News Column

MANAGEMENT'S DISCUSSION AND ANALYSIS

August 8, 2014

(Dollars in thousands, except per share data)

Postretirement Life Pension Benefits Insurance Benefits Six months ended June 30, 2014 2013 2014 2013 Net periodic pension cost: Service cost $ 21 Interest cost $ 338$ 323 67 Expected return on plan assets (454 ) (413 ) Amortization of prior service cost Amortization of unrecognized net loss 46 90 58 Net periodic pension cost $ (70 ) $ $ 146



Item 2. Management's Discussion and Analysis of Financial Condition and Results

of Operations

The following discussion and analysis should be read in conjunction with the unaudited consolidated interim financial statements contained in Part I, Item 1 of this report, and with our audited consolidated financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations" presented in our Annual Report on Form 10-K for the year ended December 31, 2013.



Cautionary Note Regarding Forward-Looking Statements:

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to risks and uncertainties. These statements are based on assumptions and may describe future plans, strategies and expectations of Peoples Financial Services Corp. and its direct and indirect subsidiaries. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. All statements in this report, other than statements of historical facts, are forward-looking statements. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Important factors that could cause our actual results to differ materially from those in the forward-looking statements include, but are not limited to: our ability to timely and efficiently integrate the operations of the former Penseco Financial Services Corporation, and to achieve the intended benefits of the merger with Penseco Financial Services Corporation; changes in interest rates; economic conditions, particularly in the our market area; legislative and regulatory changes and the ability to comply with the significant laws and regulations governing the banking and financial services business; monetary and fiscal policies of the U.S. government, including policies of the U.S. Department of Treasury and the Federal Reserve System; credit risk associated with lending activities and changes in the quality and composition of our loan and investment portfolios; demand for loan and other products; deposit flows; competition; changes in the values of real estate and other collateral securing the loan portfolio, particularly in our market area; changes in relevant accounting principles and guidelines; and inability of third party service providers to perform. Additional factors that may affect our results are discussed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2013, and in and reports we file with the Securities and Exchange Commission from time to time. 29



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Peoples Financial Services Corp. does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events. Notes to the Consolidated Financial Statements referred to in the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") are incorporated by reference into the MD&A. Certain prior period amounts may have been reclassified to conform with the current year's presentation. Any reclassifications did not have any effect on the operating results or financial position of the company.



Critical Accounting Policies:

Disclosure of our significant accounting policies are included in Note 1 to the consolidated financial statements of the Annual Report on Form 10-K for the year ended December 31, 2013. Some of these policies are particularly sensitive requiring significant judgments, estimates and assumptions.



Operating Environment:

Fiscal policy enacted by the Federal Open Market Committee ("FOMC") during the second quarter of 2014 was limited to continuing the tapering of investment purchases employed in their quantitative easing initiatives. The FOMC is scheduled to conclude this latest initiative in October 2014. Economic growth as measured by the gross domestic product ("GDP"), the value of all goods and services produced in the Nation, improved significantly in the second quarter of 2014 compared to the anemic level experienced in the prior quarter. The GDP grew 4.0% in the second quarter of 2014, an increase over the negative growth of 2.1% in the first quarter of 2014 and above the second quarter estimate of 3.0%. Despite this improvement, there is concern that the second quarter increase was a result of pent up demand brought on by the tough winter experienced in the first quarter of 2014 and that the remainder of 2014 will not continue to be as strong as the second quarter. Despite weakness in consumer, business and government spending in the second quarter of 2014, the latest monthly employment figures released by the Bureau of Labor Statistics indicate strong job creation during the first six months of 2014. Based on preliminary June 2014 numbers of 288,000 jobs being created, the economy is creating 231,000 jobs per month on average. The current growth rate is more than sufficient to satisfy an estimated 90,000 to 125,000 new entrants to the job market each month and the estimated 150,000 to 200,000 jobs estimated to be needed in order to improve the unemployment rate. With regard to inflation, rising food and energy costs caused the price index for gross domestic purchases, a measure of prices paid by United States residents, to increase to 2.1% for the most recent reporting month of June 2014, slightly above the 2.0% rate targeted by the Federal Reserve. Rising food and energy prices continue to limit other consumer spending and if sustained, may counteract the impact of job gains and weigh on GDP readings going forward. 30



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

Review of Financial Position:

Total assets grew $42,885, or at an annual rate of 5.1% to $1,731,106 at June 30, 2014, from $1,688,221 at December 31, 2013. For the six months ended June 30, 2014, total assets averaged $1,701,791, an increase of $776,337 from $925,454 for the same period of 2013, primarily due to the merger. The balance sheet growth during 2014 was driven by increases in total deposits of $43,295, an annual growth rate of 6.3%. Interest-bearing deposits increased $27,315, while noninterest-bearing deposits grew $15,980. Loans, net increased to $1,179,847 at June 30, 2014, compared to $1,176,617 at December 31, 2013. Total stockholders' equity increased $5,373 or at an annual rate of 4.5%, from $238,792 at year-end 2013 to $244,165 at June 30, 2014. For the second quarter of 2014, total assets, loans, net and deposits increased $12,845, $2,725 and $18,736. Investment Portfolio: The majority of the investment portfolio is held as available-for-sale, which allows for greater flexibility in using the investment portfolio for liquidity purposes by allowing securities to be sold when market opportunities occur. Investment securities available-for-sale totaled $312,323 at June 30, 2014, an increase of $12,608, or 4.2% from $299,715 at December 31, 2013. The increase resulted primarily from the purchase of collateralized mortgage obligations net of payments received from mortgage backed holdings. Investment securities held-to-maturity totaled $15,915 at June 30, 2014, a decrease of $1,380 or 8.0% from $17,295 at December 31, 2013 due to payments received from mortgage backed holdings. For the three months ended June 30, 2014, total investments increased $9,405 consisting of an increase of $10,097 in available-for-sale securities and a decrease of $692 in held-to-maturity securities. For the six months ended June 30, 2014, the investment portfolio averaged $320,452, an increase of $146,146 compared to $174,306 for the same period last year. The tax-equivalent yield on the investment portfolio decreased 46 basis points to 2.79% for the six months ended June 30, 2014, from 3.25% for the comparable period of 2013. The yield decline is the result of decreasing reinvestment yields as well as an overall investment strategy aimed at shortening the duration of the investment portfolio. The tax-equivalent yield decreased slightly from 2.81% in the first quarter of 2014 to 2.77% in the second quarter of 2014. Securities available-for-sale are carried at fair value, with unrealized gains or losses net of deferred income taxes reported in the accumulated other comprehensive income (loss) component of stockholders' equity. The carrying value of securities at June 30, 2014, included a net unrealized gain of $6,286 reflected as a component of accumulated other comprehensive income in stockholders' equity, net of deferred income taxes of $2,200. This compares to a net unrealized gain of $2,810 at December 31, 2013, net of deferred income taxes of $984. The Asset/Liability Committee ("ALCO") reviews the performance and risk elements of the investment portfolio monthly. Through active balance sheet management and analysis of the securities portfolio, we maintain sufficient liquidity to satisfy depositor requirements and meet the credit needs of our customers. 31



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

Loan Portfolio:

Payments and prepayments on loans were slightly lower than the amount of loan originations during the first half of 2014. As a result, loans, net increased slightly to $1,179,847 at June 30, 2014 from $1,176,617 at December 31, 2013. The marginal increase was a reflection of weak market conditions, heightened competitive forces and efforts devoted to the conversion of the core operating system in the second quarter of 2014, as a result of the merger. The net change reflected increases in commercial real estate loans, partially offset by decreases in commercial loans, residential real estate and consumer loans. Commercial real estate loans increased $26,884, or 13.0% on an annualized basis, to $439,942 at June 30, 2014 compared to $413,058 at December 31, 2013. Commercial loans decreased $13,647, or 7.8% on an annualized basis, to $337,033 at June 30, 2014 compared to $350,680 at December 31, 2013. Continued weakness in labor markets, coupled with higher food and energy prices, have hampered consumer purchasing power throughout the second quarter of 2014. Additionally, weakness in real estate markets have further cut into the wealth of consumers. Residential real estate loans decreased $4,133, or 2.6% on an annualized basis, to $317,929 at June 30, 2014 compared to $322,062 at December 31, 2013 while consumer loans decreased $5,874, or 12.9% on an annualized basis, to $84,943 at June 30, 2014 compared to $90,817 at December 31, 2013. For the six months ended June 30, 2014, loans, net averaged $1,184,541, an increase of $548,525 compared to $636,016 for the same period of 2013, primarily due to the merger. The tax-equivalent yield on the loan portfolio was 4.92% for the six months ended June 30, 2014, a 10 basis point decrease from the comparable period last year. The tax-equivalent yield on the loan portfolio declined 43 basis points to 4.71% in the second quarter of 2014 from 5.14% in the first quarter of 2014. Adjusting for the recognition of accretion on loans acquired in the merger, the decline was 30 basis points comparing the first and second quarters of 2014. For the second quarter of 2014, loans, net increased $2,725. Increases in commercial real estate loans of $30,219 were offset partially by decreases in commercial loans of $21,696, residential mortgage loans of $2,874 and consumer loans of $2,924. In addition to the risks inherent in our loan portfolio, in the normal course of business, we are also a party to financial instruments with off-balance sheet risk to meet the financing needs of our customers. These instruments include legally binding commitments to extend credit, unused portions of lines of credit and commercial letters of credit made under the same underwriting standards as on-balance sheet instruments, and may involve, to varying degrees, elements of credit risk and interest rate risk ("IRR") in excess of the amount recognized in the financial statements. Unused commitments at June 30, 2014, totaled $314,345, consisting of $280,905 in unfunded commitments of existing loan facilities and $33,440 in standby letters of credit. Due to fixed maturity dates, specified conditions within these instruments, and the ultimate needs of our customers, many will expire without being drawn upon. We believe that amounts actually drawn upon can be funded in the normal course of operations and therefore, do not represent a significant liquidity risk to us. In comparison, unused commitments, at December 31, 2013, totaled $303,309, consisting of $273,395 in unfunded commitments of existing loans and $29,914 in standby letters of credit. 32



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

Asset Quality:

National, Pennsylvania, New York and market area unemployment rates at June 30, 2014 and 2013, are summarized as follows:

June 30, June 30, 2014 2013 United States 6.1 % 7.5 % Pennsylvania (statewide) 5.8 % 7.9 % Lackawanna county 6.8 % 9.2 % Luzerne county 7.1 % 9.6 % Monroe county 7.4 % 9.6 % Susquehanna county 5.0 % 7.0 % Wayne county 5.3 % 7.1 % Wyoming county 6.5 % 9.4 % New York (statewide) 6.5 % 7.8 % Broome county 6.4 % 8.0 % The employment conditions improved for the Nation, Pennsylvania, New York as well as all seven counties representing our market areas in Pennsylvania and New York from one year ago. Despite the overall improvements, employment conditions continued to be weak as unemployment rates remained elevated relative to historical levels. Our asset quality improved in the first half of 2014. Nonperforming assets decreased $3,521 or 18.1% to $15,935 at June 30, 2014, from $19,456 at December 31, 2013. We experienced increases in accruing loans past due 90 days or more, which were more than offset by declines in nonaccrual and restructured loans and other real estate owned. As a percentage of loans, net and foreclosed assets, nonperforming assets equaled 1.35% at June 30, 2014 compared to 1.65% at December 31, 2013. The Asset Quality Committee reviews the asset quality metrics and risk elements of the loan portfolio monthly. Loans on nonaccrual status decreased $1,250 to $13,616 at June 30, 2014 from $14,866 at December 31, 2013. The decrease from year end was due primarily to a decrease of $1,257 in commercial loans, commercial real estate loans and residential real estate loans on nonaccrual status. Retail consumer loans on nonaccrual status increased $7. Other real estate owned decreased $22 to $626 at June 30, 2014 from $648 at December 31, 2013.



For the three months ended June 30, 2014, nonperforming assets deteriorated slightly to $15,935, an increase of $672 from $15,263 at March 31, 2014. Increases in nonaccrual loans of $694 and accruing loans past due 90 days or more of $30 more than offset a $52 decline in other real estate owned.

Generally, maintaining a high loan to deposit ratio is our primary goal in order to maximize profitability. However, this objective is superseded by our attempts to assure that asset quality remains strong. We continued our efforts to maintain sound underwriting standards for both commercial and consumer credit. Most commercial lending is done primarily with locally owned small businesses. 33



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

We maintain the allowance for loan losses at a level we believe adequate to absorb probable credit losses related to specifically identified loans, as well as probable incurred loan losses inherent in the remainder of the loan portfolio as of the balance sheet date. The allowance for loan losses is based on past events and current economic conditions. We employ the Federal Financial Institutions Examination Council Interagency Policy Statement, as amended December 13, 2006, and GAAP in assessing the adequacy of the allowance account. Under GAAP, the adequacy of the allowance account is determined based on the provisions of Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 310, "Receivables," for loans specifically identified to be individually evaluated for impairment and the requirements of FASB ASC 450, "Contingencies," for large groups of smaller-balance homogeneous loans to be collectively evaluated for impairment. We follow our systematic methodology in accordance with procedural discipline by applying it in the same manner regardless of whether the allowance is being determined at a high point or a low point in the economic cycle. Each quarter, loan review identifies those loans to be individually evaluated for impairment and those loans collectively evaluated for impairment utilizing a standard criteria. Internal loan review grades are assigned quarterly to loans identified to be individually evaluated. A loan's grade may differ from period to period based on current conditions and events, however, we consistently utilize the same grading system each quarter. We consistently use loss experience from the latest twelve quarters in determining the historical loss factor for each pool collectively evaluated for impairment. Qualitative factors are evaluated in the same manner each quarter and are adjusted within a relevant range of values based on current conditions. For additional disclosure related to the allowance for loan losses refer to the note entitled, "Loans, net and Allowance for Loan Losses," in the Notes to Consolidated Financial Statements to this Quarterly Report. The allowance for loan losses increased $971 to $9,622 at June 30, 2014, from $8,651 at the end of 2013. For the six months ended June 30, 2014, net charge-offs were $1,087 or 0.19% of average loans outstanding, an $889 increase compared to $198 or 0.6% of average loans outstanding in the same period of 2013. Net charge-offs were $438 or 0.15% of average loans outstanding in the second quarter of 2014, a $380 increase compared to $58 or 0.04% of average loans outstanding in the second quarter of 2013.



Deposits:

Deposits are attracted within our primary market area through the offering of various deposit instruments including demand deposit accounts, NOW accounts, money market deposit accounts, savings accounts, and time deposits, including certificates of deposit and IRA's. During the six months ended June 30, 2014, total deposits increased $43,295, or 6.3% on an annualized basis, to $1,422,802 from $1,379,507 at December 31, 2013. Interest-bearing checking deposits, including NOW and money market accounts, increased $20,951, or 10.0% on an annualized basis, to $445,508 at June 30, 2014, compared to $424,557 at December 31, 2013. Savings deposits increased $5,129, or 2.8% on an annualized basis, to $377,230 at June 30, 2014, compared to $372,101 at December 31, 2013. Demand deposits, increased $15,980, or 11.4% on an annualized basis, to $295,922 at June 30, 2014, compared to $279,942 at December 31, 2013. Time deposits less than $100 increased $26,754, or 31.8% on an annualized basis, to $194,839 at June 30, 2014, compared to $168,085 at December 31, 2013 while time deposits of $100 or more decreased $25,519, or 37.9% on an annualized basis, to $109,303 at June 30, 2014, compared to $134,822 at December 31, 2013. 34



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

For the three months ended June 30, 2014, total deposits increased $18,736 or 2.7% on an annualized basis. Growth in interest-bearing and noninterest-bearing demand deposits and time deposits of $100 or more, more than offset declines in savings and time deposits less than $100. For the six months ended June 30, interest-bearing deposits averaged $1,113,621 in 2014 compared to $585,517 in 2013, due primarily to the merger. The cost of interest-bearing deposits was 0.50% for the first half of 2014 compared to 0.45% for the same period last year. The overall cost of interest-bearing liabilities including the cost of borrowed funds, was 0.59% in 2014 compared to 0.64% in 2013. The cost of interest-bearing liabilities was unchanged at 0.59% comparing the first and second quarters of 2014. Interest rates have been at historic lows for an extended period. Short term and core deposit rates have remained flat. As such, deposits have been attracted by offering rates on longer term time deposit products and core savings accounts which are higher than other investment alternatives available to customers elsewhere in the market place.



Borrowings:

The Bank utilizes borrowings as a secondary source of liquidity for its asset/liability management. Advances are available from the Federal Home Loan Bank ("FHLB") provided certain standards related to credit worthiness have been met. Repurchase and term agreements are also available from the FHLB. Total short-term borrowings at June 30, 2014, totaled $14,088 as compared to $22,052 at December 31, 2013, a decrease of $7,964, or 36.1%. Long-term debt was $34,925 at June 30, 2014, compared to $36,743 at year end 2013. The reduction was a product of monthly contractual amortized payments made during the first half of 2014. Market Risk Sensitivity: Market risk is the risk to our earnings or financial position resulting from adverse changes in market rates or prices, such as interest rates, foreign exchange rates or equity prices. Our exposure to market risk is primarily "IRR" associated with our lending, investing and deposit-gathering activities. During the normal course of business, we are not exposed to foreign exchange risk or commodity price risk. Our exposure to IRR can be explained as the potential for change in our reported earnings and/or the market value of our net worth. Variations in interest rates affect earnings by changing net interest income and the level of other interest-sensitive income and operating expenses. Interest rate changes also affect the underlying economic value of our assets, liabilities and off-balance sheet items. These changes arise because the present value of future cash flows, and often the cash flows themselves, change with interest rates. The effects of the changes in these present values reflect the change in our underlying economic value and provide a basis for the expected change in future earnings related to interest rates. IRR is inherent in the role of banks as financial intermediaries. However, a bank with a high degree of IRR may experience lower earnings, impaired liquidity and capital positions, and most likely, a greater risk of insolvency. Therefore, banks must carefully evaluate IRR to promote safety and soundness in their activities. 35



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

As a result of economic uncertainty and a prolonged era of historically low market rates, it has become challenging to manage IRR. Due to these factors, IRR and effectively managing it are very important to both bank management and regulators. Bank regulations require us to develop and maintain an IRR management program, overseen by the Board of Directors and senior management, that involves a comprehensive risk management process in order to effectively identify, measure, monitor and control risk. Should bank regulatory agencies identify a material weaknesses in our risk management process or high exposure relative to our capital, bank regulatory agencies may take action to remedy these shortcomings. Moreover, the level of IRR exposure and the quality of our risk management process is a determining factor when evaluating capital adequacy. The ALCO, comprised of members of our Board of Directors, senior management and other appropriate officers, oversees our IRR management program. Specifically ALCO analyzes economic data and market interest rate trends, as well as competitive pressures, and utilizes computerized modeling techniques to reveal potential exposure to IRR. This allows us to monitor and attempt to control the influence these factors may have on our rate-sensitive assets ("RSA") and rate-sensitive liabilities ("RSL"), and overall operating results and financial position. One such technique utilizes a static gap model that considers repricing frequencies of RSA and RSL in order to monitor IRR. Gap analysis attempts to measure our interest rate exposure by calculating the net amount of RSA and RSL that reprice within specific time intervals. A positive gap occurs when the amount of RSA repricing in a specific period is greater than the amount of RSL repricing within that same time frame and is indicated by a RSA/RSL ratio greater than 1.0. A negative gap occurs when the amount of RSL repricing is greater than the amount of RSA and is indicated by a RSA/RSL ratio less than 1.0. A positive gap implies that earnings will be impacted favorably if interest rates rise and adversely if interest rates fall during the period. A negative gap tends to indicate that earnings will be affected inversely to interest rate changes. Our cumulative one-year RSA/RSL ratio equaled 1.83% at June 30, 2014. Given the length of time that market rates have been at historical lows and the potential for rates to rise in the future, the focus of ALCO has been to create a positive static gap position. With regard to RSA, we predominantly offer medium- term, fixed-rate loans as well as adjustable rate loans. With respect to RSL, we offer longer term promotional certificates of deposit in an attempt to increase duration. The current position at June 30, 2014, indicates that the amount of RSA repricing within one year would exceed that of RSL, thereby causing increases in market rates, to increase net interest income. However, these forward-looking statements are qualified in the aforementioned section entitled "Forward-Looking Discussion" in this Management's Discussion and Analysis. Static gap analysis, although a standard measuring tool, does not fully illustrate the impact of interest rate changes on future earnings. First, market rate changes normally do not equally or simultaneously affect all categories of assets and liabilities. Second, assets and liabilities that can contractually reprice within the same period may not do so at the same time or to the same magnitude. Third, the interest rate sensitivity table presents a one-day position. Variations occur daily as we adjust our rate sensitivity throughout the year. Finally, assumptions must be made in constructing such a table. 36



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

As the static gap report fails to address the dynamic changes in the balance sheet composition or prevailing interest rates, we utilize a simulation model to enhance our asset/liability management. This model is used to create pro forma net interest income scenarios under various interest rate shocks. Model results at June 30, 2014, produced results similar to those indicated by the one-year static gap position. In addition, parallel and instantaneous shifts in interest rates under various interest rate shocks resulted in changes in net interest income that were well within ALCO policy limits. We will continue to monitor our IRR throughout 2014 and endeavor to employ deposit and loan pricing strategies and direct the reinvestment of loan and investment repayments in order to manage our IRR position. Financial institutions are affected differently by inflation than commercial and industrial companies that have significant investments in fixed assets and inventories. Most of our assets are monetary in nature and change correspondingly with variations in the inflation rate. It is difficult to precisely measure the impact inflation has on us, however we believe that our exposure to inflation can be mitigated through asset/liability management.



Liquidity:

Liquidity management is essential to our continuing operations and enables us to meet financial obligations as they come due, as well as to take advantage of new business opportunities as they arise. Financial obligations include, but are not limited to, the following: Funding new and existing loan commitments; Payment of deposits on demand or at their contractual maturity; Repayment of borrowings as they mature; Payment of lease obligations; and Payment of operating expenses. These obligations are managed daily, thus enabling us to effectively monitor fluctuations in our liquidity position and to adapt that position according to market influences and balance sheet trends. Future liquidity needs are forecasted and strategies are developed to ensure adequate liquidity at all times.



Historically, core deposits have been the primary source of liquidity because of their stability and lower cost, in general, than other types of funding. Providing additional sources of funds are loan and investment payments and prepayments and the ability to sell both available for sale securities and mortgage loans held for sale. We believe liquidity is adequate to meet both present and future financial obligations and commitments on a timely basis.

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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

We employ a number of analytical techniques in assessing the adequacy of our liquidity position. One such technique is the use of ratio analysis to determine the extent of our reliance on noncore funds to fund our investments and loans maturing after June 30, 2014. Our noncore funds at June 30, 2014, were comprised of time deposits in denominations of $100 or more, repurchase agreements and other borrowings. These funds are not considered to be a strong source of liquidity since they are very interest rate sensitive and are considered to be highly volatile. At June 30, 2014, our net noncore funding dependence ratio, the difference between noncore funds and short-term investments to long-term assets, was 7.6%, while our net short-term noncore funding dependence ratio, noncore funds maturing within one-year, less short-term investments to long-term assets equaled 1.2%. Comparatively, our overall noncore dependence ratio improved from year-end 2013 when it was 10.0%. Similarly, our net short-term noncore funding dependence ratio was 4.1% at year-end, indicating that our reliance on noncore funds has decreased. The decrease in noncore funding reliance resulted primarily from an increase in core deposits. The Consolidated Statements of Cash Flows present the changes in cash and cash equivalents from operating, investing and financing activities. Cash and cash equivalents, consisting of cash on hand, cash items in the process of collection, deposit balances with other banks and federal funds sold, increased $26,098 during the six months ended June 30, 2014. Cash and cash equivalents decreased $11,084 for the same period last year. For the six months ended June 30, 2014, net cash inflows of $29,195 from financing activities and $10,082 from operating activities were partially offset by a $13,179 net cash outflow from investing activities. For the same period of 2013, net cash inflows of $8,190 from operating activities were more than offset by a $18,114 net cash outflow from investing activities and $1,160 from operating activities Financing activities provided net cash of $29,195 for the six months ended June 30, 2014, and used net cash of $1,160 for the same six months of 2013. Deposit gathering is our predominant financing activity. During the first six months of 2014, deposit gathering accelerated compared to the same period last year. The net increase in deposits totaled $43,866 in the six months ended June 30, 2014. Comparatively, deposit gathering provided net cash of $11,186 for the same period of 2013. We continued to attract deposits from new and existing customers, including municipalities and school districts, as well as deposits gathered in relation to natural gas activity within existing markets in Susquehanna and Wyoming Counties of Pennsylvania. Operating activities provided net cash of $10,082 for the six months ended June 30, 2014, and $8,190 for the same six months of 2013. Net income, adjusted for the effects of gains and losses along with noncash transactions such as depreciation and the provision for loan losses, is the primary source of funds from operations. Investing activities primarily include transactions related to our lending activities and investment portfolio. Investing activities used net cash of $13,179 for the six months ended June 30, 2014, compared to $18,114 for the same period of 2013. In 2014, an increase in investment portfolio activities was the primary factor causing the net cash outflow from investing activities. Comparatively, an increase in lending activities was the predominant factor causing the net cash outflow from investing activities in 2013. 38



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

We believe that our future liquidity needs will be satisfied through maintaining an adequate level of cash and cash equivalents, by maintaining readily available access to traditional funding sources, and through proceeds received from the investment and loan portfolios. The current sources of funds will enable us to meet all cash obligations as they come due.



Capital:

Stockholders' equity totaled $244,165 or $32.35 per share at June 30, 2014, compared to $238,792 or $31.62 per share at December 31, 2013. Net income of $8,029 for the six months ended June 30, 2014 was the primary factor leading to the improved capital position. Stockholders' equity was also affected by cash dividends declared of $4,681, common stock repurchases, including the retirement of outstanding stock options, of $165, common stock issuances of $39, shares retired of $109, and other comprehensive income resulting from market value fluctuations in the investment portfolio of $2,260. Dividends declared equaled $0.62 per share in 2014 and 2013. The dividend payout ratio was 58.5% for the six months ended June 30, 2014, compared to 51.7% for the same period in 2013. The Merger Agreement contemplates that, unless 80 percent of our board of directors determines otherwise, we will pay a quarterly cash dividend in an amount no less than $0.31 per share through 2018, provided that sufficient funds are legally available, and that Peoples and Peoples Bank remain "Well-capitalized" in accordance with applicable regulatory guidelines. It is the intention of the Board of Directors to continue to pay cash dividends in the future. However, these decisions are affected by operating results, financial and economic decisions, capital and growth objectives, appropriate dividend restrictions and other relevant factors. We attempt to assure capital adequacy by monitoring our current and projected capital positions to support future growth, while providing stockholders with an attractive long-term appreciation of their investments. According to bank regulation, at a minimum, banks must maintain a Tier 1 capital to risk-adjusted assets ratio of 4.0 percent and a total capital to risk-adjusted assets ratio of 8.0 percent. Additionally, banks must maintain a leverage ratio, defined as Tier 1 capital to total average assets less intangibles, of 3.0 percent. The minimum leverage ratio of 3.0 percent only applies to institutions with a composite rating of 1 under the Uniform Interagency Bank Rating System that are not anticipating or experiencing significant growth and have well-diversified risk. An additional 100 to 200 basis points are required for all but these most highly-rated institutions. Our minimum Leverage ratio was 4.0 percent at June 30, 2014 and December 31, 2013. If an institution is deemed to be undercapitalized under these standards, banking law prescribes an increasing amount of regulatory intervention, including the required institution of a capital restoration plan and restrictions on the growth of assets, branches or lines of business. Further restrictions are applied to significantly or critically undercapitalized institutions, including restrictions on interest payable on accounts, dismissal of management and appointment of a receiver. For well capitalized institutions, banking law provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe and unsound practices or receives a less than satisfactory examination report rating. 39



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

The adequacy of capital is reviewed on an ongoing basis with reference to the size, composition and quality of resources and regulatory guidelines. We seek to maintain a level of capital sufficient to support existing assets and anticipated asset growth, maintain favorable access to capital markets, and preserve high quality credit ratings. At June 30, 2014, the Bank's Tier 1 capital to total average assets was 9.88% as compared to 9.72% at December 31, 2013. The Bank's Tier 1 capital to risk weighted asset ratio was 13.83% and the total capital to risk weighted asset ratio was 14.63% at June 30, 2014. These ratios were 13.02% and 13.69% at December 31, 2013. The Bank was deemed to be well-capitalized under regulatory standards at June 30, 2014.



Review of Financial Performance:

Net income for the second quarter of 2014 equaled $3,331 or $0.44 per share compared to $2,844 or $0.64 per share for the second quarter of 2013. The results for the three months ended June 30, 2014, included pre-tax merger related expenses of $1,008. The comparable results in 2013 included nonrecurring noninterest income of $468 from bank owned life insurance proceeds. Per share data for 2013 are restated to reflect the merger exchange rates of 1.3636 shares. Return on average assets ("ROA") measures our net income in relation to total assets. Our ROA was 0.78% for the second quarter of 2014 compared to 1.22% for the same period of 2013. Return on average equity ("ROE") indicates how effectively we can generate net income on the capital invested by stockholders. Our ROE was 5.61% for the second quarter of 2014 compared to 8.51% for the second quarter of 2013. Net income for the first half of 2014 equaled $8,029 or $1.06 per share compared to $5,365 or $1.20 per share for the same period of 2013. The results for the six months ended June 30, 2014, include pre-tax merger related expenses of approximately $1,616. Our ROA and ROE were 0.95% and 6.79% through six months in 2014 compared to 1.17% and 8.08% for the same period of 2013. The merger between Peoples and Penseco was accounted for as a reverse acquisition of Peoples by Penseco. As a result of the reverse merger, Peoples is the legal acquirer and Penseco is the accounting acquirer. In a reverse merger the historical financial statements are those of the accounting acquirer. Accordingly the earnings increase was primarily a result of adhering to the accounting treatment that requires the inclusion of results of operations of both Peoples and Penseco for the three and six month periods ended June 30, 2014, compared to Penseco on a standalone basis for same period last year.



Net Interest Income:

Net interest income is still the fundamental source of earnings for commercial banks. Moreover, fluctuations in the level of net interest income can have the greatest impact on net profits. Net interest income is defined as the difference between interest revenue, interest and fees earned on interest-earning assets, and interest expense, the cost of interest-bearing liabilities supporting those assets. The primary sources of earning assets are loans and investment securities, while interest-bearing deposits, short-term and long-term borrowings comprise interest-bearing liabilities. Net interest income is impacted by: Variations in the volume, rate and composition of earning assets and interest-bearing liabilities; Changes in general market rates; and The level of nonperforming assets. 40



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

Changes in net interest income are measured by the net interest spread and net interest margin. Net interest spread, the difference between the average yield earned on earning assets and the average rate incurred on interest-bearing liabilities, illustrates the effects changing interest rates have on profitability. Net interest margin, net interest income as a percentage of earning assets, is a more comprehensive ratio, as it reflects not only the spread, but also the change in the composition of interest-earning assets and interest-bearing liabilities. Tax-exempt loans and investments carry pre-tax yields lower than their taxable counterparts. Therefore, in order to make the analysis of net interest income more comparable, tax-exempt income and yields are reported herein on a tax-equivalent basis using the prevailing federal statutory tax rate of 35.0% in 2014 and 34.0% in 2013. For the three months ended June 30, 2014, tax-equivalent net interest income increased $6,151 to $14,468 in 2014 from $8,317 in 2013. The net interest spread decreased to 3.58% for the three months ended June 30, 2014 from 3.74% for the three months ended June 30, 2013. The tax-equivalent net interest margin decreased to 3.73% for the second quarter of 2014 from 3.90% for the comparable period of 2013. Loan accretion included in loan interest income in the second quarter of 2014 related to loans acquired in the fourth quarter of 2013 was $526, resulting in an increase in the tax-equivalent net interest margin of 14 basis points. The tax-equivalent net interest margin for the first quarter of 2014 was 4.09%, which included 24 basis points related to accretion on acquired loans. The yield curve continued to be relatively steep during the first six months of 2014 as the Federal Reserve has maintained lower overnight and discount rates. Since deposit rates are affected by the short end of the yield curve and loan and securities rates tend to follow the long end of the yield curve, the continuation of the current interest rate environment may assist us in maintaining a stable net interest margin in the future. For the three months ended June 30, tax-equivalent interest income on earning assets increased $6,917, to $16,195 in 2014 as compared to $9,278 in 2013. The increase was primarily due to the growth in average earning assets which increased $701,529, to $1,557,562 for the second quarter of 2014 from $856,033 for the same period in 2013, primarily as a result of the merger. The overall yield on earning assets, on a fully tax-equivalent basis, decreased 18 basis points for the three months ended June 30, 2014 at 4.17% as compared to 4.35% for the three months ended June 30, 2013. This was a result of the continuation of the low interest rate environment along with increased market competition. The yield earned on loans decreased 20 basis points for the second quarter of 2014 to 4.71% from 4.91% for the second quarter of 2013. Average loans increased to $1,187,568 for the quarter ended June 30, 2014 compared to $641,152 for the same period in 2013. The resulting tax-equivalent interest earned on loans was $13,938 for the three month period ended June 30, 2014 compared to $7,841 for the same period in 2013, an increase of $6,097. Total interest expense increased $766, to $1,727 for the three months ended June 30, 2014 from $961 for the three months ended June 30, 2013. This increase was attributable to the increase in the average volume of interest bearing liabilities comparing the three months ended June 30, 2014 and 2013. Average interest bearing liabilities increased $533,340, to $1,172,286 in the second quarter of 2014 from $638,946 for the same period in 2013. The cost of funds decreased to 0.59% for the three months ended June 30, 2014 as compared to 0.61% for the same period in 2013. We continue to offer an above market rate on our certificate of savings account, which has attracted money that customers are not willing to invest elsewhere and has contributed to our continued growth. 41



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

For the six months ended June 30, tax-equivalent net interest income increased $13,295 to $30,001 in 2014 from $16,706 in 2013. The net interest spread decreased to 3.76% for the six months ended June 30, 2014 from 3.81% for the six months ended June 30, 2013. The tax-equivalent net interest margin for the six months ended June 30, was 3.90% in 2014 compared to 3.97% in 2013. Loan accretion included in loan interest income in the first six months of 2014 related to loans acquired in the fourth quarter of 2013 was $1,430, resulting in an increase in the tax-equivalent net interest margin of 24 basis points. For the six months ended June 30, tax-equivalent interest income increased $14,715, to $33,415 in 2014 from $18,700 in 2013. The increase was primarily due to the growth in average earning assets which increased $701,000 to $1,549,351 for the first six months of 2014 from $848,351 for the same period in 2013. The yield on earning assets, on a tax-equivalent basis, decreased for the six months ended June 30, 2014 to 4.35% as compared to 4.45% for the six months ended June 30, 2013. The tax-equivalent yield earned on loans decreased 10 basis points for the first half of 2014 to 4.92% from 5.02% for the same period of 2013. Average loans increased $548,525, to $1,184,541 for the six months ended June 30, 2014 compared to $636,016 for the same period in 2013. The resulting tax-equivalent interest earned on loans was $28,916 for the six month period ended June 30, 2014 compared to $15,839 for the same period in 2013, an increase of $13,077. The tax-equivalent yield earned on investments decreased 46 basis points for the first six months of 2014 to 2.79% from 3.25% for the same period of 2013. Average investments increased to $320,452 for the six months ended June 30, 2014 compared to $174,306 for the same period in 2013. The resulting tax-equivalent interest earned on investments was $4,432 for the six month period ended June 30, 2014 compared to $2,811 for the same period in 2013, an increase of $1,621. Total interest expense increased by $1,420, to $3,414 for the six months ended June 30, 2014 from $1,994 for the six months ended June 30, 2013. The increase was the result of an increase in the average volume of interest bearing liabilities comparing the six months ended June 30, 2014 and 2013. Average interest bearing liabilities increased to $1,169,541 for the six months ended June 30, 2014 as compared to $632,132 for the six months ended June 30, 2013. The increase in average interest bearing liabilities more than offset a favorable rate variance as the cost of funds decreased to 0.59% for the six months ended June 30, 2014 as compared to 0.64% for the same period in 2013. 42



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

The average balances of assets and liabilities, corresponding interest income and expense and resulting average yields or rates paid are summarized as follows. Averages for earning assets include nonaccrual loans. Investment averages include available-for-sale securities at amortized cost. Income on investment securities and loans is adjusted to a tax-equivalent basis using the prevailing federal statutory tax rate of 35.0% in 2014 and 34.0% in 2013. Six months ended June 2014 June 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Assets: Earning assets: Loans Taxable $ 1,110,609$ 27,159 4.93 % $ 583,885$ 14,606 5.04 % Tax exempt 73,932 1,757 4.79 52,131 1,233 4.77 Investments Taxable 219,716 1,900 1.74 113,040 888 1.58 Tax exempt 100,736 2,532 5.07 61,266 1,923 6.33 Interest bearing deposits 5,826 19 0.66 38,029 50 0.27 Federal funds sold 38,532 48 0.25 Total earning assets 1,549,351 33,415 4.35 % 848,351 18,700 4.45 % Less: allowance for loan losses (8,791 ) (6,985 ) Other assets 161,231 84,088 Total assets $ 1,701,791$ 925,454 Liabilities and Stockholders' Equity: Interest bearing liabilities: Money market accounts 215,862 390 0.36 % 175,321 200 0.23 % NOW accounts 216,962 363 0.34 107,436 109 0.20 Savings accounts 369,471 529 0.29 128,456 37 0.06 Time deposits less than $100 215,041 1,050 0.98 91,701 451 0.99 Time deposits $100 or more 96,285 439 0.92 82,603 524 1.28 Short term borrowings 20,048 58 0.58 7,721 11 0.29 Long-term debt 35,872 585 3.28 38,894 662 3.43 Total interest bearing liabilities 1,169,541 3,414 0.59 % 632,132 1,994 0.64 % Non-interest bearing demand deposits 281,337 145,377 Other liabilities 12,556 14,041 Stockholders' equity 238,357 133,904 Total liabilities and stockholders' equity $ 1,701,791



$ 925,454

Net interest income/spread $ 30,001 3.76 % $ 16,706 3.81 % Net interest margin 3.90 % 3.97 % Tax-equivalent adjustments: Loans $ 615$ 419 Investments 886 654 Total adjustments $ 1,501$ 1,073 43



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

Provision for Loan Losses:

We evaluate the adequacy of the allowance for loan losses account on a quarterly basis utilizing our systematic analysis in accordance with procedural discipline. We take into consideration certain factors such as composition of the loan portfolio, volumes of nonperforming loans, volumes of net charge-offs, prevailing economic conditions and other relevant factors when determining the adequacy of the allowance for loan losses account. We make monthly provisions to the allowance for loan losses account in order to maintain the allowance at the appropriate level indicated by our evaluations. Based on our most current evaluation, we believe that the allowance is adequate to absorb any known and inherent losses in the portfolio as of June 30, 2014. For the three months and six months ended June 30, 2014, the provision for loan losses totaled $1,201 and $2,058. The provision for loan losses was $500 and $800 for those same periods in 2013. The increase in the quarter-to-date and year-to-date provisions comparing 2014 and 2013 reflect a higher volume and concentration of commercial loans in the portfolio, as well as continued weakness in the economic environment.



Noninterest Income:

Noninterest income for the second quarter rose $721 or 23.6% to $3,778 in 2014 from $3057 in 2013. For the six months ended June 30, 2014, noninterest income totaled $7,338, an increase of $1,455 or 24.7% from $5,883 for the comparable period of 2013. Service charges, fees and commissions increased $761 or 31.4% for the first half of 2014 attributable primarily to the merger. Income generated from commissions and fees on fiduciary activities increased $321 to $1,115 for the first six months of 2014 in comparison to the same period in 2013 due to an increase in the fee structure implemented in the second half of 2013. Income generated from our wealth management division increased $162 to $352 for the first half of 2014 in comparison to the same period in 2013. Life insurance investment income increased $217 or 90.8% attributable primarily to the merger. Merchant services income decreased $167 to $1,782 for the six months ended June 30, 2014 from $1,949 for the same period last year as a result of lower transaction volumes. Noninterest Expenses: In general, noninterest expense is categorized into three main groups: employee-related expenses, occupancy and equipment expenses and other expenses. Employee-related expenses are costs associated with providing salaries, including payroll taxes and benefits, to our employees. Occupancy and equipment expenses, the costs related to the maintenance of facilities and equipment, include depreciation, general maintenance and repairs, real estate taxes, rental expense offset by any rental income, and utility costs. Other expenses include general operating expenses such as advertising, contractual services, insurance, including FDIC assessment, other taxes and supplies. Several of these costs and expenses are variable while the remainder are fixed. We utilize budgets and other related strategies in an effort to control the variable expenses. 44



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Peoples Financial Services Corp.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Dollars in thousands, except per share data)

For the second quarter, noninterest expense increased $5,383 or 78.5% to $12,239 in 2014 from $6,856 in 2013. For the six months ended June 30, 2014, noninterest expense increased $9,545 or 68.3% to $23,526 in 2014 from $13,981 in 2013. Personnel costs rose 43.2%, net occupancy and equipment costs increased 170.3% and other expenses were higher by 47.0% comparing the first six months of 2014 and 2013. Salaries and employee benefits expense, which comprise the majority of noninterest expense, totaled $4,961 for the second quarter of 2014, an increase of $1,469 or 42.1% when compared to the second quarter of 2013. Salaries and employee benefits expense totaled $10,129 for the six months ended June 30, 2014 compared to $7,075 for the same period of 2013. The $3,054 or 43.2% increase was a result of comparing the staffing expense of the merged company to that of the standalone accounting acquirer. Also included in the 2014 total were payments of $301 representing stock appreciation rights settled in cash in the first half of 2014. We experienced a $1,626 or 232.0% increase in net occupancy and equipment expense comparing the second quarters of 2014 and 2013. Net occupancy and equipment expense increased $2,558 or 170.3% comparing the six months ended June 30, 2014 and 2013. In addition to increases related to the combined entity, increased depreciation expense and other costs related to equipment and computer systems caused the increase between comparable periods. For the second quarter, other expenses increased $1,095 or 54.2% comparing 2014 to 2013. For the six months ended June 30, 2014, other expenses increased $1,913 or 47.0% compared to the same period of 2013. This increase was the result of additional expenses resulting from the merger.



Acquisition related expenses incurred in the second quarter of 2014 totaled $1,008. For the six months ended June 30, 2014, acquisition related expenses totaled $1,616.

Income Taxes: We recorded income tax expense of $762 or 18.6% of pre-tax income, and $633 or 18.2% of pre-tax income for the quarters ended June 30, 2014 and 2013. We recorded income tax expense of $2,225 or 21.7% of pre-tax income, and $1,370 or 20.3% of pre-tax income for the six months ended June 30, 2014 and 2013. The six month period includes nondeductible expenses in the first quarter that are not present in the second quarter driving the effective tax rate down for the three months ended June 30, 2014. 45



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Peoples Financial Services Corp.


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