News Column

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

August 8, 2014

Management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for Codorus Valley Bancorp, Inc. (Codorus Valley or the Corporation), a bank holding company, and its wholly-owned subsidiary, PeoplesBank, A Codorus Valley Company (PeoplesBank), are provided below. Codorus Valley's consolidated financial condition and results of operations consist almost entirely of PeoplesBank's financial condition and results of operations. Current performance does not guarantee, and may not be indicative of, similar performance in the future.



Forward-looking statements

Management of the Corporation has made forward-looking statements in this Form 10-Q. These forward-looking statements are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When words such as "believes," "expects," "anticipates" or similar expressions occur in the Form 10-Q, management is making forward-looking statements. Note that many factors, some of which are discussed elsewhere in this report and in the documents that are incorporated by reference, could affect the future financial results of the Corporation and its subsidiaries, both individually and collectively, and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this Form 10-Q. These factors include, but are not limited to, the following:



operating, legal and regulatory risks;

enacted financial reform legislation, e.g., Dodd-Frank Wall Street Reform

and Consumer Protection Act, which may have a significant impact on the

Corporation's business and results of operations;

a prolonged economic downturn;

an increase in nonperforming assets requiring loss provisions and the

incurrence of carrying costs related to nonperforming assets;

declines in the market value of investment securities considered to be

other-than-temporary;

the effects of and changes in the rate of FDIC premiums, including special

assessments;

interest rate fluctuations which could increase our cost of funds or

decrease our yield on earning assets and therefore reduce our net interest

income;

future legislative or administrative changes to U.S. governmental capital

programs;

unavailability of capital when needed or availability at less than

favorable terms;

political and competitive forces affecting banking, securities, asset

management and credit services businesses;

unauthorized disclosure of sensitive or confidential client or customer

information, whether through a breach of our computer systems or otherwise,

which may adversely affect the Corporation's operations, net income or

reputation; and

the risk that management's analysis of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.



The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report.

Critical accounting policies

We have identified critical accounting policies for the Corporation to include the allowance for loan losses, valuation of foreclosed real estate, and evaluation of other-than-temporary impairment losses of securities. There were no material changes to the critical accounting policies disclosed in the Annual Report on Form 10-K for the year ended December 31, 2013 in regards to application or related judgments and estimates. A detailed disclosure pertaining to critical accounting estimates is provided in Item 7 of the Corporation's Annual Report on Form 10-K for the year ended December 31, 2013. - 35 -



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Three months ended June 30, 2014, compared to three months ended June 30, 2013



FINANCIAL HIGHLIGHTS

The Corporation earned net income available to common shareholders (earnings) totaling $2,755,000 for the quarter ended June 30, 2014, compared to $2,583,000 for the quarter ended June 30, 2013. The $172,000 or 7 percent increase in earnings was primarily the result of an increase in net interest income and a decrease in the provision for loan losses, which more than offset an increase in noninterest expense, a decrease in noninterest income, and an increase in the provision for income taxes, as described below. Net interest income increased $988,000 or 11 percent for the second quarter of 2014, compared to the second quarter of 2013, due primarily to an increase in the volume of interest-earning assets, principally commercial loans and U.S. agency mortgage-backed securities, and a decrease in the overall cost of deposits. The provision for loan losses for the second quarter of 2014 decreased $260,000 or 46 percent compared to the second quarter of 2013. Net charge-offs in the second quarter of 2014 were $153,000, compared to $587,000 for the second quarter of 2013. The Corporation realized a recovery of $190,000 of a previous partial charge-off of an impaired commercial loan due to updated collateral appraisals resulting in a favorable fair value adjustment prior to the asset being transferred to foreclosed real estate. The $120,000 or 6 percent decrease in total noninterest income for the second quarter of 2014, compared to the second quarter of 2013, was primarily the result of a substantial decrease in net gain from sales of loans held for sale (i.e. residential mortgage loans), reflecting a sharp decrease in refinancing demand and elevated mortgage market interest rates. The $829,000 or 12 percent increase in noninterest expense for the second quarter of 2014, compared to the second quarter of 2013, was driven by increases in personnel, marketing, foreclosed real estate, and professional and legal expenses. Personnel expense increased $173,000 or 4 percent as a result of expanding the banking franchise in the third quarter of 2013, and normal business growth. Marketing expense increased $159,000 or 63 percent primarily as a result of non-recurring costs to promote PeoplesBank's 150th year in business anniversary. Foreclosed real estate expenses increased $93,000 or 126 percent as a result of increased holding costs and valuation adjustments based upon updated appraisals for selected properties. The $91,000 or 55 percent increase in professional and legal expense was due primarily to an increase in consulting expense, which supported various corporate initiatives, and normal business growth. The $137,000 or 14 percent increase in the provision for income taxes for the second quarter of 2014, compared to the second quarter of 2013, was primarily the result of a higher level of pretax earnings, and a decrease in the amount of tax-exempt income for the second quarter of 2014 as compared to the same period in 2013. - 36 -



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The schedule below presents selected performance metrics for second quarter of 2014 and 2013. Earnings per common share reflect an adjustment for the 5 percent common stock dividend distributed on December 10, 2013. Three months ended June 30, 2014 2013 Basic earnings per common share $ 0.50$ 0.55 Diluted earnings per common share $ 0.49$ 0.54 Cash dividend payout ratio 23.8 % 19.2 % Return on average assets 0.93 % 0.98 % Return on average equity 9.63 % 10.13 % Net interest margin (tax equivalent basis) 3.73 % 3.79 % Net overhead ratio 2.02 % 1.91 % Efficiency ratio 63.21 % 60.86 % Average equity to average assets 9.71 % 9.67 %



A more detailed analysis of the factors and trends affecting corporate earnings follows.

INCOME STATEMENT ANALYSIS Net interest income Net interest income for the three month period ended June 30, 2014, was $10,289,000, an increase of $988,000 or 11 percent above the second quarter of 2013. The increase was due primarily to increased interest income from a higher average volume of interest earning assets, and a decrease in the cost of deposits, partially offset by an increase in long-term debt interest expense due to an increase in borrowings. Net interest income (tax equivalent basis) annualized as a percentage of average interest earning assets, i.e., net interest margin, was 3.73 percent for the second quarter of 2014, compared to 3.79 percent for the same period in 2013. Interest income for the second quarter of 2014 totaled $12,364,000, an increase of $891,000 or 8 percent above the second quarter of 2013. The increase was driven primarily by an increase in the average volume of interest earning assets, principally commercial loans and U.S. agency mortgage-backed securities. Interest earning assets averaged $1.14 billion and yielded 4.46 percent (tax equivalent basis) for the second quarter of 2014, compared to $1.02 billion and 4.65 percent, respectively, for the second quarter of 2013. While the volume of earning assets increased, its effect on interest income was muted by lower loan yields, a reflection of the continuing low interest rate environment. Interest expense for the second quarter of 2014 totaled $2,075,000, a decrease of $97,000 or 4 percent below the second quarter of 2013. The decrease in total interest expense was driven primarily by a general decrease in deposit rates, due to the low interest rate environment, and from a larger volume of low-cost core deposits. The Corporation defines core deposits as noninterest and interest bearing demand, savings and money market deposits. The average volume of these core demand and savings deposits was $537 million for the second quarter of 2014, a $43 million or 9 percent increase above the average volume for the second quarter of 2013. The growth of core deposits is a particular focus of the Corporation because of the lower cost of funds, fee income generated by certain transaction activity, and the relationship opportunity to cross-sell other financial products and services. Decreased interest expense on deposits was partially offset by higher interest expense on long-term debt, which increased $105,000 or 55 percent due to an increase in the average volume of borrowings. Long-term debt averaged $80 million for the second quarter of 2014, compared to a $41 million average for the second quarter of 2013. The increase in long-term debt was comprised of advances from the Federal Home Loan Bank of Pittsburgh. These advances were low rate borrowings with intermediate term bullet maturities that supplement deposit funding and provide a hedge against rising market interest rates. - 37 -



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Table 1-Average Balances and Interest Rates (tax equivalent basis)

Three months ended June 30, 2014 2013 Average Yield/ Average Yield/ (dollars in thousands) Balance Interest Rate Balance Interest Rate Assets Interest bearing deposits with banks $ 36,740$ 23 0.25 % $ 44,315$ 28 0.25 % Investment securities: Taxable 149,407 951 2.55 120,860 624 2.07 Tax-exempt 76,918 752 3.92 92,784 908 3.93 Total investment securities 226,325 1,703 3.02 213,644 1,532 2.88 Loans: Taxable (1) 859,412 10,737 5.01 751,554 10,105 5.39 Tax-exempt 18,096 221 4.90 11,111 155 5.60 Total loans 877,508 10,958 5.01 762,665 10,260 5.40 Total earning assets 1,140,573 12,684 4.46 1,020,624 11,820 4.65 Other assets (2) 60,447 58,939 Total assets $ 1,201,020$ 1,079,563 Liabilities and Shareholders' Equity Deposits: Interest bearing demand $ 381,758$ 329 0.35 % $ 363,182$ 337 0.37 % Savings 41,236 20 0.19 38,194 24 0.25 Time 430,927 1,392 1.30 410,682 1,590 1.55 Total interest bearing deposits 853,921 1,741 0.82 812,058 1,951 0.96 Short-term borrowings 27,176 37 0.55 21,051 29 0.55 Long-term debt 80,463 297 1.48 40,569 192 1.90 Total interest bearing liabilities 961,560 2,075 0.87 873,678 2,172 1.00 Noninterest bearing deposits 114,409 93,442 Other liabilities 8,454 8,001 Shareholders' equity 116,597 104,442 Total liabilities and shareholders' equity $ 1,201,020$ 1,079,563 Net interest income (tax equivalent basis) $ 10,609$ 9,648 Net interest margin (3) 3.73 % 3.79 % Tax equivalent adjustment (320 ) (347 ) Net interest income $ 10,289$ 9,301



(1) Average balance includes average nonaccrual loans of $12,001,000 for 2014

and $11,726,000 for 2013.

Interest includes net loan fees of $362,000 for 2014 and $393,000 for 2013. (2) Average balance includes average bank owned life insurance, foreclosed real

estate and unrealized holding gains (losses) on investment securities. (3) Net interest income (tax equivalent basis) annualized as a percentage of

average interest earning assets. - 38 -



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Table 2-Rate/Volume Analysis of Changes in Net Interest Income (tax equivalent basis) Three months ended June 30, 2014 vs. 2013 Increase (decrease) due to change in (dollars in thousands) Volume Rate Net Interest Income Interest bearing deposits with banks $ (5 ) $ 0 $ (5 ) Investment securities: Taxable 145 182 327 Tax-exempt (155 ) (1 ) (156 ) Loans: Taxable 1,499 (867 ) 632 Tax-exempt 97 (31 ) 66 Total interest income 1,581 (717 ) 864 Interest Expense Deposits: Interest bearing demand 21 (29 ) (8 ) Savings 1 (5 ) (4 ) Time 78 (276 ) (198 ) Short-term borrowings 9 (1 ) 8 Long-term debt 185 (80 ) 105 Total interest expense 294 (391 ) (97 ) Net interest income $ 1,287$ (326 )$ 961



Changes which are due to both volume and rate are allocated in proportion to their relationship to the amount of change attributed directly to volume or rate.

Provision for loan losses

The provision for loan losses was $300,000 for the three month period ended June 30, 2014, a decrease of $260,000 or 46 percent below the provision of $560,000 for the second quarter of 2013. The decrease in the provision was consistent with a decrease in net charge-offs in the second quarter of 2014, which totaled $153,000. The current quarter benefited from a recovery of $190,000 from a previous partial charge-off of an impaired commercial loan due to updated collateral appraisals resulting in a favorable fair value adjustment prior to the asset being transferred to foreclosed real estate. Comparatively, net charge-offs totaled $587,000 for the second quarter of 2013. More information about the allowance for loan losses can be found in this report under the caption Allowance for Loan Losses on page 55. - 39 -



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Noninterest income

The following table presents the components of total noninterest income for the second quarter of 2014, compared to the second quarter of 2013.

Table 3 - Noninterest income

Three months ended Change June 30, Increase (Decrease) (dollars in thousands) 2014 2013 $ % Trust and investment services fees $ 525$ 464$ 61 13 % Income from mutual fund, annuity and insurance sales 192 173 19 11 Service charges on deposit accounts 760 670 90 13 Income from bank owned life insurance 175 185 (10 ) (5 ) Other income 164 180 (16 ) (9 ) Net gain on sales of loans held for sale 102 322 (220 ) (68 ) Gain on sales of securities 0 44 (44 ) (100 ) Total noninterest income $ 1,918$ 2,038$ (120 ) (6 )%



The discussion that follows addresses changes in selected categories of noninterest income.

Trust and investment services fees-The $61,000 or 13 percent increase in trust and investment services fees was due to appreciation in the market value of managed accounts, upon which some fees are based, and growth in traditional trust business.

Service charges on deposit accounts-The $90,000 or 13 percent increase in service charge income was due primarily to increases in overdraft fees and debit card revenue.

Net gain on sales of loans held for sale-The $220,000 or 68 percent decrease in gains from the sale of residential mortgage loans held for sale resulted from a decrease in mortgage originations, as refinancing demand and gains therefrom have declined significantly, and the higher level of mortgage interest rates has priced some borrowers out of the mortgage market. - 40 -



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Noninterest expense

The following table presents the components of total noninterest expense for the second quarter of 2014, compared to the second quarter of 2013.

Table 4 - Noninterest expense Three months ended Change June 30, Increase (Decrease) (dollars in thousands) 2014 2013 $ % Personnel $ 4,288$ 4,115$ 173 4 % Occupancy of premises, net 515 512 3 1 Furniture and equipment 551 476 75 16 Postage, stationery and supplies 163 157 6 4 Professional and legal 256 165 91 55 Marketing 413 254 159 63 FDIC insurance 173 138 35 25 Debit card processing 193 195 (2 ) (1 ) Charitable donations 32 11 21 191 Telephone 145 132 13 10 External data processing 233 167 66 40 Foreclosed real estate including (gains) losses on sales 167 74 93 126 Other 857 761 96 13 Total noninterest expense $ 7,986$ 7,157$ 829 12 %



The discussion that follows addresses changes in selected categories of noninterest expense.

Personnel-The $173,000 or 4 percent increase in personnel expense was due largely to an increase in wage expense resulting from planned staff additions that occurred in the first half of 2014 and throughout the year 2013 that affect the current period (e.g. franchise expansion), and normal business growth. Furniture and equipment-The $75,000 or 16 percent increase in furniture and equipment was due primarily to additions related to franchise/office expansion, and normal business growth, which included increases in depreciation expense on computer hardware and software.



Professional and legal-The $91,000 or 55 percent increase in professional and legal expense was due primarily to an increase in consulting expense, which supported various corporate initiatives, and normal business growth.

Marketing-The $159,000 or 63 percent increase in marketing expense was primarily the result of non-recurring costs to promote PeoplesBank's 150th year in business anniversary.

External data processing-The $66,000 or 40 percent increase in external data processing reflects increased reliance on outsourcing transaction processing to specialized vendors, which is typically performed on their hosted and secure websites thereby increasing our processing efficiency. Increases in the services offered to our client base and increases in transaction volume from normal business growth also contributed to the increase in this expense category. Foreclosed real estate-The $93,000 or 126 percent increase in foreclosed real estate expenses was a result of holding costs incurred including real estate taxes, property maintenance, and valuation adjustments based upon updated appraisals. - 41 -



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Provision for income taxes

The provision for income tax for the second quarter of 2014 was $1,114,000, compared to $977,000 for the second quarter of 2013. The $137,000 or 14 percent increase was primarily the result from a higher level of pretax earnings, and a decrease in the amount of tax-exempt income for the second quarter of 2014 as compared to the same period in 2013. For both periods, the Corporation's statutory federal income tax rate was 34 percent. The Corporation's effective income tax rate was 28 percent for the second quarter of 2014, compared to 27 percent for the second quarter of 2013. The effective tax rate differs from the statutory tax rate due to the impact of low-income housing credits and tax-exempt income, including income from bank owned life insurance. Preferred stock dividends Preferred stock dividends for the second quarter of 2014 totaled $52,000 compared to $62,000 for the second quarter of 2013. Though an annualized dividend rate of 1 percent applied to both periods, the amount of preferred stock dividends for the second quarter of 2014 decreased because, on May 30, 2014, as reported on a Form 8-K filed on the same date, the Corporation used the net proceeds from a private placement of common stock, and additional cash, to redeem $13 million of the $25 million in outstanding shares of the Corporation's preferred stock held by the United States Department of the Treasury. The Corporation is currently paying the lowest permissible dividend rate under the U.S. Treasury's Small Business Lending Fund Program (SBLF Program) as a result of originating loans that qualify for the SBLF Program in excess of a pre-determined loan portfolio baseline balance. Information about the SBLF Program is provided in this report at Note 10-Shareholders' Equity. Six months ended June 30, 2014, compared to six months ended June 30, 2013



FINANCIAL HIGHLIGHTS

The Corporation earned net income available to common shareholders (earnings) totaling $5,696,000 for the first six months of 2014, compared to $5,182,000 for the same period of 2013. The $514,000 or 10 percent increase in earnings was primarily the result of an increase in net interest income, which more than offset an increase in noninterest expense and a decrease in noninterest income as described below. Net interest income increased $2,257,000 or 12 percent for the first six months of 2014, compared to the same period of 2013, due primarily to an increase in the volume of interest-earning assets, principally commercial loans and U.S. agency mortgage-backed securities, and a decrease in the overall cost of deposits. The average balance of interest-earning assets for the first six months of 2014 increased $111 million or 11 percent compared to the same period of 2013. The provision for loan losses for the first six months of 2014 was $850,000, which was required to support growth in the commercial loan portfolio and maintain the adequacy of the allowance for loan losses. The provision was 4% higher compared to the first six months of 2013. Net charge-offs for the first six months of 2014 were $365,000, which benefited from a $190,000 recovery from a previous partial charge-off of an impaired commercial loan due to updated collateral appraisals resulting in a favorable fair value adjustment prior to the asset being transferred to foreclosed real estate. Comparatively, net charge-offs totaled $663,000 for the same period of 2013. The $397,000 or 10 percent decrease in total noninterest income for the first six months of 2014, compared to the same period of 2013, was primarily the result of a substantial decrease in net gain from the sales of residential mortgage loans, reflecting a sharp decrease in refinancing demand and higher mortgage market interest rates. Additionally, a decrease in income from the sale of mutual fund, annuity, and insurance products resulted from the lingering impact of staff turnover in 2013, and the unusually severe weather affecting sales activities in early 2014. - 42 -



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The $1,224,000 or 8 percent increase in noninterest expense for the first six months of 2014, compared to the same period of 2013, was driven by increases in several areas including personnel, furniture and equipment, marketing, charitable donations, external data processing, foreclosed real estate expenses, and professional and legal expenses. Personnel expense increased $309,000 and furniture and equipment expenses increased $124,000 as a result of expanding the banking franchise in the third quarter of 2013, and normal business growth. Marketing expense increased $320,000 primarily as a result of non-recurring costs to promote PeoplesBank's 150thyear in business anniversary. An increase in charitable contributions of $283,000 reflects increased donations to nonprofit organizations that qualify for state tax credits, which reduce future tax liabilities and effectively lower the overall cost of the donation. Foreclosed real estate expenses increased $110,000 related to holding costs and valuation adjustments based upon updated appraisals. Professional and legal expense increased $137,000 due primarily to increases in consulting expenses which supported various corporate initiatives, and increased professional services associated with normal business growth. An increase in external data processing of $100,000 reflects increased reliance on outsourcing transaction processing to specialized vendors, increases in the services offered to our client base, and increases in transaction volume from normal business growth. The $103,000 or 5 percent increase in the provision for income taxes for the first six months of 2014, compared to the same period of 2013, primarily resulted from higher level of pretax earnings and a decrease in the amount of tax-exempt income.



The schedule below presents selected performance metrics for the first six months of 2014 and 2013. Earnings per common share reflect an adjustment for the 5 percent common stock dividend distributed on December 10, 2013.

Six months ended June 30, 2014 2013 Basic earnings per common share $ 1.11$ 1.10 Diluted earnings per common share $ 1.08$ 1.08 Cash dividend payout ratio 21.7 % 19.1 % Return on average assets 0.99 % 0.99 % Return on average equity 10.21 % 10.26 % Net interest margin (tax equivalent basis) 3.85 % 3.83 % Net overhead ratio 2.03 % 1.95 % Efficiency ratio 61.98 % 61.64 % Average equity to average assets 9.65 % 9.70 %



A more detailed analysis of the factors and trends affecting corporate earnings follows.

INCOME STATEMENT ANALYSIS Net interest income Net interest income for the six-month period ended June 30, 2014, was $20,710,000, an increase of $2,257,000 or 12 percent above the same period of 2013. The increase was due primarily to increased interest income from a higher average volume of interest-earning assets. A decrease in the cost of deposits, partially offset by increased long-term debt interest expense due to an increase in borrowings, also contributed to the increase in net increase income. Net interest income (tax equivalent basis) annualized as a percentage of average interest-earning assets, i.e., net interest margin, was 3.85 percent for the first six months of 2014 compared to 3.83 percent for the same period in 2013. - 43 -



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Interest income for the first six months totaled $24,777,000, an increase of $1,943,000 or 9 percent above the same period of 2013. The increase was driven primarily by an increase in the average volume of interest earning assets, principally commercial loans and U.S. agency mortgage-backed securities. Interest earning assets averaged $1.12 billion and yielded 4.58 percent (tax equivalent basis) for the first six months of 2014, compared to $1.01 billion and 4.70 percent, respectively, for the first six months of 2013. While the volume of earning assets increased, its effect on interest income was muted by lower asset yields, a reflection of the continuing low interest rate environment. Interest expense for the first six months of 2014 totaled $4,067,000, a decrease of $314,000 or 7 percent below the same period of 2013. The decrease in total interest expense was driven primarily by a general decrease in deposit rates, due to the low interest rate environment, and from a larger volume of low-cost core deposits. The Corporation defines core deposits as noninterest and interest bearing demand, savings and money market deposits. The average volume of these core demand and savings deposits was $536 million for the six-month period ending June 30, 2014, a $47 million or 10 percent increase above the average volume for the same period of 2013. The growth of core deposits is a particular focus of the Corporation because of the lower cost of funds, fee income generated by certain transaction activity, and the relationship opportunity to cross-sell other financial products and services. Decreased interest expense on deposits was offset by higher interest expense on long-term debt, which increased $218,000 or 60 percent due to an increase in average borrowings. Long-term debt averaged $79 million for the first six months of 2014, compared to a $37 million average for the same period of 2013. The increase in long-term debt was comprised of advances from the Federal Home Loan Bank of Pittsburgh. These advances were low rate borrowings with intermediate term bullet maturities that supplement deposit funding and provide a hedge against rising market interest rates. - 44 -



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Table 5-Average Balances and Interest Rates (tax equivalent basis)

Six months ended June 30, 2014 2013 Average Yield/ Average Yield/ (dollars in thousands) Balance Interest Rate Balance Interest Rate Assets Interest bearing deposits with banks $ 20,775$ 26 0.25 % $ 33,543$ 42 0.25 % Investment securities: Taxable 146,972 1,820 2.50 124,327 1,275 2.07 Tax-exempt 79,698 1,557 3.94 93,908 1,840 3.95 Total investment securities 226,670 3,377 3.00 218,235 3,115 2.88 Loans: Taxable (1) 854,894 21,597 5.09 746,601 20,072 5.42 Tax-exempt 17,438 431 4.98 10,874 306 5.67 Total loans 872,332 22,028 5.09 757,475 20,378 5.43 Total earning assets 1,119,777 25,431 4.58 1,009,253 23,535 4.70 Other assets (2) 59,218 57,607 Total assets $ 1,178,995$ 1,066,860 Liabilities and Shareholders' Equity Deposits: Interest bearing demand $ 385,605$ 695 0.36 % $ 364,209$ 671 0.37 % Savings 40,474 45 0.22 36,967 46 0.25 Time 414,636 2,672 1.30 408,478 3,243 1.60 Total interest bearing deposits 840,715 3,412 0.82 809,654 3,960 0.99 Short-term borrowings 27,722 73 0.53 20,592 57 0.56 Long-term debt 78,650 582 1.49 37,387 364 1.96 Total interest bearing liabilities 947,087 4,067 0.87 867,633 4,381 1.02 Noninterest bearing deposits 109,967 88,363 Other liabilities 8,137 7,377 Shareholders' equity 113,804 103,487 Total liabilities and shareholders' equity $ 1,178,995$ 1,066,860 Net interest income (tax equivalent basis) $ 21,364$ 19,154 Net interest margin (3) 3.85 % 3.83 % Tax equivalent adjustment (654 ) (701 ) Net interest income $ 20,710$ 18,453



(1) Average balance includes average nonaccrual loans of $13,030,000 for 2014

and $10,249,000 for 2013. Interest includes net loan fees of $821,000 for

2014 and $721,000 for 2013. (2) Average balance includes average bank owned life insurance, foreclosed real

estate and unrealized holding gains (losses) on investment securities. (3) Net interest income (tax equivalent basis) annualized as a percentage of

average interest earning assets. - 45 -



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Table 6-Rate/Volume Analysis of Changes in Net Interest Income (tax equivalent basis) Six months ended June 30, 2014 vs. 2013 Increase (decrease) due to change in (dollars in thousands) Volume Rate Net Interest Income Interest bearing deposits with banks $ (16 ) $ 0 $ (16 ) Investment securities: Taxable 224 321 545 Tax-exempt (278 ) (5 ) (283 ) Loans: Taxable 3,116 (1,591 ) 1,525 Tax-exempt 185 (60 ) 125 Total interest income 3,231 (1,335 ) 1,896 Interest Expense Deposits: Interest bearing demand 47 (23 ) 24 Savings 4 (5 ) (1 ) Time 49 (620 ) (571 ) Short-term borrowings 15 1 16 Long-term debt 398 (180 ) 218 Total interest expense 513 (827 ) (314 ) Net interest income $ 2,718 $ (508 ) $ 2,210



Changes which are due to both volume and rate are allocated in proportion to their relationship to the amount of change attributed directly to volume or rate.

Provision for loan losses

The provision for loan losses for the first six months of 2014 was $850,000, which was required to support growth in the commercial loan portfolio and maintain the adequacy of the allowance for loan losses. The provision was 4% higher compared to the first six months of 2013. Net charge-offs for the first six months of 2014 were $365,000, which benefited from a $190,000 recovery from a previous partial charge-off of an impaired commercial loan due to updated collateral appraisals resulting in a favorable fair value adjustment prior to the asset being transferred to foreclosed real estate. Comparatively, net charge-offs totaled $663,000 for the same period of 2013. More information about the allowance for loan losses can be found in this report under the caption Allowance for Loan Losses on page 55. - 46 -



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Noninterest income

The following table presents the components of total noninterest income for the first six months of 2014 compared to the first six months of 2013.

Table 7 - Noninterest income

Six months ended Change June 30, Increase (Decrease) (dollars in thousands) 2014 2013 $ %



Trust and investment services fees $ 1,052$ 937$ 115

12 % Income from mutual fund, annuity and insurance sales 325 422 (97 ) (23 ) Service charges on deposit accounts 1,438 1,304 134 10 Income from bank owned life insurance 348 351 (3 ) (1 ) Other income 303 346 (43 ) (12 ) Net gain on sales of loans held for sale 182 641 (459 ) (72 ) Gain on sales of securities 0 44 (44 ) (100 ) Total noninterest income $ 3,648$ 4,045$ (397 ) (10 )%



The discussion that follows addresses changes in selected categories of noninterest income.

Trust and investment services fees-The $115,000 or 12 percent increase in trust and investment services fees was due to appreciation in the market value of managed accounts, upon which some fees are based, and growth in traditional trust business.

Income from mutual fund, annuity and insurance sales-The $97,000 or 23 percent decrease in income from the sale of mutual fund, annuity and insurance products by Codorus Valley Financial Advisors (CVFA), a subsidiary of PeoplesBank, was a result of the lingering impact of the resignation of three registered representatives who left CVFA in 2013. Also, the level of sales early in 2014 was adversely affected by the unusually severe winter weather.



Service charges on deposit accounts-The $134,000 or 10 percent increase in service charge income was due primarily to increases in debit card revenue and overdraft fees.

Income from bank owned life insurance (BOLI)-Income from BOLI in the first six months of 2014, compared to the same period in 2013, was relatively flat as low market interest rates depressed yields.



Other income-The $43,000 or 12 percent decrease in other income was due primarily to a decrease in income from settlement services, which has been adversely affected by the decrease in mortgage banking activity.

Net gain on sales of loans held for sale-The $459,000 or 72 percent decrease in gains from the sale of residential mortgage loans held for sale resulted from a decrease in mortgage originations, as refinancing demand and gains therefrom have declined significantly, and the higher level of mortgage interest rates has priced some prospective borrowers out of the mortgage market. - 47 -



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Noninterest expense

The following table presents the components of total noninterest expense for the first six months of 2014, compared to the first six months of 2013.

Table 8 - Noninterest expense Six months ended Change June 30, Increase (Decrease) (dollars in thousands) 2014 2013 $ % Personnel $ 8,604$ 8,295$ 309 4 % Occupancy of premises, net 1,081 1,023 58 6 Furniture and equipment 1,094 970 124 13 Postage, stationery and supplies 322 307 15 5 Professional and legal 439 302 137 45 Marketing and advertising 720 400 320 80 FDIC insurance 362 309 53 17 Debit card processing 393 373 20 5 Charitable donations 769 486 283 58 Telephone 291 266 25 9 External data processing 435 335 100 30 Foreclosed real estate including (gains) losses on sales 247 137 110 80 Other 877 1,207 (330 ) (27 ) Total noninterest expense $ 15,634$ 14,410$ 1,224 8 %



The discussion that follows addresses changes in selected categories of noninterest expense.

Personnel-The $309,000 or 4 percent increase in personnel expense was due largely to an increase in wage expense resulting from planned staff additions that occurred in the first six months of 2014 and throughout the year 2013 that affect the current period (e.g., franchise expansion), and normal business growth. Furniture and equipment-The $124,000 or 13 percent increase in furniture and equipment was due primarily to normal business growth, including expenses from the addition of two banking offices in the year 2013 that affect the current period, which includes depreciation expense on computer hardware and software. Professional and legal-The $137,000 or 45 percent increase in professional and legal expense was due primarily to increases in consulting expenses which supported various corporate initiatives, and increased professional services associated with normal business growth.



Marketing-The $320,000 or 80 percent increase in marketing expense was primarily the result of non-recurring costs to promote PeoplesBank's 150th year in business anniversary.

Charitable donations-The $283,000 or 58 percent increase in charitable donations was the result of an increase in donations to nonprofit organizations that qualify for related state tax credits. PeoplesBank uses state tax credits from donations to reduce its Pennsylvania shares tax expense, included in other expenses. State tax credits typically range from 55 to 90 percent of the amount donated, effectively lowering the cost of the donation. External data processing-The $100,000 or 30 percent increase in external data processing reflects increased reliance on outsourcing transaction processing to specialized vendors, which is typically performed on their hosted and secure websites thereby increasing our processing efficiency. Increases in the services offered to our client base and increases in transaction volume from normal business growth also contributed to the increase in this expense category. - 48 -



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Foreclosed real estate-The $110,000 or 80 percent increase in foreclosed real estate expenses was a result of holding costs incurred including real estate taxes, property maintenance, and valuation adjustments based upon updated appraisals. Other -The $330,000 or 27 percent decrease in other expense was primarily attributable to a $342,000 decrease in PA shares tax expense, a component of other expense. The decrease in shares tax expense reflected both (i) statutory changes in the formula for determining the shares tax which were favorable for the Corporation's tax basis, and (ii) changes in the volume of tax credits which originated from qualifying charitable donations described earlier.



Provision for income taxes

The provision for income tax for the first six months of 2014 was $2,064,000, compared to $1,961,000 for the same period of 2013. The $103,000 or 5 percent increase in the provision for income taxes was primarily the result of higher pretax earnings. For both periods, the Corporation's statutory federal income tax rate was 34 percent. The Corporation's effective income tax rate was 26 percent for the first six months of 2014, compared to 27 percent for the first six months of 2013. The effective tax rate differs from the statutory tax rate due to the impact of low-income housing credits and tax-exempt income, including income from bank owned life insurance.



Preferred stock dividends

Preferred stock dividends for the first six months of 2014 totaled $114,000 compared to $125,000 for the same period of 2013. Though an annualized dividend rate of 1 percent applied to both periods, the amount of preferred stock dividends for the first half of 2014 decreased because, on May 30, 2014, as reported on a Form 8-K filed on the same date, the Corporation used the net proceeds from a private placement of common stock, and additional cash, to redeem $13 million of the $25 million in outstanding shares of the Corporation's preferred stock held by the United States Department of the Treasury. The Corporation is currently paying the lowest permissible dividend rate under the U.S. Treasury's Small Business Lending Fund Program (SBLF Program) as a result of originating loans that qualify for the SBLF Program in excess of a pre-determined loan portfolio baseline balance. Information about the SBLF Program is provided in this report at Note 10-Shareholders' Equity.



BALANCE SHEET REVIEW

Interest bearing deposits with banks

On June 30, 2014, interest bearing deposits with banks totaled $21 million, compared to $2 million at year-end 2013. The increase was the result of funds generated from an increase in interest bearing deposits, and the proceeds from a $10 million borrowing from the Federal Home Loan Bank of Pittsburgh, which outpaced the deployment of funds to the loan and investment security portfolios.



Securities available-for-sale

On June 30, 2014, the fair value of securities available-for-sale totaled $227 million, which represented a slight 1 percent decrease compared to the $229 million value at year-end 2013. During the second quarter of 2014, cash inflows from U.S. agency mortgage-backed securities and state and municipal bond maturities (or bond calls) temporarily exceeded new investments in U.S. agency mortgage-backed securities. The overall composition of the Corporation's investment securities portfolio is provided in Note 3-Securities.



Loans

On June 30, 2014, total loans, net of deferred fees, totaled $888 million, which was $29 million or 3 percent higher than the level at year-end 2013. The increase in volume was due primarily to increases in commercial loans within the residential real estate investor and hotel/motel sectors, and additional loan growth in other industries (e.g., agriculture, professional services and finance). The composition of the Corporation's loan portfolio is provided in Note 5-Loans. - 49 -



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Deposits

On June 30, 2014, deposits totaled $968 million, which represented a $43 million or 5 percent increase compared to the level at year-end 2013. Of the increase in total deposits, $32 million was attributable to growth in time deposits, which reflected a special rate promotion to celebrate PeoplesBank's 150th anniversary. Additional increases in the demand (both interest and non-interest bearing) and savings categories also contributed to the increase in deposits. The composition of the Corporation's deposit portfolio is provided in Note 7-Deposits.



Long-term debt

On June 30, 2014, long-term debt totaled $80 million, which was $10 million or 14 percent above the year-end 2013 level. The increase was the result of a $10 million advance from the Federal Home Loan Bank of Pittsburgh that provides liquidity and acts as a hedge against rising market interest rates. The advance has a 38-month bullet maturity and a low fixed interest rate. A listing of outstanding long-term debt obligations is provided in Note 8-Short-Term Borrowing and Long-Term Debt.



Shareholders' equity and capital adequacy

Shareholders' equity, or capital, enables Codorus Valley to maintain asset growth and absorb losses. Total shareholders' equity was approximately $114 million on June 30, 2014, an increase of approximately $6 million or 6 percent, compared to the level at December 31, 2013. The increase in capital was primarily the result of retained earnings from profitable operations, less cash dividends paid during the first six months of 2014. The composition of shareholders' equity reflects an increase in common equity and a decrease in preferred equity as a result of the net proceeds from a $13 million private placement of common stock being used to redeem preferred stock, as discussed below.



Private placement of common stock and redemption of preferred stock

As previously announced on the Form 8-K filed on March 27, 2014, the Corporation completed the private placement of 650,000 shares of its common stock to accredited investors at a purchase price of $20 per share, pursuant to which the Corporation raised gross proceeds of $13 million. After issuance costs, net proceeds from the private placement totaled approximately $12.5 million. The net proceeds from the private placement, in addition to $0.5 million in cash, were used to redeem $13 million of the $25 million of outstanding preferred stock issued to the U.S. Department of the Treasury under its Small Business Lending Fund Program, as reported on the Form 8-K filed on May 30, 2014. More information about the private placement and the preferred stock can be found in this report at Note 10-Shareholders' Equity. For the six month periods ended June 30, 2014 and 2013, accrued dividends equated to an annualized dividend rate of 1 percent on the preferred stock outstanding.



Dividends on common stock

The Corporation has historically paid cash dividends on its common stock on a quarterly basis. The Board of Directors determines the dividend rate after considering the Corporation's capital requirements, current and projected net income, and other relevant factors. As recently announced, the Board of Directors declared a quarterly cash dividend of $0.125 per common share on July 8, 2014, payable on August 12, 2014, to shareholders of record at the close of business on July 22, 2014. This dividend follows $0.12 per common share cash dividends paid in May and February 2014. - 50 -



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Capital adequacy

The Corporation and PeoplesBank are subject to various regulatory capital requirements administered by banking regulators that involve quantitative guidelines and qualitative judgments. Quantitative measures established by regulators pertain to minimum capital ratios, as set forth in Note 9-Regulatory Matters to the financial statements. We believe that Codorus Valley and PeoplesBank were well capitalized on June 30, 2014, based on regulatory capital guidelines. On July 2, 2013, the Board of Governors of the Federal Reserve System finalized its rule implementing the Basel III regulatory capital framework, which the FDIC adopted on July 9, 2013. Under the rule, minimum requirements will increase both the quantity and quality of capital held by banking organizations. Additionally, a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5 percent and a common equity Tier 1 conservation buffer of 2.5 percent of risk-weighted assets will apply to all supervised financial institutions. The rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4 percent to 6 percent and includes a minimum leverage ratio of 4 percent for all banking organizations. The new rule also increases the risk weights for past-due loans, certain commercial real estate loans and some equity exposures, and makes selected other changes in risk weights and credit conversion factors. The rule for smaller, less complex institutions, which includes the Corporation, takes effect January 1, 2015. The new rule provides that, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold the 2.5 percent capital conservation buffer, which is to be phased in over a four year period beginning January 1, 2016, with the full 2.5 percent required as of January 1, 2019. The transition schedule for new ratios, including the capital conservation buffer, is as follows: As of January 1: 2015 2016 2017 2018 2019 Minimum common equity Tier 1 capital ratio 4.5 % 4.5 % 4.5 % 4.5 % 4.5 % Common equity Tier 1 capital conservation buffer N/A 0.625 % 1.25 % 1.875 % 2.5 % Minimum common equity Tier 1 capital ratio plus capital conservation buffer 4.5 % 5.125 % 5.75 % 6.375 % 7.0 % Phase-in of most deductions from common equity Tier 1 capital 40 % 60 % 80 % 100 % 100 % Minimum Tier 1 capital ratio 6.0 % 6.0 % 6.0 % 6.0 % 6.0 % Minimum Tier 1 capital ratio plus capital conservation buffer N/A 6.625 % 7.25 % 7.875 % 8.5 % Minimum total capital ratio 8.0 % 8.0 % 8.0 % 8.0 % 8.0 % Minimum total capital ratio plus capital conservation buffer N/A 8.625 % 9.25 % 9.875 % 10.5 % - 51 -



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As fully phased in, a banking organization with a buffer greater than 2.5% would not be subject to limits on dividend payments or discretionary bonus payments; however, a banking organization with a buffer less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The new rule also prohibits a banking organization from making dividend payments or discretionary bonus payments if its eligible net income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% as of the beginning of that quarter. Eligible net income is defined as net income for the 4 calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in net income. A summary of payout restrictions based on the capital conservation buffer is as follows: Capital Conservation Buffer Maximum Payout



(as a % of risk-weighted assets) (as a % of eligible net income)

Greater than 2.5% No payout limitation applies ?2.5% and >1.875% 60% ?1.875% and >1.25% 40% ?1.25% and >0.625% 20% ?0.625% 0%



The Corporation plans to manage its capital to ensure compliance with the new capital rules.

RISK MANAGEMENT Credit risk management The Credit Risk Management section included in the Corporation's Form 10-K for year-end 2013 provides a general overview of the Corporation's credit risk management process and loan concentrations. Credit risk represents the possibility that a loan client, counterparty or issuer may not perform in accordance with contractual terms, posing one of the most significant risks to the Corporation. Nonperforming assets The following table presents asset categories posing the greatest risk of loss and related ratios. We generally place a loan on nonaccrual status and cease accruing interest income, i.e., recognize interest income on a cash basis, as long as the loan is sufficiently collateralized, when loan payment performance is unsatisfactory and the loan is past due 90 days or more. Loans past due 90 days or more and still accruing interest represent loans that are contractually past due, but are well collateralized and in the process of collection. Foreclosed real estate represents real estate acquired to satisfy debts owed to PeoplesBank. Troubled debt restructurings pertain to loans whose terms have been modified to include a concession that we would not ordinarily consider due to the debtor's financial difficulties. Concessions granted under a troubled debt restructuring typically involve a reduction of interest rate lower than the current market rate for new debt with similar risk, the deferral of payments or extension of the stated maturity date. Troubled debt restructurings are evaluated for impairment if they have been restructured during the most recent calendar year, or if they cease to perform in accordance with the modified terms. The paragraphs and table below address significant changes in the aforementioned categories as of June 30, 2014, compared to December 31, 2013. Nonperforming assets are under the purview of in-house counsel, who continuously monitors and manages the collection of these accounts. Additionally, an internal asset quality control committee meets monthly to review nonperforming assets. We generally rely on appraisals performed by independent licensed appraisers to determine the value of collateral for impaired collateral-dependent loans. Generally, an appraisal is performed when: an account reaches 90 days past due, unless a certified appraisal was completed within the past twelve months; market values have changed significantly; the condition of the property has changed significantly; or the existing appraisal is outdated. In instances where the value of the collateral, net of costs to sell, is less than the net carrying amount for impaired commercial related loans, a specific loss allowance is established for the difference. When it is probable that some portion or an entire loan balance will not be collected, that amount is charged off as loss against the allowance. - 52 -



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Table 9 - Nonperforming Assets

June 30, December 31, (dollars in thousands) 2014 2013 Nonaccrual loans $ 6,842$ 13,231 Nonaccrual loans, troubled debt restructurings 2,122



2,069

Total nonperforming loans 8,964



15,300

Foreclosed real estate, net of allowance 4,711



4,068

Total nonperforming assets $ 13,675$ 19,368 Accruing troubled debt restructurings $ 2,186



$ 3,342

Total period-end loans, net of deferred fees $ 887,908$ 859,384 Allowance for loan losses (ALL) $ 10,460$ 9,975 ALL as a % of total period-end loans 1.18 % 1.16 % Annualized net charge-offs as a % of average total loans 0.08 % 0.10 % ALL as a % of nonperforming loans 116.69 % 65.20 % Nonperforming loans as a % of total period-end loans 1.01 %



1.78 % Nonperforming assets as a % of total period-end loans and net foreclosed real estate

1.53 % 2.24 % Nonperforming assets as a % of total period-end assets 1.14 % 1.68 % Nonperforming assets as a % of total period-end shareholders' equity 12.03 %



17.99 %

The current level of nonperforming assets has decreased by approximately $5.7 million or 29 percent when compared to year-end 2013. The decrease was primarily the result of (i) a $3.9 million payment received on a nonaccrual loan in the second quarter of 2014, (ii) the $1.05 million payoff of a nonaccrual commercial loan in the first quarter of 2014, and (iii) an approximate $0.5 million recovery from the sale of a foreclosed property in the first quarter of 2014. Generally, we remain concerned about prolonged low economic growth or weakening economic conditions and the corresponding effects it has on our commercial borrowers.



Nonaccrual loans

We evaluate the adequacy of the allowance for loan losses at least quarterly and have established a loss allowance for selected loan relationships where the net realizable value of the collateral is insufficient to repay the loan. In this regard, allowances, if applicable, are noted below within the description of the loan. Collection efforts, including modification of contractual terms for individual accounts based on prevailing market conditions and liquidation of collateral assets, are being employed to maximize recovery. Further provisions for loan losses may be required for nonaccrual loans as additional information becomes available or conditions change. There is also the potential for adjustment to the allowance as a result of regulatory examinations. A loan is returned to interest accruing status when we determine that circumstances have improved to the extent that all of the principal and interest amounts contractually due are current for at least six consecutive payments and future payments are reasonably assured. As of June 30, 2014, the nonperforming loan portfolio balance totaled $8,964,000, compared to $15,300,000 at year-end 2013. The decrease was primarily the result of a $3.9 million payment received on a nonaccrual commercial loan, a $1.05 million payoff of a nonaccrual commercial loan and reclassifications to foreclosed real estate totaling $1.6 million. For both periods the portfolio balance was comprised primarily of collateralized commercial loans. On June 30, 2014, the nonaccrual loan portfolio was comprised of twenty-two unrelated loan relationships with outstanding principal balances ranging in size from $21,200 to $2,002,000. Four unrelated commercial relationships, which represent 71 percent of the nonperforming loan portfolio balance, are described below. - 53 -



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Loan no. 1-At June 30, 2014, the outstanding principal balance of the loan relationship was $1,595,000 after a significant principal payment of $3,879,000 was received during the second quarter of 2014 from proceeds of the sale of the largest commercial property securing the loan. The remaining balance is collateralized by various smaller commercial properties, some with multiple lienholders. A $750,000 allowance for probable loan losses was established for this relationship. Management is pursuing its legal remedies to recover the remaining amount due.



Loan no. 2-At June 30, 2014, the outstanding principal balance of the loan relationship was $2,002,000, collateralized by commercial rental properties whose rents are assigned to PeoplesBank. Based on a recent appraisal of the primary real estate collateralizing the relationship, we believe that the loans are adequately collateralized. The borrower is presently operating under a troubled debt restructuring agreement.

Loan no. 3-At June 30, 2014, the outstanding principal balance of the loan relationship was $1,407,000, collateralized by various residential rental properties. A $500,000 allowance for loan losses was established for this relationship. The Bank is presently pursuing its legal remedies to recover the amount due.

Loan no. 4-At June 30, 2014, the outstanding principal balance of the loan relationship was $1,349,000, collateralized by two commercial properties. Based on an independent appraisal of the real estate collateralizing the relationship, we believe that the loans are adequately collateralized. The Bank is presently pursuing its legal remedies to recover the amount due.



Foreclosed real estate

On June 30, 2014, foreclosed real estate, net of allowance, totaled $4,711,000, compared to $4,068,000 at December 31, 2013. On June 30, 2014, the portfolio was comprised of nine unrelated accounts ranging in size from $51,000 to $1,179,000, net of related allowance. If a valuation allowance for probable loss has been established for a particular property, it is so noted in the property description below. Further valuation allowances may be required on any foreclosed property as additional information becomes available or conditions change. Foreclosed real estate is included in the other assets category on the Corporation's balance sheet. Four unrelated foreclosed real estate properties, which represent 81% of the foreclosed real estate portfolio balance, net of allowance, are described below.



Property no. 1- The carrying amount of this property at June 30, 2014 was $1,179,000, which is net of a $2,119,000 valuation allowance based on an independent appraisal, as adjusted for improvements, less estimated selling costs. The property is comprised of 266 acres of unimproved land that is zoned for residential development. Management is working towards a sale of the property.

Property no. 2- The carrying amount of this property at June 30, 2014 was $1,088,000, which is net of a $1,627,000 valuation allowance. The property is comprised of 134 approved residential building lots. Of this total, 28 lots are improved. Management is evaluating its disposition options with regard to this property.



Property no. 3 - The carrying amount of this property at June 30, 2014 is $910,000. The property is comprised of an 8 acre parcel improved for commercially developable sites. Management is evaluating its disposition options with regard to this property.

Property no. 4-The carrying amount of this residential property at June 30, 2014 was $648,000, which is net of a $132,000 valuation allowance. The property is presently listed for sale. - 54 -



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Allowance for loan losses

Although the Corporation maintains sound credit policies, certain loans deteriorate and must be charged off as losses. The allowance for loan losses is maintained to absorb losses inherent in the portfolio. The allowance is increased by provisions charged to expense and is reduced by loan charge-offs, net of recoveries. The allowance is based upon management's continuous evaluation of the loan portfolio coupled with a formal review of adequacy on a quarterly basis, which is subject to review and approval by the Board. The allowance for loan losses consists primarily of three components: specific allowances for individually impaired commercial loans; allowances calculated for pools of loans; and an unallocated component, which reflects the margin of imprecision inherent in the assumptions that underlie the evaluation of the adequacy of the allowance. The Corporation uses an internal risk rating system to evaluate individual loans. Loans are segmented into industry groups or pools with similar characteristics, and an allowance for loan losses is allocated to each segment based on quantitative factors such as recent loss history (two-year rolling average of net charge-offs) and qualitative factors, such as the results of internal and external credit reviews, changes in the size and composition of the loan portfolio, adequacy of collateral, general economic conditions and the local business outlook. Determining the level of the allowance for probable loan losses at any given period is difficult, particularly during deteriorating or uncertain economic periods. We must make estimates using assumptions and information which are often subjective and fluid. There is also the potential for adjustment to the allowance as a result of regulatory examinations. The following table presents an analysis of the activity in the allowance for loan losses for the six months ended June 30, 2014 and 2013. The $1,001,000 or 11 percent increase in the allowance from June 30, 2013 to June 30, 2014, generally supported the $119 million or 16 percent increase in loans, net of deferred fees. The provision for loan losses for the first six months of 2014 was $850,000 or 4 percent higher compared to the provision of $820,000 for the first six months of 2013. The increased provision was required to support the larger commercial loan portfolio and maintain the adequacy of the allowance for loan losses. Net charge-offs for the first six months of 2014 were $365,000 compared to $663,000 of net charge-offs for the same period of 2013. The Corporation realized a recovery in 2014 of $190,000 of a previous partial charge-off of an impaired commercial loan due to updated collateral appraisals resulting in a favorable fair value adjustment prior to the asset being transferred to foreclosed real estate. The risks and uncertainties associated with prolonged low growth or weakness in economic and business conditions, and the level of unemployment and erosion of real estate values, can adversely affect our borrowers' ability to service their loans, causing significant fluctuations in the level of charge-offs and provision expense from one period to another. Based on a comprehensive analysis of the loan portfolio, we believe that the allowance for loan losses was adequate at June 30, 2014. - 55 -



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Table 10 - Analysis of Allowance for Loan Losses

(dollars in thousands) 2014 2013 Balance-January 1, $ 9,975$ 9,302 Provision charged to operating expense 850



820

Loans charged off: Commercial, financial and agricultural 325



497

Real estate - residential mortgages 30 28 Consumer and home equity 292 208 Total loans charged off 647 733 Recoveries: Commercial, financial and agricultural 212



22

Real estate - residential mortgages 4 2 Consumer and home equity 66 46 Total recoveries 282 70 Net charge-offs 365 663 Balance-June 30, $ 10,460$ 9,459 Ratios: Allowance for loan losses as a % of total period-end loans 1.18 % 1.23 % Annualized net charge-offs as a % of average total loans 0.08 % 0.18 % Allowance for loan losses as a % of nonperforming loans 116.69 % 85.00 % Liquidity risk management Maintaining adequate liquidity provides the Corporation with the ability to meet financial obligations to depositors, loan customers, employees, and shareholders on a timely and cost effective basis in the normal course of business. Additionally, it provides funds for growth and business opportunities as they arise. Liquidity is generated from transactions relating to both the Corporation's assets and liabilities. The primary sources of asset liquidity are scheduled investment security maturities and cash inflows, funds received from customer loan payments, and asset sales. The primary sources of liability liquidity are deposit growth, short-term borrowings and long-term debt. The Consolidated Statements of Cash Flows, included in this report, present the changes in cash from operating, investing and financing activities. At June 30, 2014, we believe that liquidity was adequate based upon the potential liquidation of unpledged available-for-sale securities with a fair value totaling approximately $70 million and available credit from the Federal Home Loan Bank of Pittsburgh totaling approximately $272 million. The Corporation's loan-to-deposit ratio was 92 percent at June 30, 2014, compared to 93 percent at year-end 2013.



Off-balance sheet arrangements

The Corporation's financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist primarily of commitments to grant new loans, unfunded commitments under existing loan facilities, and letters of credit issued under the same standards as on-balance sheet instruments. Unused commitments on June 30, 2014, totaled $287 million and consisted of $204 million in unfunded commitments under existing loan facilities, $58 million to grant new loans and $25 million in letters of credit. Normally these commitments have fixed expiration dates or termination clauses and are for specific purposes. Accordingly, many of the commitments are expected to expire without being drawn upon and, therefore, generally do not present significant liquidity risk to the Corporation or PeoplesBank. - 56 -



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