News Column

HILLS BANCORPORATION - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 5, 2014

The following is management's discussion and analysis of the financial condition of Hills Bancorporation ("Hills Bancorporation" or "the Company") and its banking subsidiary Hills Bank and Trust Company ("the Bank") for the dates and periods indicated. The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.



Special Note Regarding Forward Looking Statements

This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following:



The strength of the United States economy in general and the strength of the

local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company's assets.



The effects of recent financial market disruptions, and monetary and other

governmental actions designed to address such disruptions.



The financial strength of the counterparties with which the Company or the

Company's customers do business and as to which the Company has investment

or financial exposure. The credit quality and credit agency ratings of the securities in the



Company's investment securities portfolio, a deterioration or downgrade of

which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.



The effects of, and changes in, laws, regulations and policies affecting

banking, securities, insurance and monetary and financial matters as well as

any laws otherwise affecting the Company.

The effects of changes in interest rates (including the effects of changes

in the rate of prepayments of the Company's assets) and the policies of the

Board of Governors of the Federal Reserve System.



The ability of the Company to compete with other financial institutions as

effectively as the Company currently intends due to increases in competitive

pressures in the financial services sector.



The ability of the Company to obtain new customers and to retain existing

customers.



The timely development and acceptance of products and services, including

products and services offered through alternative electronic delivery channels.



Technological changes implemented by the Company and by other parties,

including third party vendors, which may be more difficult or more expensive

than anticipated or which may have unforeseen consequences to the Company

and its customers. The ability of the Company to develop and maintain secure and reliable electronic systems. Page 37



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The ability of the Company to retain key executives and employees and the

difficulty that the Company may experience in replacing key executives and

employees in an effective manner.

Consumer spending and saving habits which may change in a manner that

affects the Company's business adversely.

The economic impact of natural disasters, terrorist attacks and military

actions.



Business combinations and the integration of acquired businesses and assets

which may be more difficult or expensive than expected.

The costs, effects and outcomes of existing or future litigation.

Changes in accounting policies and practices that may be adopted by state

and federal regulatory agencies and the Financial Accounting Standards Board.



The ability of the Company to manage the risks associated with the foregoing

as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company's financial results, is included in the Company's filings with the Securities and Exchange Commission.



Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company's critical accounting policies should be read in conjunction with the Company's consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management's Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of June 30, 2014 and December 31, 2013 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.



Overview

This overview highlights selected information and may not contain all of the information that is important to you in understanding our performance during the period. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should carefully read this entire report. The Company is a holding company engaged in the business of commercial banking. The Company's subsidiary is Hills Bank and Trust Company, Hills, Iowa (the "Bank"), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa. At June 30, 2014, the Bank has seventeen full-service locations. Page 38



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HILLS BANCORPORATION Net income for the six month period ended June 30, 2014 was $13.93 million compared to $13.72 million for the same six months of 2013, an increase of 1.46%. The $0.21. million increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first six months of 2014 are an increase in net interest income of $1.52 million and a decrease in income tax expense of $0.28 million. These changes were offset by an increase in the provision for loan losses of $0.22 million, a decrease in noninterest income of $1.04 million and an increase in noninterest expenses of $0.34 million. The Company achieved a return on average assets of 1.22% and a return on average equity of 11.22% for the twelve months ended June 30, 2014, compared to the twelve months ended June 30, 2013, which were 1.18% and 11.06%, respectively. Dividends of $1.15 per share were paid in January 2014 to 2,204 shareholders. The 2013 dividend was $1.10 per share. The Company's net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Company achieved a net interest margin on a tax-equivalent basis of 3.48% for the six months ended June 30, 2014 compared to 3.52% for the same six months of 2013. Average earning assets were $2.090 billion in 2014 and $1.980 billion in 2013.



Highlights noted on the balance sheet as of June 30, 2014 for the Company included the following:

Total assets were $2.220 billion, an increase of $52.02 million since

December 31, 2013.

Cash and cash equivalents were $30.14 million, a decrease of $13.57 million

since December 31, 2013.

Net loans were $1.870 billion, an increase of $64.12 million since December 31, 2013. Loans held for sale increased $3.03 million since December 31, 2013.



Deposit growth of $16.45 million since December 31, 2013.

Reference is made to Note 6 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements. Financial Condition



The following table sets forth the composition of the loan portfolio as of June 30, 2014 and December 31, 2013:

June 30, 2014 December 31, 2013 Amount Percent Amount Percent (Amounts In Thousands) (Amounts In Thousands) Agricultural $ 85,204 4.52 % $ 82,138 4.50 % Commercial and financial 178,227 9.44 166,102 9.10 Real estate: Construction, 1 to 4 family residential 33,942 1.80 30,309 1.66 Construction, land development and commercial 76,735 4.07 69,182 3.79 Mortgage, farmland 144,050 7.63 142,685 7.81 Mortgage, 1 to 4 family first liens 628,914 33.32 605,687 33.16 Mortgage, 1 to 4 family junior liens 107,949 5.72 105,785 5.79 Mortgage, multi-family 237,919 12.61 244,090 13.37 Mortgage, commercial 318,142 16.86 315,187 17.26 Loans to individuals 20,874 1.11 19,824 1.09 Obligations of state and political subdivisions 55,069 2.92 45,167 2.47 $ 1,887,025 100.00 % $ 1,826,156 100.00 % Net unamortized fees and costs 657



641

$ 1,887,682$ 1,826,797 Less allowance for loan losses 25,350 25,550 $ 1,862,332$ 1,801,247 Page 39



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HILLS BANCORPORATION Loan demand has been steady and is expected to remain steady or increase throughout the year ended December 31, 2014. As indicated above growth in the agricultural, 1 to 4 family real estate loans, obligation of state and political subdivisions loan portfolios as well as real estate loans secured by farmland have been primarily responsible for the increase in total loans. Management expects overall portfolio loan growth to increase as a result of general improvement in market conditions. The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment. The collateral relied upon in the loan origination policy is generally the property being financed by the Bank. The source of expected payment is generally the income produced from the property being financed. Personal guarantees are required of individuals owning or controlling at least 20% of the ownership of an entity. Limited or proportional guarantees may be accepted in circumstances if approved by the Company's Board of Directors. Financial information provided by the borrower is verified as considered necessary by reference to tax returns, or audited, reviewed or compiled financial statements. The Bank does not originate subprime loans. In order to modify, restructure or otherwise change the terms of a loan, the Bank's policy is to evaluate each borrower situation individually. Modifications, restructures, extensions and other changes are done to improve the Bank's position and to protect the Bank's capital. If a borrower is not current with its payments, any additional loans to such borrowers are evaluated on an individual borrower basis. The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge offs. When an updated appraisal value has been obtained, the Company has used the appraisal amount in determining the appropriate charge off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company's loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge offs or provisions, not to override the appraised value. In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans. Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to non-accrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If the Company determines a loan amount or portion thereof is uncollectible, the loan's credit risk rating is immediately downgraded and the uncollectible amount is charged-off. The Bank's credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses. Page 40



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HILLS BANCORPORATION The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of June 30, 2014 and December 31, 2013: June 30, 2014 December 31, 2013 % of Total % of Loans to % of Total % of Loans to Amount Allowance Total Loans Amount Allowance Total Loans (In Thousands)

(In Thousands) Agricultural $ 3,036 11.98 % 4.52 % $ 2,852 11.17 % 4.50 % Commercial and financial 4,832 19.06 9.44 4,733 18.52 9.10 Real estate: Construction, 1 to 4 family residential 1,301 5.13 1.80 1,011 3.96 1.66 Construction, land development and commercial 2,130 8.40 4.07 1,907 7.46 3.79 Mortgage, farmland 2,749 10.84 7.63 2,557 10.01 7.81 Mortgage, 1 to 4 family first liens 5,914 23.33 33.32 6,101 23.87 33.16 Mortgage, 1 to 4 family junior liens 917 3.62 5.72 963 3.77 5.79 Mortgage, multi-family 1,407 5.55 12.61 2,064 8.08 13.37 Mortgage, commercial 2,332 9.20 16.86 2,723 10.66 17.26 Loans to individuals 364 1.44 1.11 369 1.44 1.09 Obligations of state and political subdivisions 368 1.45 2.92 270 1.06 2.47 $ 25,350 100.00 % 100.00 % $ 25,550 100.00 % 100.00 % The allowance for loan losses totaled $25.35 million at June 30, 2014 compared to $25.55 million at December 31, 2013. The percentage of the allowance to outstanding loans was 1.34% and 1.40% at June 30, 2014 and December 31, 2013, respectively. The allowance was based on management's consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The decrease in the allowance in 2014 is the result of a change in the composition and allocation of loans within credit quality ratings. The adequacy of the allowance is reviewed quarterly and adjusted as appropriate after consideration has been given to the impact of economic conditions on the borrowers' ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for loan losses. Quantitative factors include the Company's historical loss experience, which is then adjusted for levels and trends in past due, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates. Management has determined that the allowance for loan losses was appropriate at June 30, 2014, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company's loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.



Residential real estate loan products that include features such as loan-to-values in excess of 100% or interest only payments, which expose a borrower to payment increases in excess of changes in the market interest rate, increase the credit risk of a loan. The Bank has not offered and does not intend to offer this type of loan product.

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HILLS BANCORPORATION Investment securities available for sale held by the Company increased by $1.30 million from December 31, 2013 to June 30, 2014. The fair value of securities available for sale was $2.63 million more than the amortized cost of such securities as of June 30, 2014. At December 31, 2013, the fair value of the securities available for sale was $1.81 million more than the amortized cost of such securities. Deposit growth was $16.45 million in the first six months of 2014. Federal funds borrowed increased $31.63 million and repurchase agreements decreased $5.07 million in the same period resulting in a net increase of $26.56 in short term borrowings. In the opinion of the Company's management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth. Brokered deposits are included in total deposits and totaled $60.65 million as of June 30, 2014 with an average rate of 0.41%. Brokered deposits were $57.77 million as of December 31, 2013 with an average interest rate of 0.44%. As of June 30, 2014 and December 31, 2013, brokered deposits were 3.51% and 3.38% of total deposits, respectively.



Dividends and Equity

In January 2014, Hills Bancorporation paid a dividend of $5.42 million or $1.15 per share. The dividend was $1.10 per share in January 2013. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders' equity as of June 30, 2014 totaled $248.44 million. Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 16.25% and 16.19% as of June 30, 2014 and December 31, 2013, respectively. The Tier 1 risk-based capital was in excess of the required minimum of 8.00%. Risk-based capital was 17.50% and 17.44% as of June 30, 2014 and December 31, 2013, respectively. As of June 30, 2014, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category. In July 2013, the Officer of the Comptroller of the Currency and Board of Governors of the Federal Reserve System adopted a final rule implementing agreements reached by the Basel Committee on Banking Supervision in "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems"(BASEL III). The final rule also adopts changes to the agencies' regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule implements a revised definition of regulatory capital, a new 4.50% common equity tier 1 minimum capital requirement, a 6.00% tier 1 capital requirement, and a tier 1 risk-based capital ratio of 8.00%. The Bank expects to remain categorized as well capitalized under the final rule when it becomes effective on January 1, 2015.



Discussion of operations for the six months ended June 30, 2014 and 2013

Net Income Overview

Net income increased $0.21 million for the six months ended June 30, 2014 compared to the first six months of 2013. Total net income was $13.93 million in 2014 and $13.72 million in the comparable period in 2013, an increase of 1.46%. The changes in net income in 2014 from the first six months of 2013 were primarily the result of the following:



Net interest income increased by $1.52 million, before provision expense,

primarily as a result of total interest expense reductions significantly

outpacing reductions in total interest income.

The provision for loan losses increased by $0.22 million.

Noninterest income decreased by $1.04 million.

Noninterest expenses increased by $0.34 million.

Income tax expense decreased by $0.28 million.

For the six-month period ended June 30, 2014 basic and diluted earnings per share were $2.96. For the six months ended June 30, 2013 basic and diluted earnings per share were both $2.91.

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Discussion of operations for the six months ended June 30, 2014 and 2013

The Company's net income continues to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of $34.73 million for the first six months of 2014 was derived from the Company's $2.090 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.48%. Average earning assets in the six months ended June 30, 2013 were $1.980 billion and the tax-equivalent net interest margin was 3.52%. The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $1.04 million change in income before income taxes in the six month period ended June 30, 2014 . Net interest income for the Company increased as a result of a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits. The Company expects continued net interest compression to impact earnings for the foreseeable future. The Company believes growth in net interest income will be contingent on the growth of the Company's earnings assets. The second significant factor affecting the Company's net income is the provision for loan losses. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to more than $1.870 billion at June 30, 2014. The provision is computed on a quarterly basis and is a result of management's determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers' ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management's review of problem and watch loans, including loans with historically higher credit risk. The provision for loan losses was a reduction of expense of $0.20 million in 2014 compared to a reduction of expense of $0.42 million in 2013. The Company believes that the provision for loan losses will increase for the foreseeable future resulting from projected increases in the size of the Company's loan portfolio as well as stabilization of credit quality. The third significant factor affecting the Company's net income is income tax expense. Federal and state income tax expenses were $5.58 million and $5.85 million for the six months ended June 30, 2014 and 2013, respectively. Income taxes as a percentage of income before taxes were 28.60% in 2014 and 29.90% in 2013. Page 43



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Discussion of operations for the six months ended June 30, 2014 and 2013

Net Interest Income

Net interest income increased for the six months ended June 30, 2014 compared to the comparable period in 2013. The increase was primarily the result of a decrease in net interest expense due to the mix of interest bearing liabilities of the bank as well as a reduction in dollar amount and rate on time deposits. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin. The net interest margin for the first six months of 2014 was 3.48% compared to 3.52% in 2013 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2014 compared to the comparable period in 2013 are shown in the following table:



Increase (Decrease) in Net Interest Income

Change in Change in Average Balance Average Rate Volume Changes Rate Changes Net Change (Amounts in Thousands) Interest income: Loans, net $ 112,244 (0.22 )% $ 2,561$ (1,885 )$ 676 Taxable securities (4,491 ) (0.18 ) (29 ) (85 ) (114 ) Nontaxable securities 18,249 (0.50 ) 363 (364 ) (1 ) Federal funds sold (16,148 ) - (20 ) - (20 ) $ 109,854$ 2,875$ (2,334 )$ 541 Interest expense: Interest-bearing demand deposits $ 35,851 (0.05 )% $ (38 ) $ 113 $ 75 Savings deposits 89,265 (0.02 ) (102 ) 54 (48 ) Time deposits (54,277 ) (0.21 ) 462 524 986 Short-term borrowings 4,555 (0.02 ) (11 ) 8 (3 ) FHLB borrowings - - - - - Interest-bearing other liabilities (50 ) (1.30 ) - 17 17 $ 75,344 $ 311 $ 716 $ 1,027 Change in net interest income $ 3,186$ (1,618 )$ 1,568 Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown on a tax-equivalent basis.



A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis) 2014



2013

Yield on average interest-earning assets 4.21 % 4.39 % Rate on average interest-bearing liabilities 0.92



1.10

Net interest spread 3.29 % 3.29 % Effect of noninterest-bearing funds 0.19



0.23

Net interest margin (tax equivalent interest income divided by average interest-earning assets)

3.48 % 3.52 % Page 44



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Discussion of operations for the six months ended June 30, 2014 and 2013

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met five times during the first six months of 2014. The target rate remains unchanged since December 31, 2008 at 0.25%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of June 30, 2014, the rate indexes for the one, three and five year indexes were 0.11%, 0.92% and 1.68%, respectively.



The

one year index decreased 15.39% from 0.13% at June 30, 2013, the three year index increased 61.40% and the five year index increased 37.70%. The three year index was 0.57% and the five year index was 1.22% at June 30, 2013. The targeted federal funds rate was 0.25% at June 30, 2014 and 2013. The Company anticipates no increases in short term rates and possible increases in long term rates in the indexes for 2014.



Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.20 million in 2014 compared to a reduction of expense of $0.42 million in 2013, an increase of $0.22 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management's determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers' ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management's review of problem and watch loans, including loans with historical higher credit risks. The increase in expense in 2014 is the result of an increase in loan volume as well as a change in the composition and allocation of balances within the credit quality ratings. The allowance for loan losses decreased $0.20 million during the first six months of 2014. In the first six months of 2014, there was an increase of $0.07 million due to the volume and composition of loans outstanding and a $0.27 million decrease in the amount allocated to the allowance due to a combination of credit quality improvements. The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the six months ended June 30, 2014 and 2013, recoveries were $1.57 million and $1.33 million, respectively; and charge-offs were $1.57 million in 2014 and $1.67 million in 2013. The allowance for loan losses totaled $25.35 million at June 30, 2014 compared to $25.55 million at December 31, 2013. The allowance represented 1.34% and 1.40% of loans held for investment at June 30, 2014 and December 31, 2013, respectively. Page 45



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Discussion of operations for the six months ended June 30, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the six months ended June 30, 2014 and 2013.

Six Months Ended June 30, 2014 2013 $ Change % Change (Amounts in thousands) Net gain on sale of loans $ 300$ 1,262$ (962 ) (76.23 )% Trust fees 2,899 2,555 344 13.46 Service charges and fees 3,849 4,376 (527 ) (12.04 ) Rental revenue on tax credit real estate 735 716 19 2.65 Net gain on sale of other real estate owned and other reposessed assets 240 150 90 60.00 Other noninterest income 1,345 1,348 (3 ) (0.22 ) $ 9,368$ 10,407$ (1,039 ) (9.98 ) Loans originated for sale in the first six months of 2014 totaled $49.19 million compared to $136.34 million in the same period in 2013, a decrease of 63.92%. In the six months ended June 30, 2014 and 2013, the net gain on sale of loans was $0.30 million and $1.26 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income. Trust fees increased $0.34 million in the first six months of 2014 as a result of assets under management increasing to $1.249 billion as of June 30, 2014 from $1.086 billion as of June 30, 2013 due to market conditions and new trust relationships. Service charges and fees decreased $0.53 million in the first six months of 2014 from their level for the comparable period in 2013. Credit card merchant fees are included in service charges and fees, and that component decreased during the same period by $0.67 million due to a change to an agent program utilized by the Bank. This decrease was offset by an increase of $0.15 million in credit card, debit card and POS Pin interchange income due to increased volume in transactions during the period. The net gain on sale of other real estate owned and other repossessed assets increased $0.09 million to a net gain of $0.24 million for the six months ended June 30, 2014. The total net gain on sale of other real estate owned for the six months ended consisted of a $0.26 million net gain on the sale of 9 properties offset by a $0.02 million fair market value adjustment on one property. During the same period in 2013, the gain consisted of a $0.16 million net gain on sale of 7 properties offset by a $0.01 million loss on sale of one property. Page 46



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Discussion of operations for the six months ended June 30, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the six months ended June 30, 2014 and 2013.

Six Months Ended June 30, 2014 2013



$ Change % Change

(Amounts in thousands) Salaries and employee benefits $ 12,642$ 12,154$ 488 4.02 % Occupancy 1,953 1,873 80 4.27 Furniture and equipment 2,473 2,467 6 0.24 Office supplies and postage 767 766 1 - Advertising and business development 1,441 1,271 170 13.38 Outside services 3,208 3,570 (362 ) (10.14 ) Rental expenses on tax credit real estate 1,083 957 126 13.17 FDIC insurance assessment 541 531 10 1.88 Other noninterest expense 687 866 (179 ) (20.67 ) $ 24,795$ 24,455$ 340 1.39 Advertising and business development expense increased $0.17 million in the first six months of 2014 compared to 2013 as a result of $0.11 million increase in mail processing expense and $0.06 million in charitable contributions. Outside services expenses decreased $0.36 million in the first six months of 2014 from their level for the comparable period in 2013. Merchant card processing charges are included in outside services expense, and that component decreased during the same period by $0.62 million due to a change to an agent program utilized by the Bank. Most other noninterest expense categories experienced marginal period-to-period fluctuations for the six months ended June 30, 2014. Page 47



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HILLS BANCORPORATION



Discussion of operations for the three months ended June 30, 2014 and 2013

Net Income Overview

Net income increased $0.27 million for the three months ended June 30, 2014 compared to the same period in 2012. Total net income was $7.18 million in 2014 and $6.91 million in the comparable period in 2013, an increase of 3.86%. For the three-month period ended June 30, 2014 and 2013, basic and diluted earnings per share were $1.53 and $1.47, respectively.



Net Interest Income

Net interest income increased for the three months ended June 30, 2014 compared to the comparable period in 2013. The increase was primarily the result of a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the three months ended June 30, 2014 was 3.49% compared to 3.48% in 2013 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2014 compared to the comparable period in 2013 are shown in the following table:



Increase (Decrease) in Net Interest Income

Change in Change in Average Balance Average Rate Volume Changes Rate Changes Net Change (Amounts in Thousands) Interest income: Loans, net $ 123,096 (0.17 )% $ 1,391$ (753 ) $ 638 Taxable securities (4,206 ) (0.09 ) (9 ) (25 ) (34 ) Nontaxable securities 17,618 (0.44 ) 172 (162 ) 10 Federal funds sold (15,731 ) - (9 ) - (9 ) $ 120,777 $



1,545 $ (940 ) $ 605

Interest expense: Interest-bearing demand deposits $ 35,979 (0.06 )% $ (19 ) $ 70 $ 51 Savings deposits 90,947 (0.03 ) (51 ) 45 (6 ) Time deposits (52,273 ) (0.20 ) 219 253 472 Short-term borrowings 7,645 0.01 (9 ) 3 (6 ) FHLB borrowings - - - - - Interest-bearing other liabilities (45 ) (0.88 ) - 6 6 $ 82,253 $ 140 $ 377 $ 517 Change in net interest income $ 1,685$ (563 )$ 1,122 Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown on a tax-equivalent basis. Page 48



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Index

HILLS BANCORPORATION



Discussion of operations for the three months ended June 30, 2014 and 2013

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis) 2014



2013

Yield on average interest-earning assets 4.20 % 4.34 % Rate on average interest-bearing liabilities 0.90



1.08

Net interest spread 3.30 % 3.26 % Effect of noninterest-bearing funds 0.19



0.22

Net interest margin (tax equivalent interest income divided by average interest-earning assets)

3.49 % 3.48 % Provision for Loan Losses The provision for loan losses was a reduction of expense of $0.25 million in 2014 as well as in 2013. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management's determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers' ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management's review of problem and watch loans, including loans with historical higher credit risks. The allowance for loan losses decreased $0.51 million during the three months ended June 30, 2014. In the three months ended June 30, 2014, there was an increase of $0.40 million due to the volume and composition of loans outstanding and a $0.91 million decrease in the amount allocated to the allowance due to an improvement in credit quality. The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended June 30, 2014 and 2013, recoveries were $0.78 million and $0.86 million, respectively; and charge-offs were $1.05 million in 2014 and $0.83 million in 2013. The allowance for loan losses totaled $25.35 million at June 30, 2014 compared to $25.55 million at December 31, 2013. The allowance represented 1.34% and 1.40% of loans held for investment at June 30, 2014 and December 31, 2013, respectively. Page 49



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Index

HILLS BANCORPORATION



Discussion of operations for the three months ended June 30, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended June 30, 2014 and 2013.

Three Months Ended June 30, 2014 2014 2013 $ Change % Change (Amounts in thousands) Net gain on sale of loans $ 189$ 521$ (332 ) (63.72 )% Trust fees 1,439 1,295 144 11.12 Service charges and fees 2,012 2,262 (250 ) (11.05 ) Rental revenue on tax credit real estate 378 397 (19 ) (4.79 ) Net gain on sale of other real estate owned and other reposessed assets 168 110 58 52.73 Other noninterest income 761 734 27 3.68 $ 4,947$ 5,319$ (372 ) (6.99 ) In the three months ended June 30, 2014 and 2013, the net gain on sale of loans was $0.19 million and $0.52 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income. Trust fees increased $0.14 million in the three months ended June 30, 2014 as a result of assets under management increasing to $1.085 billion as of June 30, 2014 from $1.054 billion as of June 30, 2013 due to market conditions and new trust relationships. Service charges and fees decreased $0.25 million in the three months ended June 30, 2014 from their level for the comparable period in 2013. Credit card merchant fees are included in service charges and fees, and that component decreased during the same period by $0.34 million due to a change to an agent program utilized by the Bank. The net gain on sale of other real estate owned and other repossessed assets increased $0.06 million to a net gain of $0.17 million for the three months ended June 30, 2014. The total net gain on sale of other real estate owned for the three months ended June 30, 2014 consisted of a $0.17 million net gain on the sale of 6 properties. During the same period in 2013, the gain consisted of a $0.12 net gain on sale of 6 properties and a $0.01 million loss on the sale of one property. Page 50



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Index

HILLS BANCORPORATION



Discussion of operations for the three months ended June 30, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended June 30, 2014 and 2013.

Three Months Ended June 30, 2014 2013 $ Change % Change (Amounts in thousands) Salaries and employee benefits $ 6,385$ 6,191$ 194 3.13 % Occupancy 944 931 13 1.40 Furniture and equipment 1,242 1,186 56 4.72 Office supplies and postage 385 386 (1 ) - Advertising and business development 813 651 162 24.88 Outside services 1,673 1,768 (95 ) (5.37 ) Rental expenses on tax credit real estate 553 613 (60 ) (9.79 ) FDIC insurance assessment 271 270 1 0.37 Other noninterest expense 271 426 (155 ) (36.38 ) $ 12,537$ 12,422$ 115 0.93 Advertising and business development expenses increased $0.16 million in the three months ended June 30, 2014 from their level for the comparable period in 2013 as a result of a $0.04 increase in mail processing expense and $0.03 in charitable contributions. Most other noninterest expense categories experienced marginal period-to-period increases for the three months ended June 30, 2014.



Income Taxes

Federal and state income tax expenses were $3.19 million and $2.86 million for the three months ended June 30, 2014 and 2013, respectively. Income taxes as a percentage of income before taxes were 30.75% in 2014 and 29.28% in 2013.



Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company's normal liquidity needs, to respond to market changes or to adjust the Company's interest rate risk position. Investment securities available for sale comprised 10.80% of the Company's total assets at June 30, 2014 compared to 11.00% at December 31, 2013. The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company's liquidity position. As of June 30, 2014, the Company had borrowed $125 million from the Federal Home Loan Bank ("FHLB") of Des Moines. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $443.06 million at June 30, 2014. As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling 180.26 million. The borrowings under these credit lines would be secured by the Bank's investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2014.



As of June 30, 2014, investment securities with a carrying value of $68.57 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2013, investment securities with a carrying value of $42.02 million were pledged.

Page 51



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Index HILLS BANCORPORATION Contractual Obligations



There have been no material changes with regard to contractual obligations disclosed in the Company's Form 10-K for the year ended December 31, 2013.


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