News Column

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

August 8, 2014

Overview. Landmark Bancorp, Inc. is a one-bank holding company incorporated under the laws of the State of Delaware and is engaged in the banking business through its wholly-owned subsidiary, Landmark National Bank (the "Bank"). The Company is listed on the Nasdaq Global Market under the symbol "LARK." The Bank is dedicated to providing quality financial and banking services to its local communities. Our strategy includes continuing a tradition of quality assets while growing our commercial, commercial real estate and agriculture loan portfolios. We are committed to developing relationships with our borrowers and providing a total banking service. The Bank is principally engaged in the business of attracting deposits from the general public and using such deposits, together with borrowings and other funds, to originate one-to-four family residential real estate, construction and land, commercial real estate, commercial, agriculture, municipal and consumer loans. Although not our primary business function, we do invest in certain investment and mortgage-related securities using deposits and other borrowings as funding sources.

Our results of operations depend generally on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Net interest income is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. In addition, we are subject to interest rate risk to the degree that our interest-earning assets mature or reprice at different times, or at different speeds, than our interest-bearing liabilities. Our results of operations are also affected by non-interest income, such as service charges, loan fees and gains from the sale of newly originated loans and gains or losses on investments. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, professional fees, data processing expenses, amortization of intangibles, federal deposit insurance costs, advertising and provision for loan losses.



We are significantly impacted by prevailing economic conditions, including federal monetary and fiscal policies, and federal regulation of financial institutions. Deposit balances are influenced by numerous factors such as competing investments, the level of income and the personal rate of savings within our market areas. Factors influencing lending activities include the demand for housing and the interest rate pricing competition from other lending institutions.

Currently, our business consists of ownership of the Bank, with its main office in Manhattan, Kansas and twenty-eight additional branch offices in central, eastern, southeast and southwest Kansas. In August 2013, we entered into an agreement to acquire Citizens Bank, National Association ("Citizens Bank"), and such acquisition was completed on November 1, 2013 with the merger of Citizens Bank with and into the Bank. Citizens Bank had its main office in Fort Scott, Kansas and seven branches located in eastern Kansas, and had approximately $195 million in assets at the time it was acquired. Critical Accounting Policies. Critical accounting policies are those which are both most important to the portrayal of our financial condition and results of operations, and require our management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Our critical accounting policies relate to the valuation of the allowance for loan losses, valuation of real estate owned, valuation of investment securities, accounting for income taxes and the accounting for goodwill and other intangible assets, all of which involve significant judgment by our management. Information about our critical accounting policies is included under Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2013. Summary of Results. During the second quarter of 2014, we recorded net earnings of $2.1 million, which was an increase from the $1.4 million of net earnings in the second quarter of 2013. In the first six months of 2014, our net earnings were $3.8 million, an increase from the $2.8 million of net earnings recorded in the same period of 2013. The increase in our net earnings during 2014 was principally the result of our acquisition of Citizens Bank, which was reflected in our results for the three and six months ended June 30, 2014. 21 The following table summarizes earnings and key performance measures for the periods presented. Three months ended June 30, Six months ended June 30, (Dollars in thousands, except per share amounts) 2014 2013 2014 2013 Net earnings: Net earnings $ 2,077$ 1,409$ 3,776$ 2,849 Basic earnings per share (1) $ 0.65$ 0.46$ 1.19$ 0.93 Diluted earnings per share (1) $ 0.65$ 0.45$ 1.18$ 0.91 Earnings ratios: Return on average assets (2) 1.01 % 0.88 % 0.92 % 0.90 % Return on average equity (2) 12.46 % 8.79 % 11.66 % 8.98 % Equity to total assets 8.22 % 9.72 % 8.22 % 9.72 % Net interest margin (2) (3) 3.47 % 3.34 % 3.48 % 3.36 % Dividend payout ratio 29.23 %

40.43 % 32.20 % 39.58 %



(1) Per share values for the periods ended June 30, 2013 have been adjusted to

give effect to the 5% stock dividend paid during December 2013.

(2) Ratios have been annualized and are not necessarily indicative of the results

for the entire year.

(3) Net interest margin is presented on a fully tax equivalent basis, using a 34%

federal tax rate.

Interest Income. Interest income of $6.9 million for the quarter ended June 30, 2014 increased $1.7 million, or 32.1%, as compared to the same period of 2013. Interest income on loans increased $1.3 million, or 31.5%, to $5.2 million for the quarter ended June 30, 2014. The increase in interest income on loans was primarily the result of the acquisition of Citizens Bank, which increased our average outstanding loan balances from $323.4 million during the second quarter of 2013 to $422.4 million during the second quarter of 2014. Interest income on investment securities increased $413,000, or 34.1%, to $1.6 million for the second quarter of 2014, as compared to $1.2 million in the same period of 2013. The increase in interest income on investment securities was also primarily the result of the acquisition of Citizens Bank, which increased our average balance of investment securities from $241.7 million during the second quarter of 2013 to $309.3 million during the second quarter of 2014. Interest income of $13.7 million for the six months ended June 30, 2014 increased $3.3 million, or 31.8%, as compared to the same period of 2013. Interest income on loans increased $2.5 million, or 31.7%, to $10.5 million for the six months ended June 30, 2014. The increase in interest income on loans was primarily the result of our acquisition of Citizens Bank, which increased our average outstanding loan balances from $322.6 million during the first six months of 2013 to $418.8 million during the same period of 2014. Interest income on investment securities increased $778,000, or 32.0%, to $3.2 million for the first six months of 2014, as compared to $2.4 million in the same period of 2013. The increase in interest income on investment securities was also primarily the result of our acquisition of Citizens Bank, which increased our average balance of investment securities from $231.0 million during first six months of 2013 to $308.1 million during the same period of 2014. Interest Expense. Interest expense during the quarter ended June 30, 2014 increased $39,000, or 5.2%, to $797,000 as compared to the same period of 2013. Interest expense on interest-bearing deposits decreased $32,000, or 9.3%, to $314,000, despite increased average balances in the second quarter of 2014, primarily as a result of lower rates on our certificates of deposit accounts. Our total cost of interest-bearing deposits declined from 0.33% during the second quarter of 2013 to 0.23% during the second quarter of 2014 as we were able to reprice our certificates of deposit lower in the current low interest rate environment. Our average interest-bearing deposit balances increased from $425.9 million to $548.2 million from the second quarter of 2013 to the second quarter of 2014, due primarily to the acquisition of Citizens Bank. For the second quarter of 2014, interest expense on borrowings increased $71,000, or 17.2%, to $483,000 as compared to the same period of 2013, due primarily to an increase in our average outstanding borrowings. Our average outstanding borrowings increased from $61.5 million during the second quarter of 2013 to $70.3 million during the second quarter of 2014 as a result of borrowings assumed in the Citizens Bank acquisition. Interest expense during the six months ended June 30, 2014 increased $49,000, or 3.2%, to $1.6 million as compared to the same period of 2013. Interest expense on interest-bearing deposits decreased $92,000, or 12.6%, to $640,000, despite increased average balances in the first half of 2014, primarily as a result of lower rates on our certificates of deposit accounts. Our total cost of interest-bearing deposits declined from 0.35% during the first six months of 2013 to 0.23% during the same period of 2014 as we were able to reprice our certificates of deposit lower in the current low interest rate environment. Our average interest-bearing deposit balances increased from $425.0 million to $549.4 million from the first six months of 2013 to the same period of 2014, due primarily to the acquisition of Citizens Bank. For the first half of 2014, interest expense on borrowings increased $141,000, or 17.2%, to $962,000 as compared to the same period of 2013, due primarily to an increase in our average outstanding borrowings. Our average outstanding borrowings increased from $59.7 million during the first six months of 2013 to $70.1 million during the same period of 2014 as a result of borrowings assumed in the Citizens Bank acquisition. 22

Net Interest Income. Net interest income increased $1.6 million, or 36.7%, to $6.1 million for the second quarter of 2014 compared to the same period of 2013. Our net interest margin, on a tax-equivalent basis, increased to 3.47% during the second quarter of 2014 from 3.34% during the same period of 2013. The increases in net interest income and net interest margin were primarily the result of the acquisition of Citizens Bank, which increased average interest-earning assets from $573.0 million in the second quarter of 2013 to $742.3 million in the second quarter of 2014. Net interest income increased $3.2 million, or 36.8%, to $12.1 million for the first six months of 2014 compared to the same period of 2013. Our net interest margin, on a tax-equivalent basis, increased to 3.48% during the first six months of 2014 from 3.36% during the same period of 2013. The increases in net interest income and net interest margin were primarily the result of the acquisition of Citizens Bank, which increased average interest-earning assets from $569.2 million in the first six months of 2013 to $739.6 million in the same period of 2014. We do not expect any further increases in our net interest margin in the near term, and it is possible that our net interest margin will decline in future periods, as we may be unable to lower our cost of deposits to the extent necessary to offset the decline in yield on our loans and investment securities as they continue to reprice lower in the current low interest rate environment.



See the Average Assets/Liabilities and Rate/Volume tables at the end of Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for additional details on asset yields, liability rates and net interest margin.

Provision for Loan Losses. We maintain, and our Board of Directors monitors, an allowance for losses on loans. The allowance is established based upon management's periodic evaluation of known and inherent risks in the loan portfolio, review of significant individual loans and collateral, review of delinquent loans, past loss experience, adverse situations that may affect the borrowers' ability to repay, current and expected market conditions, and other factors management deems important. Determining the appropriate level of reserves involves a high degree of management judgment and is based upon historical and projected losses in the loan portfolio and the collateral value or discounted cash flows of specifically identified impaired loans. Additionally, allowance policies are subject to periodic review and revision in response to a number of factors, including current market conditions, actual loss experience and management's expectations. We recorded a $300,000 provision for loan losses during the second quarters of both 2014 and 2013. We recorded net loan charge-offs of $791,000 during the second quarter of 2014 compared to net loan charge-offs of $29,000 during the same period of 2013. The increase in net loan charge-offs during the six months ended June 30, 2014 was principally associated with a commercial loan relationship which was previously identified as impaired and which was liquidated during the second quarter of 2014. We recorded a $450,000 provision for loan losses during the first six months of 2014 compared to $600,000 in the same period of 2013. We recorded net loan charge-offs of $841,000 during the first six months of 2014 compared to net loan charge-offs of $276,000 during the same period of 2013. The loan charge-offs in both periods were primarily associated with previously identified and impaired commercial loan relationships.



For further discussion of the allowance for loan losses, refer to the "Asset Quality and Distribution" section below.

Non-interest Income. Total non-interest income was $4.1 million in the second quarter of 2014, an increase of $1.6 million, or 63.1%, compared to the same period of 2013, primarily as a result of the Citizens Bank acquisition. The higher non-interest income resulted from increases of $967,000 in gains on sales of loans, $517,000 in fees and service charges and $129,000 in other non-interest income. Our gains on sales of loans increased as a result of an increase in the volume of mortgages loans sold, as well as improved pricing on those loans. The increase in fees and service charges was primarily a result of additional service charges received on our deposit accounts and service fee income on one-to-four family residential real estate loans serviced for others. While the increase in gains on sales of loans and fees and service charges were primarily attributable to the acquisition of Citizens Bank, these items also experienced organic growth. The increase in other non-interest income was driven by higher lease revenue relating to the leased portion of a branch acquired

from Citizens Bank. 23

Total non-interest income was $7.4 million in the first six months of 2014, an increase of $2.2 million, or 42.6%, compared to the same period of 2013, primarily as a result of the Citizens Bank acquisition. The higher non-interest income resulted from increases of $1.1 million in gains on sales of loans, $879,000 in fees and service charges and $309,000 in other non-interest income. Our gains on sales of loans increased as a result of an increase in the volume of mortgages loans sold, as well as improved pricing on those loans. The increase in fees and service charges was primarily a result of additional service charges received on our deposit accounts and service fee income on one-to-four family residential real estate loans serviced for others. While the increase in gains on sales of loans and fees and service charges were primarily attributable to the acquisition of Citizens Bank, these items also experienced organic growth. The increase in other non-interest income was driven by higher lease revenue relating to the leased portion of a branch acquired from Citizens Bank. Non-interest Expense. Non-interest expense increased $2.2 million, or 45.9%, to $7.1 million for the second quarter of 2014 compared to the same period of 2013. The increase in non-interest expense was primarily the result of increases of $1.0 million in compensation and benefits, $361,000 in occupancy and equipment, $332,000 in other non-interest expense, $314,000 in amortization expense and $99,000 in data processing. The increases in compensation and benefits, occupancy and equipment, other non-interest expense and data processing in the second quarter of 2014 primarily reflected ongoing operating costs relating to the eight additional branches assumed in the Citizens Bank acquisition. The increase in amortization expense in the second quarter of 2014 was primarily the result of a lower level of expense recorded during the second quarter of 2013 as a result of the reversal of a $212,000 valuation allowance against our mortgage servicing rights portfolio. Non-interest expense increased $4.2 million, or 42.7%, to $13.9 million for the first six months of 2014 compared to the same period of 2013. The increase in non-interest expense was primarily the result of increases of $2.1 million in compensation and benefits, $772,000 in occupancy and equipment, $525,000 in other non-interest expense, $395,000 in amortization expense and $251,000 in data processing. The increases in compensation and benefits, occupancy and equipment, other non-interest expense and data processing in the first six months of 2014 primarily reflected ongoing operating costs relating to the eight additional branches assumed in the Citizens Bank acquisition. The increase in amortization expense in the first six months of 2014 was primarily the result of a lower level of expense recorded during the same period of 2013 as a result of the reversal of a $212,000 valuation allowance against our mortgage servicing rights portfolio. Income Tax Expense. During the second quarter of 2014, we recorded income tax expense of $792,000, compared to $417,000 during the same period of 2013. Our effective tax rate increased from 22.8% in the second quarter of 2013 to 27.6% in the second quarter of 2014 as a result of higher earnings before income taxes, while tax-exempt income remained relatively stable between the periods. During the first six months of 2014, we recorded income tax expense of $1.4 million, compared to $812,000 during the same period of 2013. Our effective tax rate increased from 22.2% in the first six months of 2013 to 26.6% in the same period of 2014 as a result of higher earnings before income taxes, while tax-exempt income remained relatively stable between the periods. Financial Condition. Despite measured improvement in certain metrics, general uncertainty with respect to economic conditions in the United States continues to affect our asset quality and performance. Although the geographic markets in which the Company operates have been impacted by these economic conditions in recent years, the effect has generally not been as severe as those experienced in some areas of the United States. In addition, our loan portfolio is diversified across various types of loans and collateral throughout the markets in which we operate. Despite a few lingering problem loans that management continues to work to resolve, our asset quality has generally improved over the past few years. Outside of identified problem assets, management believes that it continues to have a high quality asset base and solid core earnings, and anticipates that its efforts to run a high quality financial institution with a sound asset base will continue to create a strong foundation for continued growth and profitability in the future. Asset Quality and Distribution. Our primary investing activities are the origination of one-to-four family residential real estate, construction and land, commercial real estate, commercial, agriculture, municipal and consumer loans and the purchase of investment and mortgage-backed securities. Total assets increased to $836.0 million at June 30, 2014, compared to $828.8 million at December 31, 2013. Net loans, excluding loans held for sale, decreased to $412.7 million at June 30, 2014 from $414.0 million at December 31, 2013. The $1.3 million decrease in loans was primarily the result of lower outstanding balances of commercial, commercial real estate and construction and land loans, partially offset by increases in each of our other loan categories. The overall decline in loan balances was the result of multiple factors, including reduced loan demand from our customers, early payoffs and charge-offs. 24 The allowance for loan losses is established through a provision for loan losses based on our evaluation of the risk inherent in the loan portfolio and changes in the nature and volume of our loan activity. This evaluation, which includes a review of all loans with respect to which full collectability may not be reasonably assured, considers the fair value of the underlying collateral, economic conditions, historical loan loss experience, level of classified loans and other factors that warrant recognition in providing for an appropriate allowance for loan losses. At June 30, 2014, our allowance for loan losses totaled $5.1 million, or 1.23% of gross loans outstanding, as compared to $5.5 million, or 1.32% of gross loans outstanding, at December 31, 2013. As of June 30, 2014 and December 31, 2013, approximately $21.8 million and $14.6 million, respectively, of loans not included in the non-performing asset table were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Even though certain borrowers are experiencing moderate cash flow problems as well as some deterioration in collateral value, management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at June 30, 2014 and December 31, 2013, respectively. Loans past due 30-89 days and still accruing interest totaled $1.4 million, or 0.34% of gross loans at both June 30, 2014 and December 31, 2013. At June 30, 2014, $6.6 million in loans were on non-accrual status, or 1.57% of gross loans, compared to $9.8 million, or 2.35% of gross loans, at December 31, 2013. Non-accrual loans consist of loans 90 or more days past due and certain impaired loans. There were no loans 90 days delinquent and accruing interest at June 30, 2014 or December 31, 2103. Our impaired loans totaled $11.1 million at June 30, 2014 compared to $16.8 million at December 31, 2013. The difference in the Company's non-accrual loan balances and impaired loan balances at June 30, 2014 was related to TDRs that were accruing interest but still classified as impaired. We recorded net loan charge-offs of $841,000 during the first six months of 2014 compared to net loan charge-offs of $276,000 during the same period of 2013. The loan charge-offs in both periods were primarily associated with previously identified and impaired commercial loan relationships. At each of June 30, 2014 and December 31, 2013, the Company had seven loan relationships consisting of eleven outstanding loans that were classified as TDRs. The Company did not classify any loan restructurings during the first

six months of 2014 as a TDR. As part of our credit risk management, we continue to manage the loan portfolio to identify problem loans and have placed additional emphasis on commercial real estate and construction and land relationships. We are working to resolve the remaining problem credits or move the non-performing credits out of the loan portfolio. At June 30, 2014, we had $191,000 of real estate owned compared to $400,000 at December 31, 2013. As of June 30, 2014, real estate owned primarily consisted of a few residential real estate properties. The Company is currently marketing all of the remaining properties in real estate owned. Many financial institutions, including us, experienced a general increase in non-performing assets during the recent financial crisis, as even well-established business borrowers developed cash flow, profitability and other business-related problems as a result of economic conditions. While we believe that our allowance for loan losses at each of June 30, 2014 and December 31, 2013 was appropriate, there can be no assurances that loan losses will not exceed the estimated amounts. We believe that we use the best information available to determine the allowance for loan losses; however, unforeseen market conditions could result in adjustment to the allowance for loan losses. In addition, net earnings could be significantly affected if circumstances differ substantially from the assumptions used in establishing the allowance for loan losses. Deterioration in the local economy or real estate values may create additional problem loans for us and require further adjustment to our allowance for loan losses.

Liability Distribution. Our primary ongoing sources of funds are deposits, FHLB borrowings, proceeds from principal and interest payments on loans and investment securities and proceeds from the sale of mortgage loans and investment securities. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates and economic conditions. We experienced a $3.0 million decrease in total deposits during the first six months of 2014, to $684.5 million at June 30, 2014, from $687.5 million at December 31, 2013. The decrease in deposits was primarily due to lower money market and NOW balances, which were primarily associated with seasonable declines in our municipal accounts. This decline was partially offset by higher balances of non-interest bearing deposits and time deposits of $100,000 or greater. Total borrowings decreased $187,000 to $68.6 million at June 30, 2014, from $68.7 million at December 31, 2013. Non-interest-bearing deposits at June 30, 2014, were $132.1 million, or 19.3% of deposits, compared to $124.5 million, or 18.1%, at December 31, 2013. Money market and NOW deposit accounts were 42.7% of our deposit portfolio and totaled $292.7 million at June 30, 2014, compared to $307.0 million, or 44.7%, at December 31, 2013. Savings accounts increased to $73.8 million, or 10.8% of deposits, at June 30, 2014, from $69.8 million, or 10.1%, at December 31, 2013. Certificates of deposit totaled $186.0 million, or 27.2% of deposits, at June 30, 2014, compared to $186.2 million, or 27.1%, at December 31, 2013. 25



Certificates of deposit at June 30, 2014, scheduled to mature in one year or less totaled $129.3 million. Historically, maturing deposits have generally remained with the Bank, and we believe that a significant portion of the deposits maturing in one year or less will remain with us upon maturity.

Cash Flows. During the six months ended June 30, 2014, our cash and cash equivalents decreased by $11.7 million. Our operating activities provided net cash of $4.5 million during the first six months of 2014. Our investing activities used net cash of $12.3 million during the first six months of 2014, primarily as a result of purchasing investment securities. Financing activities used net cash of $3.9 million during the first six months of 2014 primarily as a result of decreased deposits and dividend payments. Liquidity. Our most liquid assets are cash and cash equivalents and investment securities available for sale. The levels of these assets are dependent on the operating, financing, lending and investing activities during any given year. These liquid assets totaled $336.5 million at June 30, 2014 and $330.0 million at December 31, 2013. During periods in which we are not able to originate a sufficient amount of loans and/or periods of high principal prepayments, we generally increase our liquid assets by investing in short-term, high-grade investments. Liquidity management is both a daily and long-term function of our strategy. Excess funds are generally invested in short-term investments. Excess funds are typically generated as a result of increased deposit balances, while uses of excess funds are generally deposit withdrawals and loan advances. In the event we require funds beyond our ability to generate them internally, additional funds are generally available through the use of FHLB advances, a line of credit with the FHLB, other borrowings or through sales of investment securities. At June 30, 2014, we had outstanding FHLB advances of $35.7 million and no borrowings against our line of credit with the FHLB. At June 30, 2014, we had collateral pledged to the FHLB that would allow us to borrow an additional $29.9 million, subject to FHLB credit requirements and policies. At June 30, 2014, we had no borrowings through the Federal Reserve discount window, while our borrowing capacity with the Federal Reserve was $12.7 million. We also have various other federal funds agreements, both secured and unsecured, with correspondent banks totaling approximately $50.0 million in available credit under which we had no outstanding borrowings at June 30, 2014. We had other borrowings of $32.9 million at June 30, 2014, which included $20.8 million of subordinated debentures, $12.0 million in repurchase agreements and $120,000 on a line of credit. The Company has a $7.5 million line of credit from an unrelated financial institution maturing on November 1, 2014, with an interest rate that adjusts daily based on the prime rate plus 0.25%, and a floor of 3.75%. This line of credit has covenants specific to capital and other financial ratios, all of which remained satisfied by the Company or were waived by the unrelated financial institution as of and for the period ending June 30, 2014. Off Balance Sheet Arrangements. As a provider of financial services, we routinely issue financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by us generally to guarantee the payment or performance obligation of a customer to a third party. While these standby letters of credit represent a potential outlay by us, a significant amount of the commitments may expire without being drawn upon. We have recourse against the customer for any amount the customer is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by us. Most of the standby letters of credit are secured, and in the event of nonperformance by the customers, we have the right to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. The contract amount of these standby letters of credit, which represents the maximum potential future payments guaranteed by us, was $1.2 million at June 30, 2014.



At June 30, 2014, we had outstanding loan commitments, excluding standby letters of credit, of $67.8 million. We anticipate that sufficient funds will be available to meet current loan commitments. These commitments consist of unfunded lines of credit and commitments to finance real estate loans.

Capital. Current regulatory capital regulations require financial institutions (including banks and bank holding companies) to meet certain regulatory capital requirements. Institutions are required to have minimum leverage capital equal to 4% of total average assets and total qualifying capital equal to 8% of total risk weighted assets in order to be considered "adequately capitalized." As of June 30, 2014 and December 31, 2013, both the Company and the Bank were rated "well capitalized," which is the highest rating available under the regulatory capital regulations framework for prompt corrective action. Management believes that as of June 30, 2014, the Company and the Bank met all capital adequacy requirements to which we are subject. 26

In July 2013 the Board of Governors of the Federal Reserve System approved a final rule to implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The final rule increases minimum requirements for both the quantity and quality of capital held by banking organizations. The rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5% and a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The final rule also adjusted the methodology for calculating risk-weighted assets to enhance risk sensitivity. We are in the process of evaluating the full impact of the new regulation to which we will be subject beginning January 1, 2015, but believe we would have been considered "well capitalized" under the new regulation if it had been in effect as of June 30, 2014.



The following is a comparison of the Company's regulatory capital to minimum capital requirements at June 30, 2014 and December 31, 2013:

To be well-capitalized under prompt For capital corrective Actual adequacy purposes action provisions

(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio As of June 30, 2014 Leverage $ 62,672 7.76 % $ 32,298 4.0 % $ 40,372 5.0 % Tier 1 Capital $ 62,672 12.36 % $ 20,288 4.0 % $ 30,432 6.0 %

Total Risk Based Capital $ 73,169 14.43 % $ 40,576 8.0 % $ 50,720 10.0 % As of December 31, 2013 Leverage $ 58,605 7.89 % $ 29,710 4.0 % $ 37,137 5.0 % Tier 1 Capital $ 58,605 11.61 % $ 20,189 4.0 % $ 30,283 6.0 % Total Risk Based Capital $ 69,888 13.85 % $ 40,378

8.0 % $ 50,472 10.0 %



The following is a comparison of the Bank's regulatory capital to minimum capital requirements at June 30, 2014 and December 31, 2013:

To be well-capitalized under prompt For capital corrective Actual adequacy purposes action provisions

(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio As of June 30, 2014 Leverage $ 66,473 8.25 % $ 32,221 4.0 % $ 40,276 5.0 % Tier 1 Capital $ 66,473 13.14 % $ 20,231 4.0 % $ 30,347 6.0 %

Total Risk Based Capital $ 72,226 14.28 % $ 40,462 8.0 % $ 50,578 10.0 % As of December 31, 2013 Leverage $ 62,553 8.46 % $ 29,565 4.0 % $ 36,956 5.0 % Tier 1 Capital $ 62,553 12.43 % $ 20,133 4.0 % $ 30,200 6.0 % Total Risk Based Capital $ 68,243 13.56 % $ 40,267

8.0 % $ 50,333 10.0 %



Dividends. During the quarter ended June 30, 2014, we paid a quarterly cash dividend of $0.19 per share to our stockholders.

The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of June 30, 2014. The National Bank Act imposes limitations on the amount of dividends that a national bank may pay without prior regulatory approval. Generally, the amount is limited to the bank's current year's net earnings plus the adjusted retained earnings for the two preceding years. As of June 30, 2014, approximately $9.7 million was available to be paid as dividends to the Company by the Bank without prior regulatory approval. 27 Additionally, our ability to pay dividends is limited by the subordinated debentures that are held by three business trusts that we control. Interest payments on the debentures must be paid before we pay dividends on our capital stock, including our common stock. We have the right to defer interest payments on the debentures for up to 20 consecutive quarters. However, if we elect to defer interest payments, all deferred interest must be paid before we may pay dividends on our capital stock.



Average Assets/Liabilities. The following table reflects the tax-equivalent yields earned on average interest-earning assets and costs of average interest-bearing liabilities for the periods indicated (derived by dividing income or expense by the monthly average balance of assets or liabilities, respectively) as well as "net interest margin" (which reflects the effect of the net earnings balance) for the periods shown:

Three months ended Three months ended June 30, 2014 June 30, 2013 Average Average Average Average balance Interest yield/rate balance Interest yield/rate (Dollars in thousands) Assets Interest-earning assets: Interest-bearing deposits at banks $ 10,603$ 8

0.30 % $ 7,881$ 10 0.51 % Investment securities (1) 309,317 1,926 2.50 % 241,671 1,496 2.48 % Loans receivable, net (2) 422,399 5,287 5.02 % 323,446 4,021 4.99 %

Total interest-earning assets 742,319 7,221 3.90 % 572,998 5,527 3.87 % Non-interest-earning assets 84,845 68,385 Total $ 827,164



$ 641,383

Liabilities and Stockholders' Equity Interest-bearing liabilities: Money market and NOW accounts $ 289,503$ 68

0.09 % $ 211,733$ 41 0.08 % Savings accounts 74,245 6 0.03 % 49,946 4 0.03 % Certificates of deposit 184,494 240 0.52 % 164,194 301 0.74 % Total deposits 548,242 314 0.23 % 425,873 346 0.33 %

FHLB advances and other borrowings 70,337 483 2.75 % 61,543 412 2.69 % Total interest-bearing liabilities 618,579 797 0.52 % 487,416 758 0.62 % Non-interest-bearing liabilities 141,707

89,706 Stockholders' equity 66,878 64,261 Total $ 827,164$ 641,383 Interest rate spread (3) 3.38 % 3.25 % Net interest margin (4) $ 6,424 3.47 % $ 4,769 3.34 %

Tax-equivalent interest - imputed 348 323 Net interest income $ 6,076$ 4,446 Ratio of average interest-earning assets to average interest-bearing liabilities 120.0 % 117.6 %



(1) Income on tax exempt securities is presented on a fully tax-equivalent basis,

using a 34% federal tax rate.

(2) Includes loans classified as non-accrual. Income on tax-exempt loans is

presented on a fully tax-equivalent basis, using a 34% federal tax rate.

(3) Interest rate spread represents the difference between the average yield

earned on interest-earning assets and the average rate paid on

interest-bearing liabilities.

(4) Net interest margin represents annualized, tax-equivalent net interest income

divided by average interest-earning assets. 28 Six months ended Six months ended June 30, 2014 June 30, 2013 Average Average Average Average balance Interest yield/rate balance Interest yield/rate (Dollars in thousands) Assets Interest-earning assets: Interest-bearing deposits at banks $ 12,704$ 16 0.25 % $ 15,606$ 20 0.26 % Investment securities (1) 308,122 3,813 2.50 % 231,019 2,996 2.61 % Loans receivable, net (2) 418,819 10,541 5.08 % 322,562 8,020 5.01 % Total interest-earning assets 739,645 14,370 3.92 % 569,187 11,036 3.91 % Non-interest-earning assets 84,851 67,806 Total $ 824,496$ 636,993 Liabilities and Stockholders' Equity Interest-bearing liabilities: Money market and NOW accounts $ 291,989$ 139 0.10 % $ 209,619$ 88 0.08 % Savings accounts 73,508 12 0.03 % 48,815 8 0.03 % Certificates of deposit 183,880 489 0.54 % 166,571 636 0.77 % Total deposits 549,377 640 0.23 % 425,005 732 0.35 % FHLB advances and other borrowings 70,138 962 2.77 % 59,702 821 2.77 % Total interest-bearing liabilities 619,515 1,602 0.52 % 484,707 1,553 0.65 %

Non-interest-bearing liabilities 139,673

88,343 Stockholders' equity 65,308 63,943 Total $ 824,496$ 636,993 Interest rate spread (3) 3.40 % 3.26 % Net interest margin (4) $ 12,768 3.48 % $ 9,483 3.36 % Tax-equivalent interest - imputed 692 655 Net interest income $ 12,076$ 8,828 Ratio of average interest-earning assets to average interest-bearing liabilities 119.4 % 117.4 %



(1) Income on tax exempt securities is presented on a fully tax-equivalent basis,

using a 34% federal tax rate.

(2) Includes loans classified as non-accrual. Income on tax-exempt loans is

presented on a fully tax-equivalent basis, using a 34% federal tax rate.

(3) Interest rate spread represents the difference between the average yield

earned on interest-earning assets and the average rate paid on

interest-bearing liabilities.

(4) Net interest margin represents annualized, tax-equivalent net interest income

divided by average interest-earning assets. 29

Rate/Volume Table.The following table describes the extent to which changes in tax-equivalent interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities affected the Company's interest income and expense for periods indicated. The table distinguishes between (i) changes attributable to rate (changes in rate multiplied by prior volume), (ii) changes attributable to volume (changes in volume multiplied by prior rate), and (iii) net change (the sum of the previous columns). The net changes attributable to the combined effect of volume and rate that cannot be segregated have been allocated proportionately to the change due to volume and the change due to rate. Three months ended June 30, Six months ended June 30, 2014 vs 2013 2014 vs 2013 Increase/(decrease) attributable to Increase/(decrease) attributable to Volume Rate Net Volume Rate Net (Dollars in thousands) (Dollars in thousands) Interest income: Interest-bearing deposits at banks $ 10 $ (12 )

$ (2 ) $ (3 ) $ (1 )$ (4 ) Investment securities 418 12 430 935 (118 ) 817 Loans 1,242 24 1,266 2,409 112 2,521 Total 1,670 24 1,694 3,341 (7 ) 3,334 Interest expense: Deposits 586 (618 ) (32 ) 536 (628 ) (92 ) Other borrowings 61 10 71 141 - 141 Total 647 (608 ) 39 677 (628 ) 49 Net interest income $ 1,023$ 632$ 1,655$ 2,664$ 621$ 3,285


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Source: Edgar Glimpses


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