News Column

SANDY SPRING BANCORP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 7, 2014

The Company

Sandy Spring Bancorp, Inc. (the "Company") is the bank holding company for Sandy Spring Bank (the "Bank"). The Company is registered as a bank holding company pursuant to the Bank Holding Company Act of 1956, as amended (the "Holding Company Act"). As such, the Company is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Company began operating in 1988. The Bank was founded in 1868 and is the oldest banking business based in Maryland. The Bank is independent, community oriented, and conducts a full-service commercial banking business through 46 community offices located in Anne Arundel, Carroll, Frederick, Howard, Montgomery and Prince George's counties in Maryland, and Arlington, Fairfax and Loudoun counties in Virginia. The Bank is a state chartered bank subject to supervision and regulation by the Federal Reserve and the State of Maryland. The Bank's deposit accounts are insured by the Deposit Insurance Fund administered by the Federal Deposit Insurance Corporation (the "FDIC") to the maximum permitted by law. The Bank is a member of the Federal Reserve System and is an Equal Housing Lender. The Company, the Bank, and its other subsidiaries are Affirmative Action/Equal Opportunity Employers.



Overview

Net income for the Company for the second quarter of 2014 totaled $7.0 million ($0.28 per diluted share) as compared to net income of $12.2 million ($0.49 per diluted share) for the second quarter of 2013. For the first six months of 2014, net income totaled $17.9 million ($0.71 per diluted share), compared to net income of $22.7 million ($0.91 per diluted share), for the first six months of 2013. These results reflect the following events:



Average total loans for the second quarter of 2014 increased 10% compared to

the second quarter of 2013 due primarily to organic growth in the residential

mortgage and commercial investor real estate portfolios.

The net interest margin was 3.48% for the second quarter of 2014, compared to

3.51% for the second quarter of 2013 and 3.47% for the first quarter of 2014.

The decline from the prior year was the result of lower loan yields, primarily

in the commercial loan portfolio.

The provision for loan and lease losses was a charge of $0.2 million for the

second quarter of 2014 compared to a credit of $2.9 million for the second

quarter of 2013 and a credit of $1.0 million for the first quarter of 2014. The

increase in the provision for the second quarter of 2014 compared to the prior

year quarter was due primarily to an increase in the overall loan portfolio

during the quarter together with the timing of historical losses in the prior

year.

Non-interest income decreased $0.5 million or 4% for the second quarter of 2014

compared to the second quarter of 2013 due largely to a decrease in mortgage

banking activities resulting from a lower volume of refinancing activity. This

decrease was partially offset by a 5% increase in wealth management income due

to higher assets under management. 35



Non-performing loans decreased to $41.7 million at June 30, 2014 compared to

$46.2 million at June 30, 2013. The coverage ratio of the allowance for loan

and lease losses to non-performing loans was 91% at June 30, 2014 compared to a

coverage ratio of 84% at June 30, 2013.

A one-time charge of $6.1 million before taxes for damages resulting from

claims against the Company based on the actions of a former employee of CommerceFirst Bank, which was acquired by the Company in 2012. In the first six months of 2014, the Mid-Atlantic region continued to experience moderate economic improvement. Concerns over a slow-growth national economy and consumer and business uncertainty continued to impede both the regional and national economic outlook. While the housing markets have improved, this sector is still significantly below levels experienced in prior economic recoveries due in part to higher long-term interest rates and a lack of second-time home buyers. Positive trends in housing and consumer spending, together with a declining unemployment rate have been offset by concerns over the long-term effects of the Affordable Care Act and an increasing number of people leaving the workforce. The effect of geopolitical events in Europe and the Middle East and slower growth abroad also continue to provide underlying volatility. Together with state and municipal budget challenges across the country, these factors have caused enough Uncertainty, particularly among both individual consumers and small and large businesses, continues to suppress confidence and thus constrain the pace of economic growth and lending. Despite this challenging business environment, the Company has emphasized the fundamentals of community banking as it has maintained strong levels of liquidity and capital while overall credit quality has continued to improve. The net interest margin decreased to 3.48% in the second quarter of 2014 compared to 3.51% for the second quarter of 2013. During 2014, lower rates on average interest-earning assets and a slowing decline in funding costs served to offset the effect of loan growth. Average loans increased 10% for the second quarter of 2014 compared to the prior year quarter, while average total deposits increased 3% for the quarter compared to 2013.



Liquidity remained strong due to the borrowing lines with the Federal Home Loan Bank of Atlanta and the Federal Reserve and the size and composition of the investment portfolio.

The Company's credit quality continued to improve as non-performing assets decreased to $43.7 million at June 30, 2014 from $51.0 million at June 30, 2013. This decrease was due primarily to a combination of the Company's continuing efforts at resolution of non-performing loans, particularly in the commercial real estate portfolio. Non-performing assets represented 1.03% of total assets at June 30, 2014 compared to 1.25% at June 30, 2013. The ratio of net recoveries to average loans and leases was (0.03)% for the second quarter of 2014, compared to (0.10)% for the prior year quarter. Non-interest income decreased 4% in the second quarter of 2014 compared to the second quarter of 2013. This decline was driven by a significant decrease in mortgage banking income due primarily to lower origination of saleable mortgage loans. This was partially offset by a 5% increase in wealth management income due to market activity and growth in assets under management. Service charges on deposits decreased 3% due to lower overdraft fees. Non-interest expenses increased 24% in the second quarter of 2014 compared to the second quarter of 2013 due to the accrued expenses totaling $6.1 million related to a jury verdict against the Company for compensatory and punitive damages and related legal and other fees. The litigation involved actions by a former employee of CommerceFirst Bank, which was acquired by the Company in 2012. The Company is currently appealing this decision. Excluding this expense accrual, non-interest expenses increased 2% compared to the prior year quarter due primarily to higher occupancy and outside data services expenses. Total assets at June 30, 2014 increased 3% compared to December 31, 2013 primarily due to organic loan growth in the second quarter which was funded by a 6% increase in deposits. Loan balances increased 5% compared to the prior year end due primarily to increases of 9% in residential mortgage and construction loans, 6% in consumer loans and 5% in commercial investor real estate loans. Customer funding sources, which include deposits plus other short-term borrowings from core customers, increased 5% compared to balances at December 31, 2013. The increase in customer funding sources was driven primarily by a combined increase of 12% in interest-bearing and noninterest-bearing checking accounts together with increases of 8% in regular savings accounts and 35% in retail repurchase agreements. The Company continued to manage its net interest margin, primarily by managing rates on certificates of deposit and by utilizing short-term FHLB borrowings during this extended period of historically low interest rates. During the same period, stockholders' equity increased $18 million due to net income in the first six months of 2014. 36



Consolidated Average Balances, Yields and Rates

Six Months Ended June 30, 2014 2013 Annualized Annualized Average (1) Average Average (1) Average



(Dollars in thousands and tax-equivalent) Balances Interest

Yield/Rate Balances Interest Yield/Rate Assets Residential mortgage loans (2)

$ 646,238$ 11,191 3.46 % $ 577,905$ 10,686 3.70 % Residential construction loans 140,147 2,612 3.76 119,737 2,036 3.43 Commercial ADC loans 165,319 4,253 5.19 154,648 4,102 5.35 Commercial investor real estate loans 566,275 13,872 4.94 479,878 12,319 5.18 Commercial owner occupied real estate loans 582,042 14,213 5.08 564,468 15,103 5.53 Commercial business loans 349,162 8,091

4.67 342,679 9,042 5.18 Leasing 459 12 5.22 2,075 68 6.53 Consumer loans 383,983 6,326 3.34 359,114 6,164 3.49

Total loans and leases (3) 2,833,625 60,570 4.34 2,600,504 59,520 4.64 Taxable securities 699,460 8,715 2.49 750,167 8,594 2.29 Tax-exempt securities (4) 302,398 6,527 4.32 299,569 6,524 4.36 Interest-bearing deposits with banks 33,853 42 0.25 34,156 43 0.25 Federal funds sold 475 - 0.22 475 - 0.22 Total interest-earning assets 3,869,811 75,854 3.96 3,684,871 74,681 4.08 Less: allowance for loan and lease losses (38,864 ) (42,650 ) Cash and due from banks 45,268 46,242 Premises and equipment, net 45,787

47,832 Other assets 209,535 216,984 Total assets $ 4,131,537$ 3,953,279 Liabilities and Stockholders' Equity Interest-bearing demand deposits $ 468,677 194

0.08 % $ 433,200 183 0.09 % Regular savings deposits 255,667 97 0.08 237,467 106 0.09 Money market savings deposits 871,464 546 0.13 883,765 789 0.18 Time deposits 462,591 1,540 0.67 503,908 1,773 0.71

Total interest-bearing deposits 2,058,399 2,377

0.23 2,058,340 2,851 0.28 Other borrowings 65,889 75 0.23 61,132 87 0.29 Advances from FHLB 573,619 6,451 2.27 460,892 6,412 2.81 Subordinated debentures 35,000 437 2.50 35,000 450 2.57

Total interest-bearing liabilities 2,732,907 9,340 0.69 2,615,364 9,800 0.76 Noninterest-bearing demand deposits 862,830

818,326 Other liabilities 27,984 33,235 Stockholders' equity 507,816 486,354

Total liabilities and stockholders' equity $ 4,131,537$ 3,953,279 Net interest income and spread $ 66,514 3.27 % $ 64,881 3.32 % Less: tax-equivalent adjustment 2,613 2,623 Net interest income $ 63,901$ 62,258 Interest income/earning assets 3.96 % 4.08 % Interest expense/earning assets

0.48 0.53 Net interest margin 3.48 % 3.55 %



(1) Tax-equivalent income has been adjusted using the combined marginal federal

and state rate of 39.88% for 2014 and 2013. The annualized taxable-equivalent

adjustments utilized in the above table to compute yields aggregated to $2.6

million and $2.6 million in 2014 and 2013, respectively.

(2) Includes residential mortgage loans held for sale. Home equity loans and

lines are classified as consumer loans.

(3) Non-accrual loans are included in the average balances.

(4) Includes only investments that are exempt from federal taxes.

37 Results of Operations



For the Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013

Net income for the Company for the first six months of 2014 totaled $17.9 million ($0.71 per diluted share) compared to net income of $22.7 million ($0.91 per diluted share) for the first six months of 2013.

Net Interest Income

The largest source of the Company's operating revenue is net interest income, which is the difference between the interest earned on interest-earning assets and the interest paid on interest-bearing liabilities. For purposes of this discussion and analysis, the interest earned on tax-exempt investment securities has been adjusted to an amount comparable to interest subject to normal income taxes. The result is referred to as tax-equivalent interest income and tax-equivalent net interest income. The following discussion of net interest income should be considered in conjunction with the review of the information provided in the preceding table. Net interest income for the first six months of 2014 was $63.9 million compared to $62.3 million for the first six months of 2013. On a tax-equivalent basis, net interest income for the six months ended June 30, 2014 was $66.5 million compared to $64.9 million for the six months ended June 30, 2013, an increase of 3%. The preceding table provides an analysis of net interest income performance that reflects a net interest margin that decreased to 3.48% for the first six months of 2014 compared to 3.55% for the first six months of 2013. Average interest-earning assets increased by 5% while average interest-bearing liabilities increased 4% in the first half of 2014. Average noninterest-bearing deposits increased 5% in the first six months of 2014 while the percentage of average noninterest-bearing deposits to total deposits increased to 30% for the first six months of 2014 compared to 29% for the first six months of 2013. The decrease in the net interest margin was caused by the effect of lower rates on interest-earning assets that exceeded the benefit of lower rates on interest-bearing deposits and borrowings.



Effect of Volume and Rate Changes on Net Interest Income

The following table analyzes the reasons for the changes from year-to-year in the principal elements that comprise net interest income:

2014 vs. 2013 2013 vs. 2012 Increase Increase Or Due to Change In Average:* Or Due to Change In Average:*



(Dollars in thousands and tax equivalent) (Decrease) Volume

Rate (Decrease) Volume



Rate

Interest income from earning assets: Loans and leases $ 1,050$ 5,136$ (4,086 )$ 3,714$ 6,278$ (2,564 ) Securities 124 (700 ) 824 (1,919 ) (308 ) (1,611 ) Other earning assets (1 ) (1 ) - (3 ) (2 ) (1 ) Total interest income 1,173

4,435 (3,262 ) 1,792 5,968



(4,176 )

Interest expense on funding of earning assets: Interest-bearing demand deposits 11

21 (10 ) 12 25 (13 ) Regular savings deposits (9 ) 8 (17 ) 2 14 (12 ) Money market savings deposits (243 ) (11 ) (232 ) (194 ) 29 (223 ) Time deposits (233 ) (140 ) (93 ) (853 ) (285 ) (568 ) Total borrowings 14 1,333 (1,319 ) (826 ) 566 (1,392 ) Total interest expense (460 ) 1,211 (1,671 ) (1,859 ) 349 (2,208 ) Net interest income $ 1,633$ 3,224$ (1,591 )$ 3,651$ 5,619$ (1,968 )



* Variances that are the combined effect of volume and rate, but cannot be

separately identified, are allocated to the volume and rate variances based on

their respective relative amounts. Interest Income The Company's total tax-equivalent interest income for the first six months of 2014 increased 2% compared to the prior year period. The previous table shows that, in 2014, the increase in average loans and leases was offset by a continued decline in earning asset yields with respect to the loan portfolio. 38

In the first six months of 2014, the average balance of the loan portfolio increased 9% compared to the prior year period. This growth was primarily in the commercial investor real estate, residential mortgage and consumer loan portfolios. These increases were driven by organic loan growth as the regional economy improved. The yield on average loans and leases decreased by 30 basis points due to the continued prevailing low interest rate environment as relatively higher rate loans were paid off and new loans were originated at comparatively lower rates. The decline in the portfolio yield was driven primarily by a decrease of 16 basis points in the yield in the combined residential mortgage portfolio, a decrease of 37 basis points in the commercial loan portfolio and a decrease of 15 basis points in the yield on the overall consumer loan portfolio. The decrease in the yield on the mortgage loan portfolio was due to declining rates on both new and existing adjustable rate mortgage loans, which the Company does not sell but maintains in the portfolio, while the decline in the yield on the commercial loan portfolio was due to the continuing low interest rate environment and competition for quality loans. The average yield on total investment securities increased 16 basis points while the average balance of the portfolio declined 5% for the first six months of 2014 compared to the first six months of 2013. The increase in the yield on investments was due primarily to amortization of mortgage-backed securities together with calls and maturities of other securities.



Interest Expense

Interest expense decreased by $0.5 million or 5% in the first six months of 2014 compared to the first six months of 2013, primarily as a result of a 7 basis point decrease in the average rate paid on interest-bearing liabilities. Average deposits increased 2% during the first six months of 2014 compared to the first six months of 2013. Average noninterest-bearing and interest-bearing checking accounts increased $80 million or 6% and regular savings accounts increased $18 million or 8% as clients kept funds in short-term instruments to preserve liquidity. This growth was partially offset by a decrease in average certificates of deposit of $41 million or 8% in the first six months of 2014 compared to the prior year period. This decrease was primarily due to the Company's management of rates offered on certificates in an effort to preserve the Company's net interest margin during this extended period of historically low interest rates. Average balances of money market accounts decreased $12 million or 1% in the first six months of 2014 compared to the first six months of 2013. In addition, the average rate paid on advances from the Federal Home Loan Bank of Atlanta decreased 54 basis points for the first six months of 2014 compared to the first six months of 2013 due to an increase in short-term advances to take advantage of current low interest rates.



Non-interest Income

Non-interest income amounts and trends are presented in the following table for the periods indicated: Six Months Ended June 30, 2014 2014/2013 2014/2013 (Dollars in thousands) 2014 2013 $ Change % Change Securities gains $ - $ 118 $ (118 ) (100.0 )% Service charges on deposit accounts 4,061 4,219 (158 ) (3.7 ) Mortgage banking activities 886 2,764 (1,878 ) (67.9 ) Wealth management income 9,207 8,574 633 7.4 Insurance agency commissions 2,601 2,385 216 9.1 Income from bank owned life insurance 1,206 1,235 (29 ) (2.3 ) Visa check fees 2,147 2,036 111 5.5 Other income 2,835 3,303 (468 ) (14.2 ) Total non-interest income $ 22,943$ 24,634$ (1,691 ) (6.9 ) Total non-interest income was $22.9 million for the first six months of 2014 compared to $24.6 million for the first six months of 2013. The primary drivers of non-interest income for the first six months of 2014 were declines in mortgage banking income and other non-interest income which were somewhat offset by increases in wealth management income and income from insurance agency commissions. Further detail by type of non-interest income follows:



Income from mortgage banking activities decreased in 2014 compared to 2013 due

primarily to significantly reduced loan origination volumes from refinancing

activity.

Wealth management income is comprised of income from trust and estate services,

investment management fees earned by West Financial Services, the Company's

investment management subsidiary, and fees on sales on investment products and

services. Trust services fees increased 15% compared to the prior year period,

due to an increase in assets under management. Investment management fees in

West Financial Services increased 11% for the first six months of 2014 compared

to the first six months of 2013, also due to higher assets under management.

Fees on sales of investment products and services decreased 13% for the first

half of 2014, due to one-time sales of insurance policies in 2013 and lower

sales of securities products in the second quarter of 2014. Overall total

assets under management increased to $2.7 billion at June 30, 2014 compared to

$2.3 billion at June 30, 2013 as a result of positive market movements and

additions from new and existing clients. 39



Insurance agency commissions increased in 2014 compared to 2013 due primarily

to higher annual contingency commissions in the first quarter based on annual

policy performance.

Other non-interest income decreased during the first six months of 2014

compared to the prior year period due mainly to gains on sales and dispositions

of loans and fixed assets and a non-recurring legal settlement, all of which

occurred in the first quarter of 2013.

Service charges on deposits decreased in 2014 compared to 2013 due primarily to

a decline in overdraft fees.

Income from bank owned life insurance decreased in the first six months of 2014

compared to the first six months of 2013 due to the decline in the interest

rates paid on these policies. The Company invests in bank owned life insurance

products in order to manage the cost of employee benefit plans. Investments

totaled $87.4 million at June 30, 2014 and $84.9 million at June 30, 2013 and

were well diversified by carrier in accordance with defined policies and

practices. The average tax-equivalent yield on these insurance contract assets

was 4.64% for the first six months of 2014 compared to 4.92% for the prior year

period.

No net OTTI losses were recognized in earnings in either the first six months

of 2014 or 2013. Non-interest Expense Non-interest expense amounts and trends are presented in the following table for the years indicated: Six Months Ended June 30, 2014 2014/2013 2014/2013 (Dollars in thousands) 2014 2013 $ Change % Change

Salaries and employee benefits $ 32,829$ 32,509$ 320 1.0 % Occupancy expense of premises 6,746

6,178 568 9.2 Equipment expenses 2,518 2,476 42 1.7 Marketing 1,344 1,270 74 5.8 Outside data services 2,432 2,266 166 7.3 FDIC insurance 1,093 1,177 (84 ) (7.1 )

Amortization of intangible assets 594 922 (328 ) (35.6 ) Litigation settlement and associated costs 6,128

- 6,128 - Professional fees 2,206 2,582 (376 ) (14.6 ) Other real estate owned 9 (244 ) 253 (103.7 ) Other expenses 5,791 6,195 (404 ) (6.5 ) Total non-interest expense $ 61,690$ 55,331$ 6,359 11.5 Non-interest expenses totaled $61.7 million in 2014 compared to $55.3 million in 2013. This increase in expenses was driven primarily by nonrecurring litigation expenses mentioned previously. Excluding the litigation expenses, non-interest expenses remained virtually level with the prior year period.



Further detail by category of non-interest expense follows:

Salaries and employee benefits, the largest component of non-interest expenses,

remained virtually level compared to the prior year period. Salaries increased

5% compared to the prior year period due to a larger staff and merit increases

which were offset by decreases in commission and incentive compensation due

largely to lower mortgage origination volumes. Benefits expense decreased 11%

in 2014 compared to 2013 due primarily to a decrease in pension expense

resulting from a higher discount rate assumption and higher projected returns

on plan assets. The average number of full-time equivalent employees was 722 in

the first six months of 2014 compared to 706 in the first six months of 2013.

Occupancy expenses increased in 2014 compared to 2013 due primarily to a

significant increase in weather-related expenses in the first six months of

2014. Equipment expenses remained level for 2014 compared to 2013.

Marketing expenses increased in 2014 compared to 2013 due to higher advertising

and public relations expenses. 40



The growth in outside data services expenses was due to contractual increases

by providers and higher bankcard account activity.

FDIC insurance expense decreased in 2014 compared to 2013 as the Company's

growth in assets was more than offset by a lower assessment rate due to

improved financial ratios.

Intangibles amortization decreased in 2014 due to the costs of prior year

acquisitions which were fully amortized during the period.

Professional fees declined as legal fees associated with loan workouts

decreased in the first six months of 2014 compared to the prior year period.

Other real estate owned expenses increased compared to the prior year period

due to a gain on the sale of one property in the second quarter of 2013.

Other non-interest expenses, excluding the nonrecurring litigation expenses

mentioned above, decreased 7% in 2014 compared to 2013 due mainly to decreases

in various categories of operating expenses. Income Taxes The Company had income tax expense of $8.1 million in the first six months of 2014, compared to expense of $11.6 million in the first six months of 2013. The resulting effective rate was 31% for the first six months of 2014 and 34% for the first six months of 2013. The effective rate decreased in 2014 compared to 2013 due to tax exempt income comprising a greater proportion of income before taxes. Results of Operations



For the Three Months Ended June 30, 2014 Compared to the Three Months Ended June 30, 2013

Net income for the Company for the second quarter of 2014 totaled $7.0 million ($0.28 per diluted share) compared to net income of $12.1 million ($0.49 per diluted share) for the second quarter of 2013. Net Interest Income Net interest income for the second quarter of 2014 was $32.3 million compared to $30.9 million for the second quarter of 2013. On a tax-equivalent basis, net interest income for the second quarter of 2014 was $33.6 million compared to $32.2 million for the second quarter of 2013, an increase of 4%. Average interest-earning assets increased by 5% while average interest-bearing liabilities increased 4% in the second quarter of 2014. Average noninterest-bearing deposits increased 7% in the second quarter of 2014 while the percentage of average noninterest-bearing deposits to total deposits increased to 30% for the second quarter of 2014 compared to 29% for the second quarter of 2013. The decrease in the net interest margin was caused by the effect of lower rates on interest-earning assets that exceeded the benefit of lower rates on interest-bearing deposits and borrowings.



Interest Income

The Company's total tax-equivalent interest income for the second quarter of 2014 totaled $38.3 million compared to $37.1 million for the second quarter of 2013, an increase of 3%. In the second quarter of 2014, the average balance of the loan portfolio increased 10% compared to the prior year period. This growth was primarily in the commercial investor real estate, residential mortgage and construction and consumer loan portfolios. These increases were driven by organic loan growth as the regional economy improved. The yield on average loans and leases decreased by 23 basis points due to the continued prevailing low interest rate environment as relatively higher rate loans were paid off and new loans were originated at comparatively lower rates. The decline in the portfolio yield was driven primarily by a decrease of 15 basis points in the yield in the combined residential mortgage portfolio, a decrease of 24 basis points in the commercial loan portfolio and a decrease of 15 basis points in the yield on the overall consumer loan portfolio. The decrease in the yield on the mortgage loan portfolio was due to declining rates on both new and existing adjustable rate mortgage loans, which the Company does not sell but maintains in the portfolio, while the decline in the yield on the commercial and consumer loan portfolios was due to the continuing low interest rate environment and competition for quality loans. The average yield on total investment securities increased 15 basis points while the average balance of the portfolio rose 5% for the second quarter of 2014 compared to the second quarter of 2013. The decrease in the yield on investments was due primarily to amortization of mortgage-backed securities whose proceeds were used to fund loan growth. 41 Interest Expense Interest expense decreased by $0.2 million or 3% in the second quarter of 2014 compared to the second quarter of 2013, primarily as a result of a 6 basis point decrease in the average rate paid on interest-bearing liabilities. Deposit activity during the second quarter was driven primarily by growth in regular savings and demand deposit accounts. Average noninterest-bearing and interest-bearing checking accounts increased $95 million or 7% and regular savings accounts increased $22 million or 9% as clients kept funds in short-term instruments to preserve liquidity. This growth was partially offset by a decrease in average certificates of deposit of $34 million or 7% in the second quarter of 2014 compared to the prior year period. This decrease was primarily due to the Company's management of rates offered on certificates in an effort to preserve the Company's net interest margin during this extended period of historically low interest rates. Average balances of money market accounts decreased $10 million or 1% in the second quarter of 2014 compared to the second quarter of 2013. In addition, the average rate paid on advances from the Federal Home Loan Bank of Atlanta decreased 45 basis points for the second quarter of 2014 compared to the second quarter of 2013 due to an increase in short-term advances to take advantage of current low interest rates.



Non-interest Income

Non-interest income amounts and trends are presented in the following table for the periods indicated: Three Months Ended June 30, 2014/2013 2014/2013 (Dollars in thousands) 2014 2013 $ Change % Change Securities gains $ - $ 62 $ (62 ) (100.0 )% Service charges on deposit accounts 2,089 2,150 (61 ) (2.8 ) Mortgage banking activities 570 1,237 (667 ) (53.9 ) Wealth management income 4,741 4,532 209 4.6 Insurance agency commissions 961 1,036 (75 ) (7.2 ) Income from bank owned life insurance 608 623

(15 ) (2.4 ) Bank card fees 1,169 1,079 90 8.3 Other income 1,556 1,496 60 4.0

Total non-interest income $ 11,694$ 12,215

$ (521 ) (4.3 )

Total non-interest income was $11.7 million for the second quarter of 2014 compared to $12.2 million for the second quarter of 2013. The primary drivers of non-interest income for the second quarter of 2014 were a decline in mortgage banking income that was somewhat offset by increases in wealth management income and bank card fees. Further detail by type of non-interest income follows:



Income from mortgage banking activities decreased in 2014 compared to 2013 due

primarily to significantly reduced loan origination volumes from refinancing

activity.

Wealth management income is comprised of income from trust and estate services,

investment management fees earned by West Financial Services, the Company's

investment management subsidiary, and fees on sales on investment products and

services. Trust services fees increased 16% compared to the prior year period,

due to one-time fees and an increase in assets under management. Investment

management fees in West Financial Services increased 12% for the second quarter

of 2014 compared to the second quarter of 2013, also due to higher assets under

management. Fees on sales of investment products and services decreased 25% for

the second quarter of 2014, due to one-time sales of insurance policies in the

second quarter of 2013 and lower sales of securities products in the second

quarter of 2014. Overall total assets under management increased to $2.7

billion at June 30, 2014 compared to $2.3 billion at June 30, 2013 as a result

of positive market movements and additions from new and existing clients.

Insurance agency commissions decreased in 2014 compared to 2013 due primarily

to a decrease in physicians' liability insurance.

Service charges on deposits decreased in 2014 compared to 2013 due primarily to

a decline in overdraft fees.

Income from bank owned life insurance decreased in the second quarter of 2014

compared to the second quarter of 2013 due to the decline in the interest rates

paid on these policies.

Other non-interest income decreased during the second quarter of 2014 compared

to the prior year period due mainly to gains on sales and dispositions of loans

and fixed assets and a non-recurring legal settlement, all of which occurred in

the second quarter of 2013.

No net OTTI losses were recognized in earnings in either the second quarter of

2014 or 2013. 42

Non-interest Expense Non-interest expense amounts and trends are presented in the following table for the years indicated: Three Months Ended June 30, 2014/2013 2014/2013 (Dollars in thousands) 2014 2013 $ Change % Change Salaries and employee benefits 16,474 $ 16,163$ 311 1.9 % Occupancy expense of premises 3,274

2,996 278 9.3 Equipment expenses 1,262 1,227 35 2.9 Marketing 802 755 47 6.2 Outside data services 1,216 1,114 102 9.2 FDIC insurance 573 581 (8 ) (1.4 )

Amortization of intangible assets 224 461 (237 ) (51.4 ) Litigation settlement and associated costs 6,128

- 6,128 - Professional fees 1,292 1,332 (40 ) (3.0 ) Other real estate owned 9 (281 ) 290 (103.2 ) Other expenses 2,887 3,160 (273 ) (8.6 ) Total non-interest expense $ 34,141$ 27,508$ 6,633 24.1 Non-interest expenses totaled $34.1 million in 2014 compared to $27.5 million in 2013. This increase in expenses was driven primarily by nonrecurring litigation expenses mentioned previously. Further detail by category of non-interest expense follows:



Salaries and employee benefits, the largest component of non-interest expenses,

remained virtually level compared to the prior year period. Salaries increased

4% compared to the prior year quarter due to a larger staff and merit increases

which were somewhat offset by decreases in commission and incentive

compensation due largely to lower mortgage origination volumes. Benefits

expenses decreased 6% compared to the second quarter of 2013 due primarily to a

decrease in pension expense resulting from a higher discount rate assumption

and higher projected returns on plan assets. The average number of full-time

equivalent employees was 723 in the second quarter of 2014 compared to 713 in

the second quarter of 2013.

Occupancy expenses increased in 2014 compared to 2013 due primarily to weather

related expenses and repairs in the second quarter of 2014. Equipment increased

for 2014 compared to 2013 due to upgraded power equipment installed in the

branch network.

Marketing expenses increased in 2014 compared to 2013 due to higher advertising

expenses.

The growth in outside data services expenses was due to contractual increases

by providers and bankcard account activity.

FDIC insurance expense remained virtually level for the second quarter of 2014

compared to the second quarter of 2013 as the Company's growth in assets was

offset by a lower assessment rate due to improved financial ratios.

Intangibles amortization decreased in 2014 due to the costs of prior year

acquisitions which were fully amortized during the period.

Professional fees declined as legal fees decreased in the second quarter of

2014 compared to the prior year quarter due to lower expenses related to loan

workouts.

Other real estate owned expenses increased compared to the prior year period

due to a gain on the sale of one property in the second quarter of 2013.

Other non-interest expenses decreased in 2014 compared to the prior year

quarter due mainly to decreases in various categories of operating expenses.

Income Taxes The Company had income tax expense of $2.7 million in the second quarter of 2014, compared to expense of $6.4 million in the second quarter of 2013. The resulting effective rate was 28% for the second quarter of 2014 compared to 34% for the second quarter of 2013. The effective rate decreased in 2014 compared to 2013 due to tax exempt income comprising a greater proportion of income before taxes. 43



Operating Expense Performance

Management views the GAAP efficiency ratio as an important financial measure of expense performance and cost management. The ratio expresses the level of non-interest expenses as a percentage of total revenue (net interest income plus total non-interest income). Lower ratios indicate improved productivity.



Non-GAAP Financial Measures

The Company also uses a traditional efficiency ratio that is a non-GAAP financial measure of operating expense control and efficiency of operations. Management believes that its traditional ratio better focuses attention on the operating performance of the Company over time than does a GAAP ratio, and is highly useful in comparing period-to-period operating performance of the Company's core business operations. It is used by management as part of its assessment of its performance in managing non-interest expenses. However, this measure is supplemental, and is not a substitute for an analysis of performance based on GAAP measures. The reader is cautioned that the non-GAAP efficiency ratio used by the Company may not be comparable to GAAP or non-GAAP efficiency ratios reported by other financial institutions. In general, the efficiency ratio is non-interest expenses as a percentage of net interest income plus non-interest income. Non-interest expenses used in the calculation of the non-GAAP efficiency ratio exclude goodwill impairment losses, the amortization of intangibles, and non-recurring expenses. Income for the non-GAAP ratio includes the favorable effect of tax-exempt income, and excludes securities gains and losses, which vary widely from period to period without appreciably affecting operating expenses, and non-recurring gains. The measure is different from the GAAP efficiency ratio, which also is presented in this report. The GAAP measure is calculated using non-interest expense and income amounts as shown on the face of the Consolidated Statements of Income. The GAAP and non-GAAP efficiency ratios are reconciled and provided in the following table. The GAAP efficiency ratio increased in 2014 compared to the prior year due to the litigation expenses mentioned previously. The non-GAAP efficiency ratio increased in 2014 compared to the prior year due primarily to a decrease in non-interest income.

In addition, the Company uses pre-tax, pre-provision income as a measure of the level of recurring income before taxes. Management believes this provides financial statement users with a useful metric of the run-rate of revenues and expenses which is readily comparable to other financial institutions. This measure is calculated by adding (subtracting) the provision (credit) for loan and lease losses, and the provision for income taxes back to net income. This metric increased in the second quarter of 2014 compared to the prior year period due primarily to growth in net interest income. 44



GAAP and Non-GAAP Financial Measures

Three Months Ended Six Months Ended June 30, June 30, (Dollars in thousands) 2014 2013 2014 2013 Pre-tax pre-provision income: Net income $ 6,982$ 12,162$ 17,910$ 22,720 Plus non-GAAP adjustment: Litigation expenses 6,128 - 6,128 - Income taxes 2,722 6,353 8,068 11,639 Provision (credit) for loan and lease losses 158 (2,876 ) (824 ) (2,798 ) Pre-tax pre-provision income $ 15,990$ 15,639$ 31,282$ 31,561 Efficiency ratio - GAAP basis: Non-interest expenses $ 34,141$ 27,508 $



61,690 $ 55,331

Net interest income plus non-interest income $ 44,003$ 43,147$ 86,844$ 86,892 Efficiency ratio - GAAP basis 77.59 % 63.75 % 71.04 % 63.68 % Efficiency ratio - Non-GAAP basis: Non-interest expenses $ 34,141$ 27,508$ 61,690$ 55,331 Less non-GAAP adjustment: Amortization of intangible assets 224 461 594 922 Litigation expenses 6,128 - 6,128 -



Non-interest expenses - as adjusted $ 27,789$ 27,047$ 54,968$ 54,409

Net interest income plus non-interest income $ 44,003$ 43,147$ 86,844$ 86,892 Plus non-GAAP adjustment: Tax-equivalent income 1,331 1,312 2,613 2,623 Less non-GAAP adjustments: Securities gains - 62 - 118 Net interest income plus non-interest income - as adjusted $ 45,334$ 44,397 $



89,457 $ 89,397

Efficiency ratio - Non-GAAP basis 61.30 % 60.92 %

61.45 % 60.86 % FINANCIAL CONDITION

The Company's total assets were $4.2 billion at June 30, 2014, an increase of $128 million or 3% compared to $4.1 billion at December 31, 2013. Interest-earning assets increased $109 million to $3.9 billion at June 30, 2014 compared to December 31, 2013. The increase in interest-earning assets was primarily due to organic growth in the loan portfolio which was funded by deposit growth. 45 Analysis of Loans and Leases A comparison of the loan portfolio at the dates indicated is presented in the following table: June 30, 2014 December 31, 2013 Period-to-Period Change (Dollars in thousands) Amount % Amount % $ Change % Change Residential real estate: Residential mortgage $ 668,536 23.0 % $ 618,381 22.2 % $ 50,155 8.1 % Residential construction 149,321 5.1 129,177 4.7 20,144 15.6 Commercial real estate: Commercial owner occupied real estate 581,795 20.0 592,823 21.3 (11,028 ) (1.9 ) Commercial investor real estate 577,813 19.9 552,178 19.8 25,635 4.6 Commercial acquisition, development and construction 178,972 6.1 160,696 5.8 18,276 11.4 Commercial Business 357,472 12.3 356,651 12.8 821 0.2 Leases 260 - 703 - (443 ) (63.0 ) Consumer 396,775 13.6 373,657 13.4 23,118 6.2 Total loans and leases $ 2,910,944 100.0 % $ 2,784,266 100.0 % $ 126,678 4.5 Total loans and leases, excluding loans held for sale, increased $127 million or 5% at June 30, 2014 compared to December 31, 2013. The commercial loan portfolio increased $34 million or 2% at June 30, 2014 compared to the prior year end largely due to increases in investor real estate and ADC loans which were somewhat offset by a decrease in owner occupied loans. These trends reflect both an improving economy and increased competition in the Company's marketplace

for quality commercial loans. The residential real estate portfolio, which is comprised of residential construction and permanent residential mortgage loans, reflected a 9% increase at June 30, 2014 compared to December 31, 2013. Permanent residential mortgages, most of which are 1-4 family, increased 8% due to higher loan origination volumes of adjustable rate and non-saleable mortgage loans which the Company elected to retain in its portfolio. The Company generally retains adjustable rate mortgages in its portfolio and sells the fixed rate mortgages that it originates in the secondary mortgage market whenever possible. Residential construction loans increased 16% at June 30, 2014 compared to the balance at December 31, 2013 due to increased construction activity as a result of a slowly improving economy. The consumer loan portfolio increased 6% at June 30, 2014 compared to December 31, 2013 due to growth in home equity lines of credit as the Company continued to aggressively promote this product line. 46



Analysis of Investment Securities

The composition of investment securities at the periods indicated is presented in the following table: June 30, 2014 December 31, 2013 Period-to-Period Change (Dollars in thousands) Amount % Amount % $ Change % change



Available-for-Sale:

U.S. government agencies and corporations $ 144,443 14.7 % $ 139,466 13.7 % $ 4,977 3.6 % State and municipal 167,831 17.1 165,428 16.3 2,403 1.5 Mortgage-backed 404,745 41.4 442,250 43.5 (37,505 ) (8.5 ) Corporate debt 2,001 0.2 2,004 0.2 (3 ) (0.1 ) Trust preferred 1,142 0.1 1,413 0.1 (271 ) (19.2 ) Marketable equity securities 723 - 723 - - - Total available-for-sale 720,885 73.5 751,284 73.8 (30,399 ) (4.0 ) Held-to-Maturity and Other Equity U.S. government agencies and corporations 64,508 6.6 64,505 6.4 3 - State and municipal 158,792 16.2 159,889 15.8 (1,097 ) (0.7 ) Mortgage-backed 218 - 244 - (26 ) (10.7 ) Other equity securities 36,127 3.7 40,687 4.0 (4,560 ) (11.2 ) Total held-to-maturity and other equity 259,645 26.5 265,325 26.2 (5,680 ) (2.1 ) Total securities $ 980,530 100.0 % $ 1,016,609 100.0 % $ (36,079 ) (3.5 )



Available-for-sale securities decreased 4% at June 30, 2014 compared to December 31, 2013 due to amortization of mortgage-backed securities and calls and maturities of other investments, while held-to-maturity securities remained level compared to the prior year-end.

The investment portfolio consists primarily of U.S. Agency securities, U.S. Agency mortgage-backed securities, U.S. Agency collateralized mortgage obligations and state and municipal securities. The duration of the portfolio was 3.5 years at June 30, 2014 and 3.9 years at December 31, 2013. The Company considers the duration of the portfolio to be adequate for liquidity purposes. This investment strategy has resulted in a portfolio with low credit risk that would provide the required liquidity needed to meet increased loan demand. The portfolio is monitored on a continuing basis with consideration given to interest rate trends and the structure of the yield curve and with constant assessment of economic projections and analysis. At June 30, 2014, the trust preferred portfolio included one pooled trust preferred security backed by debt issued by banks and thrifts, which totaled $1.3 million, with a fair value of $1.1 million. The fair value of this security was determined by a third party valuation specialist due to the limited trading activity for this security in the marketplace. The specialist used an income valuation approach technique (present value) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The methodology, observable inputs and significant assumptions employed by the specialist to determine fair value are provided in Note 2 - Investments in the Notes to the Condensed Consolidated Financial Statements. As a result of this valuation, it was determined that the pooled trust preferred security had not incurred any credit-related OTTI for the three months ended June 30, 2014. Cumulative credit-related OTTI of $0.5 million has been recognized in earnings through June 30, 2014. Non-credit related OTTI on this security, which is not expected to be sold and which the Company has the ability to hold until maturity, was $0.2 million at June 30, 2014. This non-credit related OTTI was recognized in accumulated other comprehensive income ("OCI") at June 30, 2014. Other Earning Assets Residential mortgage loans held for sale remained virtually level at June 30, 2014 compared to the balance at December 31, 2013. The aggregate of federal funds sold and interest-bearing deposits with banks increased $17 million to $45 million at June 30, 2014 compared to December 31, 2013. 47 Deposits The composition of deposits at the periods indicated is presented in the following table: June 30, 2014 December 31, 2013 Period-to-Period Change (Dollars in thousands) Amount % Amount % $ Change % change Noninterest-bearing deposits $ 984,700 32.4 % $ 836,198 29.1 % $ 148,502 17.8 % Interest-bearing deposits: Demand 469,195 15.4 460,824 16.0 8,371 1.8 Money market savings 859,994 28.3 870,653 30.2 (10,659 ) (1.2 ) Regular savings 263,018 8.6 243,813 8.5 19,205 7.9



Time deposits of less than $100,000 251,743 8.3 263,636 9.2

(11,893 ) (4.5 )



Time deposits of $100,000 or more 210,020 7.0 202,101 7.0

7,919 3.9 Total interest-bearing deposits 2,053,970 67.6 2,041,027 70.9 12,943 0.6 Total deposits $ 3,038,670 100.0 % $ 2,877,225 100.0 % $ 161,445 5.6 Total deposits increased $161 million or 6% at June 30, 2014 compared to December 31, 2013. This increase was due primarily to increases in combined noninterest-bearing and interest-bearing checking accounts together with regular savings. These increases were somewhat offset by a decline in certificates of deposit, as the Company managed its deposit mix. From a funding perspective, the overall increase in deposits enabled the Company to decrease borrowings 8% at June 30, 2014 compared to December 31, 2013.



Capital Management

Management monitors historical and projected earnings, dividends and asset growth, as well as risks associated with the various types of on and off-balance sheet assets and liabilities, in order to determine appropriate capital levels. During the second quarter of 2014, total stockholders' equity increased $18 million to $517 million at June 30, 2014, from $499 million at December 31, 2013. This increase was due primarily to net income during the year. The ratio of average equity to average assets was 12.29% for the first six months of 2014, as compared to 12.30% for the first six months of 2013. Bank holding companies and banks are required to maintain capital ratios in accordance with guidelines adopted by the federal bank regulators. These guidelines are commonly known as Risk-Based Capital guidelines. The actual regulatory ratios and required ratios for capital adequacy, in addition to the ratios required to be categorized as "well capitalized", are summarized for the Company in the following table. Risk-Based Capital Ratios Minimum Ratios at Regulatory June 30, 2014 December 31, 2013 Requirements Total Capital to risk-weighted assets 15.66 % 15.65 % 8.00 % Tier 1 Capital to risk-weighted assets 14.48 %

14.42 % 4.00 % Tier 1 Leverage 11.37 % 11.32 % 3.00 %

Tier 1 capital of $463 million and total qualifying capital of $501 million each included $35.0 million in trust preferred securities that are considered regulatory capital for purposes of determining the Company's Tier 1 capital ratio. As of June 30, 2014, the most recent notification from the Bank's primary regulator categorized the Bank as a "well-capitalized" institution under the prompt corrective action rules of the Federal Deposit Insurance Act. Designation as a well-capitalized institution under these regulations is not a recommendation or endorsement of the Company or the Bank by federal bank regulators. 48 In July 2013, the Federal Reserve Board approved revisions to its capital adequacy guidelines and prompt corrective action rules that implement the revised standards of the Basel Committee on Banking Supervision, commonly called Basel III, and address relevant provisions of the Dodd-Frank Act. The rules include new risk-based capital and leverage ratios, which are effective January 1, 2015, and revise the definition of what constitutes "capital" for calculating those ratios. The new minimum capital level requirements applicable to the Company and the Bank will be: (1) a new common equity Tier 1 capital ratio of 4.5%; (2) a Tier 1 capital ratio of 6% (increased from 4%); (3) a total capital ratio of 8% (unchanged from current rules); and (4) a Tier 1 leverage ratio of 4%. The rules eliminate the inclusion of certain instruments, such as trust preferred securities, from Tier 1 capital. Instruments issued prior to May 19, 2010 will be grandfathered for companies with consolidated assets of $15 billion or less. The rules also establish a "capital conservation buffer" of 2.5% above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The new capital conservation buffer requirement will be phased in beginning in January 2016 at 0.625% of risk-weighted assets and will increase by that amount each year until fully implemented in January 2019. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses to executive officers if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such action. Tangible Common Equity Tangible equity, tangible assets and tangible book value per share are non-GAAP financial measures calculated using GAAP amounts. Tangible common equity and tangible assets exclude the balances of goodwill and other intangible assets from stockholder's equity and total assets, respectively. Management believes that this non-GAAP financial measure provides information to investors that may be useful in understanding our financial condition. Because not all companies use the same calculation of tangible equity and tangible assets, this presentation may not be comparable to other similarly titled measures calculated by other companies. A reconciliation of the non-GAAP ratio of tangible equity to tangible assets and tangible book value per share is provided in the following table.



Tangible Common Equity Ratio - Non-GAAP

(Dollars in thousands, except per share data) June 30, 2014December 31,2013 Tangible common equity ratio:

Total stockholders' equity $ 517,269 $



499,363

Accumulated other comprehensive income (loss) (5,233 )

2,970 Goodwill (84,171 ) (84,171 ) Other intangible assets, net (737 ) (1,330 ) Tangible common equity $ 427,128 $ 416,832 Total assets $ 4,234,342$ 4,106,100 Goodwill (84,171 ) (84,171 ) Other intangible assets, net (737 ) (1,330 ) Tangible assets $ 4,149,434$ 4,020,599 Tangible common equity ratio 10.29 % 10.37 % Tangible book value per share $ 17.04 $ 16.68 Credit Risk

The fundamental lending business of the Company is based on understanding, measuring and controlling the credit risk inherent in the loan portfolio. The Company's loan and lease portfolio is subject to varying degrees of credit risk. Credit risk entails both general risks, which are inherent in the process of lending, and risk specific to individual borrowers. The Company's credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry or collateral type. Typically, each consumer and residential lending product has a generally predictable level of credit losses based on historical loss experience. Home mortgage and home equity loans and lines generally have the lowest credit loss experience. Loans secured by personal property, such as auto loans, generally experience medium credit losses. Unsecured loan products, such as personal revolving credit, have the highest credit loss experience and for that reason, the Company has chosen not to engage in a significant amount of this type of lending. Credit risk in commercial lending can vary significantly, as losses as a percentage of outstanding loans can shift widely during economic cycles and are particularly sensitive to changing economic conditions. Generally, improving economic conditions result in improved operating results on the part of commercial customers, enhancing their ability to meet their particular debt service requirements. Improvements, if any, in operating cash flows can be offset by the impact of rising interest rates that may occur during improved economic times. Inconsistent economic conditions may have an adverse effect on the operating results of commercial customers, reducing their ability to meet debt service obligations. 49

Current economic data has shown that the Mid-Atlantic region remains one of the stronger markets in the nation. While the Company deals with the effects of a very slow and uneven economic recovery and its resulting effects on its borrowers, it continues to seek relationship opportunities, particularly in the real estate sector. Total non-performing loans increased 4% to $42 million at June 30, 2014 compared to the balance at December 31, 2013 as the Company pursued an aggressive workout strategy on weak loan credits. While the diversification of the lending portfolio among different commercial, residential and consumer product lines along with different market conditions of the D.C. suburbs, Northern Virginia and Baltimore metropolitan area has mitigated some of the risks in the portfolio, local economic conditions and levels of non-performing loans may continue to be influenced by the economic activity being experienced in various business sectors on both a regional and national level.

To control and manage credit risk, management has a credit process in place to reasonably ensure that credit standards are maintained along with an in-house loan administration accompanied by oversight and review procedures. The primary purpose of loan underwriting is the evaluation of specific lending risks and involves the analysis of the borrower's ability to service the debt as well as the assessment of the value of the underlying collateral. Oversight and review procedures include the monitoring of portfolio credit quality, early identification of potential problem credits and the aggressive management of problem credits. As part of the oversight and review process, the Company maintains an allowance for loan and lease losses (the "allowance"). The allowance represents an estimation of the losses that are inherent in the loan and lease portfolio. The adequacy of the allowance is determined through careful and ongoing evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish an adequate allowance for loan losses. Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period operating expense. The methodology for assessing the appropriateness of the allowance includes: (1) a general allowance that reflects historical losses, as adjusted, by credit category, and (2) a specific allowance for impaired credits on an individual or portfolio basis. This methodology is further described in the section entitled "Critical Accounting Policies" and in "Note 1 - Significant Accounting Policies" of the Notes to the Consolidated Financial Statements. The amount of the allowance is reviewed monthly and approved quarterly by the Credit and Investment Risk Committee of the board of directors. The Company recognizes a collateral dependent lending relationship as non-performing when either the loan becomes 90 days delinquent or as a result of factors (such as bankruptcy, interruption of cash flows, etc.) considered at the monthly credit committee meeting. When a commercial loan is placed on non-accrual status, it is considered to be impaired and all accrued but unpaid interest is reversed. Classification as an impaired loan is based on a determination that the Company may not collect all principal and interest payments according to contractual terms. Impaired loans exclude large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment such as leases, residential real estate and consumer loans. Typically, all payments received on non-accrual loans are applied to the remaining principal balance of the loans. Integral to the assessment of the allowance process is an evaluation that is performed to determine whether a specific allowance on an impaired loan is warranted and, when losses are confirmed, a charge-off is taken to reduce the loan to its net realizable value. Any further collateral deterioration results in either further specific allowances being established or additional charge-offs. At such time an action plan is agreed upon for the particular loan and an appraisal will be ordered depending on the time elapsed since the prior appraisal, the loan balance and/or the result of the internal evaluation. A current appraisal on large loans is usually obtained if the appraisal on file is more than 12 months old and there has been a material change in market conditions, zoning, physical use or the adequacy of the collateral based on an internal evaluation. The Company's policy is to strictly adhere to regulatory appraisal standards. If an appraisal is ordered, no more than a 30 day turnaround is requested from the appraiser, who is selected by Credit Administration from an approved appraiser list. After receipt of the updated appraisal, the assigned credit officer will recommend to the Chief Credit Officer whether a specific allowance or a charge-off should be taken. The Chief Credit Officer has the authority to approve a specific allowance or charge-off between monthly credit committee meetings to insure that there are no significant time lapses during this process. 50

The Company's methodology for evaluating whether a loan is impaired begins with risk-rating credits on an individual basis and includes consideration of the borrower's overall financial condition, payment record and available cash resources that may include the sufficiency of collateral value and, in a select few cases, verifiable support from financial guarantors. In measuring impairment, the Company looks primarily to the discounted cash flows of the project itself or to the value of the collateral as the primary sources of repayment of the loan. The Company may consider the existence of guarantees and the financial strength and wherewithal of the guarantors involved in any loan relationship. Guarantees may be considered as a source of repayment based on the guarantor's financial condition and respective payment capacity. Accordingly, absent a verifiable payment capacity, a guarantee alone would not be sufficient to avoid classifying the loan as impaired.



Management has established a credit process that dictates that structured procedures be performed to monitor these loans between the receipt of an original appraisal and the updated appraisal. These procedures include the following:

An internal evaluation is updated quarterly to include borrower financial

statements and/or cash flow projections.



The borrower may be contacted for a meeting to discuss an updated or revised

action plan which may include a request for additional collateral.



Re-verification of the documentation supporting the Company's position with

respect to the collateral securing the loan. At the monthly credit committee meeting the loan may be downgraded and a specific allowance may be decided upon in advance of the receipt of the appraisal.



Upon receipt of the updated appraisal (or based on an updated internal

financial evaluation) the loan balance is compared to the appraisal and a

specific allowance is decided upon for the particular loan, typically for the

amount of the difference between the appraisal and the loan balance.



The Company will specifically reserve for or charge-off the excess of the loan

amount over the amount of the appraisal net of closing costs. In certain cases

the Company may establish a larger reserve due to knowledge of current market

conditions or the existence of an offer for the collateral that will facilitate

a more timely resolution of the loan. If an updated appraisal is received subsequent to the preliminary determination of a specific allowance or partial charge-off, and it is less than the initial appraisal used in the initial charge-off, an additional specific allowance or charge-off is taken on the related credit. Partially charged-off loans are not written back up based on updated appraisals and always remain on non-accrual with any and all subsequent payments applied to the remaining balance of the loan as principal reductions. No interest income is recognized on loans that have been partially charged-off. Loans that have their terms restructured (e.g., interest rates, loan maturity date, payment and amortization period, etc.) in circumstances that provide payment relief or other concessions, to a borrower experiencing financial difficulty are considered troubled debt restructured loans (TDR's). All restructurings that constitute concessions to a borrower experiencing financial difficulties are considered impaired loans and may either be in accruing status or non-accruing status. Non-accruing restructured loans may return to accruing status provided there is a sufficient period of payment performance in accordance with the restructure terms. Loans may be removed from disclosure as an impaired loan in the year subsequent to the restructuring if their revised loans terms are considered to be consistent with terms that can be obtained in the credit market for loans with comparable risk. The Company may extend the maturity of a performing or current loan that may have some inherent weakness associated with the loan. However, the Company generally follows a policy of not extending maturities on non-performing loans under existing terms. Maturity date extensions only occur under revised terms that clearly place the Company in a position to increase the likelihood of or assure full collection of the loan under the contractual terms and /or terms at the time of the extension that may eliminate or mitigate the inherent weakness in the loan. These terms may incorporate, but are not limited to additional assignment of collateral, significant balance curtailments/liquidations and assignments of additional project cash flows. Guarantees may be a consideration in the extension of loan maturities. As a general matter, the Company does not view extension of a loan to be a satisfactory approach to resolving non-performing credits. On an exception basis, certain performing loans that have displayed some inherent weakness in the underlying collateral values, an inability to comply with certain loan covenants which are not affecting the performance of the credit or other identified weakness may be extended. 51 Collateral values or estimates of discounted cash flows (inclusive of any potential cash flow from guarantees) are evaluated to estimate the probability and severity of potential losses. The actual occurrence and severity of losses involving impaired credits can differ substantially from estimates. The determination of the allowance requires significant judgment, and estimates of probable losses in the loan and lease portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future additions to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, federal and state regulatory agencies, as an integral part of their examination process, and independent consultants engaged by the Bank, periodically review the loan and lease portfolio and the allowance. Such reviews may result in adjustments to the allowance based upon their analysis of the information available at the time of each examination. The Company makes provisions for loan and lease losses in amounts necessary to maintain the allowance at an appropriate level, as established by use of the allowance methodology previously discussed. The provision for loan and lease losses was a credit of $0.8 million for the first six months of 2014 compared to a credit of $2.8 million for the first six months of 2013. Historical net charge-offs represent a principal component in the application of the Company's allowance methodology. The timing of confirmed losses compared to that of the related historical period was the primary driver of the change in the provision for the first six months of 2014 compared to the prior year period. Substantially all of the fixed-rate residential mortgage loans originated by the Company are sold in the secondary mortgage market. Concurrent with such sales, the Company is required to make customary representations and warranties to the purchasers about the mortgage loans and the manner in which they were originated. The related sale agreements grant the purchasers recourse back to the Company, which could require the Company to repurchase loans or to share in any losses incurred by the purchasers. This recourse exposure typically extends for a period of nine to eighteen months after the sale of the loan although the time frame for repurchase requests can extend for an indefinite period. Such transactions could be due to a number of causes including borrower fraud or early payment default. The Company has seen a very limited number of repurchase and indemnity demands from purchasers for such events and routinely monitors its exposure in this regard. The Company maintains a liability of $0.5 million for probable losses due to repurchases. The Company believes that this reserve

is adequate.



Allowance for Loan and Lease Losses

During the second quarter of 2014, there were no changes in the Company's methodology for assessing the appropriateness of the allowance for loan and lease losses from the prior year. Variations can occur over time in the estimation of the adequacy of the allowance as a result of the credit performance of borrowers. No portion of the allowance was unallocated at June 30, 2014 or December 31, 2013.

At June 30, 2014, total non-performing loans and leases were $41.7 million, or 1.43% of total loans and leases, compared to $40.0 million, or 1.44% of total loans and leases, at December 31, 2013. Timely recognition and aggressive management of problem credits has resulted in the significant reduction of the migration of these loans into non-accrual status during this period. The allowance represented 91% of non-performing loans and leases at June 30, 2014 as compared to 97% at December 31, 2013. The decrease in this ratio was due primarily to the increase in non-performing loans and leases mentioned on the previous page. The allowance for loan and lease losses as a percent of total loans and leases was 1.30% at June 30, 2014 as compared to 1.39% at December 31, 2013. This decrease was due to a combination of loan growth and the impact of the decline in historical losses on the allowance calculation at June 30, 2014 compared to the prior year end. Continued analysis of the actual loss history on the problem credits in 2013 and 2014 provided an indication that the coverage of the inherent losses on the problem credits was adequate. The Company continues to monitor the impact of the economic conditions on our commercial customers, the reduced inflow of non-accruals, lower inflow in criticized loans and the significant decline in early stage delinquencies. The improvement in these credit metrics supports management's outlook for continued improved credit quality performance. The balance of impaired loans was $37.4 million, with specific allowances of $4.1 million against those loans at June 30, 2014, as compared to $32.5 million with allowances of $3.1 million, at December 31, 2013. 52 The Company's borrowers are concentrated in nine counties in Maryland, three counties in Virginia and in Washington D.C. Commercial and residential mortgages, including home equity loans and lines, represented 76% of total loans and leases at June 30, 2014 and at December 31, 2013. Certain loan terms may create concentrations of credit risk and increase the Company's exposure to loss. These include terms that permit the deferral of principal payments or payments that are smaller than normal interest accruals (negative amortization); loans with high loan-to-value ratios; loans, such as option adjustable-rate mortgages, that may expose the borrower to future increases in repayments that are in excess of increases that would result solely from increases in market interest rates; and interest-only loans. The Company does not make loans that provide for negative amortization or option adjustable-rate mortgages.



Summary of Loan and Lease Loss Experience

The following table presents the activity in the allowance for loan and lease losses for the periods indicated:

Six Months Ended Year Ended (Dollars in thousands) June 30, 2014 December 31, 2013 Analysis of Allowance for Loan Losses: Balance, January 1 $ 38,766 $ 42,957 Provision (credit) for loan and lease losses (824 ) (1,084 )



Charge-offs:

Commercial business (225 ) (2,915 ) Commercial real estate: Commercial acquisition, development and construction - (85 ) Commercial investor real estate - (4,774 ) Commercial owner occupied real estate

(265 ) (240 ) Leasing - - Consumer (416 ) (1,853 ) Residential real estate: Residential mortgage (267 ) (1,194 ) Residential construction

(3 ) (104 ) Total charge-offs (1,176 ) (11,165 ) Recoveries: Commercial business 965 818 Commercial real estate: Commercial acquisition, development and construction - 3,080 Commercial investor real estate 28 3,354 Commercial owner occupied real estate

- 425 Leasing - 10 Consumer 74 198 Residential real estate: Residential mortgage 91 162 Residential construction 35 11 Total recoveries 1,193 8,058 Net recoveries (charge-offs) 17 (3,107 ) Balance at end of period $ 37,959 $ 38,766 Allowance for loan losses to loans 1.30 % 1.39 % Annualized net charge-offs to average loans and leases

0.00 % 0.12 % 53 Analysis of Credit Risk



The following table presents information with respect to non-performing assets and 90-day delinquencies for the periods indicated:

June 30, December 31, (Dollars in thousands) 2014 2013 Non-Performing Assets: Loans and leases 90 days past due: Commercial business $ 1 $ - Commercial real estate: Commercial AD&C - - Commercial investor real estate - - Commercial owner occupied real estate - -

Leasing - - Consumer 3 1 Residential real estate: Residential mortgage - - Residential construction - - Total loans and leases 90 days past due 4 1 Non-accrual loans and leases: Commercial business 4,309 3,400 Commercial real estate: Commercial AD&C 3,739 4,127 Commercial investor real estate 6,731 6,802 Commercial owner occupied real estate 10,868 5,936

Leasing - - Consumer 2,058 2,259 Residential real estate: Residential mortgage 4,501 5,735 Residential construction 2,143 2,315 Total non-accrual loans and lease 34,349 30,574 Total restructured loans - accruing 7,364 9,459 Total non-performing loans and leases 41,717 40,034 Other assets and real estate owned (OREO) 1,967 1,338 Total non-performing assets $ 43,684$ 41,372 Market Risk Management The Company's net income is largely dependent on its net interest income. Net interest income is susceptible to interest rate risk to the extent that interest-bearing liabilities mature or re-price on a different basis than interest-earning assets. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income. Net interest income is also affected by changes in the portion of interest-earning assets that are funded by interest-bearing liabilities rather than by other sources of funds, such as noninterest-bearing deposits and stockholders' equity. The Company's interest rate risk management goals are (1) to increase net interest income at a growth rate consistent with the growth rate of total assets, and (2) to minimize fluctuations in net interest margin as a percentage of interest-earning assets. Management attempts to achieve these goals by balancing, within policy limits, the volume of floating-rate liabilities with a similar volume of floating-rate assets; by keeping the average maturity of fixed-rate asset and liability contracts reasonably matched; by maintaining a pool of administered core deposits; and by adjusting pricing rates to market conditions on a continuing basis. 54 The Company's board of directors has established a comprehensive interest rate risk management policy, which is administered by management's Asset Liability Management Committee ("ALCO"). The policy establishes limits on risk, which are quantitative measures of the percentage change in net interest income (a measure of net interest income at risk) and the fair value of equity capital (a measure of economic value of equity or "EVE" at risk) resulting from a hypothetical change in U.S. Treasury interest rates for maturities from one day to thirty years. The Company measures the potential adverse impacts that changing interest rates may have on its short-term earnings, long-term value, and liquidity by employing simulation analysis through the use of computer modeling. The simulation model captures optionality factors such as call features and interest rate caps and floors imbedded in investment and loan portfolio contracts. As with any method of gauging interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used by the Company. When interest rates change, actual movements in different categories of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. As an example, certain money market deposit accounts are assumed to reprice at 100% of the interest rate change in each of the up rate shock scenarios even though this is not a contractual requirement. As a practical matter, management would likely lag the impact of any upward movement in market rates on these accounts as a mechanism to manage the bank's net interest margin. Finally, the methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan customers' ability to service their debts, or the impact of rate changes on demand for loan, lease, and deposit products.



The Company prepares a current base case and eight alternative simulations at least once a quarter and reports the analysis to the board of directors. In addition, more frequent forecasts are produced when interest rates are particularly uncertain or when other business conditions so dictate.

The statement of condition is subject to quarterly testing for eight alternative interest rate shock possibilities to indicate the inherent interest rate risk. Average interest rates are shocked by +/- 100, 200, 300, and 400 basis points ("bp"), although the Company may elect not to use particular scenarios that it determines are impractical in a current rate environment. It is management's goal to structure the balance sheet so that net interest earnings at risk over a twelve-month period and the economic value of equity at risk do not exceed policy guidelines at the various interest rate shock levels. The Company augments its quarterly interest rate shock analysis with alternative external interest rate scenarios on a monthly basis. These alternative interest rate scenarios may include non-parallel rate ramps and non-parallel yield curve twists. If a measure of risk produced by the alternative simulations of the entire balance sheet violates policy guidelines, ALCO is required to develop a plan to restore the measure of risk to a level that complies with policy limits within two quarters.

Measures of net interest income at risk produced by simulation analysis are indicators of an institution's short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution. Estimated Changes in Net Interest Income Change in Interest Rates: + 400 bp + 300 bp + 200 bp +



100 bp - 100 bp - 200 bp -300 bp -400 bp Policy Limit

23.50 % 17.50 % 15.00 %



10.00 % 10.00 % 15.00 % 17.50 % 23.50 % June 30, 2014

(4.04 )% (1.75 )% (0.17 )% (0.22 )% N/A N/A N/A N/A



December 31, 2013 (7.20 )% (4.14 )% (1.63 )% (0.88 )% N/A

N/A N/A N/A As shown above, measures of net interest income at risk improved from December 31, 2013 at all rising interest rate shock levels. All measures remained well within prescribed policy limits. The decrease in the risk position with respect to net interest income from December 31, 2013 to June 30, 2014 was the result of an increase in interest-bearing deposits with banks, which will reprice immediately should rates rise in the future. Contributing to the decreased risk position is the decline in short-term FHLB borrowings which reduces the Company's exposure to increases in interest rates, in addition to an increase in short-term loans, which is beneficial in a rising interest rate environment. The measures of equity value at risk indicate the ongoing economic value of the Company by considering the effects of changes in interest rates on all of the Company's cash flows, and by discounting the cash flows to estimate the present value of assets and liabilities. The difference between these discounted values of the assets and liabilities is the economic value of equity, which, in theory, approximates the fair value of the Company's net assets. 55



Estimated Changes in Economic Value of Equity (EVE) Change in Interest Rates:

+ 400 bp + 300 bp + 200 bp +



100 bp - 100 bp - 200 bp -300 bp -400 bp Policy Limit

35.00 % 25.00 % 20.00 %



10.00 % 10.00 % 20.00 % 25.00 % 35.00 % June 30, 2014

(11.07 )% (7.66 )% (4.41 )% (2.00 )% N/A N/A N/A N/A



December 31, 2013 (15.27 )% (10.86 )% (6.21 )% (2.15 )% N/A

N/A N/A N/A Measures of the economic value of equity ("EVE") at risk improved from December 31, 2013 to June 30, 2014 in all rising shock scenarios. The significant positive impact in EVE was driven by higher core deposit balances in noninterest-bearing and interest-bearing checking accounts and regular savings accounts resulting in increased premiums should rates increase. Shorter durations in the investment portfolio are also a contributing factor to the

reduced risk in EVE. Liquidity Management Liquidity is measured by a financial institution's ability to raise funds through loan and lease repayments, maturing investments, deposit growth, borrowed funds, capital and the sale of highly marketable assets such as investment securities and residential mortgage loans. The Company's liquidity position, considering both internal and external sources available, exceeded anticipated short-term and long-term needs at June 30, 2014. Management considers core deposits, defined to include all deposits other than time deposits of $100 thousand or more, to be a relatively stable funding source. Core deposits equaled 72% of total interest-earning assets at June 30, 2014. In addition, loan and lease payments, maturities, calls and pay downs of securities, deposit growth and earnings contribute a flow of funds available to meet liquidity requirements. In assessing liquidity, management considers operating requirements, the seasonality of deposit flows, investment, loan and deposit maturities and calls, expected funding of loans and deposit withdrawals, and the market values of available-for-sale investments, so that sufficient funds are available on short notice to meet obligations as they arise and to ensure that the Company is able to pursue new business opportunities. Liquidity is measured using an approach designed to take into account, in addition to factors already discussed above, the Company's growth and mortgage banking activities. Also considered are changes in the liquidity of the investment portfolio due to fluctuations in interest rates. Under this approach, implemented by the Funds Management Subcommittee of ALCO under formal policy guidelines, the Company's liquidity position is measured weekly, looking forward at thirty day intervals from thirty (30) to three hundred sixty (360) days. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. Resulting projections as of June 30, 2014, show short-term investments exceeding short-term borrowings by $21 million over the subsequent 360 days. This projected excess of liquidity versus requirements provides the Company with flexibility in how it funds loans and other earning assets. The Company also has external sources of funds, which can be drawn upon when required. The main sources of external liquidity are available lines of credit with the Federal Home Loan Bank of Atlanta and the Federal Reserve. The line of credit with the Federal Home Loan Bank of Atlanta totaled $1.3 billion, of which $946 million was available for borrowing based on pledged collateral, with $537 million borrowed against it as of June 30, 2014. The line of credit at the Federal Reserve totaled $407 million, all of which was available for borrowing based on pledged collateral, with no borrowings against it as of June 30, 2014. Other external sources of liquidity available to the Company in the form of unsecured lines of credit granted by correspondent banks totaled $55 million at June 30, 2014, against which there were no outstanding borrowings. In addition, the Company had a secured line of credit with a correspondent bank of $20 million as of June 30, 2014. Based upon its liquidity analysis, including external sources of liquidity available, management believes the liquidity position was appropriate at June 30, 2014. The parent company ("Bancorp") is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, Bancorp is responsible for paying any dividends declared to its common shareholders and interest and principal on outstanding debt. Bancorp's primary source of income is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to Bancorp in any calendar year, without the receipt of prior approval from the Federal Reserve, cannot exceed net income for that year to date plus retained net income (as defined) for the preceding two calendar years. Based on this requirement, as of June 30, 2014, the Bank could have declared a dividend of $62 million to Bancorp. At June 30, 2014, Bancorp had liquid assets of $12 million. 56 Arrangements to fund credit products or guarantee financing take the form of loan commitments (including lines of credit on revolving credit structures) and letters of credit. Approvals for these arrangements are obtained in the same manner as loans. Generally, cash flows, collateral value and risk assessment are considered when determining the amount and structure of credit arrangements.



Commitments to extend credit in the form of consumer, commercial real estate and business at the dates indicated were as follows:

June 30, December 31, (In thousands) 2014 2013 Commercial $ 187,474$ 184,083

Real estate-development and construction 99,365 100,826 Real estate-residential mortgage 22,305 13,908 Lines of credit, principally home equity and business lines 779,148 710,202 Standby letters of credit 57,926 59,745



Total Commitments to extend credit and available credit lines $ 1,146,218

$ 1,068,764


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Source: Edgar Glimpses


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