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ROYAL BANCSHARES OF PENNSYLVANIA INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 12, 2014

The following discussion and analysis is intended to assist in understanding and evaluating the changes in the financial condition and earnings performance of the Company and its subsidiaries for the three and six month periods ended June 30, 2014 and 2013. This discussion and analysis should be read in conjunction with the Company's consolidated financial statements and notes thereto for the year ended December 31, 2013, included in the Company's Form 10-K for the year ended December 31, 2013. FORWARD-LOOKING STATEMENTS From time to time, Royal Bancshares of Pennsylvania, Inc. (the "Company") may include forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters in this and other filings with the Securities and Exchange Commission. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. When we use words such as "believes," "expects," "anticipates" or similar expressions, we are making forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The risks and uncertainties that may affect the operations, performance development and results of the Company's business include the following: general economic conditions, including their impact on capital expenditures; interest rate fluctuations; business conditions in the banking industry; the regulatory environment: the nature, extent, and timing of governmental actions and reforms; rapidly changing technology and evolving banking industry standards; competitive factors, including increased competition with community, regional and national financial institutions; changes in generally accepted accounting principles; new service and product offerings by competitors and price pressures and similar items. All forward-looking statements contained in this report are based on information available as of the date of this report. These statements speak only as of the date of this report, even if subsequently made available by the Company on its website, or otherwise. The Company expressly disclaims any obligation to update any forward-looking statement to reflect future statements to reflect future events or developments.



CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry. Applications of the principles in the Company's preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates. Note 1 to the Company's Consolidated Financial Statements (included in Item 8 of the Form 10-K for the year ended December 31, 2013) lists significant accounting policies used in the development and presentation of the Company's consolidated financial statements. The following discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other quantitative and qualitative factors that are necessary for an understanding and evaluation of the Company and its results of operations. We completed an internal review of this financial information. This review requires substantive judgment and estimation. As disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, we have identified other-than-temporary impairment on investment securities, accounting for allowance for loan and lease losses, valuation allowance of deferred tax assets, loans held for sale, the valuation of other real estate owned, net periodic pension costs and the pension benefit obligation as among the most critical accounting policies and estimates. These critical accounting policies and estimates are important to the presentation of the Company's financial condition and results of operations, and they require difficult, subjective or complex judgments as a result of the need to make estimates. 43 --------------------------------------------------------------------------------



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Financial Highlights and Business Results

On June 29, 1995, pursuant to the plan of reorganization approved by the shareholders of Royal Bank America, formerly Royal Bank of Pennsylvania ("Royal Bank"), all of the outstanding shares of common stock of Royal Bank were acquired by Royal Bancshares and were exchanged on a one-for-one basis for common stock of Royal Bancshares. The principal activities of the Company are supervising Royal Bank, which engages in a general banking business principally in Montgomery, Chester, Bucks, Philadelphia and Berks counties in Pennsylvania and in central and southern New Jersey and Delaware. The Company also has a wholly owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities. The Company's results of operations depend primarily on net interest income, which is the difference between interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities. Interest-earning assets consist principally of loans and investment securities, while interest-bearing liabilities consist primarily of deposits and borrowings. Refer to the "Net Interest Income and Net Interest Margin" section in Management's Discussion and Analysis of Financial Condition and Results of Operation below for additional information on interest yield and cost. Royal Bank principally generates commercial real estate loans primarily secured by first mortgage liens, construction loans for commercial real estate projects and residential home development, land development loans, tax liens and leases. At June 30, 2014, commercial real estate loans, commercial and industrial loans, leases, and construction and land development loans comprised 44%, 19%, 12%, and 11%, respectively, of the total loan portfolio. Construction loans and land development loans can have more risk associated with them, especially when a weakened economy, such as we have experienced the past few years, adversely impacts the commercial rental or home sales market. Net income is also affected by the provision for loan and lease losses and the level of non-interest income as well as by non-interest expenses, including salary and benefits, occupancy expenses and other operating expenses. From 2008 through 2012, the Company recorded significant impairment charges on non-accrual loans, OREO and investment securities, which weighed heavily on earnings and was the largest contributing factor to the Company's losses in those years. Also contributing to the losses were increased costs associated with the historically high level of non-performing assets and legal expenses related to credit quality issues and the tax lien subsidiaries. Finally, the establishment of a valuation allowance in 2008 and subsequent years that currently amounts to $37.2 million, has prevented the Company from utilizing tax credits from losses during the past five years. Management successfully executed the Company's strategic plan which included improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio, cutting the overall level of expenses, and returning to profitability. While the Company's past deleveraging strategy improved the risk profile of the Company by shedding higher risk assets and paying off higher cost brokered CDs, it has had a negative impact on income. The deleveraging has resulted in lower average loan balances and a higher proportion of lower yielding investment securities, which have negatively impacted net interest income, a principal source of income. While credit quality costs associated with non-performing assets negatively affect financial results, their impact has diminished as the overall level of non-performing assets has declined. The financial results for the first half of 2014 illustrate the further progress of the Company's current multi-faceted strategic plan with the goal of consistent profitability. A key strategy in 2014 has been to refresh Royal Bank's retail products and branch network. During 2014, the Company reorganized the retail division to better serve existing customers, develop the retail sales teams, and attain new customer relationships. Royal Bank held a successful 50th anniversary campaign, offering a Kindle to new customers who met certain deposit account opening criteria. The Company relocated the Villanova and Phoenixville branches and will soon relocate two additional branches to more convenient, high-traffic locations within similar markets. Additionally, customers now have access to 55,000 ATMs nationwide from a new arrangement. During 2014, five highly experienced industry veterans joined the Company. These included two commercial relationship managers, two retails sales managers and the head of sales and product training. Their collective experience spans community and regional banks. The hiring of these individuals was funded through the rightsizing of the organization and is fully integrated into the Company's budget. In July we introduced Royal Bank's exciting fresh logo and the enhanced website. The redesigned products and contemporary technology are the future platform for enhanced banking convenience for commercial, consumer and retail customers. Overall positive financial results have benefited from our rebranding and the ability to attract and retain commercial and consumer customers. 44 --------------------------------------------------------------------------------



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Consolidated Net Income (Loss)

Net income for the second quarter of 2014 amounted to $1.4 million and basic and diluted earnings per share of $0.04 compared to a net loss of $803,000 and basic and diluted loss per share of $0.10 for the comparable quarter in 2013. Contributing to the 2013 net loss was a $1.65 million loss contingency accrual for a settlement of the class action lawsuit related to the Company's tax lien subsidiaries. After adjusting for the noncontrolling interest, the Company's 60% share of the loss contingency amounted to $990,000. Additional items that positively contributed to the $2.2 million improvement for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013 included: Net interest income grew $641,000, or 13.0%. Professional and legal fees decreased $419,000, or 51.9%. Salaries and benefits declined $241,000, or 9.1%. Credit related expenses decreased $153,000, or 21.2%.



Included in the 2nd quarter of 2013 was a legal settlement expense related to a

tax lien subsidiary, of which the Company's share was $990,000 after adjusting

for noncontrolling interest.

Gains on sales of AFS investment securities increased $92,000.

Partially offsetting these positive items was a decrease in the credit for loan and lease losses of $88,000, an $87,000 reduction in gains on the sale of other real estate owned, and a $75,000 increase in occupancy and equipment expenses. For the six months ended 2014, net income amounted to $2.9 million and basic and diluted earnings per share of $0.10 compared to a net loss of $685,000 and basic and diluted loss per share of $0.13 for the comparable period in 2013. The $3.6 million improvement for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013 was mainly related to the following items:



Net interest income grew $1.4 million, or 14.4%.

Professional and legal fees decreased $476,000, or 32.4%.

Salaries and benefits declined $650,000, or 11.9%.

Credit for loan and lease losses improved $300,000.

Credit related expenses decreased $433,000, or 32.6%.

Included in the six month loss in 2013 was a legal settlement expense related

to a tax lien subsidiary, of which the Company's share was $990,000 after

adjusting for noncontrolling interest.

Partially offsetting these positive items was a $135,000 increase in occupancy and equipment expenses, a $128,000 increase in marketing and advertising expenses, and a $120,000 reduction in gains on the sale of other real estate owned. Interest Income Total interest income of $7.2 million for the second quarter of 2014 grew $466,000, or 6.9%, from the comparable quarter of 2013. The improvement was primarily driven by an increase of $663,000 quarter versus quarter in interest income on investment securities which was partially offset by a decline of $194,000 in interest income on loans and leases. Average interest-earning assets amounted to $690.5 million in the second quarter of 2014, which resulted in an increase of $5.3 million, or 0.8%, from the level of $685.2 million in the second quarter of 2013. The increase in average interest-earning assets was mainly related to a $6.9 million increase in average loans to $370.1 million and a $4.9 million increase in average investment securities to $312.1 million for the quarter ended June 30, 2014. Average cash equivalents declined $6.5 million quarter over quarter. While average loan balances increased $6.9 million for the second quarter of 2014, the associated interest income declined $194,000 and was directly related to the tax lien portfolio. Interest income related to tax liens fell $305,000 quarter over quarter due to an $9.8 million, or 45.9% decline in average balances. Interest income on the remaining loan portfolio increased $112,000.



Total interest income of $14.4 million for the first six months of 2014 grew $865,000, or 6.4%, from the comparable period in 2013. The improvement was primarily driven by an increase of $1.3 million quarter versus quarter in interest income on investment securities. Average interest-earning assets amounted to $690.6 million for the first six months of 2014,

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which resulted in a decline of $4.8 million, or 0.7%, from the level of $695.4 million in the first six months of 2013. The decrease in average interest-earning assets was mainly related to a $7.8 million decline in average cash equivalents to $7.3 million and a $7.1 million decrease in average investment securities to $315.1 million for the six months ended June 30, 2014. While average loan balances increased $10.1 million to $368.2 million for the first six months of 2014, the associated interest income declined $431,000 and was directly related to the tax lien portfolio. Interest income related to tax liens fell $738,000 year over year due to a $10.6 million, or 46.0% decline in average balances. Interest income on the remaining loan portfolio increased $307,000. For the second quarter of 2014, the yield on average interest-earning assets of 4.19% amounted to an enhancement of 24 basis points from the yield of 3.95% for the prior year's second quarter. Driving the improvement in yield quarter over quarter was an increase of 82 basis points in the average yield on investments (2.51% versus 1.69%) which contributed $663,000 to interest income. The average yield on loans declined 32 basis points (5.69% versus 6.01%). The investment yield in the second quarter of 2013 was negatively impacted by the accelerated amortization of premiums due to prepayments of government agency mortgage-backed ("MBS") and collateralized mortgage obligation ("CMO") securities. The decrease in loan yields reflects the decline in higher yielding tax liens quarter versus quarter which adversely effected interest income by $305,000. For the six months ended June 30, 2014, the yield on average interest-earning assets of 4.19% amounted to an enhancement of 28 basis points from the yield of 3.91% for the comparable 2013 period. Driving the improvement in yield quarter over quarter was an increase of 87 basis points in the average yield on investments (2.48% versus 1.61%) which contributed $1.3 million to interest income. The average yield on loans declined 40 basis points (5.74% versus 6.14%). The investment yield in the first six months of 2013 was negatively impacted by the accelerated amortization of premiums due to prepayments of government agency mortgage-backed ("MBS") and collateralized mortgage obligation ("CMO") securities. The decrease in loan yields reflects the decline in higher yielding tax liens year over year which adversely effected interest income by $738,000. Interest Expense Total interest expense of $1.6 million in the second quarter of 2014 declined $175,000, or 9.7%, from the comparable quarter of 2013. The reduction in interest expense was primarily associated with a decline in the average interest rates paid on average interest-bearing liabilities as well as slightly lower average balances of such liabilities. For the second quarter of 2014, average interest-bearing liabilities of $597.2 million decreased $1.2 million, or 0.2%, from $598.4 million for the comparable period in 2013. For the three months ended June 30, 2014, average certificates of deposit amounted to $229.9 million which reflected a decline of $5.6 million, or 2.4% from the comparable quarter of 2013. The decline in this average balance combined with a reduction in the average interest rate resulted in a decrease in interest expense of $116,000. Average borrowings amounted to $137.4 million which represented an increase of $3.5 million, or 2.6% from the comparable quarter of 2013. Despite the increase in the average balance of borrowings, the interest expense decreased $69,000 from the comparable quarter of 2013 as a result of a reduction in the interest rates paid on these borrowings. Total interest expense of $3.2 million in the first two quarters of 2014 declined $530,000, or 14.0%, from the comparable quarters of 2013. The reduction in interest expense was primarily associated with a decline in the average interest rates paid on average interest-bearing liabilities as well as lower average balances of such liabilities. For the first six months of 2014, average interest-bearing liabilities of $596.1 million decreased $11.9 million, or 2.0%, from $608.0 million for the comparable period in 2013. For the six months ended June 30, 2014, average certificates of deposit, average NOW and money market accounts and average borrowings amounted to $233.2 million, $210.8 million and $133.9 million, respectively, and reflected declines of $7.1 million, or 3.0%, $5.0 million, or 2.3% and $145,000, or 0.1%, respectively, from the comparable period of 2013. These declines in average balances combined with interest rate reductions resulted in interest expense decreases of $281,000 and $264,000 for average CDs and borrowings, respectively. The average interest rate paid on average total interest-bearing liabilities during the second quarter of 2014 amounted to 1.09%, which represented an improvement of 11 basis points from the average interest rate paid during the comparable quarter of 2013. During the second quarter of 2014 the average interest rate paid on average interest-bearing deposits was 0.78% which resulted in a decline of 9 basis points from the level of 0.87% during the comparable quarter of 2013. Quarter versus quarter lower average interest rates were paid on CDs (1.27% in 2014 versus 1.43% in 2013), while NOW and 46 --------------------------------------------------------------------------------



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money market rates slightly increased 2 basis points (0.31% in 2014 versus 0.29% in 2013). The decline in average interest rates paid on CDs was attributed to lower rates on new accounts and the continued run off of maturing retail CDs. The average interest rate paid for borrowings during the second quarter of 2014 was 2.11%, which amounted to a reduction of 26 basis points from the average rate paid of 2.37% during the second quarter of 2013. The average interest rate paid on average total interest-bearing liabilities during the first two quarters of 2014 amounted to 1.10%, which represented an improvement of 15 basis points from the average interest rate paid during the comparable quarters of 2013. During the first six months of 2014 the average interest rate paid on average interest-bearing deposits was 0.79% which resulted in a decline of 9 basis points from the level of 0.88% during the comparable period of 2013. Year over year lower average interest rates were paid on CDs (1.26% in 2014 versus 1.46% in 2013), while NOW and money market rates slightly increased 3 basis points (0.32% in 2014 versus 0.29% in 2013). The decline in average interest rates paid on CDs was attributed to lower rates on new accounts and the continued run off of maturing retail CDs. The average interest rate paid for borrowings during the first six months of 2014 was 2.16%, which amounted to a reduction of 40 basis points from the average rate paid of 2.56% during the first six months of 2013.



Net Interest Income and Margin

Net interest income for the quarter ended June 30, 2014 amounted to $5.6 million resulting in an increase of $641,000, or 13.0%, from the comparable quarter of 2013. The improvement in net interest income was primarily attributed to an increase in the average yield on investment securities and a net reduction in the average rates paid on average interest-bearing liabilities quarter versus quarter. The increase in the average yield on investment securities was due to higher yields on new purchases. Additionally, the prepayments on government agency MBS and CMO investment securities declined, which had a positive effect on the amortization of premiums. The decrease in average CD and borrowing balances combined with their respective interest rate reductions contributed $185,000 to the decline in interest expense. Net interest income for the six months ended June 30, 2014 amounted to $11.1 million resulting in an increase of $1.4 million, or 14.4%, from the comparable period of 2013. The improvement in net interest income was primarily attributed to an increase in the average yield on investment securities and a net reduction in the average rates paid on average interest-bearing liabilities quarter versus quarter. The increase in the average yield on investment securities was due to higher yields on new purchases. Additionally, the prepayments on government agency MBS and CMO investment securities declined, which had a positive effect on the amortization of premiums. The decrease in average CD and borrowing balances combined with their respective interest rate reductions contributed $545,000 to the decline in interest expense. The net interest margin for the second quarter of 2014 was 3.25%, which grew 35 basis points from 2.90% for the comparable quarter of 2013. Quarter over quarter, the contribution from the 82 basis point improvement in the average yield on investment securities (2.51% versus 1.69%) was partially offset by the 32 basis point reduction in the average yield on loans and leases (5.69% versus 6.01%). The average yield on interest-earning assets for the second quarter of 2014 was 4.19% compared to 3.95% for the same period in 2013. Funding costs improved from an average interest rate paid of 1.20% for the second quarter of 2013 to 1.09% for the second quarter of 2014. The Company continued to redeem and re-price maturing retail CDs which led to a 16 basis point reduction in average interest rates paid quarter over quarter (1.27% in 2014 versus 1.43% in 2013). Additionally the average rates paid on borrowings declined 26 basis points (2.11% in 2014 versus 2.37% in 2013). The net interest margin for the first six months of 2014 was 3.24%, which grew 42 basis points from 2.82% for the comparable period of 2013. Year over year, the contribution from the 87 basis point improvement in the average yield on investment securities (2.48% versus 1.61%) was partially offset by the 40 basis point reduction in the average yield on loans and leases (5.74% versus 6.14%). The average yield on interest-earning assets for the first six months of 2014 was 4.19% compared to 3.91% for the same period in 2013. Funding costs improved from an average interest rate paid of 1.25% for the first six months of 2013 to 1.10% for the first six months of 2014. The Company continued to redeem and re-price maturing retail CDs which led to a 20 basis point reduction in average interest rates paid quarter over quarter (1.26% in 2014 versus 1.46% in 2013). Additionally the average rates paid on borrowings declined 40 basis points (2.16% in 2014 versus 2.56% in 2013). 47 --------------------------------------------------------------------------------



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The following table represents the average daily balances of assets, liabilities and shareholders' equity and the respective interest-earning assets and interest-bearing liabilities, as well as average rates for the periods indicated. The loans outstanding include non-accruing loans. The yields are presented on an annualized basis.

For the three months ended For the three months ended June 30, 2014 June 30, 2013 Average (In thousands, except percentages) Average Balance Interest Yield Balance Interest Yield Cash equivalents $ 8,284 $ 5 0.24 % $ 14,774$ 8 0.22 % Investment securities 312,118 1,954 2.51 % 307,216 1,291 1.69 % Loans 370,116



5,250 5.69 % 363,183 5,444 6.01 % Total interest earning assets

690,518 7,209 4.19 % 685,173 6,743 3.95 % Non-earning assets 49,365 55,017 Total average assets $ 739,883$ 740,190 Interest-bearing deposits NOW and money markets $ 211,381 166 0.31 % $ 210,778 153 0.29 % Savings 18,520 7 0.15 % 18,189 10 0.22 % Time deposits 229,906



726 1.27 % 235,508 842 1.43 % Total interest bearing deposits

459,807



899 0.78 % 464,475 1,005 0.87 % Borrowings

137,441



723 2.11 % 133,952 792 2.37 % Total interest bearing liabilities

597,248



1,622 1.09 % 598,427 1,797 1.20 % Non-interest bearing deposits

64,702 58,865 Other liabilities 24,517 30,310 Shareholders' equity 53,416 52,588 Total average liabilities and equity $ 739,883$ 740,190 Net interest margin $ 5,587 3.25 % $ 4,946 2.90 % For the six months ended For the six months ended June 30, 2014 June 30, 2013 Average Average (In thousands, except percentages) Balance Interest Yield Balance Interest Yield Cash equivalents $ 7,344$ 10 0.27 % $ 15,139$ 15 0.20 % Investment securities 315,128 3,876 2.48 % 322,229 2,575 1.61 % Loans 368,152 10,474 5.74 % 358,058 10,905 6.14 % Total interest earning assets 690,624 14,360 4.19 % 695,426 13,495 3.91 % Non-earning assets 46,014 53,128 Total average assets $ 736,638$ 748,554 Interest-bearing deposits NOW and money markets $ 210,810 333 0.32 % $ 215,768 315 0.29 % Savings 18,199 16 0.18 % 17,887 19 0.21 % Time deposits 233,233



1,463 1.26 % 240,361 1,744 1.46 % Total interest bearing deposits

462,242



1,812 0.79 % 474,016 2,078 0.88 % Borrowings

133,863



1,435 2.16 % 134,008 1,699 2.56 % Total interest bearing liabilities

596,105



3,247 1.10 % 608,024 3,777 1.25 % Non-interest bearing deposits

64,310 58,620 Other liabilities 24,137 28,704 Shareholders' equity 52,086 53,206 Total average liabilities and equity $ 736,638$ 748,554 Net interest margin $ 11,113 3.24 % $ 9,718 2.82 % 48

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Table of Contents Rate Volume Analysis The following table sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income for the three and six month periods ended June 30, 2014, as compared to the respective period in 2013, into amounts attributable to both rates and volume variances. For the three months ended For the six months ended June 30, June 30, 2014 vs. 2013 2014 vs. 2013 Increase (decrease) Increase (decrease) (In thousands) Volume Rate Total Volume Rate Total Interest income Interest-bearing deposits $ (3) $



- $ (3)$ (10)$ 5$ (5) Total short term earning assets

(3) - (3) (10) 5 (5) Investments securities (46) 709 663 (93) 1,394 1,301 Loans Commercial demand loans (133) 163 30 (218) 223 5 Commercial mortgages (114) (160) (274) 15 (276) (261) Residential and home equity 240 (34) 206 437 (114) 323 Leases receivables 176 (77) 99 265 2 267 Tax certificates (291) (14) (305) (609) (129) (738) Other loans 2 (2) - (5) (4) (9) Loan fees 50 - 50 (18) - (18) Total loans (70)



(124) (194) (133) (298) (431) Total (decrease) increase in interest income

$ (119)$ 585$ 466$ (236)$ 1,101$ 865 Interest expense Deposits NOW and money market $ 1$ 12$ 13$ (7)$ 25$ 18 Savings - (3) (3) - (3) (3) Time deposits (20) (96) (116) (50) (231) (281) Total deposits (19) (87) (106) (57) (209) (266) Trust preferred 26 158 184 - (7) (7) Borrowings (1)



(252) (253) (1) (256) (257) Total increase (decrease) in interest expense

$ 6 $



(181) $ (175)$ (58)$ (472)$ (530) Total (decrease) increase in net interest income

$ (125)$ 766$ 641$ (178)$ 1,573$ 1,395 Credit Risk Management The Company's loan and lease portfolio (the "credit portfolio") is subject to varying degrees of credit risk. The Company maintains an allowance for loan and lease losses (the "allowance") to absorb losses in the loan and lease portfolio. The allowance is based on the review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio. The allowance represents an estimation made pursuant to FASB ASC Topic 450, "Contingencies" ("ASC Topic 450") or FASB ASC Topic 310, "Receivables" ("ASC Topic 310"). The adequacy of the allowance is determined through evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level. Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period expense. The Company's systematic methodology for assessing the appropriateness of the allowance includes: (1) general reserves reflecting historical loss rates by loan type, (2) specific reserves for risk-rated credits based on probable losses on an individual or portfolio basis and (3) qualitative reserves based upon current economic conditions and other risk factors. The loan portfolio is stratified into loan segments that have similar risk characteristics. The general allowance is based upon historical loss rates using a weighted three-year rolling average of the historical loss experienced within each loan segment. The qualitative factors used to adjust the historical loss experience address various risk characteristics of the 49 --------------------------------------------------------------------------------



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Company's loan and lease portfolio include evaluating: (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the growth trends of categories of loans comprising the loan and lease portfolio, (4) concentrations of loans and leases to specific industry segments, and (5) changes in economic conditions on both a local and national level, (6) quality of loan review and board oversight, (7) changes in lending policies and procedures, and (8) changes in lending staff. Each factor is assigned a value to reflect improving, stable or declining conditions based on management's best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a report accompanying the allowance calculation. The specific reserves are determined utilizing standards required under ASC Topic 310. A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Non-accrual loans and loans restructured under a troubled debt restructuring are evaluated for impairment on an individual basis considering all known relevant factors that may affect loan collectability such as the borrower's overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of current collateral values (current appraisals or rent rolls for income producing properties), and risks inherent in different kinds of lending (such as source of repayment, quality of borrower and concentration of credit quality). Non-accrual loans that experience insignificant payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and industrial loans, commercial real estate loans and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. The estimated fair values of substantially all of the Company's impaired loans are measured based on the estimated fair value of the loan's collateral. The Company obtains third-party appraisals on the fair value of real estate collateral. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower's financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Once a loan is determined to be impaired it will be deducted from the portfolio and the net remaining balance will be used in the general and qualitative analysis. A specific reserve is established for an impaired loan if its carrying value exceeds its estimated fair value. The amount of the allowance is reviewed and approved by the Chief Financial Officer ("CFO"), Chief Administrative and Risk Officer ("CARO"), Chief Lending Officer ("CLO"), and Chief Credit Officer ("CCO") on at least a quarterly basis. Management believes that the allowance at June 30, 2014 is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future changes to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination. Due to the continuing improvement in the credit quality of the loan portfolio and the decline in non-accrual loan balances, the Company recorded credits to the allowance of $75,000 and $714,000 for the three and six months ended June 30, 2014, respectively, compared to credits of $163,000 and $414,000 for the three and six months ended June 30, 2013, respectively. The allowance decreased $2.1 million from $13.7 million at December 31, 2013 to $11.6 million at June 30, 2014. The decline in the allowance was directly related to the charge-off of specific reserves and a reduction of approximately $20.0 million in classified and impaired loans. The allowance was 3.06% of total loans and leases held for investment at June 30, 2014 compared to 3.73% at December 31, 2013. 50 --------------------------------------------------------------------------------



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Changes in the allowance were as follows:

For the three months ended For the six months ended June 30, June 30, (In thousands) 2014 2013 2014 2013 Balance at period beginning $



11,866 $ 15,389$ 13,671$ 17,261 Charge-offs Commercial real estate

- - (350) (835) Construction and land development - - - (820) Commercial & industrial - (21) (452) (195) Multi-family - - - - Residential real estate - - - - Leases (244) (99) (362) (108) Tax certificates - (138) (265) (285) Total charge-offs (244) (258) (1,429) (2,243) Recoveries Commercial real estate - 23 - 127 Construction and land development - 95 - 191 Commercial & industrial 8 6 12 9 Multi-family - - - - Residential real estate 4 5 6 156 Leases 9 10 22 20 Tax certificates 1 72 1 72 Total recoveries 22 211 41 575 Net charge offs (222) (47) (1,388) (1,668) Credit for loan and lease losses (75) (163) (714) (414) Balance at period end $ 11,569$ 15,179$ 11,569$ 15,179



An analysis of the allowance by loan type is set forth below:

June 30, 2014 December 31, 2013 Percent of Percent of outstanding outstanding loans in each loans in each Allowance category to Allowance category to (In thousands, except percentages) amount total loans amount total loans Commercial real estate $ 4,971 40.9 % $ 5,498 40.5 % Construction and land development 2,033 10.9 % 2,316 12.3 % Commercial and industrial 1,525 19.0 % 3,006 21.7 % Multi-family 416 3.5 % 402 3.2 % Residential real estate 690 10.6 % 473 7.0 % Leases 1,352 12.2 % 1,223 11.6 % Tax certificates 408 2.6 % 555 3.5 % Consumer 24 0.3 % 15 0.2 % Unallocated 150 - % 183 - % Total allowance $ 11,569 100.00 % $ 13,671 100.0 % 51

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The following table presents the principal amounts of non-accrual loans and other real estate owned: June 30, December 31, (Amounts in thousands) 2014 2013 Non-accrual LHFI (1) $ 7,664$ 10,157 Non-accrual LHFS 1,396 - Other real estate owned 9,811 9,617 Total nonperforming assets $ 18,871$ 19,774 Nonperforming assets to total assets 2.59 % 2.70 % Total non-accrual loans to total loans 2.39 % 2.76 % ALLL to non-accrual LHFI 150.95 % 134.60 % ALLL to total LHFI 3.06 % 3.73 %



(1) Generally, a loan is placed on non-accruing status when it has been delinquent for a period of 90 days or more. This excludes non-accrual loans held for sale of $1.4 million at June 30, 2014.

The composition of non-accrual loans is as follows:

As of June 30, 2014 As of December 31, 2013 Loan Specific Loan Specific (In thousands) balance reserves balance reserves Non-accrual loans held for investment Commercial real estate $ 1,335 $ - $ 2,325$ 331 Construction and land development 902 - 2,650 - Commercial & industrial 2,885 - 3,629 452 Residential real estate 1,004 30 632 19 Leases 398 71 467 60 Tax certificates 1,140 - 454 24 Total non-accrual LHFI $ 7,664$ 101$ 10,157$ 886 Non-accrual loans held for sale Construction and land development $ 1,396 $ - $ - $ - Total non-accrual LHFS $ 1,396 $ - $ - $ - Total non-accrual loans $ 9,060$ 101$ 10,157$ 886 52

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Non-accrual loan activity for the first two quarters of 2014 is set forth below: 1st Quarter Activity Payments and other Transfer to (In thousands)



Balance at January 1, 2014 Additions decreases Charge-offs/Impairment* OREO Balance at March 31, 2014 Non-accrual loans held for investment Commercial real estate

$ 2,325 $ - $ (395) $ (350) $ - $ 1,580 Construction and land development 2,650 - (332) - - 2,318 Commercial & industrial 3,629 99 (339) (452) - 2,937 Residential real estate 632 114 - - - 746 Leases 467 278 - (118) - 627 Tax certificates 454 1,521 - (265) (573) 1,137 Total non-accrual loans $ 10,157 $ 2,012$ (1,066) $ (1,185) $ (573) $ 9,345 2nd Quarter Activity Payments and other Transfer to (In thousands)



Balance at March 31, 2014 Additions decreases Charge-offs/Impairment* OREO Balance at June 30, 2014 Non-accrual loans held for investment Commercial real estate

$ 1,580 $ - $ (245) $ - $ - $ 1,335 Construction and land development 2,318 - (1,416) - - 902 Commercial & industrial 2,937 - (52) - - 2,885 Multi-family - - - - - - Residential real estate 746 258 - - - 1,004 Leases 627 15 - (244) - 398 Tax certificates 1,137 312 - - (309) 1,140 Total non-accrual LHFI $ 9,345 $ 585$ (1,713) $ (244) $ (309) $ 7,664 Non-accrual loans held for sale Construction and land development(1) $ - $ 1,396 $ - $ - $ - $ 1,396 Total non-accrual LHFS $ - $ 1,396 $ - $ - $ - $ 1,396 Total non-accrual loans $ 9,345 $ 1,981$ (1,713) $ (244) $ (309) $ 9,060



*Charge-offs on LHFI were recorded in the allowance.

(1) Additions column shows the transfer from non-accrual LHFI to non-accrual LHFS.

Total non-accrual loans at June 30, 2014 were $9.1 million compared to $10.2 million at December 31, 2013. The decrease of $1.1 million was the result of $1.4 million in charge-offs mostly related to specific reserves, $1.4 million reduction in existing non-accrual loan balances through payments and payoffs, and $882,000 in transfers to OREO, which were partially offset by additions of $2.6 million. The tax certificate portfolio accounted for the majority of the new non-accrual activity and transfers to OREO. If interest had been accrued, such income would have been approximately $213,000 and 53 --------------------------------------------------------------------------------



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$488,000 for the three and six months ended June 30, 2014, respectively. The Company had no loans past due 90 days or more on which it has continued to accrue interest during the quarter. Typically, loans are restored to accrual status when the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt. Impaired Loans The Company identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Impaired loans include troubled debt restructurings ("TDRs"). The Company does not accrue interest income on impaired non-accrual loans. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis. The Company recognizes interest income under the accrual basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to the Company. If these factors do not exist, the Company does not recognize income. The following is a summary of information pertaining to impaired loans and leases: June 30, December 31, (In thousands) 2014 2013



Impaired LHFI with a valuation allowance $ 1,083$ 3,835

Impaired LHFI without a valuation allowance 13,828



14,671

Impaired LHFS 1,396



-

Total impaired loans and leases $ 16,307 $



18,506

Valuation allowance related to impaired LHFI $ 101 $ 886 For the six months ended June 30, (In thousands) 2014 2013 Average investment in impaired loans $ 16,973$ 24,593 Interest income recognized on impaired loans and leases



$ 196$ 273 Interest income recognized on a cash basis on impaired loans and leases $ 196$ 273

Troubled Debt Restructurings

A loan modification is deemed a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics. All loans classified as TDRs are considered to be impaired. TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual restructured principal and interest is no longer in doubt. At June 30, 2014, the Company had eleven TDRs, with a total carrying value of $9.6 million. At the time of the modifications, three of the loans were already classified as impaired non-accrual loans. At December 31, 2013, the Company had twelve TDRs with a total carrying value of $12.1 million. The Company's policy for TDRs is to recognize income on currently performing restructured loans under the accrual method.



Other Real Estate Owned

OREO increased $194,000 from $9.6 million at December 31, 2013 to $9.8 million at June 30, 2014. During the past twelve months there was a shift in OREO composition from real estate acquired through, or in lieu of foreclosure in settlement of loans to real estate acquired through foreclosure related to tax liens. Set forth below is a table which details the changes in OREO from December 31, 2013 to June 30, 2014. 54 -------------------------------------------------------------------------------- Table of Contents For the six months ended June 30, 2014 (In thousands) Loans Tax Liens Total Beginning balance $ 1,725$ 7,892$ 9,617 Net proceeds from sales (143) (1,770)

(1,913) Net gains on sales 16 444 460 Transfers in - 882 882 Cash additions - 1,103 1,103 Impairment charge (99) (239) (338) Ending balance $ 1,499$ 8,312$ 9,811 At June 30, 2014, OREO was comprised of $769,000 in land, $496,000 in commercial real estate, $8.3 million in tax liens, and residential real estate with a fair value of $234,000. During the first half of 2014, the Company sold seven condominiums related to a construction project in Minneapolis, Minnesota in which the Company is a participant. The Company received its pro rata share of net proceeds in the amount of $143,000 and recorded a net gain of $16,000. During the first quarter of 2014, the Company recorded impairment charges of $74,000 on the remaining, larger condominium units and $25,000 on the commercial real estate due to a recent agreement of sale. As shown in the table above the composition of the OREO assets has evolved to properties primarily acquired through the tax lien portfolio. During the first half of 2014, the Company transferred $882,000 to OREO which represents 18 properties and added $1.1 million in lien redemptions on existing properties. During the same period the Company sold 22 of the tax lien properties, received proceeds of $1.8 million, and recorded net gains of $444,000 as a result of these sales. Additionally, the Company recorded impairment charges of $239,000 in the first half of 2014 related to the tax lien properties. At December 31, 2013, OREO assets acquired through the tax lien portfolio were $7.9 million and were comprised of 59 properties.



Credit Classification Process

The Company uses a nine point risk rating classification system commonly used in the financial services industry. The first four risk rating classifications are rated Pass. The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. During the underwriting process, the CCO assigns each loan with an initial risk rating, which is approved by the appropriate loan committee. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee. The loan review function is outsourced to a third party vendor which examines credit quality and portfolio management. The loan review vendor applies the Company's loan rating system to specific credits and reviews approximately 50% of the total commercial loan portfolio. Emphasis is on the larger new and seasoned loan relationships and includes criticized and classified loans. Additionally, the loan review vendor ensures that all critical industry segments are adequately represented in their review. The loan review vendor will also review loans specifically requested by management. Upon completion of a loan review, a copy of any review receiving an adverse classification by the reviewer is presented to the Classified, Charge-off and Impairment Committee ("CCIC") for discussion. The CCO is the primary bank officer dealing with the third party vendor during the reviews. Loans on the Company's Special Assets Committee list are also subject to loan review even though they are receiving the daily attention of an assigned officer and monthly attention of the Special Assets Committee. A watch list is maintained and reviewed at each meeting of CCIC. CCIC was formed to formalize the process and documentation required to classify, remove from classification, impair or charge-off a loan. The CCIC, which is comprised of the CEO, CARO, CFO, CCO, and CLO meet as required and provide regular updated reports to the Board of Directors. Loans are added to the watch list, even though the loans may be current or less than 30 days delinquent if they exhibit elements of substandard creditworthiness. The watch list contains a statement for each loan as to why it merits special attention, and this list is 55 --------------------------------------------------------------------------------



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distributed to the Board of Directors on a monthly basis. Loans may be removed from the watch list if the CCIC determines that exception items have been resolved or creditworthiness has improved. Additionally, if loans become serious collection matters and are listed on the Company's monthly delinquent loan or Special Assets Committee lists, they may be removed from the watch list. Minutes outlining the CCIC's findings and recommendations are issued after each meeting for follow-up by individual loan officers.



Potential Problem Loans

Potential problem loans are loans not currently classified as non-performing loans, but for which management has doubts as to the borrowers' ability to comply with present repayment terms. The loans are usually delinquent more than 30 days but less than 90 days and include non-impaired substandard loans. Potential problem loans amounted to approximately $7.5 million and $9.1 million at June 30, 2014 and December 31, 2013. The $1.6 million decline in potential problem loans included one $4.1 million relationship which paid off in full during the second quarter of 2014 but was partially offset by a $2.5 million commercial real estate loan that was past due less than 60 days at June 30, 2014.



Non-interest Income

Non-interest income for the second quarter of 2014 was $816,000 compared to $961,000 for the comparable quarter of 2013 resulting in a decrease of $145,000. Service charges and fees declined $107,000 ($218,000 in 2014 versus $325,000 in 2013), of which $88,000 was related to the leasing subsidiary. Additionally net gains on the sale of OREO declined $87,000 ($331,000 in 2014 versus $418,000 in 2013). Partially mitigating these reductions was an increase of $67,000 in net gains on the sale of AFS investment securities ($92,000 in 2014 versus $25,000 in 2013). For the six months ended June 30, 2014, non-interest income was $1.6 million compared to $2.4 million for the comparable period in 2013 resulting in a decrease of $781,000. During the first six months of 2013, the Company recorded $678,000 in gains on the sale of premises and equipment predominantly related to the sale of two Company owned properties. There were no such gains in 2014. Additionally, net gains on the sale of OREO declined $120,000 ($460,000 in 2014 versus $580,000 in 2013) and service charges and fees declined $107,000 ($531,000 in 2014 versus $638,000 in 2013). Partially offsetting these items was a $127,000 increase in net gains on the sales of loans and leases ($143,000 in 2014 versus $16,000 in 2013). Non-interest Expense Non-interest expense significantly improved by $2.5 million from $7.5 million for the second quarter of 2013 to $5.0 million for the second quarter of 2014. The second quarter of 2013, included a $1.65 million legal settlement expense related to a tax lien subsidiary, of which the Company's share was $990,000. As credit quality has improved and with the resolution of the tax lien legal issues, quarter versus quarter professional and legal fees declined $419,000 ($389,000 in 2014 versus $808,000 in 2013), OREO expenses and impairment fell $76,000 ($452,000 in 2014 versus $528,000 in 2013), and impairment on LHFS fell $53,000 ($0 in 2014 versus $53,000 in 2013). In addition, salaries and benefits decreased $241,000 ($2.4 million in 2014 versus $2.7 million in 2013) due to a reduction in the workforce. Partially offsetting these declines was a $75,000 increase in occupancy and equipment expenses ($621,000 in 2014 versus $546,000 in 2013) and was due to branch relocations and minor renovations, along with higher utility costs. Additionally, marketing and advertising expenses grew $57,000 ($123,000 in 2014 versus $66,000 in 2013) for promotion of the Company's new and enhanced products and services. Non-interest expense considerably improved by $3.4 million from $13.7 million for the six months ended June 30, 2013 to $10.3 million for the first six months of 2014. As mentioned previously, 2013 included a $1.65 million legal settlement expense related to a tax lien subsidiary, of which the Company's share was $990,000. Additional improvements include a $650,000 decrease in salaries and benefits ($4.8 million in 2014 versus $5.5 million in 2013) due to a reduction in the workforce and a $433,000 decrease in credit quality expenses. As asset credit quality continued to improve, OREO expenses and impairment declined $159,000 ($738,000 in 2014 versus $897,000 in 2013), impairment on LHFS fell $153,000 ($0 in 2014 versus $153,000 in 2013), loan collection expenses decreased $121,000 ($157,000 in 2014 versus $278,000 in 2013). Professional and legal fees declined $476,000 ($992,000 in 2014 versus $1.5 million in 2013) and the Company did not record restructuring charges in 2014 ($0 in 2014 versus $111,000 in 2013). The 2013 restructuring 56 --------------------------------------------------------------------------------



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charges were related to the reduction in work force of twelve employees which occurred during the first quarter of 2013. Partially offsetting these declines was a $135,000 increase in occupancy and equipment expenses ($1.2 million in 2014 versus $1.1 million in 2013) and, as mentioned previously, was due to branch relocations and minor renovations, along with higher utility costs. Additionally, marketing and advertising expenses increased $128,000 ($239,000 in 2014 versus $111,000 in 2013) for promotion of the Company's new and enhanced products and services. Income Tax Expense Total income tax expense for the first and second quarters of 2014 and the comparable quarters of 2013 was $0. Despite net income of $2.9 million for the first six months of 2014, the Company did not record a tax expense due to the net operating loss carryforward from prior years. The Company concluded at June 30, 2014 and December 31, 2013 that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets. Management's conclusion was based on consideration of the relative weight of the available evidence and the uncertainty of future market conditions on results of operations. As a result the Company has recorded a cumulative non-cash charge of $37.2 million in the consolidated statement of operations that began in the period ended December 31, 2008 related to the establishment of a valuation allowance for the deferred tax asset for the portion of the future tax benefit that more likely than not will not be utilized in the future. The effective tax rate for the first six months of both 2014 and 2013 was 0%.



Results of Operations by Business Segments

Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision makers in deciding how to allocate and assess resources and performance. The Company's chief operating decision makers are the CEO and the CARO. The Company has identified two reportable operating segments, "Community Banking" and "Tax Liens".


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