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EVANS BANCORP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 4, 2014

This Quarterly Report on Form 10-Q may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that involve substantial risks and uncertainties. When used in this report, or in the documents incorporated by reference herein, the words "anticipate," "believe," "estimate," "expect," "intend," "may," "plan," "seek," and similar expressions identify such forward-looking statements. These forward-looking statements include statements regarding the Company's business plans, prospects, growth and operating strategies, statements regarding the asset quality of the Company's loan and investment portfolios, and estimates of the Company's risks and future costs and benefits. These forward-looking statements are based largely on the expectations of the Company's management and are subject to a number of risks and uncertainties, including but not limited to: general economic conditions, either nationally or in the Company's market areas, that are worse than expected; increased competition among depository or other financial institutions; inflation and changes in the interest rate environment that reduce the Company's margins or reduce the fair value of financial instruments; changes in laws or government regulations affecting financial institutions, including changes in regulatory fees, monetary policy, and capital requirements; the Company's ability to enter new markets successfully and capitalize on growth opportunities; the Company's ability to successfully integrate acquired entities; changes in accounting pronouncements and practices, as adopted by financial institution regulatory agencies, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board; changes in consumer spending, borrowing and saving habits; changes in the Company's organization, compensation and benefit plans; and other factors discussed elsewhere in this Quarterly Report on Form 10-Q, as well as in the Company's periodic reports filed with the SEC, in particular the "Risk Factors" discussed in Item 1A of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Many of these factors are beyond the Company's control and are difficult to predict. Because of these and other uncertainties, the Company's actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein. Forward-looking statements speak only as of the date they are made. The Company undertakes no obligation to publicly update or revise forward-looking information, whether as a result of new, updated information, future events or otherwise.



APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

The Company's Unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q are prepared in accordance with U.S. GAAP and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the Company's Unaudited Consolidated Financial Statements and Notes. These estimates, assumptions and judgments are based on information available as of the date of the Unaudited Consolidated Financial Statements. Accordingly, as this information changes, the Unaudited Consolidated Financial Statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments, and as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques. Refer to Note 3 - "Fair Value Measurements" to the Company's Unaudited Consolidated Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q for further detail on fair value measurement. Significant accounting policies followed by the Company are presented in Note 1 - "Organization and Summary of Significant Accounting Policies" to the Audited Consolidated Financial Statements included in Item 8 in its Annual Report on Form 10-K for the year ended December 31, 2013. These policies, along with the disclosures presented in the other Notes to the Company's Audited Consolidated Financial Statements contained in its Annual Report on Form 10-K and in this financial review, provide information on how significant assets and liabilities are presented in the Company's Unaudited Consolidated Financial Statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions and estimates underlying those amounts, management has identified the determination of the allowance for loan and lease losses and valuation of goodwill to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new information becomes available. 41 --------------------------------------------------------------------------------

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Allowance for Loan and Lease Losses

The allowance for loan and lease losses represents management's estimate of probable losses in the Company's loan and lease portfolio. Determining the amount of the allowance for loan and lease losses is considered a critical accounting estimate because it requires significant judgment on the part of management and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the Company's Unaudited Consolidated Balance Sheets. Note 1 to the Audited Consolidated Financial Statements included in Item 8 in the Company's Annual Report on Form 10-K for the year ended December 31, 2013, describes the methodology used to determine the allowance for loan and lease losses. Goodwill The amount of goodwill reflected in the Company's Unaudited Consolidated Financial Statements is required to be tested by management for impairment on at least an annual basis. The test for impairment of goodwill on the identified reporting unit is considered a critical accounting estimate because it requires judgment on the part of management and the use of estimates related to the growth assumptions and market multiples used in the valuation model. The goodwill impairment testing is typically performed annually as of December 31st. No impairment charges were incurred in the most recent test and the fair value of the tested reporting unit substantially exceeded its fair value. There were no triggering events in the six month period ended June 30, 2014 that resulted in an interim impairment test.



ANALYSIS OF FINANCIAL CONDITION

Loan and Lease Activity

Total loans and leases grew to $663.4 million at June 30, 2014, a $2.7 million, or 0.4%, increase from total loans and leases of $660.7 million at March 31, 2014, and a $16.4 million, or 2.5%, increase from total loans and leases of $647.0 million at December 31, 2013. Loans secured by real estate were $547.5 million at June 30, 2014 and at March 31, 2014, reflecting no quarter over quarter change in the outstanding balances of loans secured by real estate, however, reflecting an increase of $9.6 million, or 1.8%, in loans secured by real estate from $537.9 million at December 31, 2013. The Company's commercial real estate portfolio has historically been the fastest growing part of the real estate portfolio, however, the growth in the real estate portfolio during the second quarter of 2014 was muted by large pay-offs experienced in the current quarter in the commercial and multi-family portfolio. As of June 30, 2014, commercial construction loans of $31.2 million increased $3.4 million, or 12.4%, since March 31, 2014, and $7.3 million, or 30.5% since December 31, 2013. The Company sold more residential mortgages originated during the second quarter of 2014 than during the first quarter of 2014. During the second quarter of 2014, the Company sold approximately 43.5% of the residential mortgages originated during that quarter to FNMA, as compared with approximately 8.7% of the residential mortgages originated during the first quarter of 2014. Residential mortgages increased to $97.2 million at June 30, 2014, a $0.7 million, or 0.8%, increase from $96.4 million at March 31, 2014, and a $3.1 million, or 3.3%, increase from December 31, 2013. However, residential mortgage originations decreased to $7.8 million and $13.5 million in the three and six month periods ended June 30, 2014, respectively, compared with $9.7 million and $18.2 million in the three and six month periods ended June 30, 2013. The Bank sells certain fixed rate residential mortgages to FNMA, while maintaining the servicing rights for those mortgages. In the three month period ended June 30, 2014, the Bank sold mortgages to FNMA totaling $3.4 million, as compared with no mortgages sold to FNMA in the three month period ended June 30, 2013. During the six month periods ended June 30, 2014 and 2013, the Bank sold $3.4 million and $0.8 million in mortgages, respectively, to FNMA, reflecting the Company's strategy to sell more loans in the current rate environment.



At

June 30, 2014, the Bank had a loan servicing portfolio principal balance of $63.8 million upon which it earns servicing fees, as compared with $63.5 million at December 31, 2013. The value of the mortgage servicing rights for that portfolio was $0.5 million at June 30, 2014 and December 31, 2013. At June 30, 2014, there were $0.2 million in residential mortgage loans held-for-sale, compared with no residential mortgages held for sale at December 31, 2013. The Company had no commercial loans held-for-sale at June 30, 2014 or December 31, 2013. The Company has never been contacted by FNMA to repurchase any loans due to improper documentation or fraud. The Company continues to focus on diversified growth with commercial and industrial ("C&I") lending as a way to achieve such diversification in its loan portfolio. In the second quarter of 2014, C&I balances increased $0.5 million, or 0.5%, from $111.0 million at March 31, 2014 to $111.5 million at June 30, 2014. C&I loans increased $4.5 million, or 4.2%, from $107.0 million at December 31, 2013, due to utilization on existing lines and growth in the C&I portfolio. 42

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Credit Quality of Loan Portfolio

Total non-performing loans and leases, defined as accruing loans and leases greater than 90 days past due and non-accrual loans and leases, totaled $5.4 million, or 0.82% of total loans and leases outstanding, as of June 30, 2014, compared with $5.2 million, or 0.79% of total loans and leases outstanding, as of March 31, 2014, and $13.7 million, or 2.12% of total loans and leases outstanding at December 31, 2013. The decrease in non-performing loans and leases from December 31, 2013 was due to a commercial real estate loan that returned to accrual status in 2014 after a period of demonstrated repayment performance. In the second quarter of 2014, commercial credits graded as "special mention" and "substandard" decreased $0.6 million from $31.7 million at March 31, 2014 and $0.8 million from $30.3 million at December 31, 2013 to $31.1 million at June 30, 2014, as a result loan pay-offs and risk rating upgrades and downgrades during the first six months of the year. As noted in Note 4 to these Unaudited Financial Statements, internal risk ratings are the credit quality indicators used by the Company's management to determine the appropriate allowance for loan and lease losses for commercial credits. "Special mention" and "substandard" loans are weaker credits with a higher risk of loss than "pass" or "watch" credits. The allowance for loan and lease losses totaled $11.5 million, or 1.74% of total loans and leases outstanding as of June 30, 2014, compared with $11.7 million, or 1.78% of total loans and leases outstanding as of March 31, 2014 and $11.5 million, or 1.78% of total loans and leases outstanding at December 31, 2013. The $0.2 million decrease in the allowance during the quarter was driven by a large decrease in the reserve held on a commercial loan that was paid off during the quarter. The net charge-off (recovery) ratio in the second quarter of 2014 increased to 0.24% of average net loans and leases, compared with a ratio of (0.05)% at March 31, 2014 and (0.15)% at December 31, 2013, driven by a single commercial loan relationship charge-off of $0.4 million in the current quarter. The second quarter coverage ratio of the allowance for loan and lease losses to non-performing loans and leases was 212%, a slight decrease from 225% at March 31, 2014 but an increased from the fourth quarter of 2013 at 84%, due to the commercial mortgage credit relationship that was returned to accrual status in 2014, as discussed above. Investing Activities Total securities were $104.4 million at June 30, 2014, compared with $97.0 million at March 31, 2014 and $102.0 million at December 31, 2013. Interest-bearing deposits at other banks, which consist of overnight funds kept at correspondent banks and the Federal Reserve, decreased to $1.2 million at June 30, 2014 from $30.1 million at March 31, 2014 and from $27.3 million at December 31, 2013. Interest-bearing cash decreased in the second quarter due to utilization of excess cash position to fund loans, purchase securities, and pay down borrowings. Securities and interest-bearing deposits at correspondent banks made up 16.1% of the Bank's total average interest earning assets in the second quarter of 2014, compared with 16.8% in the first quarter of 2014 and 18.7% in the fourth quarter of 2013. The Company's highest concentration in its securities portfolio was in available for sale tax-advantaged debt securities issued by state and political subdivisions with 30.6% at June 30, 2014, compared with 32.9% at March 31, 2014 and 31.2% at December 31, 2013. The concentration in U.S. government-sponsored agency bonds was 29.7% of the total securities portfolio at June 30, 2014, compared with 28.9% and 31.3% at March 31, 2014 and December 31, 2013, respectively. U.S. government-sponsored mortgage-backed securities comprised 37.8% of the securities portfolio at June 30, 2014, compared with 35.7% and 35.1% at March 31, 2014 and December 31, 2013, respectively. Management believes that the credit quality of the securities portfolio as a whole is strong as the portfolio has no individual securities in a significant unrealized loss position. Interest rates have been near historic lows and long-term rates have decreased in the first half of 2014 compared to the fourth quarter of 2013, resulting in an increase in the net unrealized gain position of the available-for-sale investment portfolio to $1.6 million at June 30, 2014 from $0.9 million at March 31, 2014 and from $0.3 million at December 31, 2013. The Company monitors extension and prepayment risk in the securities portfolio to limit potential exposures. Available-for-sale securities with a total fair value of $96.8 million at June 30, 2014, compared with $93.6 million at March 31, 2014 and $71.1 million at December 31, 2013, were pledged as collateral to secure public deposits and for other purposes required or permitted by law. The Company has no direct exposure to subprime mortgages, nor does the Company hold private mortgage-backed securities, credit default swaps, or FNMA or FHLMC preferred stock investments in its investment portfolio.



Funding Activities

Total deposits at June 30, 2014 were $707.2 million, compared with $721.9 million and $706.6 million at March 31, 2014 and December 31, 2013, respectively, reflecting a decrease of $14.7 million, or 2.0%, from March 31, 2014, but a slight increase of $0.6 million, or 0.1%, from December 31, 2013. The increase in deposit balances during the first quarter of 2014 was driven by growth in municipal NOW products due to seasonality of tax collections received. Since March 31, 2014, municipal NOW and savings deposits decreased



$17.5 million, or 29.9%, due to the seasonality of municipal deposits.

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Table of Contents The Company's retail deposit growth vehicle for the last three years has been its complementary Better Checking and Better Savings products, which are included in the NOW and regular savings deposit categories, respectively, on the Company's balance sheet. However, the growth in NOW and savings deposits slowed in 2013 as the Better Checking and Better Savings products begin to mature and the Company continued to lower rates on selected deposit products given the Company's current excess liquidity and declining net interest margin in this extended low rate environment. Demand deposits, totaling $148.6 million and $132.8 million at June 30, 2014 and 2013, respectively, drove much of the 2.1% year-over-year increase in total deposits mostly due to commercial demand deposit growth.



In the second quarter of 2014, time deposits decreased slightly to $108.2 million from $108.7 million and $110.1 million at March 31, 2014 and December 31, 2013, respectively. Time deposit rates remain low, resulting in recent balance declines, as customers have preferred liquid savings deposits.

Other borrowings, which typically include the Bank's overnight line of credit and other advances with the FHLBNY, were $6.0 million at June 30, 2014, and $9.0 million at March 31, 2014 and December 31, 2013. The Company remains in an overall liquid position, and therefore has not needed to add to its wholesale borrowings. 44

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ANALYSIS OF RESULTS OF OPERATIONS

Average Balance Sheet

The following tables present the significant categories of the assets and liabilities of the Company, interest income and interest expense, and the corresponding yields earned and rates paid for the periods indicated. The assets and liabilities are presented as daily averages. The average loan and lease balances include both performing and non-performing loans and leases. Investments are included at amortized cost. Yields are presented on a non-tax-equivalent basis.

Three Months Ended Three Months Ended June 30, 2014 June 30, 2013 Average Interest Average Interest Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate (dollars in thousands) (dollars in thousands) ASSETS Interest-earning assets: Loans and leases, net $ 647,169$ 7,879 4.87 % $ 585,431$ 7,277 4.97 % Taxable securities 72,330 455 2.52 % 64,025 404 2.52 % Tax-exempt securities 33,050 243 2.94 % 36,002 267 2.97 % Interest bearing deposits at banks 18,625 15 0.32 % 74,617 45 0.24 %



Total

interest-earning

assets 771,174 $ 8,592 4.46 %



760,075 $ 7,993 4.21 %

Non interest-earning assets: Cash and due from banks 14,192 14,027 Premises and equipment, net 11,047 11,382 Other assets 39,705 35,405 Total Assets $ 836,118$ 820,889 LIABILITIES & STOCKHOLDERS' EQUITY Interest-bearing liabilities: NOW $ 73,873$ 82 0.44 % $ 69,698$ 85 0.49 % Regular savings 383,875 253 0.26 % 385,532 274 0.28 % Time deposits 108,699 422 1.55 % 111,615 451 1.62 % Other borrowed funds 7,645 68 3.56 % 10,645 93 3.49 % Junior subordinated debentures 11,330 79 2.79 % 11,330 81 2.86 % Securities sold U/A to repurchase 13,435 6 0.18 % 14,729 7 0.19 % Total interest-bearing liabilities 598,857 $ 910 0.61 % 603,549 $ 991 0.66 % Noninterest-bearing liabilities: Demand deposits 145,018 128,369 Other 10,101 10,991 Total liabilities $ 753,976$ 742,909 Stockholders' equity 82,142 77,980 Total Liabilities and Equity $ 836,118$ 820,889 Net interest earnings $ 7,682$ 7,002 Net interest margin 3.98 % 3.68 % Interest rate spread 3.85 % 3.55 % 45

-------------------------------------------------------------------------------- Table of Contents Six Months Ended Six Months Ended June 30, 2014 June 30, 2013 Average Interest Average Interest Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate (dollars in thousands) (dollars in thousands) ASSETS Interest-earning assets: Loans and leases, net $ 644,229$ 15,389 4.78 % $ 580,709$ 14,529 10.01 % Taxable securities 71,176 904 2.54 % 64,002 821 5.13 % Tax-exempt securities 33,273 488 2.93 % 35,080 536 6.11 % Interest bearing deposits at banks 22,400 31 0.28 % 76,523 64 0.33 % Total interest-earning assets 771,078 $ 16,812 4.36 % 756,314 $ 15,950 4.22 % Non interest-earning assets: Cash and due from banks 14,555 14,197 Premises and equipment, net 11,128 11,302 Other assets 39,747 35,560 Total Assets $ 836,508$ 817,373 LIABILITIES & STOCKHOLDERS' EQUITY Interest-bearing liabilities: NOW $ 72,532$ 157 0.43 % $ 68,767$ 199 1.16 % Regular savings 386,373 518 0.27 % 383,180 601 0.63 % Time deposits 109,122 837 1.53 % 110,917 900 3.25 % Other borrowed funds 8,320 147 3.53 % 14,298 245 6.85 % Junior subordinated debentures 11,330 159 2.81 % 11,330 161 5.68 % Securities sold U/A to repurchase 14,154 13 0.18 % 14,622 15 0.41 % Total interest-bearing liabilities 601,831 $ 1,831 0.61 % 603,114 $ 2,121 0.70 % Noninterest-bearing liabilities: Demand deposits 142,274 125,373 Other 11,090 11,851 Total liabilities $ 755,195$ 740,338 Stockholders' equity 81,313 77,035 Total Liabilities and Equity $ 836,508$ 817,373 Net interest earnings $ 14,981$ 13,829 Net interest margin 3.89 % 3.66 % Interest rate spread 3.75 % 3.51 % 46

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Table of Contents Net Income Net income was $1.6 million in the second quarter of 2014, down from $1.9 million in the second quarter of 2013, primarily due to litigation expense of $1.0 million ($0.6 million after tax), or approximately $0.14 per share in the current quarter. Excluding the litigation expense, net income was $2.2 million, a 15.8% increase over second quarter 2013 of $1.9 million. The litigation accrual is related to New York Attorney General's allegations relating the Bank's residential mortgage fair lending practices, as previously in the Company's SEC filings. Although the Company has not incurred actual payments related to the investigation to date, the Company has recorded an accrual based on estimated outcomes from legal proceedings. As a result of the litigation accrual, return on average equity was 7.52% for the second quarter of 2014 compared with 9.86% in the second quarter of 2013. For the six months ended June 30, 2014, Evans recorded net income of $3.6 million, or $0.84 per diluted share, a 3.9% decrease from net income of $3.7 million, or $0.89 per diluted share, in the same period in 2013. The return on average equity was 8.74% for the six-month period ended June 30, 2014, compared with 9.71% for the same period in 2013, as a result of the litigation accrual recorded during the second quarter of 2014.



Other Results of Operations - Quarterly Comparison

Net interest income was $7.7 million for the second quarter, an increase of 9.7% from the prior-year period, and up 5.3% from the trailing first quarter of 2014. Growth in loans, specifically in the commercial and residential real estate portfolios, and non-interest bearing demand deposits drove the increase over both periods. Net interest margin increased 19 basis points to 3.98% from 3.79% in the trailing first quarter, primarily driven by an increase in the yield on interest-earning assets. Net interest margin improved 30 basis points over the 2013 second quarter rate of 3.68%. The increase in net interest margin from the prior-year period was due to a 5 basis point decrease in pricing on Evans' interest bearing liabilities, combined with a 25 basis point increase in the yield on interest-earning assets due to utilization of lower interest-earning fed funds into higher yielding loans. The provision for loan and lease losses was $0.2 million in the 2014 second quarter, up from $0.1 million in the prior-year period. When compared with the trailing first quarter of 2014, the provision increased by only $23 thousand due to offsetting changes in specific reserves held on individually evaluated loans. Non-interest income was $3.1 million, or 28.4% of total revenue, in the quarter, down $0.2 million, or 5.0%, from the prior-year period. Insurance agency revenue of $1.6 million was down 8.1% from the 2013 second quarter, due mostly to decreases in profit sharing revenue. Income tax expense for the quarter was $0.7 million, representing an effective tax rate of 29.2%, compared with an effective tax rate of 33.2% in the second quarter of 2013. The effective tax rate decreased as a result of tax-exempt income comprising a larger percentage of total income in the second quarter of 2014, as compared with the second quarter of 2013.



Other Results of Operations - Year-to-Date Comparison

Net interest income was $15.0 million for the first six months of 2014, up $1.2 million or 8.3% from the first six months of 2013. The increase in net interest income from prior year-to-date net interest income is attributed to a 13.7% decrease in interest expense related to lower rates on interest-bearing deposits. The Company's net interest margin increased by 23 basis points to 3.75% in the first six months of 2014, compared with 3.52% in the first six months of 2013. The Company's average interest-earning assets increased by 2.0% when compared to prior year, and yields on those assets also increased 14 basis points when compared with the prior year period. The year over year increase in margin was also driven by a 9 basis point decrease interest paid on interest-bearing liabilities from 0.70% in the first six months of 2013 to 0.61% in the first six months of 2014. Provision for loan and lease losses of $0.3 million decreased $0.2 million in the first six months of 2014 when compared with the first six months of 2013. The year-over-year decrease is attributed to a decrease in the reserve held on a commercial loan that was paid off during the quarter and an increase in leasing recoveries realized in 2014. Non-interest income for the first six months of 2014 decreased $0.1 million or 1.2% from the prior year period to $6.4 million, representing 30.1% of total revenue for the first six months of 2014 compared with 32.1% of total revenue for the first six months of 2013. Income on the Company's bank owned life insurance increased 22.4% in the first six months of 2014 compared with the prior year due to purchases made in the third quarter of 2013. Premiums on loans sold increased 62.6% year over year, as the Company has 47 --------------------------------------------------------------------------------



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begun to sell more loans to FNMA in the current year as compared with the prior year period. Bank charges decreased 6.4% in the first six months of 2014, compared with the prior year period. Insurance service and fees slightly decreased 0.2% in the first six months of 2014 compared with the first six months of 2013, driven by a $0.1 million decrease in profit-sharing income when compared with the prior year period. Total non-interest expense increased $1.6 million, or 11.3%, in the first six months of 2014 from the first six months of 2013, mostly due to a $1.0 million litigation expense recorded in the second quarter, as discussed above. A $0.7 million increase in salaries and employee benefits expense and a $0.1 million increase advertising expense during the first six months of 2014 compared with the first six months of 2013 also contributed to the 11.3% increase in total non-interest expense, which was partially offset by a $0.1 decrease in occupancy expense and a $0.1 million decrease in technology and communication expense from the prior six-month period. The increase in salaries and employee benefits reflects merit increases for employees and increased costs in employee health insurance premiums and retirement benefits. The year over year decrease in occupancy expense was driven by a $0.1 million software impairment loss realized in 2013.



As a result, the Company's efficiency ratio for the first six months of 2014 increased to 74.06% compared with 69.81% during the prior-year period.

The unfavorable increase in the efficiency ratio was mostly due to the $1.0 million litigation expense incurred in 2014, which had the impact of increasing the efficiency ratio for the first six months of 2014 by 4.67%. Income tax expense for the first six months ended June 30, 2014, was $1.6 million, representing an effective tax rate of 30.3%, compared with an effective tax rate of 31.9% in the prior year period. The effective tax rate decreased as a result of tax-exempt income comprising a larger percentage of total income in the first six months of 2014, as compared with the first six months of 2013. CAPITAL The Company consistently maintains regulatory capital ratios significantly above the federal "well capitalized" standard, including a Tier 1 leverage ratio of 10.04% and 10.36% at June 30, 2014 and December 31, 2013, respectively. Book value per share of the Company's common stock was $19.84 at June 30, 2014, compared with $19.18 at December 31, 2013. Tangible book value per share (a non-GAAP measure) at June 30, 2014 was $17.90, compared with $17.26 at December 31, 2013. The increase in both book value and tangible book value per share is a result of the Company's repurchase of shares in the first quarter. Tangible book value per share is a non-GAAP financial measure. The Company calculates tangible book value per share by dividing tangible book value by the number of common shares outstanding, as compared to GAAP book value per share, which the Company calculates by dividing GAAP book value by the number of common shares outstanding. Management believes that this information is consistent with treatment by bank regulatory agencies, which exclude intangible assets from the calculation of risk-based capital ratios. Accordingly, management believes that this non-GAAP financial measure provides information that is important to investors and that is useful in understanding the Company's capital position and ratios. Further, management believes that presentation of this measure, together with the accompanying reconciliation, provides a complete understanding of factors and trends affecting the Company's business and allows investors to view the Company's performance in a manner similar to management, the financial services industry, bank stock analysts and regulatory agencies. However, this non-GAAP financial measure is supplemental and is not a substitute for an analysis based on GAAP financial measures. Note that other companies may use different calculations for this measure, and therefore the Company's presentation of tangible book value per share may not be comparable to similarly titled measures reported by other companies. Investors should review the Company's consolidated financial statements in their entirety and should not rely on any single financial measure. A reconciliation of this non-GAAP financial measure, tangible book value per share, to the most directly comparable GAAP financial measure, book value, is set forth in the following table: 48 --------------------------------------------------------------------------------

Table of Contents ($ in thousands, except per share data) June 30, 2014



December 31, 2013

Stockholders' equity ("book value") $ 82,949 $



80,712

Goodwill (related to insurance agency reporting unit) (8,101)



(8,101)

Intangible assets (related to insurance agency reporting unit) (27) (108) Tangible book value $ 74,821 $ 72,503 Number of common shares outstanding 4,179,758 4,201,362 Tangible book value per share $ 17.90 $ 17.26 On February 18, 2014, the Company declared a cash dividend of $0.31 per share on the Company's outstanding common stock. The dividend was paid on April 8, 2014 to shareholders of record as of March 18, 2014. LIQUIDITY The Bank utilizes cash flows from the investment portfolio and federal funds sold balances to manage the liquidity requirements related to loan demand and deposit fluctuations. The Bank also has many borrowing options. As a member of the FHLB the Bank is able to borrow funds at competitive rates. Advances of up to $178.8 million can be drawn on the FHLB via an Overnight Line of Credit Agreement between the Bank and the FHLB. An amount equal to 25% of the Bank's total assets could be borrowed through the advance programs under certain qualifying circumstances. The Bank also has the ability to purchase up to $14.0 million in federal funds from its correspondent banks. By placing sufficient collateral in safekeeping at the Federal Reserve Bank, the Bank could borrow at the discount window. The Bank's liquidity needs also can be met by more aggressively pursuing time deposits, or accessing the brokered time deposit market, including the Certificate of Deposit Account Registry Service ("CDARS") network. The Company's primary source of liquidity is dividends from the Bank. Additionally, the Company has access to capital markets as a funding source. Cash flows from the Bank's investment portfolio are laddered, so that securities mature at regular intervals, to provide funds from principal and interest payments at various times as liquidity needs may arise. Contractual maturities are also laddered, with consideration as to the volatility of market prices. At June 30, 2014, approximately 7.1% of the Bank's securities had contractual maturity dates of one year or less and approximately 30.9% had maturity dates of five years or less. Management, on an ongoing basis, closely monitors the Company's liquidity position for compliance with internal policies, and believes that available sources of liquidity are adequate to meet funding needs in the normal course of business. As part of that monitoring process, management calculates the 90-day liquidity each month by analyzing the cash needs of the Bank. Included in the calculation are liquid assets and potential liabilities. Management stresses the potential liabilities calculation to ensure a strong liquidity position. Included in the calculation are assumptions of some significant deposit run-off as well as funds needed for loan closings and investment purchases. At June 30, 2014, in the Company's internal stress test, the Company had net short-term liquidity of $64.6 million as compared with $121.8 million at December 31, 2013, due to the usage of cash for loan growth. Available assets of $125.7 million, divided by public and purchased funds of $125.4 million, resulted in a long-term liquidity ratio of 100% at June 30, 2014, compared with 119% at December 31, 2013. Management does not anticipate engaging in any activities, either currently or in the long term, for which adequate funding would not be available and which would therefore result in significant pressure on liquidity. However, continued economic recession could negatively impact the Company's liquidity.



The Company believes that the Bank maintains a sufficient level of U.S. government and government agency securities and New York State municipal bonds that can be pledged as collateral for municipal deposits.

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