from other banks, federal funds purchased, and repurchase agreements. Short-term borrowings decreased $3.9 million, or 35.8%, to $6.9 million as of June 30, 2014. Other borrowings, representing advances from the Federal Home Loan Bank of Cincinnati, declined $247,000, or 2.1%, for the six months ended June 30, 2014 as a result of scheduled principal payments. Stockholders' equity. Stockholders' equity increased $5.7 million, or 10.7%, to $59.2 million at June 30, 2014 from $53.5 million at December 31, 2013. This growth was the result of increases in accumulated other comprehensive income ("AOCI") and retained earnings of $3.1 million, or 138.4%, $2.3 million, or 8.4%, respectively. The change to AOCI is due to available-for-sale securities fair value adjustments. 29

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RESULTS OF OPERATIONS General. Net income for the three months ended June 30, 2014, was $1.6 million, a $74,000, or 4.4% decrease from the amount earned during the same period in 2013. Diluted earnings per share for the quarter was $0.79 compared to $0.83 for the same period in 2013. Net income for the six months ended June 30, 2014, was $3.4 million, a $32,000, or 1.0% increase from the amount earned during the same period in 2013. Diluted earnings per share for the quarter was $1.65 compared to $1.66 for the same period in 2013. The Company's annualized return on average assets (ROA) and return on average equity (ROE) for the quarter were 0.96% and 11.58%, respectively, compared with 1.02% and 12.47% for the same period in 2013. The Company's annualized return on average assets (ROA) and return on average equity (ROE) for the six month period were 1.02% and 12.33%, respectively, compared with 1.02% and 12.32% for the same period in 2013. Net interest income. Net interest income, the primary source of revenue for the Company, is determined by the Company's interest rate spread, which is defined as the difference between income on earning assets and the cost of funds supporting those assets, and the relative amounts of interest-earning assets and interest-bearing liabilities. Management periodically adjusts the mix of assets and liabilities, as well as the rates earned or paid on those assets and liabilities in order to manage and improve net interest income. The level of interest rates and changes in the amount and composition of interest-earning assets and liabilities affect the Company's net interest income. Historically from an interest rate risk perspective, it has been management's goal to maintain a balance between steady net interest income growth and the risks associated with interest rate fluctuations. Net interest income for the three months ended June 30, 2014 totaled $5.8 million, an increase of 5.3% from that reported in the comparable period of 2013. The net interest margin was 4.04% for the quarter of 2014, up from the 3.88% reported for the same quarter of 2013. The increase is attributable to lower interest-bearing liability costs, which decreased 24 basis points to 0.80%. Net interest income for the six months ended June 30, 2014 totaled $11.8 million, an increase of 6.0% from that reported in the comparable period of 2013. The net interest margin was 4.12% for the first half of 2014, up from the 3.90% reported for the same period of 2013. The increase is attributable to lower interest-bearing liability costs, which decreased 25 basis points to 0.81%. Interest income. Interest income decreased $28,000, or 0.4%, for the three months ended June 30, 2014, compared to the same period in the prior year. This is attributable to decreases in interest earned on taxable investment securities, partially offset by tax-exempt interest and interest and fees on loans. Interest income decreased $53,000, or 0.4%, for the six months ended June 30, 2014, compared to the same period in the prior year. This is attributable to decreases in interest earned on taxable investment securities, partially offset by interest and fees on loans. Interest earned on loans receivable increased $25,000, or 0.5%, for the three months ended June 30, 2014, compared to the same period in the prior year. This increase is attributable to an increase in the average balance of $37.2 million, or 9.1% from June 30, 2013, partially offset by a 43 basis point decline in the average yield. Interest earned on loans receivable increased $147,000, or 1.3%, for the six months ended June 30, 2014, compared to the same period in the prior year. This increase is attributable to an increase in the average balance of $37.2 million, or 9.1% from June 30, 2013, partially offset by a 39 basis point decline in the average yield. Interest earned on securities decreased $60,000, or 4.4%, for the three months ended June 30, 2014, compared to the same period in the prior year. The average balance decreased $26.7 million, or 14.2% while the 4.24% yield on the investment portfolio was an increase of 51 basis points, from 3.73%, for the same period in the prior year. Interest earned on securities decreased $203,000, or 7.3%, for the six months ended June 30, 2014, compared to the same period in the prior year. The average balance decreased $30.2 million, or 15.9% while the 4.26% yield on the investment portfolio was an increase of 50 basis points, from 3.76%, for the same period in the prior year. Interest expense. Interest expense decreased $324,000, or 23.9%, for the three months ended June 30, 2014, compared to the same period in the prior year. The decline was mostly attributed to a 24 basis point decline in total interest-bearing liabilities when compared to the same period in the prior year. It was further impacted by a decrease in the average balance of money market deposits of $4.6 million, or 5.8%, compared to the same period in the prior year. Interest expense decreased $720,000, or 25.8%, for the six months ended June 30, 2014, compared to the same period in the prior year. The decline was mostly attributed to a 25 basis point decline in total interest-bearing liabilities when compared to the same period in the prior year. It was further impacted by a decrease in the average balance of interest-bearing liabilities of $10.4 million, or 2.0%, compared to the same period in the prior year. Interest incurred on deposits, the largest component of the Company's interest-bearing liabilities, declined $290,000, or 23.8%, for the three months ended June 30, 2014, compared to the same period in the prior year. This decrease was attributed to a decline in the average rate paid on deposits to 0.74% from 0.97% for the same period in the prior year. This improvement was exacerbated by a decrease in the average balance of interest-bearing deposits of $3.6 million, or 0.7%, to $501.6 million when compared to $505.2 million for the same period in the prior year. Interest incurred on deposits declined $647,000, or 25.7%, for the six months ended June 30, 2014, compared to the same period in the prior year. This decrease was attributed to a decline in the average rate paid on deposits to 0.76% from 1.00% for the same period in the prior year. This improvement was exacerbated by a decrease in the average balance of interest-bearing deposits of $13.5 million, or 2.7%, to $495.9 million when compared to $509.3 million for the same period in the prior year. 30 --------------------------------------------------------------------------------



Interest incurred on borrowings decreased $34,000, or 24.6%, for the three months ended June 30, 2014, compared to the same period in the prior year. Interest incurred on borrowings decreased $73,000, or 27.0%, for the six months ended June 30, 2014, compared to the same period in the prior year.

Provision for loan losses. The provision for loan losses represents the charge to income necessary to adjust the allowance for loan and lease losses to an amount that represents management's assessment of the estimated probable incurred credit losses inherent in the loan portfolio. Each quarter management performs a review of estimated probable incurred credit losses in the loan portfolio. Based on this review, a provision for loan losses of $120,000 was recorded for the quarter ended June 30, 2014 compared to $300,000 for the quarter ended June 30, 2013. The provision for loan losses was lower due to decreases in nonperforming loans. Nonperforming loans were $10.5 million, or 2.3% of total loans at June 30, 2014 compared with $12.9 million, or 3.1% at June 30, 2013. Net charge-offs were $6,000 for the quarter ended June 30, 2014 compared with $283,000 for the quarter ended June 30, 2013. A provision for loan losses of $300,000 was recorded for the six months ended June 30, 2014 compared to $613,000 for the same period in June 30, 2013. Net charge-offs were $217,000 for the six months ended June 30, 2014 compared with $643,000 for the same period ended June 30, 2013. Noninterest income. Noninterest income increased $38,000 for the three months ended June 30, 2014 over the comparable 2013 period. This increase was largely the result of an increase in net investment security gains of $74,000, partially offset by a decrease in service charges on deposit account of $42,000, or 8.2%. Noninterest income decreased $115,000 for the six months ended June 30, 2014 over the comparable 2013 period. This decrease was largely the result of a decline in net investment security gains of $117,000, or 66.9%, partially offset by an increase in other income of $58,000, or 14.1%. This change in other income was the result of increases in miscellaneous fees and charges of $25,000, or 54.5%, and check order fees of $18,000, or 155.6%. Noninterest expense. Noninterest expense of $4.6 million for the second quarter of 2014 was 16.5% or $650,000 more than the second quarter of 2013. Salaries and benefits and other expense increased $362,000, or 19.0%, and $94,000, or 15.8% respectively. These were partially offset by a decrease in Ohio state franchise tax of $56,000, or 37.6%. Noninterest expense of $8.8 million for the six months ended June 30, 2014 was 11.0% or $878,000 more than the same period in 2013. Salaries and benefits and other expense increased $507,000, or 13.4%, and $244,000, or 21.5% respectively. These were partially offset by decreases in Ohio state franchise tax of $127,000, or 41.9%. Provision for income taxes. The Company recognized $414,000 in income tax expense, which reflected an effective tax rate of 20.4% for the three months ended June 30, 2014, as compared to $476,000 with an effective tax rate of 22.0% for the comparable 2013 period. The Company recognized $913,000 in income tax expense, which reflected an effective tax rate of 21.3% for the six months ended June 30, 2014, as compared to $958,000 with an effective tax rate of 22.3% for the comparable 2013 period.



CRITICAL ACCOUNTING ESTIMATES

The Company's critical accounting estimates involving the more significant judgments and assumptions used in the preparation of the consolidated financial statements as of June 30, 2014, have remained unchanged from December 31, 2013.

31 -------------------------------------------------------------------------------- Average Balance Sheet and Yield/Rate Analysis. The following table sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resultant average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resultant average costs, net interest income, interest rate spread and the net interest margin earned on average interest-earning assets. For purposes of this table, average balances are calculated using monthly averages and the average loan balances include nonaccrual loans and exclude the allowance for loan and lease losses, and interest income includes accretion of net deferred loan fees. Interest and yields on tax-exempt securities (tax-exempt for federal income tax purposes) are shown on a fully tax-equivalent basis utilizing a federal tax rate of 34%. Yields and rates have been calculated on an annualized basis utilizing monthly interest amounts. For the Three Months Ended June 30, 2014 2013 Average Average Average Average (Dollar amounts in thousands) Balance Interest Yield/Cost Balance Interest Yield/Cost Interest-earning assets: Loans receivable $ 446,478 5,575 5.01 % $ 409,229$ 5,550 5.44 % Investment securities (3) 161,802 1,309 4.24 % 188,541 1,369 3.73 % Interest-bearing deposits with other banks 15,727 35 0.89 % 19,120 28 0.59 % Total interest-earning assets 624,007 6,919 4.45 % 616,890 6,947 4.77 % Noninterest-earning assets 47,032 44,911 Total assets $ 671,039$ 661,801 Interest-bearing liabilities: Interest-bearing demand deposits $ 61,224 50 0.33 % $ 61,612 53 0.35 % Money market deposits 74,675 74 0.40 % 79,253 75 0.38 % Savings deposits 178,832 141 0.32 % 178,901 151 0.34 % Certificates of deposit 186,915 664 1.42 % 185,468 940 2.03 % Borrowings 16,253 104 2.57 % 17,931 138 3.09 % Total interest-bearing liabilities 517,899 1,033 0.80 % 523,165 1,357 1.04 % Noninterest-bearing liabilities Other liabilities 97,335 84,437 Stockholders' equity 55,805 54,199 Total liabilities and stockholders' equity $ 671,039$ 661,801 Net interest income $ 5,886$ 5,590 Interest rate spread (1) 3.65 % 3.73 % Net interest margin (2) 4.04 % 3.88 % Ratio of average interest-earning assets to average interest-bearing liabilities 120.49 % 117.91 %



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(1) Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities

(2) Net interest margin represents net interest income as a percentage of average interest-earning assets.

(3) Tax-equivalent adjustments to interest income for tax-exempt securities were $389 and $378 for the three months ended June 30 2014 and 2013, respectively.

32 -------------------------------------------------------------------------------- Analysis of Changes in Net Interest Income. The following table analyzes the changes in interest income and interest expense, between the three month periods ended June 30, 2014 and 2013, in terms of: (1) changes in volume of interest-earning assets and interest-bearing liabilities and (2) changes in yields and rates. The table reflects the extent to which changes in the Company's interest income and interest expense are attributable to changes in rate (change in rate multiplied by prior period volume), changes in volume (changes in volume multiplied by prior period rate) and changes attributable to the combined impact of volume/rate (change in rate multiplied by change in volume). The changes attributable to the combined impact of volume/rate are allocated on a consistent basis between the volume and rate variances. Changes in interest income on securities reflects the changes in interest income on a fully tax-equivalent basis. 2014 versus 2013 Increase (decrease) due to (Dollar amounts in thousands) Volume Rate Total Interest-earning assets: Loans receivable $ 505$ (480 )$ 25 Investment securities (249 ) 189 (60 ) Interest-bearing deposits with other banks (5 ) 12



7

Total interest-earning assets 251 (279 )



(28 )

Interest-bearing liabilities: Interest-bearing demand deposits - (3 ) (3 ) Money market deposits (4 ) 3 (1 ) Savings deposits - (10 ) (10 ) Certificates of deposit 7 (283 ) (276 ) Borrowings (13 ) (21 ) (34 ) Total interest-bearing liabilities (10 ) (314 ) (324 ) Net interest income $ 261$ 35$ 296 33

-------------------------------------------------------------------------------- Average Balance Sheet and Yield/Rate Analysis. The following table sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resultant average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resultant average costs, net interest income, interest rate spread and the net interest margin earned on average interest-earning assets. For purposes of this table, average balances are calculated using monthly averages and the average loan balances include nonaccrual loans and exclude the allowance for loan and lease losses, and interest income includes accretion of net deferred loan fees. Interest and yields on tax-exempt securities (tax-exempt for federal income tax purposes) are shown on a fully tax-equivalent basis utilizing a federal tax rate of 34%. Yields and rates have been calculated on an annualized basis utilizing monthly interest amounts. For the Six Months Ended June 30, 2014 2013 Average Average Average Average (Dollars in thousands) Balance Interest Yield/Cost Balance Interest Yield/Cost Interest-earning assets: Loans receivable $ 445,404$ 11,269 5.10 % $ 408,232$ 11,122 5.49 % Investment securities (3) 159,288 2,573 4.26 % 189,499 2,776 3.76 % Interest-bearing deposits with other banks 13,727 66 0.97 % 18,881 63 0.67 % Total interest-earning assets 618,419 13,908 4.79 % 616,612 13,961 4.81 % Noninterest-earning assets 46,849 46,393 Total assets $ 665,268$ 663,005 Interest-bearing liabilities: Interest-bearing demand deposits $ 57,719 92 0.32 % $ 62,630 111 0.36 % Money market deposits 75,301 150 0.40 % 78,956 156 0.40 % Savings deposits 177,938 279 0.32 % 178,275 309 0.35 % Certificates of deposit 184,897 1,348 1.47 % 189,472 1,940 2.06 % Borrowings 21,443 197 1.85 % 18,385 270 2.96 % Total interest-bearing liabilities 517,298 2,066 0.81 % 527,718 2,786 1.06 % Noninterest-bearing liabilities Other liabilities 92,779 80,600 Stockholders' equity 55,191 54,687 Total liabilities and stockholders' equity $ 665,268$ 663,005 Net interest income $ 11,842$ 11,175 Interest rate spread (1) 3.99 % 3.75 % Net interest margin (2) 4.12 % 3.90 % Ratio of average interest-earning assets to average interest-bearing liabilities 119.55 % 116.84 %



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(1) Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities

(2) Net interest margin represents net interest income as a percentage of average interest-earning assets.

(3) Tax-equivalent adjustments to interest income for tax-exempt securities were $792 and $761 for the six months ended June 30 2014 and 2013, respectively.

34 -------------------------------------------------------------------------------- Analysis of Changes in Net Interest Income. The following table analyzes the changes in interest income and interest expense, between the six month periods ended June 30, 2014 and 2013, in terms of: (1) changes in volume of interest-earning assets and interest-bearing liabilities and (2) changes in yields and rates. The table reflects the extent to which changes in the Company's interest income and interest expense are attributable to changes in rate (change in rate multiplied by prior period volume), changes in volume (changes in volume multiplied by prior period rate) and changes attributable to the combined impact of volume/rate (change in rate multiplied by change in volume). The changes attributable to the combined impact of volume/rate are allocated on a consistent basis between the volume and rate variances. Changes in interest income on securities reflects the changes in interest income on a fully tax-equivalent basis. 2014 versus 2013 Increase (decrease) due to (Dollars in thousands) Volume Rate Total Interest-earning assets: Loans receivable $ 1,013$ (866 )$ 147 Investment securities (564 ) 361 (203 ) Interest-bearing deposits with other banks (17 ) 20



3

Total interest-earning assets 432 (485 )



(53 )

Interest-bearing liabilities: Interest-bearing demand deposits (9 ) (10 ) (19 ) Money market deposits (7 ) 1 (6 ) Savings deposits (1 ) (29 ) (30 ) Certificates of deposit (47 ) (545 ) (592 ) Borrowings 45 (118 ) (73 ) Total interest-bearing liabilities (19 ) (701 ) (720 ) Net interest income $ 451$ 216$ 667 LIQUIDITY Management's objective in managing liquidity is maintaining the ability to continue meeting the cash flow needs of banking customers, such as borrowings or deposit withdrawals, as well as the Company's own financial commitments. The principal sources of liquidity are net income, loan payments, maturing and principal reductions on securities and sales of securities available for sale, federal funds sold and cash and deposits with banks. Along with its liquid assets, the Company has additional sources of liquidity available to ensure that adequate funds are available as needed. These include, but are not limited to, the purchase of federal funds, and the ability to borrow funds under line of credit agreements with correspondent banks and a borrowing agreement with the Federal Home Loan Bank of Cincinnati, Ohio and the adjustment of interest rates to obtain depositors. Management believes the Company has the capital adequacy, profitability and reputation to meet the current and projected needs of its customers. For the six months ended June 30, 2014, the adjustments to reconcile net income to net cash from operating activities consisted mainly of depreciation and amortization of premises and equipment, the provision for loan losses, net amortization of securities and net changes in other assets and liabilities. For a more detailed illustration of sources and uses of cash, refer to the Condensed Consolidated Statements of Cash Flows. INFLATION Substantially all of the Company's assets and liabilities relate to banking activities and are monetary in nature. The consolidated financial statements and related financial data are presented in accordance with U.S. Generally Accepted Accounting Principles ("GAAP"). GAAP currently requires the Company to measure the financial position and results of operations in terms of historical dollars, with the exception of securities available for sale, impaired loans and other real estate loans that are measured at fair value. Changes in the value of money due to rising inflation can cause purchasing power loss. Management's opinion is that movements in interest rates affect the financial condition and results of operations to a greater degree than changes in the rate of inflation. It should be noted that interest rates and inflation do affect each other, but do not always move in correlation with each other. The Company's ability to match the interest sensitivity of its financial assets to the interest sensitivity of its liabilities in its asset/liability management may tend to minimize the effect of changes in interest rates on the Company's performance. 35

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REGULATORY MATTERS The Company is subject to the regulatory requirements of the Federal Reserve System as a bank holding company. The affiliate bank is subject to regulations of the Federal Deposit Insurance Corporation ("FDIC") and the State of Ohio, Division of Financial Institutions. The Federal Reserve Board and the FDIC have extensive authority to prevent and to remedy unsafe and unsound practices and violations of applicable laws and regulations by institutions and holding companies. The agencies may assess civil money penalties, issue cease-and-desist or removal orders, seek injunctions, and publicly disclose those actions. In addition, the Ohio Division of Financial Institutions possesses enforcement powers to address violations of Ohio banking law by Ohio-chartered banks.



REGULATORY CAPITAL REQUIREMENTS

The Company is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings and other factors and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the company's operations. The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion and plans for capital restoration are required. 36 --------------------------------------------------------------------------------



The following tables illustrate the Company's and Bank's capital ratios:

Middlefield Banc Corp.



The Middlefield Banking Co.

June 30, June 30, 2014 2014 Amount Ratio Amount Ratio (Dollar amounts in thousands) Total Capital (to Risk-weighted Assets) Actual $ 67,469 14.45 % $ 65,748 14.09 % For Capital Adequacy Purposes 37,344 8.00 37,326 8.00 To Be Well Capitalized 46,680 10.00 46,658 10.00 Tier I Capital (to Risk-weighted Assets) Actual $ 61,618 13.20 % $ 59,919 12.84 % For Capital Adequacy Purposes 18,672 4.00 18,663 4.00 To Be Well Capitalized 28,008 6.00 27,995 5.00 Tier I Capital (to Average Assets) Actual $ 61,618 9.31 % $ 59,919 9.05 % For Capital Adequacy Purposes 26,482 4.00 26,482 4.00 To Be Well Capitalized 33,102 5.00 33,102 5.00 Middlefield Banc Corp. The Middlefield Banking Co. Emerald Bank December 31, December 31, December 31, 2014 2014 2014 Amount Ratio Amount Ratio Amount Ratio (Dollar amounts in thousands) Total Capital (to Risk-weighted Assets) Actual $ 64,220 14.06 % $ 53,194 13.77 % $ 9,482 13.76 % For Capital Adequacy Purposes 36,541 8.00 30,906 8.00 5,514 8.00 To Be Well Capitalized 45,676 10.00 38,632 10.00 6,893 10.00 Tier I Capital (to Risk-weighted Assets) Actual $ 58,494 12.81 % $ 48,364 12.52 % $ 8,605 12.48 % For Capital Adequacy Purposes 18,270 4.00 15,453 4.00 2,757 4.00 To Be Well Capitalized 27,406 6.00 23,179 6.00 4,136 6.00 Tier I Capital (to Average Assets) Actual $ 58,494 8.97 % $ 48,364 8.51 % $ 8,605 10.92 % For Capital Adequacy Purposes 26,093 4.00 22,735 4.00 3,152 4.00 To Be Well Capitalized 32,617 5.00 28,419 5.00 3,940 5.00 37



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