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SHORE BANCSHARES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

August 14, 2014

Unless the context clearly suggests otherwise, references to "the Company", "we", "our", and "us" in the remainder of this report are to Shore Bancshares, Inc. and its consolidated subsidiaries.

Forward-Looking Information

Portions of this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including statements that include the words "anticipate", "estimate", "should", "expect", "believe", "intend", and similar expressions, are expressions about our confidence, policies, and strategies, the adequacy of capital levels, and liquidity and are not guarantees of future performance. Such forward-looking statements involve certain risks and uncertainties, including economic conditions, competition in the geographic and business areas in which we operate, inflation, fluctuations in interest rates, legislation, and governmental regulation. These risks and uncertainties are described in detail in the section of the periodic reports that Shore Bancshares, Inc. files with the Securities and Exchange Commission (the "SEC") entitled "Risk Factors" (see Item 1A of Part II of this report and Item 1A of Part I of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013). Actual results may differ materially from such forward-looking statements, and we assume no obligation to update forward-looking statements at any time except as required by law.



Introduction

The following discussion and analysis is intended as a review of significant factors affecting the Company's financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes presented elsewhere in this report, as well as the audited consolidated financial statements and related notes included in the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013. Shore Bancshares, Inc. is the largest independent financial holding company headquartered on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland located in Easton, Maryland ("Talbot Bank") and CNB located in Centreville, Maryland (together with Talbot Bank, the "Banks"). The Banks operate 18 full service branches in Kent County, Queen Anne's County, Talbot County, Caroline County and Dorchester County in Maryland and Kent County, Delaware. The Company engages in the insurance business through three insurance producer firms, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC and Jack Martin Associates, Inc.; and an insurance premium finance company, Mubell Finance, LLC (all of the foregoing are collectively referred to as the "Insurance Subsidiaries"). Each of these entities is a wholly-owned subsidiary of Shore Bancshares, Inc. The Company engages in the trust services business through the trust department at CNB under the trade name Wye Financial & Trust. The Company owned a wholesale insurance company, Tri-State General Insurance Agency, LTD ("TSGIA"), until it was sold on June 6, 2014.



The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Select Market under the symbol "SHBI".

Shore Bancshares, Inc. maintains an Internet site at www.shorebancshares.com on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.



Regulatory Enforcement Actions

Talbot Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the "Consent Agreement") with the Federal Deposit Insurance Corporation (the "FDIC"), a Stipulation and Consent to the Issuance of a Consent Order (the "Maryland Consent Agreement" and together with the Consent Agreement, the "Consent Agreements") with the Maryland Commissioner of Financial Regulation (the "Commissioner") and an Acknowledgement of Adoption of the Order by the Commissioner (the "Acknowledgement"). The FDIC and the Commissioner issued the related Consent Order (the "Order"), effective May 24, 2013. The description of the material terms of the Consent Agreements, the Order and the Acknowledgement, along with Talbot Bank's progress with the requirements of such documents,

are set forth below. Management. Talbot Bank is required to have and retain experienced, qualified management, and to assess management's ability to (1) comply with the requirements of the Order; (2) operate Talbot Bank in a safe and sound manner; (3) comply with all applicable laws, rules and regulations; and (4) restore all aspects of Talbot Bank to a safe and sound condition, including capital adequacy, asset quality, and management effectiveness. Talbot Bank has implemented certain changes to comply with the Order, which include expanding its credit administration and loan workout units with the addition of experienced new staff members, in an effort to accelerate the resolution of Talbot Bank's credit issues and position Talbot Bank for future growth. Additionally, Talbot Bank is conducting an internal and external search for

a chief financial officer. 25 Board Participation. Talbot Bank's board of directors is required to increase its participation in the affairs of Talbot Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all Talbot Bank activities, including comprehensive, documented meetings to be held no less frequently than monthly. The board of directors must also develop a program to monitor Talbot Bank's compliance with the Order. Talbot Bank has completed a plan to increase the participation of its board of directors which includes increasing the frequency of board meetings from monthly to biweekly and establishing a risk management committee of the board which is responsible for monitoring Talbot Bank's compliance with the Order. Loss Charge-Offs. The Order requires that Talbot Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified "Loss" by the FDIC or the Commissioner. Talbot Bank has eliminated from its books

all such classified assets. Classified Assets Reduction. Within 60 days of the effective date of the Order, Talbot Bank was required to submit a Classified Asset Plan to the FDIC and the Commissioner to reduce the risk position in each asset in excess of $750,000 which was classified "Substandard" and "Doubtful" by the FDIC or the Commissioner. Talbot Bank revised its existing Classified Asset Plan to address the terms of the Order and submitted the updated plan to the FDIC and the Commissioner in accordance with the Order. Allowance for Loan and Lease Losses. Within 60 days of the effective date of the Order, the board of directors was required to review the adequacy of the allowance for loan and lease losses (the "ALLL"), establish a policy for determining the adequacy of the ALLL and submit such ALLL policy to the FDIC and the Commissioner. Talbot Bank amended its ALLL policy to comply with the terms of the Order and submitted the updated policy to the FDIC and the Commissioner in accordance with the Order. Loan Policy. Within 60 days from the effective date of the Order, Talbot Bank was required to (i) review its loan policies and procedures ("Loan Policy") for adequacy, (ii) make all appropriate revisions to the Loan Policy to address the lending deficiencies identified by the FDIC, and (iii) submit the Loan Policy to the FDIC and the Commissioner. Talbot Bank completed its review of and made the required revisions to the Loan Policy. The updated Loan Policy was submitted to the FDIC and the Commissioner in accordance with the terms of the Order. Loan Review Program. Within 30 days from the effective date of the Order, the Board was required to establish a program of independent loan review that provides for a periodic review of Talbot Bank's loan portfolio and the identification and categorization of problem credits (the "Loan Review Program") and submit the Loan Review Program to the FDIC and the Commissioner. Talbot Bank enhanced its existing Loan Review Program and submitted it to the FDIC and the Commissioner in accordance with the terms of the Order. Capital Requirements. Within 90 days from the effective date of the Order, Talbot Bank was required to meet and maintain the following minimum capital levels, after establishing an appropriate ALLL, (i) a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8%, and (ii) a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 12%. As of June 30, 2014, the leverage ratio and total risk-based capital ratio were 8.97% and 13.30%, respectively, for Talbot Bank, which exceeded the Order's minimum capital requirements. Profit and Budget Plan. Within 60 days from the effective date of the Order and within 30 days of each calendar year-end thereafter, Talbot Bank was and will be required to submit a profit and budget plan to the FDIC and the Commissioner consisting of goals and strategies, consistent with sound banking practices, and taking into account Talbot Bank's other plans, policies or other actions required by the Order. In accordance with the Order, Talbot Bank developed a profit and budget plan which was submitted to the FDIC and the Commissioner within 60 days from the effective date of the Order and one which was submitted within 30 days of the end of 2013. Dividend Restriction. While the Order is in effect, Talbot Bank cannot declare or pay dividends or fees to the Company without the prior written consent of the FDIC and the Commissioner. Talbot Bank is in compliance with this provision

of the Order. Brokered Deposits. The Order provides that Talbot Bank may not accept, renew, or rollover any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. Talbot Bank is in compliance with this provision of the Order. 26



Oversight Committee. Within 30 days from the effective date of the Order, Talbot Bank was required to establish a board committee to monitor and coordinate compliance with the Order. Talbot Bank has established a board committee to comply with this provision of the Order.

Progress Reports. Within 45 days from the end of each calendar quarter following the effective date of the Order, Talbot Bank must furnish the FDIC and the Commissioner with progress reports detailing the form, manner and results of any actions taken to secure compliance with the Order. Talbot Bank has and will continue to submit progress reports to comply with this provision of the Order.



The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. The financial information contained within the financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses, goodwill and other intangible assets, deferred tax assets, and fair value are critical accounting policies. These policies are considered critical because they relate to accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.



Allowance for Credit Losses

The allowance for credit losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Topic 450, "Contingencies", of the Financial Accounting Standards Board's Accounting Standards Codification ("ASC"), which requires that losses be accrued when they are probable of occurring and estimable; and (ii) ASC Topic 310, "Receivables", which requires that losses be accrued based on the differences between the loan balance and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management uses many factors to estimate the inherent loss that may be present in our loan portfolio, including economic conditions and trends, the value and adequacy of collateral, the volume and mix of the loan portfolio, and our internal loan processes. Actual losses could differ significantly from management's estimates. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions could change. Three basic components comprise our allowance for credit losses: (i) the specific allowance; (ii) the formula allowance; and (iii) the unallocated allowance. Each component is determined based on estimates that can and do change when the actual events occur. The specific allowance is established against impaired loans (i.e., nonaccrual loans and TDRs) based on our assessment of the losses that may be associated with the individual loans. The specific allowance remains until charge-offs are made. An impaired loan may show deficiencies in the borrower's overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The formula allowance is used to estimate the loss on internally risk-rated loans, exclusive of those identified as impaired. Loans are grouped by type (construction, residential real estate, commercial real estate, commercial or consumer). Each loan type is assigned allowance factors based on management's estimate of the risk, complexity and size of individual loans within a particular category. Loans identified as special mention, substandard, and doubtful are adversely rated. These loans are assigned higher allowance factors than favorably rated loans due to management's concerns regarding collectability or management's knowledge of particular elements regarding the borrower. The unallocated allowance captures losses that have impacted the portfolio but have yet to be recognized in either the specific or formula allowance. Management has significant discretion in making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection with the valuation of collateral, the estimation of a borrower's prospects of repayment, and the establishment of the allowance factors in the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors is a continuing exercise, based on management's ongoing assessment of the totality of all factors, including, but not limited to, delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, national and local economic trends, concentrations of credit, the quality of the loan review system and the effect of external factors such as competition and regulatory requirements, and their impact on the portfolio. Allowance factors may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based on the same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in management's perception and assessment of these factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs. 27



Goodwill and Other Intangible Assets

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill and other intangible assets are required to be recorded at fair value. Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment. Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter, or on an interim basis if circumstances dictate. Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing. Impairment testing requires that the fair value of each of the Company's reporting units be compared to the carrying amount of its net assets, including goodwill. The Company's reporting units were identified based on an analysis of each of its individual operating segments (i.e., the Banks and Insurance Subsidiaries). If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles to record an impairment loss. Goodwill and other intangible assets at June 30, 2014 decreased $2.6 million from the end of 2013 mainly due to the sale of the Company's wholesale insurance subsidiary, TSGIA, on June 6, 2014.



Deferred Tax Assets

Deferred tax assets and liabilities are determined by applying the applicable federal and state income tax rates to cumulative temporary differences. These temporary differences represent differences between financial statement carrying amounts and the corresponding tax bases of certain assets and liabilities. Deferred taxes result from such temporary differences. A valuation allowance, if needed, reduces deferred tax assets to the amount most likely to be realized, which is based on estimates of future taxable income, recoverable taxes paid in prior years and expected results of tax planning strategies.



Fair Value

The Company measures certain financial assets and liabilities at fair value. Investment securities are significant financial assets measured at fair value on a recurring basis. Impaired loans and other real estate owned are significant financial assets measured at fair value on a nonrecurring basis. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. In determining fair value, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs, reducing subjectivity. OVERVIEW

The Company reported net income of $1.305 million for the second quarter of 2014, or diluted income per common share of $0.13, compared to net income of $361 thousand, or diluted income per common share of $0.04, for the second quarter of 2013. For the first quarter of 2014, the Company reported net income of $1.258 million, or diluted income per common share of $0.15. When comparing the second quarter of 2014 to the second quarter of 2013, the primary reasons for the improved results were a $1.8 million decline in the provision for credit losses and an increase in noninterest income of $566 thousand, which were partially offset by a decline in net interest income of $554 thousand and an increase in noninterest expense of $158 thousand. When comparing the second quarter of 2014 to the first quarter of 2014, the primary reasons for the higher net income were a decrease in noninterest expense of $198 thousand and an increase in net interest income of $124 thousand, which were mainly offset by a decrease in noninterest income of $260 thousand. For the first six months of 2014, the Company reported net income of $2.6 million, or diluted income per common share of $0.28, compared to net income of $583 thousand, or diluted income per common share of $0.07, for the first six months of 2013. Earnings improved due to a decline in the provision for credit losses of $2.9 million, an increase in noninterest income of $864 thousand and a decline in noninterest expense of $218 thousand, which were partially offset by a decline in net interest income of $708 thousand. Basic and diluted earnings per share for the second quarter of 2014 and the first half of 2014 were impacted by the increase in weighted average shares due to the Company's public offer and sale of its common stock, which is discussed below. Weighted average shares increased to 10.0 million for the second quarter of 2014 from 8.5 million for both the second quarter of 2013 and the first quarter of 2014. Similarly, weighted average shares increased to 9.3 million for the first half of 2014 from 8.5 million for the first half of 2013. 28

During the second quarter of 2014, the Company sold 4,140,000 shares of its common stock for a price of $8.25 per share (the "stock sale"). The Company received $31.2 million in net proceeds after deducting certain direct costs related to the stock sale, primarily underwriting discounts and commissions. The Company contributed $20.0 million of the net proceeds to its wholly-owned subsidiary, Talbot Bank, to satisfy regulatory capital requirements, and intends to use the remaining net proceeds for general corporate purposes. Much of the improvement in the second quarter of 2014 when compared to the second quarter of 2013, and the first half of 2014 when compared to the first half of 2013 was due to lower credit-related expenses as a result of the execution of an agreement to sell loans and other real estate owned (the "Asset Sale") by Talbot Bank, which was recorded in the third quarter and completed during the fourth quarter of 2013. Per the agreement, assets included in the Asset Sale had an aggregate book value of $45.0 million, which consisted of nonaccrual loans ($11.1 million), accruing TDRs ($30.4 million), adversely classified performing loans ($1.8 million) and other real estate owned ($1.7 million). Subsequently, $3.5 million in loans included in the agreement were not sold. These loans were reclassified from loans held for sale at December 31, 2013 to loans at March 31, 2014. With the Asset Sale, the Company has refocused its efforts on healthy loan originations and overall business development, however, the slowly improving local economy is delaying any substantial progress. RESULTS OF OPERATIONS Net Interest Income

Tax-equivalent net interest income is net interest income adjusted for the tax-favored status of income from certain loans and investments. As shown in the table below, tax-equivalent net interest income was $8.5 million for the second quarter of 2014 and $9.0 million for the second quarter of 2013. Tax-equivalent net interest income was $8.3 million for the first quarter of 2014. The decrease in net interest income for the second quarter of 2014 when compared to the second quarter of 2013 was primarily due to lower volumes of and yields earned on average loans, partially offset by lower volumes of and rates paid on average time deposits, and money market and savings deposits. The increase in net interest income for the second quarter of 2014 when compared to the first quarter of 2014 was primarily due to higher volumes of and yields earned on average investment securities and lower volumes of and rates paid on average time deposits. Net interest margin is tax-equivalent net interest income (annualized) divided by average earning assets. Our net interest margin was 3.49% for the second quarter of 2014, compared to 3.60% for the second quarter of 2013 and 3.50% for the first quarter of 2014. The lower net interest margin for the second quarter of 2014 when compared to the second quarter of 2013 and the first quarter of 2014 was mainly due to a decline in loan yields as a result of refinancing activity.

On a tax-equivalent basis, interest income declined $1.2 million, or 11.5%, for the second quarter of 2014 when compared to the second quarter of 2013. The decrease in interest income was due to a 3.2% decline in average balances of earning assets (i.e., loans, investment securities, federal funds sold and interest-bearing deposits with other banks) combined with a 37 basis point decrease in yields earned on average earning assets. Loan activity had the largest impact on the decline in interest income primarily due to the Asset Sale, loan charge-offs and decreased loan demand. For the second quarter of 2014, average loans decreased 9.8% and the yield earned on loans declined from 5.19% to 5.00% when compared to the second quarter of 2013, which reduced interest income by $1.3 million. Other earning assets impacting the change in interest income included taxable investment securities, which increased $42.5 million and, although the related yield declined 16 basis points, improved interest income $101 thousand. The balance of taxable investment securities increased due to purchases that were partly funded by the proceeds from the stock sale, while the yield on taxable investment securities decreased because reinvestment rates on investment securities purchased were lower than yields on investment securities that matured or were sold from the end of the second quarter of 2013 to the end of the second quarter of 2014. Although the average balances of the remaining components of average earning assets increased $1.7 million, the yields earned declined 3 basis points, which in aggregate decreased interest income $3 thousand. Tax-equivalent interest income increased $66 thousand, or less than 1.0%, when compared to the first quarter of 2014 mainly due to higher volumes of and yields earned on average investment securities, which were partially offset by lower yields on loans. Interest expense decreased $678 thousand, or 38.7%, when comparing the second quarter of 2014 to the second quarter of 2013. The decrease in interest expense was due to a 31 basis point decline in rates paid on interest-bearing liabilities (i.e., deposits and borrowings) and a 5.5% decline in average balances of interest-bearing liabilities. Changes in the rates and balances related to time deposits, and money market and savings deposits had the largest impact on interest expense. For the three months ended June 30, 2014, the rates paid on time deposits (i.e., certificates of deposit $100,000 or more and other time deposits) decreased 24 basis points and the average balances of these deposits decreased $46.1 million, or 11.5%, when compared to the same period last year, which reduced interest expense $366 thousand. The decrease in average time deposits reflected a reduction in the Company's liquidity needs and the lower rates reflected current market conditions. Additionally, the rates paid on money market and savings deposits decreased 55 basis points and the average balances of these deposits decreased $4.3 million, or 1.9%, which reduced interest expense $310 thousand. The lower rates paid on money market and savings deposits were mainly due to terminating the interest rate caps associated with the deposits from the Promontory Insured Network Deposits Program ("IND Program") while the decrease in balances was primarily due to the decline in deposits associated with the IND Program, which the Company fully exited in June 2013. When comparing the second quarter of 2014 to the first quarter of 2014, interest expense decreased $56 thousand, or 4.9%. The decline was primarily due to lower interest rates paid on and average balances of time deposits. 29



The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the three months ended June 30, 2014 and 2013.

For the Three Months Ended For the Three Months Ended June 30, 2014 June 30, 2013 Average Income(1)/ Yield/ Average Income(1)/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Earning assets Loans (2), (3) $ 708,718$ 8,833 5.00 % $ 785,442$ 10,166 5.19 % Investment securities: Taxable 183,128 669 1.46 140,614 568 1.62 Tax-exempt 431 4 4.23 579 7 4.81 Federal funds sold 1,476 - 0.05 2,992 1 0.10

Interest-bearing deposits 79,223 39

0.20 75,847 40 0.21 Total earning assets 972,976 9,545 3.93 % 1,005,474 10,782 4.30 % Cash and due from banks 20,376 22,510 Other assets 64,915 66,967

Allowance for credit losses (9,675 ) (17,099 ) Total assets $ 1,048,592



$ 1,077,852

Interest-bearing liabilities Demand deposits $ 171,004 60 0.14 % $ 162,589 61 0.15 % Money market and savings deposits (4) 220,850 66 0.12 225,117 376 0.67 Certificates of deposit $100,000 or more 171,830 477 1.11 203,641 670 1.32 Other time deposits 183,336 468 1.02 197,644 641 1.30 Interest-bearing deposits 747,020 1,071 0.58 788,991 1,748 0.89 Short-term borrowings 8,633 5 0.22 10,752 6 0.24

Total interest-bearing liabilities 755,653 1,076

0.57 % 799,743 1,754 0.88 % Noninterest-bearing deposits 168,221 154,586 Other liabilities 7,629 9,315 Stockholders' equity 117,089 114,208 Total liabilities and stockholders' equity $ 1,048,592$ 1,077,852 Net interest spread $ 8,469 3.36 % $ 9,028 3.42 % Net interest margin 3.49 % 3.60 % Tax-equivalent adjustment Loans $ 21 $ 24 Investment securities 1 3 Total $ 22 $ 27



(1) All amounts are reported on a tax-equivalent basis computed using the

statutory federal income tax rate of 34.0%, exclusive of the alternative

minimum tax rate and nondeductible interest expense.

(2) Average loan balances include nonaccrual loans.

(3) Interest income on loans includes amortized loan fees, net of costs, and all

are included in the yield calculations.

(4) Interest on money market and savings deposits for the three months ended June

30, 2013 included an adjustment to expense related to interest rate caps and

the hedged deposits from the IND Program associated with them. This

adjustment increased interest expense $279 thousand for the three months

ended June 30, 2013. Interest expense for the three months ended June 30,

2014 did not reflect this adjustment because the interest rate caps were

terminated in June of 2013. Tax-equivalent net interest income for the six months ended June 30, 2014 was $16.8 million, as seen in the table below. This represented a decrease of $716 thousand, or 4.1%, when compared to the same period last year. The decrease was mainly due to lower volumes of and yields earned on average loans, partially offset by lower volumes of and rates paid on time deposits, and money market and savings deposits. Rates paid on deposits declined enough to improve the net interest margin to 3.50% for the first half of 2014 from the 3.45% for the

first half of 2013.

On a tax-equivalent basis, interest income was $19.0 million for the first six months of 2014, a decrease of $2.4 million, or 11.2%, when compared to the first six months of 2013, mainly due to the impact of loan activity. For the first six months of 2014, average loans declined 9.7% and the related yield declined 12 basis points when compared to the same period in 2013. Interest expense was $2.2 million for the six months ended June 30, 2014, a decrease of $1.7 million, or 43.2%, when compared to the same period last year. Average interest-bearing liabilities decreased $60.0 million, or 7.3%, while rates paid declined 37 basis points to 0.58% primarily due to time deposit, and money market and savings deposit activity. For the first six months of 2014, the average balance of time deposits decreased $48.9 million, or 11.9%, when compared to the same period last year, and the average rate paid on these deposits declined 28 basis points, which reduced interest expense $836 thousand. For the six months ended June 30, 2014, the average balance of money market and savings deposits decreased $13.0 million, or 5.5%, when compared to the same period last year, and the average rate paid on these deposits declined 70 basis points, which reduced interest expense $826 thousand. As with the quarterly results, the decrease in average time deposits reflected a reduction in the Company's liquidity needs while the lower rates reflected current market conditions, and the decrease in money market and savings deposits was primarily due to the decline in deposits associated with the IND Program while the lower rates paid on these deposits were mainly due to terminating the interest rate caps associated with these deposits. 30



The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the six months ended June 30, 2014 and 2013.

For the Six Months Ended For the Six Months Ended June 30, 2014 June 30, 2013 Average Income(1)/ Yield/ Average Income(1)/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Earning assets Loans (2), (3) $ 708,216$ 17,730 5.05 % $ 784,604$ 20,098 5.17 % Loans held for sale 1,206 - - - - - Investment securities: Taxable 169,203 1,190 1.42 143,380 1,211 1.70 Tax-exempt 432 9 4.24 580 14 4.83 Federal funds sold 1,591 - 0.05 5,573 3 0.11 Interest-bearing deposits 89,010 95 0.22 90,869 90 0.20 Total earning assets 969,658 19,024 3.96 % 1,025,006 21,416 4.21 % Cash and due from banks 21,536 23,731 Other assets 65,555 68,070 Allowance for credit losses (10,158 ) (16,849 ) Total assets $ 1,046,591$ 1,099,958 Interest-bearing liabilities Demand deposits $ 172,395 122 0.14 % $ 168,120 132 0.16 % Money market and savings deposits (4) 221,610 133 0.12 234,597 959 0.82 Certificates of deposit $100,000 or more 175,292 977 1.12 209,929 1,410 1.35 Other time deposits 185,137 966 1.05 199,399 1,369 1.38 Interest-bearing deposits 754,434 2,198 0.59 812,045 3,870 0.96 Short-term borrowings 8,987 10 0.22 11,366 14 0.25 Total interest-bearing liabilities 763,421 2,208 0.58 % 823,411 3,884 0.95 % Noninterest-bearing deposits 164,926

153,285 Other liabilities 7,433 9,033 Stockholders' equity 110,811 114,229 Total liabilities and stockholders' equity $ 1,046,591$ 1,099,958 Net interest spread $ 16,816 3.38 % $ 17,532 3.26 % Net interest margin 3.50 % 3.45 % Tax-equivalent adjustment Loans $ 43 $ 49 Investment securities 3 5 Total $ 46 $ 54



(1) All amounts are reported on a tax-equivalent basis computed using the

statutory federal income tax rate of 34.0%, exclusive of the alternative

minimum tax rate and nondeductible interest expense.

(2) Average loan balances include nonaccrual loans.

(3) Interest income on loans includes amortized loan fees, net of costs, and all

are included in the yield calculations.

(4) Interest on money market and savings deposits for the six months ended June

30, 2013 included an adjustment to expense related to interest rate caps and

the hedged deposits from the IND Program associated with them. This

adjustment increased interest expense $695 thousand for the six months ended

June 30, 2013. Interest expense for the six months ended June 30, 2014 did

not reflect this adjustment because the interest rate caps were terminated in

June of 2013. 31 Noninterest Income Total noninterest income for the second quarter of 2014 increased $566 thousand, or 14.3%, when compared to the second quarter of 2013. Included in total noninterest income for the second quarter of 2013 was a $1.3 million loss incurred to terminate the interest rate caps. This loss was substantially offset by $913 thousand in gains on sales of investment securities. These transactions, along with smaller losses on sales of other real estate owned ($119 thousand) and a gain on the TSGIA sale ($114 thousand), were the primary reasons for the increase in noninterest income for the second quarter of 2014 when compared to the second quarter of 2013. When compared to the first quarter of 2014, noninterest income declined $260 thousand, or 5.4%, for the second quarter of 2014. The decrease from the first quarter of 2014 was primarily due to a decline in insurance agency commissions ($541 thousand) that was partially offset by the gain on the TSGIA sale and an increase in other noninterest income ($99 thousand). Insurance agency commissions for the second quarter of 2014 were lower when compared to the first quarter of 2014 due to the fact that contingency commission payments are typically received in the first quarter of the year. Included in other noninterest income for the second quarter of 2014 was $77 thousand more in income from an insurance investment than in the first quarter of 2014. Total noninterest income for the six months ended June 30, 2014 increased $864 thousand, or 10.2%, when compared to the same period in 2013. Included in total noninterest income for the first half of 2013 were the $1.3 million loss incurred to terminate the interest rate caps and the $913 thousand in gains on sales of investment securities discussed above. In addition, the growth of insurance agency commissions and investment fee income of $167 thousand and $103 thousand, respectively, and the gain on the TSGIA sale improved noninterest income in the first half of 2014 when compared to the first half of 2013.



Noninterest Expense

Total noninterest expense for the second quarter of 2014 increased $158 thousand, or 1.6%, when compared to the second quarter of 2013 and declined $198 thousand, or 2.0%, when compared to the first quarter of 2014. The increase in total noninterest expense from the second quarter of 2013 was primarily due to higher loan collection costs included in other noninterest expense. The decrease from the first quarter of 2014 was primarily due to a decline in almost all expense categories, $212 thousand of which was due to approximately one less month of expenses for TSGIA as a result of its sale in early June 2014. This decline was somewhat offset by an increase in other noninterest expenses, which included higher collection expense for loans. Total noninterest expense for the six months ended June 30, 2014 declined $218 thousand, or 1.1%, when compared to the same period in 2013. The decrease was primarily due to lower write-downs of other real estate owned of $552 thousand, or 75.8%, which was partially offset by higher expenses in almost all other expense categories, which aggregated $334 thousand, or 1.7%.



Income Taxes

For the second quarter of 2014 and 2013, the Company reported income tax expense of $803 thousand and $143 thousand, respectively, while the effective tax rate was 38.1% and 28.4%, respectively. For the first six months of 2014 and 2013, the Company reported income tax expense of $1.6 million and $247 thousand, respectively, while the effective tax rate was 37.9% and 29.8%, respectively. The lower tax rates for the second quarter and first six months of 2013 when compared to the same periods in 2014 were due to the impact of the tax benefits of the Company's affiliates with pretax losses which partially offset the tax expense of the affiliates with pretax income.



ANALYSIS OF FINANCIAL CONDITION

Loans

Loans, including loans held for sale, totaled $709.7 million at June 30, 2014 and $715.4 million at December 31, 2013, a decline of $5.8 million, or less than 1.0%. At December 31, 2013, $3.5 million of nonaccrual construction loans were classified as held for sale and were reclassified to loans during the first quarter of 2014. Commercial real estate loans reflected the largest decline ($6.8 million) from the end of 2013 primarily due to net loan repayments and charge offs. Fewer high-quality loan opportunities due to the slowly improving local economy continue to impede overall loan growth. The decline in commercial real estate loans was partially offset by an increase in residential real estate loans ($2.3 million). Loans included deferred costs, net of deferred fees, of $322 thousand at June 30, 2014 and $341 thousand at December 31, 2013. We do not engage in foreign or subprime lending activities. See Note 4, "Loans and Allowance for Credit Losses", in the Notes to Consolidated Financial Statements and below under the caption "Allowance for Credit Losses" for additional information. 32 Our loan portfolio has a commercial real estate loan concentration, which is defined as a combination of construction and commercial real estate loans. Construction loans were $68.3 million , or 9.6% of total loans, at June 30, 2014, similar to the $68.1 million, or 9.5% of total loans, including loans held for sale, at December 31, 2013. Commercial real estate loans were $297.8 million, or 41.9% of total loans, at June 30, 2014, compared to $304.6 million, or 42.6% of total loans, including loans held for sale, at December 31, 2013. Allowance for Credit Losses We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses at least quarterly and adjusts the provision for credit losses based on this analysis. The evaluation of the adequacy of the allowance for credit losses is based primarily on a risk rating system of individual loans, as well as on a collective evaluation of smaller balance homogenous loans, each grouped by loan type. Each loan type is assigned allowance factors based on criteria such as past credit loss experience, local economic and industry trends, and other measures which may impact collectibility. Please refer to the discussion above under the caption "Critical Accounting Policies" for an overview of the underlying methodology management employs to maintain the allowance. The provision for credit losses was $950 thousand for the second quarter of 2014, $2.7 million for the second quarter of 2013 and $975 thousand for the first quarter of 2014. The lower level of provision for credit losses when comparing the second quarter of 2014 to the second quarter of 2013 was primarily due to decreases in loan charge-offs and nonaccrual loans. The lower level of provision for credit losses when comparing the second quarter of 2014 to the first quarter of 2014 was primarily due to declines in nonaccrual loans. The provision for credit losses for the first six months of 2014 declined to $1.9 million from $4.9 million for the first six months of 2013. Net charge-offs were $1.9 million for the second quarter of 2014 and $2.7 million for the second quarter of 2013, as shown in the following table. Net charge-offs were $1.6 million for the first quarter of 2014. Net charge-offs were $3.6 million and $5.1 million for the first six months of 2014 and 2013, respectively. Management remains focused on its efforts to dispose of problem loans and to charge off nonperforming assets as rapidly as possible, to enable the Company to continue to improve its overall credit quality and reduce problem loans. The allowance for credit losses as a percentage of average loans was 1.28% for the second quarter of 2014, lower than the 2.00% for the second quarter of 2013 and 1.42% for the first quarter of 2014, which reflects improved credit quality in the loan portfolio. Management believes that the provision for credit losses and the resulting allowance were adequate to provide for probable losses inherent in our loan portfolio at June 30, 2014. 33



The following table presents a summary of the activity in the allowance for credit losses for the three and six months ended June 30, 2014 and 2013.

For the Three Months Ended For the Six Months Ended June 30, June 30,

(Dollars in thousands) 2014 2013 2014 2013 Allowance balance - beginning of period $ 10,069$ 15,735$ 10,725$ 15,991 Charge-offs: Construction (224 ) (802 ) (241 ) (1,509 ) Residential real estate (315 ) (1,096 ) (987 ) (1,889 ) Commercial real estate (1,523 ) (872 ) (1,613 ) (1,947 ) Commercial (95 ) (136 ) (937 ) (223 ) Consumer (20 ) (13 ) (147 ) (62 ) Totals (2,177 ) (2,919 ) (3,925 ) (5,630 ) Recoveries: Construction 1 1 11 2 Residential real estate 63 59 106 298 Commercial real estate 7 90 13 93 Commercial 157 50 207 102 Consumer 6 7 14 17 Totals 234 207 351 512 Net charge-offs (1,943 ) (2,712 ) (3,574 ) (5,118 )

Provision for credit losses 950 2,700 1,925 4,850



Allowance balance - end of period $ 9,076$ 15,723

$ 9,076$ 15,723

Average loans outstanding during the period $ 708,718$ 785,442$ 708,216$ 784,604 Net charge-offs (annualized) as a percentage of average loans outstanding during the period 1.10 % 1.38 % 1.02 % 1.32 % Allowance for credit losses at period end as a percentage of average loans 1.28 % 2.00 %

1.28 % 2.00 %



Nonperforming Assets and Accruing TDRs

As shown in the following table, nonperforming assets decreased to $19.4 million at June 30, 2014 from $22.2 million at December 31, 2013, primarily due to a $3.0 million decline in nonaccrual loans, including nonaccrual loans held for sale. In addition, accruing TDRs declined $686 thousand to $25.4 million at June 30, 2014 from $26.1 million at December 31, 2013. The ratio of nonaccrual loans to total assets improved to 1.43% at June 30, 2014 from 1.72% at December 31, 2013. In addition, the ratio of accruing TDRs to total assets improved to 2.39% at June 30, 2014 from 2.47% at December 31, 2013. The Company continues to focus on the resolution of its nonperforming and problem loans. The efforts to accomplish this goal include frequently contacting borrowers until the delinquency is cured or until an acceptable payment plan has been agreed upon; obtaining updated appraisals; provisioning for credit losses; charging off loans; transferring loans to other real estate owned; aggressively marketing other real estate owned; and selling loans. The reduction of nonperforming and problem loans is and will continue to be a high priority

for the Company. 34



The following table summarizes our nonperforming assets and accruing TDRs at June 30, 2014 and December 31, 2013.

June 30, December 31, (Dollars in thousands) 2014 2013 Nonperforming assets Nonaccrual loans excluding nonaccrual loans held for sale Construction $ 7,980$ 3,949 Residential real estate 3,037 5,166 Commercial real estate 3,873 4,671 Commercial 261 792 Consumer 25 48 Total nonaccrual loans excluding nonaccrual loans held for sale 15,176



14,626

Loans 90 days or more past due and still accruing Construction - - Residential real estate - 20 Commercial real estate - - Commercial - 250 Consumer 5 -

Total loans 90 days or more past due and still accruing 5 270 Other real estate owned 4,201



3,779

Total nonperforming assets excluding nonaccrual loans held for sale 19,382



18,675

Nonaccrual loans held for sale -



3,521

Total nonperforming assets including nonaccrual loans held for sale $ 19,382$ 22,196 Accruing TDRs Construction $ 3,898$ 1,620 Residential real estate 16,195 14,582 Commercial real estate 5,253 9,791 Commercial 56 95 Consumer - - Total accruing TDRs $ 25,402$ 26,088



Total nonperforming assets and accruing TDRs excluding nonaccrual loans held for sale

$ 44,784$ 44,763 Nonaccrual loans held for sale -



3,521

Total nonperforming assets and accruing TDRs including nonaccrual loans held for sale

$ 44,784



$ 48,284

As a percent of total loans (1): Nonaccrual loans 2.14 % 2.54 % Accruing TDRs 3.58 % 3.65 % Nonaccrual loans and accruing TDRs 5.72 % 6.19 %



As a percent of total loans and other real estate owned (1): Nonperforming assets

2.72 % 3.09 % Nonperforming assets and accruing TDRs 6.27 %

6.72 % As a percent of total assets: Nonaccrual loans 1.43 % 1.72 % Nonperforming assets 1.82 % 2.11 % Accruing TDRs 2.39 % 2.47 %

Nonperforming assets and accruing TDRs 4.21 %

4.58 %



(1) The calculations for December 31, 2013 include loans held for sale that were

reclassified to loans during the first quarter of 2014. 35 Investment Securities The investment portfolio is comprised of securities that are either available for sale or held to maturity. Investment securities available for sale are stated at estimated fair value based on quoted prices. They represent securities which may be sold as part of the asset/liability management strategy or in response to changing interest rates. Net unrealized holding gains and losses on these securities are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders' equity. Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts. We have the intent and current ability to hold such securities until maturity. At June 30, 2014, 98% of the portfolio was classified as available for sale and 2% as held to maturity, similar to the 97% and 3%, respectively, at December 31, 2013. With the exception of municipal securities, our general practice is to classify all newly-purchased securities as available for sale. See Note 3, "Investment Securities", in the Notes to Consolidated Financial Statements for additional details on the composition of our investment portfolio. Investment securities totaled $207.9 million at June 30, 2014, a $55.6 million, or 36.5%, increase since December 31, 2013. The increase was mainly in mortgage-backed securities due to purchases that were partly funded by the proceeds from the stock sale. At the end of June 2014, 68.9% of the securities available for sale were mortgage-backed, 28.2% were U.S. Government agencies and 2.6% were U.S. Treasuries, compared to 54.9%, 41.1% and 3.6%, respectively, at year-end 2013. Our investments in mortgage-backed securities are issued or guaranteed by U.S. Government agencies or government-sponsored agencies.



Deposits

Total deposits at June 30, 2014 were $913.5 million, a $20.0 million, or 2.1%, decrease when compared to the level at December 31, 2013. The decrease in total deposits was mainly due to a decline in time ($23.4 million) and interest-bearing demand deposits ($8.9 million), which was partially offset by an increase in money market and savings deposits ($11.3 million).



Short-Term Borrowings

Short-term borrowings at June 30, 2014 and December 31, 2013 were $7.8 million and $10.1 million, respectively. Short-term borrowings generally consist of securities sold under agreements to repurchase, which are issued in conjunction with cash management services for commercial depositors, overnight borrowings from correspondent banks and short-term advances from the Federal Home Loan Bank (the "FHLB"). Short-term advances are defined as those with original maturities of one year or less. At June 30, 2014 and December 31, 2013, short-term borrowings included only repurchase agreements.



Liquidity and Capital Resources

We derive liquidity through increased customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. As seen in the Consolidated Statements of Cash Flows in the Financial Statements, the net decrease in cash was $36.7 million for the first half of 2014 compared to a net decrease in cash of $75.7 million for the first half of 2013. The decline in cash in 2014 was mainly due to the purchase of investment securities that were partly funded by the proceeds from the stock sale. The decline in cash in 2013 was primarily due to a reduction in money market deposit accounts as a result of fully exiting the IND Program in June 2013. To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term funds markets through arrangements with correspondent banks. The Banks had $15.5 million in federal funds lines of credit and a reverse repurchase agreement available on a short-term basis from correspondent banks at June 30, 2014 and December 31, 2013. The Banks are also members of the FHLB, which provides another source of liquidity. Through the FHLB, the Banks had credit availability of approximately $53.8 million and $46.9 million at June 30, 2014 and December 31, 2013, respectively. These lines of credit are paid for monthly on a fee basis of 0.09%. CNB has pledged, under a blanket lien, all qualifying residential loans under borrowing agreements with the FHLB, whereas Talbot Bank is required to provide specific loans and cash or investment securities as collateral due to its current credit rating with the FHLB. Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our future ability to maintain liquidity at satisfactory levels. Total stockholders' equity increased $34.2 million to $137.5 million at June 30, 2014 when compared to December 31, 2013 primarily due to the proceeds from the stock sale. Due to the success of the stock sale, total stockholders' equity to total assets increased to 12.91% at June 30, 2014 from 9.80% at December 31, 2013, providing additional capital strength to the Company and its subsidiaries. 36 Bank regulatory agencies have adopted various capital standards for financial institutions, including risk-based capital standards. The primary objectives of the risk-based capital framework are to provide a more consistent system for comparing capital positions of financial institutions and to take into account the different risks among financial institutions' assets and off-balance sheet items. Risk-based capital standards have been supplemented with requirements for a minimum Tier 1 capital to average assets ratio (leverage ratio). The minimum ratios for capital adequacy purposes are 4.00%, 4.00% and 8.00% for the Tier 1 leverage, Tier 1 risk-based capital and total risk-based capital ratios, respectively. To be categorized as well capitalized, a bank must maintain minimum ratios of 5.00%, 6.00% and 10.00% for its Tier 1 leverage, Tier 1 risk-based capital and total risk-based capital ratios, respectively. The Company contributed $20.0 million of the net proceeds of the stock sale to Talbot Bank to satisfy regulatory capital requirements.



The following tables present the capital ratios for Shore Bancshares, Inc., Talbot Bank and CNB as of June 30, 2014 and December 31, 2013.

Tier 1 Tier 1 Total leverage risk-based risk-based June 30, 2014 ratio capital ratio capital ratio Company 10.65 % 14.81 % 16.04 % Talbot Bank 8.97 % 12.05 % 13.30 % CNB 9.28 % 13.72 % 14.97 % Tier 1 Tier 1 Total leverage risk-based risk-based December 31, 2013 ratio capital ratio capital ratio Company 7.03 % 10.09 % 11.34 % Talbot Bank 4.98 % 6.92 % 8.17 % CNB 9.16 % 13.82 % 15.07 %


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