News Column

ORRSTOWN FINANCIAL SERVICES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

Overview

The Company is a bank holding company that has elected status as a financial holding company, with a wholly-owned bank subsidiary, Orrstown Bank. At June 30, 2014, the Company had total assets of $1,167,308,000, total liabilities of $1,064,856,000 and total shareholders' equity of $102,452,000. Currently, the U.S. economy appears to be slowly recovering from one of its longest and most severe economic recessions in recent history. The economic recovery has been slower than anticipated, but signs of growth have continued into the second quarter of 2014. However, the continued uncertainty with the economy, together with the challenging regulatory environment, will continue to affect the Company and the markets in which it does business, and may impact the Company's results in the future. American households are being affected by higher fuel and food costs, which affects household spending and may slow economic growth. During the middle of 2013, mortgage interest rates rose, leading to a reduction in the number of customers refinancing their residential mortgages which contributed to lower revenues.



Caution About Forward Looking Statements

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management's current views as to likely future developments, and use words like "may," "will," "expect," "estimate," "anticipate" or similar terms. Forward-looking statements are statements that include projections, predictions, expectations, or beliefs about events or results or otherwise are not statements of historical facts, including, but not limited to, statements related to new business development, new loan opportunities, growth in the balance sheet and fee based revenue lines of business, reducing risk assets, and mitigating losses in the future. Actual results and trends could differ materially from those set forth in such statements and there can be no assurances that we will achieve the desired level of new business development and new loans, growth in the balance sheet and fee based revenue lines of business, continue to reduce risk assets or mitigate losses in the future. Factors that could cause actual results to differ from those expressed or implied by the forward looking statements include, but are not limited to, the following: ineffectiveness of the Company's business strategy due to changes in current or future market conditions; the effects of competition, including industry consolidation and development of competing financial products and services; changes in laws and regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act; interest rate movements; changes in credit quality; inability to raise capital under favorable conditions, volatilities in the securities markets; deteriorating economic conditions, and other risks and uncertainties, including those detailed in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013, the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2014 and this Quarterly Report on Form 10-Q under the 36



--------------------------------------------------------------------------------

Table of Contents

sections titled "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" and in other filings made with the Commission. The statements are valid only as of the date hereof and the Company disclaims any obligation to update this information.

The following is a discussion of our consolidated financial condition at June 30, 2014 and results of operations for the three and six months ended June 30, 2014 and 2013. Throughout this discussion, the yield on earning assets is stated on a fully taxable-equivalent basis and balances represent average daily balances unless otherwise stated. The discussion and analysis should be read in conjunction with our Consolidated Financial Statements (Unaudited) and Notes thereto presented elsewhere in this report. Certain prior period amounts, presented in this discussion and analysis, have been reclassified to conform to current period classifications.



Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with GAAP and follow general practices within the financial services industry in which it operates. Management, in order to prepare the Company's consolidated financial statements, is required to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the balance sheet date through the date the financial statements are filed with the Commission. As this information changes, the consolidated financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources. The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, the Company has identified the adequacy of the allowance for loan losses and accounting for income taxes as critical accounting policies. The allowance for loan losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. The Company recognizes deferred tax assets and liabilities for the future effects of temporary differences and tax credits. Enacted tax rates are applied to cumulative temporary differences based on expected taxable income in the periods in which the deferred tax asset or liability is anticipated to be realized. Future tax rate changes could occur that would require the recognition of income or expense in the statement of operations in the period in which they are enacted. Deferred tax assets must be reduced by a valuation allowance if in management's judgment it is "more likely than not" that some portion of the asset will not be realized. Management may need to modify its judgment in this regard from one period to another should a material change occur in the business environment, tax legislation, or in any other business factor that could impair the Company's ability to benefit from the asset in the future. Based upon the Company's prior cumulative taxable losses, projections for future taxable income and other available evidence, management determined that there was not sufficient positive evidence to outweigh the cumulative loss, and concluded it was not more likely than not that the net deferred tax asset would be realized. Accordingly, a full valuation allowance was recorded at June 30, 2014 and December 31, 2013. Management will continue to update its analysis quarterly, and after a period of sustainable taxable income, the valuation allowance may be reversed in part or in total. However, there can be no assurance that there will be a future reversal of all or any portion of the valuation allowance on our deferred tax asset. Readers of the consolidated financial statements should be aware that the estimates and assumptions used in the Company's current financial statements may need to be updated in future financial presentations for changes in circumstances, business or economic conditions in order to fairly represent the condition of the Company at that time. 37



--------------------------------------------------------------------------------

Table of Contents

RESULTS OF OPERATIONS

QUARTER ENDED JUNE 30, 2014 COMPARED TO QUARTER ENDED JUNE 30, 2013

Summary

The Company recorded net income of $2,873,000 for the second quarter of 2014 compared to net income of $3,408,000 for the same period in 2013. Basic and diluted earnings per share (EPS) for the second quarter of 2014 were $0.35, compared to $0.42 for the second quarter of 2013. Net interest income of $8,500,000 was $799,000 higher for the three months ended June 30, 2014 than in 2013. As a result of the improvement in the Company's asset quality and earnings performance, the Company was able to invest its excess liquidity previously kept in interest bearing bank balances into higher yielding securities and its loan portfolio. In addition, lower average balances of nonaccrual loans allowed for greater recognition of interest income. Net income for the three months ended June 30, 2013 was favorably influenced by a negative provision for loan losses of $1,400,000 with no similar benefit in 2014. Net income for the three months ended June 30, 2014 benefited from higher levels of gains on sales of securities and real estate owned, which, in the aggregate, were $893,000 higher than the three months ended June 30, 2013.



Net Interest Income

Net interest income, which is the difference between interest income and fees on interest-earning assets and interest expense on interest-bearing liabilities, is the primary component of the Company's revenue. Interest earning assets include loans, securities and interest bearing deposits with banks. Interest bearing liabilities include deposits and borrowed funds. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 35% federal corporate tax rate. Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities and the composition of those assets and liabilities. The "net interest spread" and "net interest margin" are two common statistics related to changes in net interest income. The net interest spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. The net interest margin is defined as the ratio of net interest income to average earning assets. Through the use of noninterest bearing, demand deposits, certain other liabilities, and stockholders' equity, the net interest margin exceeds the net interest spread, as these funding sources are non-interest bearing.



The table below presents net interest income on a fully taxable equivalent basis, net interest spread and net interest margin for the quarters ended June 30, 2014 and 2013.

For the three months ended June 30, 2014, net interest income measured on a fully tax equivalent basis increased $788,000 to $8,901,000 from $8,113,000 in the corresponding period in 2013. The primary reason for the increase in net interest income was an increase in the rates on interest earning assets coupled with being able to lower the cost of funds, or interest bearing liabilities. Interest income earned on loans decreased from $8,140,000 for the quarter ended June 30, 2013 to $7,589,000 for the same period in 2014, a $551,000 decline. The primary reason for the decline was a decrease in rates earned from 4.84% in the quarter ended June 30, 2013 to 4.49% in the same period in 2014. Offset by an increase in the average balance of loans from $674,847,000 for the second quarter of 2013 to $677,963,000 for the same period in 2014. Competitive market conditions have led to slower growth opportunities, while also leading to lower interest rates of returns. Securities interest income increased $1,179,000 to $2,390,000 for the quarter ended June 30, 2014, from $1,211,000 for the same period in 2013. The average balance on securities has increased from $370,675,000 in the second quarter of 2013 to $432,335,000 for the same period in 2014. Rates earned on securities increased from a tax equivalent yield of 1.31% for the three months ended June 30, 2013 to 2.22% in the same period in 2014. Interest expense on deposits and borrowings for the three months ended June 30, 2014 was $1,085,000, a decrease of $203,000, from $1,288,000 in the same period in 2013. The Company's cost of funds on interest bearing liabilities has declined to 0.46% for the quarter ended June 30, 2014 from 0.53% for the same period in 2013. The interest rate environment has allowed the Company to lower the rates offered on its savings accounts, and as time deposits and long-term debt mature, it has also been able to replace the funds at slightly lower rates. The Company's net interest spread of 3.11% increased 28 basis points in the quarter ended June 30, 2014 as compared to the same period in 2013. Net interest margin for the quarter ended June 30, 2014 was 3.18%, a 28 basis point increase from 2.90% for the quarter ended June 30, 2013. 38



--------------------------------------------------------------------------------

Table of Contents

The table that follows shows average balances and interest yields on a fully taxable equivalent basis (FTE) for the quarters ended June 30, 2014 and 2013: June 30, 2014 June 30, 2013 Tax Tax Tax Tax Average Equivalent Equivalent Average Equivalent Equivalent (Dollars in thousands) Balance Interest Rate Balance Interest Rate Assets Federal funds sold & interest bearing bank balances $ 12,375 $ 7 0.24 % $ 78,150 $ 50 0.26 % Securities 432,335 2,390 2.22 370,675 1,211 1.31 Loans 677,963 7,589 4.49 674,847 8,140 4.84 Total interest-earning assets 1,122,673 9,986 3.57 1,123,672 9,401 3.36 Other assets 61,222 72,908 Total $ 1,183,895$ 1,196,580 Liabilities and Shareholders' Equity Interest bearing demand deposits $ 484,709$ 208 0.17 $ 480,467$ 191 0.16 Savings deposits 84,749 34 0.16 78,897 32 0.17 Time deposits 311,890 718 0.92 365,983 916 1.00 Short term borrowings 44,284 31 0.28 16,236 8 0.20 Long term debt 23,146 94 1.63 35,671 141 1.59 Total interest bearing liabilities 948,778 1,085 0.46 977,254 1,288 0.53 Non-interest bearing demand deposits 122,584 119,244 Other 13,615 11,292 Total Liabilities 1,084,977 1,107,790 Shareholders' Equity 98,918 88,790 Total $ 1,183,895$ 1,196,580 Net interest income (FTE)/net interest spread 8,901 3.11 % 8,113 2.83 % Net interest margin 3.18 % 2.90 % Tax-equivalent adjustment (401 ) (412 ) Net interest income $ 8,500$ 7,701 NOTES: Yields and interest income on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate. For yield calculation purposes, nonaccruing loans are included in the average loan balance. Provision for Loan Losses The Company recorded no provision for loan losses for the three months ended June 30, 2014, compared to a negative provision, or a reversal of amounts previously provided, of $1,400,000 for the three months ended June 30, 2013. During the second quarter of 2013, the Company received payments on classified loans with partial charge-offs previously recorded. As these payments received during the second quarter of 2013 exceeded the carrying value of the related loans, the excess was included in recoveries of loan amounts previously charged off. As the allowance for loan losses was deemed adequate prior to those recoveries, the amount of the recoveries was recorded as a negative provision for loan losses. For the three months ended June 30, 2014, net charge-offs totaled $72,000. Both quantitative and qualitative factors are considered in the determination of the adequacy of the allowance for loan losses. The favorable historical charge-off data combined with relatively stable economic and market conditions has resulted in the determination that no additional provision for loan losses was required to replenish the net charge-offs recorded and additional reserves needed on impaired loans during the three months ended June 30, 2014.



See further discussion in the "Allowance for Loan Losses" section.

39



--------------------------------------------------------------------------------

Table of Contents

Noninterest Income

Noninterest income, excluding securities gains, totaled $4,536,000 for the three months ended June 30, 2014, compared to $4,664,000 for the same period in 2013. Several factors contributed to the change in revenues for the second quarter of 2014 compared to the same period in 2013, as noted below.



The Company experienced a decline in service charges on deposits and other

services charges from $1,723,000 for the three months ended June 30, 2013

to $1,659,000 for the same period in 2014. This decline reflects trends noted in more conservative consumer spending behavior.



Orrstown Financial Advisors revenues, which included trust and estate fees

and brokerage income, totaled $1,788,000 for the three months ended

June 30, 2014 compared to $1,590,000 for the three months ended June 30,

2013, an increase of 12.5%. Favorable market conditions led to higher

trading and related commissions, as well as elevated estate fees recorded

during the period. In several recent quarters, mortgage interest rates were rising, leading



to a reduction in the number of customers refinancing their residential

mortgages and home sales in the Company's primary market area have

decreased. These events have resulted in lower mortgage banking income,

which totaled $562,000 for the three months ended June 30, 2014, a decline

of 49.1% from $1,105,000 in the same period of 2013. The higher interest

rate environment positively impacted 2013's results as the fair value of

our mortgage servicing rights improved, which allowed for the recovery of

$296,000 of our impairment reserve in the second quarter of 2013, with no

similar recovery in the same period in 2014.



Other income for the three months ended June 30, 2014 of $289,000, was

principally comprised of gains in sale of real estate owned totaling

$259,000. The other income for the three months ended June 30, 2013, included a loss on sale of real estate owned of $32,000. Securities gains totaled $602,000 for the three months ended June 30, 2014 compared to $0 for the same period in 2013. For the most recent period, asset/liability management strategies and interest rate conditions resulted in gains on sales of securities, as market conditions presented opportunities to reduce interest rate risk while maintaining earnings from our securities portfolio.



Noninterest Expenses

Noninterest expenses amounted to $10,765,000 for the three months ended June 30, 2014, compared to $10,327,000 for the corresponding prior year period, an increase of 4.2%. The changes in certain components of noninterest expenses between the quarters ended June 30, 2014 and 2013, as described below, are reflective of the Company's investments to build a stronger foundation for future growth and to better serve the needs of our customers, combined with improvements in financial condition and asset quality.

As the Company began to introduce new product offerings, improve the



effectiveness of alternate delivery channels and enter new markets, it

experienced increased occupancy, furniture and equipment, and data

processing expenses. For the three months ended June 30, 2014, these

expenses totaled $1,730,000, an increase of 17.4% over the $1,473,000 for

the same period in 2013. In December 2013, the Company outsourced its core

processing system to a third party provider, to capitalize on additional

products and services that the provider offers. In connection with the migration to the new platform, upgrades in certain equipment were also



required. In the fourth quarter of 2013, the Company opened its financial

services facility office in Lancaster, Pennsylvania, resulting in a full quarter of occupancy charges in the second quarter of 2014, with no corresponding charge in the same period in 2013.



Salaries and employee benefits totaled $5,879,000 for the three months

ended June 30, 2014, an increase of 9.1% over the same period in 2013, and

a 1.2% increase over the first quarter of 2014. The increase in salaries

and benefits is primarily the result of additions to staff that were hired

in the latter part of 2013, allowing for enhanced risk management

processes and practices and greater depth in the information technology

and operations departments, and less reliance on outside consultants. As

previously announced, the Company eliminated 32 positions in its

operations and retail staff in the second quarter of 2014, and incurred

approximately $150,000 of charges in connection with this reduction in

workforce in the second quarter of 2014. The 1.2% increase in salaries and

benefits for the three months ended June 30, 2014 as compared to the first

three months of 2014 was the result of company-wide merit increases which

took effect in the second quarter, severance charges, and work through

dates of severed employees through the second quarter as the Company

transitioned work responsibilities. It is anticipated that greater savings

from the workforce reduction will result in the third quarter of 2014.



Advertising and bank promotions expense decreased $56,000 to $218,000 for

the three months ended June 30, 2014 from $274,000 for the same period in

2013. Advertising and bank promotions were used to advance the Company's

growth initiatives and introduction of new products and services,

including the Bank's first ever advertising on television and increased

direct mail efforts. The Company accelerated some of its planned annual

marketing spending into the first quarter of 2014, which resulted in lower

marketing expenses in the second quarter of 2014 in comparison to the same

period in the prior year. 40



--------------------------------------------------------------------------------

Table of Contents

FDIC insurance expense decreased $267,000 to $359,000 for the three months

ended June 30, 2014 compared to $626,000 for the same period in 2013. The

42.7% decrease is primarily the result of a lower assessment rate, as the Company's risk profile improved.



Taxes, other than income, decreased from $244,000 for the second quarter

of 2013 to $156,000 for the second quarter in 2014, due to a change in the

assessment rate and methodology for state bank shares tax.

The Company's efficiency ratio increased slightly for the three months ended June 30, 2014 to 81.1% compared to 80.1% for the same period in 2013. The higher, or less favorable, ratio between the periods presented was primarily the result of higher noninterest expenses in comparison to the increases noted in revenues. The efficiency ratio expresses noninterest expense as a percentage of tax equivalent net interest income and noninterest income, excluding securities gains, intangible asset amortization and other real estate income and expenses.



Income Tax Expense

Income tax expense totaled $0 for the three months ended June 30, 2014, compared to $30,000 for the three months ended June 30, 2013. During the third quarter of 2012, an evaluation was completed on the net deferred tax asset that existed at that time, which principally resulted from credit and credit related losses and expenses that the Company had experienced. As a result of the taxable losses that were generated during 2012, and our inability to fully offset the tax to the two preceding carryback years allowed by tax regulation, our net deferred tax asset was dependent on tax planning strategies and future taxable income. Based on forecasted taxable income at that time, combined with limited available tax planning strategies, we were not able to conclude that the deferred tax asset would more likely than not be realized in its entirety, and as such, a valuation allowance was established for the full amount beginning in the third quarter of 2012, which resulted in a charge at that time of $19,872,000. As of June 30, 2014, while improvements have been noted in our operating results, we continue to believe that the valuation allowance is appropriate. The evaluation is updated quarterly and if the Company continues to experience profitability, reversal of the valuation in part, or in full, becomes more likely. The tax expense in 2013 pertains to estimated federal alternative minimum tax.



SIX MONTHS ENDED JUNE 30, 2014 COMPARED TO SIX MONTHS ENDED JUNE 30, 2013

Summary

The Company recorded net income of $4,851,000 for the six months ended June 30, 2014 compared to net income of $4,968,000 for the same period in 2013. Basic and diluted EPS for the six months ended June 30, 2014 were $0.60, compared to $0.61 for the six months ended June 30, 2013. As a result of the improvement in the Company's asset quality and earnings performance, the Company was able to invest its excess liquidity previously kept in interest bearing bank balances into higher yielding securities and its loan portfolio. In addition, lower average balances of nonaccrual loans allowed for greater recognition of interest income.



Net Interest Income

The table below presents net interest income on a fully taxable equivalent basis, net interest spread and net interest margin for the six months ended June 30, 2014 and 2013.

For the six months ended June 30, 2014, net interest income measured on a fully tax equivalent basis increased $1,168,000 to $17,843,000 from $16,675,000 in the corresponding period in 2013. The primary reason for the increase in net interest income was an increase in the rates on interest earning assets coupled with being able to lower the cost of funds, or interest bearing liabilities. Interest income earned on loans decreased from $16,669,000 for the quarter ended June 30, 2013 to $15,330,000 for the same period in 2014, a $1,339,000 decline. The primary reason for the decline was the average balance of loans decreased from $684,835,000 for the six months ended June 30, 2013 to $675,178,000 for the same period in 2014, and a decrease in rates earned from 4.91% in the quarter ended June 30, 2013 to 4.58% in the same period in 2014. Loans paying off at higher rates than the new loans originated, as well as competitive market conditions have led to the decline in interest rates. Securities interest income increased $2,108,000 to $4,668,000 for the six months ended June 30, 2014, from $2,560,000 for the same period in 2013. The average balance on securities has increased from $356,453,000 for the six months ended June 30, 2013 to $422,703,000 for the same period in 2014. Rates earned on securities increased from a tax equivalent yield of 1.45%



for the six months ended June 30, 2013 to 2.23% in the same period in 2014. Investments in higher yielding securities, as well as slower prepayment speeds on mortgage-backed securities led to an increase in yields earning on securities.

Interest expense on deposits and borrowings for the six months ended June 30, 2014 was $1,916,000, a decrease of $447,000, from $2,363,000 in the same period in 2013. The Company's cost of funds on interest bearing liabilities has declined to 0.46% for the six months ended June 30, 2014 from 0.55% for the same period in 2013. The interest rate environment has allowed the Company to lower the rates offered on its demand deposits, including interest bearing demand, money market and savings, and as time deposits and long-term debt mature, it has also been able to replace the funds at slightly lower rates. 41



--------------------------------------------------------------------------------

Table of Contents

The Company's net interest spread of 3.17% increased 26 basis points for the six months ended June 30, 2014 as compared to the same period in 2013. Net interest margin for the six months ended June 30, 2014 was 3.24%, a 26 basis point increase from 2.98% for the six months ended June 30, 2013. The table that follows shows average balances and interest yields on a fully taxable equivalent basis (FTE) for the six months ended June 30, 2014 and 2013: June 30, 2014 June 30, 2013 Tax Tax Tax Tax Average Equivalent Equivalent Average Equivalent Equivalent (Dollars in thousands) Balance Interest Rate Balance Interest Rate Assets Federal funds sold & interest bearing bank balances $ 12,637 $ 15 0.24 % $ 86,456$ 111 0.26 % Securities 422,703 4,668 2.23 356,453 2,560 1.45 Loans 675,178 15,330 4.58 684,835 16,669 4.91 Total interest-earning assets 1,110,518 20,013 3.63 1,127,744 19,340 3.46 Other assets 61,101 71,557 Total $ 1,171,619$ 1,199,301 Liabilities and Shareholders' Equity Interest bearing demand deposits $ 481,556$ 394 0.16 $ 481,427$ 408 0.17 Savings deposits 82,586 67 0.16 77,204 63 0.16 Time deposits 311,295 1,455 0.94 375,237 1,892 1.02 Short term borrowings 47,484 64 0.27 13,591 14 0.21 Long term debt 20,551 190 1.86 36,496 288 1.59 Total interest bearing liabilities 943,472 2,170 0.46 983,955 2,665 0.55 Non-interest bearing demand deposits 119,415 115,846 Other 12,289 11,257 Total Liabilities 1,075,176 1,111,058 Shareholders' Equity 96,443 88,243 Total $ 1,171,619$ 1,199,301 Net interest income (FTE)/net interest spread 17,843 3.17 % 16,675 2.91 % Net interest margin 3.24 % 2.98 % Tax-equivalent adjustment (827 ) (867 ) Net interest income $ 17,016$ 15,808 NOTES: Yields and interest income on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate. For yield calculation purposes, nonaccruing loans are included in the average loan balance. Provision for Loan Losses The Company recorded no provision for loan losses for the six months ended June 30, 2014. The Company recorded a negative provision for loan losses, or a reversal of amounts previously provided, of $1,400,000 for the six months ended June 30, 2013. In the past six quarters, the Company has recorded net recoveries of $409,000, which has resulted in favorable net charge-off ratios during this period. Both quantitative and qualitative factors are considered in the determination of the adequacy of the allowance for loan losses. The favorable historical charge-off data combined with stable economic and market conditions has resulted in the determination that no additional provision for loan losses was required to replenish the net charge-offs recorded during the second quarter of 2014. While management believes the Company's allowance for loan losses is adequate based on information currently available, future adjustments, including additional provisions for loan losses or the reversal of amounts previously provided, to the reserve and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management's assumptions as to future delinquencies or loss rates. 42



--------------------------------------------------------------------------------

Table of Contents

See further discussion in the "Allowance for Loan Losses" section.

Noninterest Income

Noninterest income, excluding securities gains, totaled $8,377,000 for the six months ended June 30, 2014, compared to $8,974,000 for the same period in 2013. Several factors contributed to the change in revenues for the second quarter of 2014 compared to the same period in 2013, as noted below.



The Company experienced a decline in service charges on deposits and other

services charges from $3,365,000 for the six months ended June 30, 2013 to

$3,116,000 for the same period in 2014. This decline reflects trends noted

in more conservative consumer spending behavior and lower loan balances. Brokerage income of $1,017,000 for the six months ended June 30, 2014 represented a decrease of $59,000 from the same period in 2013, due primarily to elevated commission volumes on insurance products in 2013.



Partially offsetting these unfavorable variances were trust fees generated

by Orrstown Financial Advisors, which totaled $2,427,000 for the six

months ended June 30, 2014, an increase of 6.5% from the same period in

2013, partially attributable to higher estate fees in 2014 as compared to

2013. During the past several quarters, mortgage interest rates have risen,



leading to a reduction in the number of customers refinancing their

residential mortgages and home sales in the Company's primary market have

decreased. These events have resulted in an $836,000 decline in mortgage

banking revenues to $1,021,000 for the six months ended June 30, 2014

compared to the same period in 2013. The high interest rate environment

positively impacted 2013's results as the fair value of our mortgage

servicing rights improved, which allowed for the recovery of $364,000 of

our impairment reserve in the first six months of 2013, with no similar

recovery in the same period in 2014. Other income of $324,000 for the six months ended June 30, 2013 was a



$406,000 improvement on the $82,000 loss reported for the same period in

2013. The primary reason for the increase was due to $259,000 in gains on

sales of other real estate owned for the six months ended June 30, 2014, compared to $158,000 in losses recorded for the same period in 2013. Securities gains totaled $1,199,000 for the six months ended June 30, 2014 compared to $122,000 for the same period in 2013. For both periods, asset/liability management strategies and interest rate conditions resulted in gains on sales of securities, as market conditions presented opportunities to reduce interest rate risk while maintaining earnings from our securities portfolio.



Noninterest Expenses

Noninterest expenses amounted to $21,741,000 for the six months ended June 30, 2014, compared to $21,276,000 for the corresponding prior year period. The changes in certain components of noninterest expenses between the quarters ended June 30, 2013 and 2014, as described below. For the six months ended June 30, 2014, furniture and equipment, data processing, and occupancy expenses totaled $3,582,000, an increase of 22.4% over the $2,926,000 for the same period in 2013. In December 2013, the Company outsourced its core processing system to a third party provider, to capitalize on additional products and services that the



outsourced solution offered. In connection with the migration to the new

platform, upgrades in certain equipment were also required. In the fourth

quarter of 2013, the Company opened its financial services facility office

in Lancaster, Pennsylvania, resulting in a full six months of occupancy

charges in the first three months of 2014, with no corresponding charge in

the same period in 2013. Salaries and employee benefits totaled $11,691,000 for the six months



ended June 30, 2014, compared to $11,133,000 for the six months ended

June 30, 2013, an increase of $558,000, or 5.0%. The increase in salaries

and benefits is primarily the result of additions to staff that were hired

in the latter part of 2013, allowing for enhanced risk management

processes and practices and greater depth in the information technology

and operations departments, and less reliance on outside consultants.

Advertising and bank promotions expense increased $158,000 to $643,000 for

the six months ended June 30, 2014 from $485,000 for the same period in

2013. Advertising and bank promotions were used to advance the Company's

growth initiatives and introduction of new products and services,

including the Bank's first ever advertising on television and increased

direct mail efforts.



FDIC insurance expense decreased $468,000 to $823,000 for the six months

ended June 30, 2014 compared to $1,291,000 for the same period in 2013.

The 36.3% decrease is primarily the result of a lower assessment rate, as

the Company's risk profile improved.



Professional service fees, including loan review assistance, legal fees

and accounting expenses, have decreased $162,000 to $1,176,000 for the six months ended June 30, 2014, from $1,338,000 in the same period in 2013. The decrease was primarily the result of costs associated with the settlement of litigation which were incurred during the quarter ended March 31, 2013, with no similar charge in 2014. 43



--------------------------------------------------------------------------------

Table of Contents

Taxes, other than income, decreased from $488,000 for the three months

ended June 30, 2013 to $314,000 for the same period in 2014, due to a

change in the assessment rate and methodology for state bank shares tax.

The Company's efficiency ratio increased for the six months ended June 30, 2014 to 83.1%, compared to 81.8% for the same period in 2013. The higher, or less favorable, ratio between the two periods was primarily the result of higher noninterest expenses in comparison to the increases noted in revenues.



Income Tax Expense

Income tax expense totaled $0 and $60,000 for the six months ended June 30, 2014 and 2013, on pre-tax income of $4,851,000, and $5,028,000 for the six months ended June 30, 2014 and 2013. As a result of our net operating loss carry forwards, combined with a full valuation allowance on its net deferred tax asset, no income tax expense was recognized for the six months ended June 30, 2014. The net expense in 2013 pertains to estimated federal alternative minimum tax. FINANCIAL CONDITION



A substantial amount of time is devoted by management to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and minimization of risk associated with such investments.

Securities Available for Sale The Company utilizes securities available for sale as a tool for managing interest rate risk, enhancing income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings. As of June 30, 2014, securities available for sale were $389,961,000, a decrease of $16,982,000, from December 31, 2013's balance of $406,943,000. Many of the securities have monthly cash flows which will provide cash flow to fund loan growth as the loan pipeline expands.



Loan Portfolio

The Company offers various products to meet the credit needs of our borrowers, principally consisting of commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments. The risks associated with lending activities differ among the various loan classes, and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans, and general economic conditions. All of these factors may adversely impact the borrower's ability to repay its loans, and impact the associated collateral. See Note 3, "Loans Receivable and Allowance for Loan Losses," in the Notes to the Consolidated Financial Statements for a detailed description of the Company's loan classes and differing levels of credit risk associated with each class, which information is incorporated herein by reference. 44



--------------------------------------------------------------------------------

Table of Contents

The loan portfolio, excluding residential loans held for sale, broken out by classes as of June 30, 2014 and December 31, 2013 is as follows:

June 30, December 31, (Dollars in thousands) 2014 2013 Commercial real estate: Owner-occupied $ 105,193$ 111,290 Non-owner occupied 141,143 135,953 Multi-family 28,538



22,882

Non-owner occupied residential 50,948



55,272

Acquisition and development:

1-4 family residential construction 4,172



3,338

Commercial and land development 17,445



19,440

Commercial and industrial 38,593



33,446

Municipal 59,290



60,996

Residential mortgage:

First lien 125,767



124,728

Home equity - term 20,333



20,131

Home equity - Lines of credit 81,476



77,377

Installment and other loans 5,956

6,184 $ 678,854$ 671,037 The loan portfolio at June 30, 2014 of $678,854,000 reflected an increase of $7,816,000 from $671,037,000 at December 31, 2013. Growth was achieved in the portfolio despite active loan collection efforts, in which the Company collected $9,400,000 in pay downs/payoffs, charge-offs or foreclosure on nonaccrual loans during the six months ended June 30, 2014. Current economic and market conditions in the Company's markets have tempered loan growth, and competition for new business opportunities remains strong.



Asset Quality

Risk Elements

The Company's loan portfolios are subject to varying degrees of credit risk. Credit risk is mitigated through the Company's underwriting standards, on-going credit review, and monitoring of asset quality measures. Additionally, loan portfolio diversification, limiting exposure to a single industry or borrower, and requiring collateral also mitigate the Company's risk of credit loss.



The Company's loan portfolio is principally to borrowers in south central Pennsylvania and Washington County, Maryland. As the majority of loans are concentrated in this geographic region, a substantial portion of the debtor's ability to honor their obligations may be affected by the level of economic activity in the market area.

Nonperforming assets include nonaccrual and restructured loans and foreclosed real estate. In addition, loans past due 90 days or more and still accruing are also deemed to be risk assets. For all loan classes, the accrual of interest income ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to accrue on loans past due 90 days or more if the collateral is adequate to cover principal and interest, and the loan is in the process of collection. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is generally reversed and charged against interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending on management's assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, the loans have performed in accordance with the contractual terms of the note for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on contract terms of the loan. Loans, the terms of which are modified, are classified as troubled debt restructurings if a concession was granted, for legal or economic reasons, related to a debtor's financial difficulties. Concessions granted under a troubled debt restructuring typically involve a temporary deferral of scheduled loan payments, an extension of a loan's stated maturity date, temporary reduction in interest rates, or below market rates. If a modification occurs while the loan is on accruing status, it will continue to accrue interest under the modified terms. Nonaccrual troubled debt restructurings are restored to accrual status if scheduled principal and interest payments, 45



--------------------------------------------------------------------------------

Table of Contents

under the modified terms, are current for six months after modification, and the borrower continues to demonstrate its ability to meet the modified terms. Troubled debt restructurings are evaluated individually for impairment if they have been restructured during the most recent calendar year, or if they are not performing according to their modified terms. The following table presents the Company's risk elements, including information concerning the aggregate balances of nonaccrual, restructured loans still accruing, loans past due 90 days or more, and foreclosed real estate as of June 30, 2014, December 31, 2013 and June 30, 2013. Relevant asset quality ratios are also presented. June 30, December 31, June 30, (Dollars in thousands) 2014 2013 2013 Nonaccrual loans (cash basis) $ 20,528$ 19,347$ 18,047 Other real estate (OREO) 1,415 987 1,072 Total nonperforming assets 21,943 20,334 19,119 Restructured loans still accruing 6,104 5,988 1,691 Loans past due 90 days or more and still accruing 123 0 0 Total risk assets $ 28,170$ 26,322$ 20,810 Loans 30-89 days past due $ 5,614$ 3,963$ 3,233 Asset quality ratios: Nonaccrual loans to loans 3.02 % 2.88 % 2.68 % Nonperforming assets to assets 1.88 % 1.73 % 1.60 % Total nonperforming assets to total loans and OREO 3.23 % 3.03 % 2.84 % Total risk assets to total loans and OREO 4.14 % 3.92 % 3.09 % Total risk assets to total assets 2.41 % 2.23 % 1.75 % Allowance for loan losses to total loans 3.01 % 3.12 % 2.99 % Allowance for loan losses to nonaccrual loans 99.50 % 108.36 % 111.36 % Allowance for loan losses to nonaccrual and restructured loans still accruing 76.69 % 82.75 % 101.82 % 46



--------------------------------------------------------------------------------

Table of Contents

A further breakdown of impaired loans at June 30, 2014 and December 31, 2013 is as follows: June 30, 2014 December 31, 2013 Restructured Other Restructured Nonaccrual Loans Still Impaired Nonaccrual Loans Still Loans Accruing Still Accruing Total Loans Accruing Total Commercial real estate: Owner occupied $ 4,007 $ 194 $ 0 $ 4,201$ 4,362 $ 200 $ 4,562 Non-owner occupied 8,116 4,186 0 12,302 2,849 4,268 7,117 Multi-family 99 0 0 99 322 0 322 Non-owner occupied residential 2,170 0 0 2,170 4,493 0



4,493

Acquisition and development Commercial and land development 401 921 0 1,322 2,106 1,071 3,177 Commercial and industrial 1,832 0 0 1,832 2,001 0 2,001 Residential mortgage: First lien 3,772 803 90 4,575 2,926 449 3,375 Home equity - term 72 0 0 72 107 0 107 Home equity - lines of credit 56 0 0 56 181 0 181 Installment and other loans 3 0 0 3 0 0 0 $ 20,528$ 6,104 $ 90 $ 26,632$ 19,347$ 5,988$ 25,335 As of June 30, 2014, the Company had 90 lending relationships that had loans that were considered impaired, and were included in the impaired loan balance of $26,632,000, compared to 68 lending relationships with an impaired loan balance of $25,375,000 at December 31, 2013. The exposure to these borrowers with impaired loans is summarized in the following table, along with the partial charge-offs taken to date and the specific reserves established on the relationships at June 30, 2014 and December 31, 2013. Partial Specific # of Recorded Charge-offs Reserves at (Dollars in thousands) Loans Investment to Date Period End June 30, 2014 Relationships greater than $1,000,000 4 $ 12,323 $ 506 $ 2,844 Relationships greater than $500,000 but less than $1,000,000 4 2,405 0 0 Relationships greater than $250,000 but less than $500,000 18 6,053 1,192 140 Relationships less than $250,000 64 5,851 1,157 85 90 $ 26,632$ 2,855$ 3,069 December 31, 2013 Relationships greater than $1,000,000 6 $ 13,014 $ 543 $ 0 Relationships greater than $500,000 but less than $1,000,000 6 3,664 120 0 Relationships greater than $250,000 but less than $500,000 11 4,083 913 455 Relationships less than $250,000 45 4,574 1,050 158 68 $ 25,335$ 2,626 $ 613 The Company takes partial charge-offs on collateral dependent loans whose carrying value exceeded their estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. ASC 310 impairment reserves remain in those situations in which updated appraisals are pending, and represent management's estimate of potential loss. Of the relationships deemed to be impaired at June 30, 2014, four have outstanding book balances in excess of $1,000,000, totaling $12,323,000, or 46% of the total impaired loan balance. Sixty-four of the relationships, or 71% of the total number of impaired relationships, have recorded balances less than $250,000. A summary of the impaired relationships in excess of $1,000,000 are discussed below. 47



--------------------------------------------------------------------------------

Table of Contents

In the second quarter of 2014, the Company classified a $5,450,000 relationship as impaired, after it was determined that the borrowers' cash flows appeared to be insufficient to meet its debt service requirements. After an evaluation of the loan, it was determined an impairment reserve of $2,800,000 was warranted, based on the deficiency of the collateral. The Company has not taken a charge-off on the loan as of June 30, 2014, as it is in preliminary stages of work out with the borrower and its guarantor, and has ordered a new appraisal. In 2013, the Company classified a relationship with a borrower in the food service and entertainment industry as impaired, based on the restructuring negotiations with the borrower. Although the restructured note matured in May 2014, and is included in the 30-89 days past due category, monthly principal and interest payments continue to be made and the Company anticipates extending the maturity date. Management expects the note to continue to perform and considers the loan adequately supported by the collateral securing the note, allowing for the note to remain on accrual status. This relationship, with a balance of nearly $3,500,000 at June 30, 2014, is classified as impaired, as by definition, troubled debt restructurings are impaired. After evaluation of the relationship in accordance with impairment guidance, it was determined no reserve was required. An additional relationship that the Company has determined to be impaired at June 30, 2014 is with a real estate developer who also actively leases residential properties. This relationship consists of separate loans with total outstanding book balances of $2,000,000, secured by different parcels of land or residential structures. Recent appraisals on the collateral securing the outstanding loans resulted in the relationship being placed in nonaccrual status, as the softening of real estate prices and rental prices, and the lengthening of absorption periods resulted in it being classified and evaluated as a collateral dependent impaired loan. To date, partial charge-offs or specific reserves of approximately 25.0% of the outstanding loan balances have been taken. In the fourth quarter of 2013, the Company moved a note to a commercial lessor with an outstanding balance of approximately $1,450,000 to nonaccrual status. The balance of the note at June 30, 2014 was $1,370,000. This decision was made, despite the loan being current as to both principal and interest, as a result of declining cash flows of the Company, and the potential for further reduction in cash available to service debt in the near future. The Company believes it is well secured on this loan, and does not feel a loss will be incurred on it. The Company has approximately 81 additional relationships with borrowers that include loans that are individually evaluated for impairment, and has taken a similar approach to those mentioned above in determining the extent of full or partial charge-offs that were required, or ASC 310 reserves that may be needed. The determination of the Company's charge-offs or impairment reserve determination included an evaluation of the outstanding loan balance, and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships as of June 30, 2014. However, over time, additional information may become known that could result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed. The Company's foreclosed real estate balance of $1,415,000 consists of 11 properties owned by the Company, six of which were commercial properties and totaled $1,045,000, and five residential properties that totaled $370,000. The largest commercial property is a commercial land parcel with a carrying value of $266,000. A second commercial property with a carrying value of $262,000 was land originally purchased by the Company for future expansion purposes. During 2011, it was determined that this property was no longer in the Company's strategic plans, and as such, the Company re-designated the property as held for sale. The remaining properties have carrying values less than $210,000 and are also carried at the lower of cost or fair value, less costs to dispose.



As of June 30, 2014, the Company believes the value of foreclosed assets represents their fair values, but if the real estate market remains challenging, additional charges may be needed.

Credit Risk Management

Allowance for Loan Losses

The Company maintains the allowance for loan losses at a level believed adequate by management to absorb losses inherent in the portfolio. The allowance is established and maintained through a provision for loan losses charged to earnings. Quarterly, management assesses the adequacy of the allowance for loan losses utilizing a defined methodology, which considers specific credit evaluation of impaired loans, past loan loss historical experience, and qualitative factors. Management believes the approach properly addresses the requirements of ASC Section 310-10-35 for loans individually identified as impaired, and ASC Subtopic 450-20 for loans collectively evaluated for impairment, and other bank regulatory guidance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. See Note 3, "Loans Receivable and Allowance for Loan Losses" in the Notes to the Consolidated Financial Statements for a description of the methodology for establishing the allowance and provision for loan losses and related procedures in establishing the appropriate level of reserve, which information is incorporated herein by reference. 48



--------------------------------------------------------------------------------

Table of Contents

The following tables summarize the Bank's ratings based on its internal risk rating system as of June 30, 2014 and December 31, 2013:

Special Non-Impaired Impaired - (Dollars in thousands) Pass Mention Substandard Substandard Doubtful Total June 30, 2014 Commercial real estate: Owner-occupied $ 88,853$ 3,457$ 8,682$ 4,201$ 0$ 105,193 Non-owner occupied 114,505 8,374 5,962 12,302 0 141,143 Multi-family 26,272 1,421 746 99 0 28,538 Non-owner occupied residential 39,889 6,791 2,098 2,170 0 50,948 Acquisition and development: 1-4 family residential construction 3,833 0 339 0 0 4,172 Commercial and land development 14,103 1,058 962 1,322 0 17,445 Commercial and industrial 35,118 1,600 43 1,712 120 38,593 Municipal 59,290 0 0 0 0 59,290 Residential mortgage: First lien 121,143 0 49 4,575 0 125,767 Home equity - term 20,261 0 0 72 0 20,333 Home equity - Lines of credit 81,405 15 0 56 0 81,476 Installment and other loans 5,953 0 0 0 3 5,956 $ 610,625$ 22,716$ 18,881$ 26,509$ 123$ 678,854 December 31, 2013 Commercial real estate: Owner-occupied $ 92,063$ 3,305$ 11,360$ 4,107$ 455$ 111,290 Non-owner occupied 107,113 6,904 14,819 7,117 0 135,953 Multi-family 20,091 2,132 337 322 0 22,882 Non-owner occupied residential 42,007 4,982 3,790 4,493 0 55,272 Acquisition and development: 1-4 family residential construction 3,292 0 46 0 0 3,338 Commercial and land development 14,118 1,433 712 3,177 0 19,440 Commercial and industrial 28,933 2,129 383 1,878 123 33,446 Municipal 60,996 0 0 0 0 60,996 Residential mortgage: First lien 121,353 0 0 3,327 48 124,728 Home equity - term 20,024 0 0 94 13 20,131 Home equity - Lines of credit 77,187 0 9 181 0 77,377 Installment and other loans 6,184 0 0 0 0 6,184 $ 593,361$ 20,885$ 31,456$ 24,696$ 639$ 671,037 Potential problem loans are defined as performing loans, which have characteristics that cause management to have concerns as to the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as non-performing loans in the future. Generally, management feels that "Substandard" loans that are currently performing and not considered impaired, result in some doubt as to the borrower's ability to continue to perform under the terms of the loan, and represent potential problem loans. Additionally, the "Special Mention" classification is intended to be a temporary classification, and is reflective of loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank's position at some future date. "Special Mention" loans represent an elevated risk, but their weakness does not yet justify a more severe, or classified rating. These loans require follow-up by lenders on the information that may cause the potential weakness, and once resolved, the loan classification may be downgraded to "Substandard," or alternatively, could be upgraded to "Pass." 49



--------------------------------------------------------------------------------

Table of Contents

Activity in the allowance for loan losses for the three months ended June 30, 2014 and 2013 is as follows:

Commercial Consumer Acquisition Commercial Commercial and and Residential Installment (Dollars in thousands) Real Estate Development



Industrial Municipal Total Mortgage and Other Total Unallocated Total June 30, 2014 Balance, beginning of period

$ 13,719 $



474 $ 919$ 244$ 15,356$ 3,112

$ 126 $ 3,238$ 1,903$ 20,497 Provision for loan losses

645 407 (224 ) (66 ) 762 (741 ) 81 (660 ) (102 ) 0 Charge-offs (415 ) (34 ) (55 ) 0 (504 ) (16 ) (54 ) (70 ) 0 (574 ) Recoveries 104 5 353 0 462 7 33 40 0 502 Balance, end of period $ 14,053 $ 852 $ 993$ 178$ 16,076$ 2,362



$ 186 $ 2,548$ 1,801$ 20,425

June 30, 2013 Balance, beginning of period $ 12,165 $



2,614 $ 1,353$ 285$ 16,417$ 3,388

$ 112 $ 3,500$ 2,000$ 21,917 Provision for loan losses

630 (2,080 ) (366 ) (31 ) (1,847 ) 604 38 642 (195 ) (1,400 )

Charge-offs (1,535 ) 1 (114 ) 0 (1,648 ) (225 ) (26 ) (251 ) 0 (1,899 ) Recoveries 28 1,411 2 0 1,441 29 10 39 0 1,480 Balance, end of period $ 11,288$ 1,946$ 875$ 254$ 14,363$ 3,796 $ 134 $ 3,930$ 1,805$ 20,098 Activity in the allowance for loan losses for the six months ended June 30, 2014 and 2013 is as follows: Commercial Consumer Acquisition Commercial Commercial and and Residential Installment (Dollars in thousands) Real Estate Development



Industrial Municipal Total Mortgage and Other Total Unallocated Total June 30, 2014 Balance, beginning of period

$ 13,215 $



670 $ 864$ 244$ 14,993$ 3,780

$ 124 $ 3,904$ 2,068$ 20,965 Provision for loan losses

1,383 211 (164 ) (66 ) 1,364 (1,222 ) 125 (1,097 ) (267 ) 0 Charge-offs (674 ) (34 ) (64 ) 0 (772 ) (209 ) (121 ) (330 ) 0 (1,102 ) Recoveries 129 5 357 0 491 13 58 71 0 562 Balance, end of period $ 14,053 $



852 $ 993$ 178$ 16,076$ 2,362

$ 186 $ 2,548$ 1,801$ 20,425

June 30, 2013 Balance, beginning of period $ 13,719 $



3,502 $ 1,635$ 223$ 19,079$ 2,275

$ 85 $ 2,360$ 1,727$ 23,166 Provision for loan losses

157 (2,826 ) (658 ) 31 (3,296 ) 1,749 69 1,818 78 (1,400 ) Charge-offs (2,677 ) (144 ) (114 ) 0 (2,935 ) (263 ) (46 ) (309 ) 0 (3,244 ) Recoveries 89 1,414 12 0 1,515 35 26 61 0 1,576 Balance, end of period $ 11,288$ 1,946$ 875$ 254$ 14,363$ 3,796 $ 134 $ 3,930$ 1,805$ 20,098 The allowance for loan losses totaled $20,425,000 at June 30, 2014, a decrease of $540,000 from $20,965,000 at December 31, 2013, principally due to a net charge-off recorded during the period, with no provision for loan losses. Despite a decline from December 31, 2013, asset quality metrics remain strong, with the allowance for total loans ratio at 3.01% at June 30, 2014, and the allowance for loan losses to nonaccrual loans coverage ratio at 99.5%. 50



--------------------------------------------------------------------------------

Table of Contents

A summary of relevant asset quality ratios for the three and six months ended June 30, 2014 and 2013 are as follows:

Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Ratio of annualized net charge-offs to average loans outstanding 0.04 % 0.25 % 0.16 % 0.49 % Provision for loan losses to net charge-offs 0.00 % (334.13 )% 0.00 % (83.93 )% Net charge-offs were $72,000 and $540,000 for the three and six months ended June 30, 2014, compared to $419,000 and $1,668,000 for the same periods in 2013. The lower levels of charge-offs in 2014 significantly decreased the annualized ratio of charge-offs to average loans outstanding and reduced the provision for loan losses to charge-off ratio. The majority of the charge-offs remain in the commercial real estate loan portfolios. The following summarizes the ending loan balance individually or collectively evaluated for impairment based upon loan type, as well as the allowance for loan losses allocation for each at June 30, 2014 and December 31, 2013. Commercial Consumer Acquisition Commercial Commercial and and Residential Installment (Dollars in thousands) Real Estate Development Industrial Municipal Total Mortgage and Other Total Unallocated Total June 30, 2014 Loans allocated by: Individually evaluated for impairment $ 18,772$ 1,322



$ 1,832 $ 0 $ 21,926$ 4,703 $

3 $ 4,706 $ 0 $ 26,632 Collectively evaluated for impairment 307,050 20,295 36,761 59,290 423,396 222,873 5,953 228,826 0 652,222 $ 325,822$ 21,617$ 38,593$ 59,290$ 445,322$ 227,576$ 5,956$ 233,532 $ 0 $ 678,854 Allowance for loan losses allocated by: Individually evaluated for impairment $ 2,945 $ 0



$ 0 $ 0 $ 2,945 $ 121 $

3 $ 57 $ 0 $ 3,069 Collectively evaluated for impairment 11,108 852 993 178 13,131 2,241 183 2,491 1,801 17,356 $ 14,053 $ 852 $ 993$ 178$ 16,076$ 2,362 $ 186 $ 2,548$ 1,801$ 20,425 December 31, 2013 Loans allocated by: Individually evaluated for impairment $ 16,494$ 3,177



$ 2,001 $ 0 $ 21,672$ 3,663 $

0 $ 3,663 $ 0 $ 25,335 Collectively evaluated for impairment 308,903 19,601 31,445 60,996 420,945 218,573 6,184 224,757 0 645,702 $ 325,397$ 22,778$ 33,446$ 60,996$ 442,617$ 222,236$ 6,184$ 228,420 $ 0 $ 671,037 Allowance for loan losses allocated by: Individually evaluated for impairment $ 552 $ 0



$ 0 $ 0 $ 552 $ 61 $

0 $ 61 $ 0 $ 613 Collectively evaluated for impairment 12,663 670 864 244 14,441 3,719 124 3,843 2,068 20,352 $ 13,215 $ 670 $ 864$ 244$ 14,993$ 3,780 $ 124 $ 3,904$ 2,068$ 20,965 Despite an increase in the commercial real estate segment's allowance for loan losses individually evaluated for impairment from $552,000 at December 31, 2013 to $2,945,000 at June 30, 2014, the Company has not recorded a provision for loan losses during 2014. The reason a provision was not required is a result of the Company's favorable historical charge-off data combined with relatively stable and economic and market conditions, which allowed for the reduction in the reserve requirements needed for loans collectively evaluated for impairment, in total, which funded the specific reserve needs. The allowance for loan losses allocations presented above represent the reserve allocations on loan balances outstanding at June 30, 2014 and December 31, 2013. In addition to the reserve allocations on impaired loans noted above, 27 loans, with outstanding general ledger principal balances of $4,717,000, have had cumulative partial charge-offs to the allowance for loan losses recorded totaling $2,855,000 at June 30, 2014. As updated appraisals were received on collateral dependent loans, partial charge-offs were taken to the extent the loans' principal balance exceeded their fair value. Management believes the allocation of the allowance for loan losses between the various loan segments adequately reflects the inherent risk in each portfolio, and is based on the methodology outlined in "Note 3 - Loans Receivable and Allowance for Loan Losses" included in the Notes to the Consolidated Financial Statements. Management re-evaluates and makes certain enhancements to its methodology used to establish a reserve to better reflect the risks inherent in the different segments of the portfolio, particularly in light of changes in levels of charge-offs, with noticeable differences between the different loan segments. Management believes these enhancements to the allowance for loan losses methodology improve the accuracy of quantifying losses presently inherent in the portfolio. Management charges actual loan losses to the reserve and bases the provision for loan losses on the overall analysis taking the methodology into account. 51



--------------------------------------------------------------------------------

Table of Contents

The unallocated portion of the allowance for loan losses reflects estimated inherent losses within the portfolio that have not been detected. This reserve results due to risk of error in the specific and general reserve allocation, other potential exposure in the loan portfolio, variances in management's assessment of national and local economic conditions and other factors management believes appropriate at the time. The unallocated portion of the allowance has decreased from $2,068,000 at December 31, 2013 to $1,801,000 at June 30, 2014 and represents 8.8% of the entire allowance for loan losses balance at June 30, 2014, down slightly from 9.9% at December 31, 2013. While management believes the Company's allowance for loan losses is adequate based on information currently available, future adjustments, including additional provisions for loan losses or the reversal of amounts previously provided, to the reserve and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management's assumptions as to future delinquencies or loss rates.



Deposits

Total deposits were $981,705,000 at June 30, 2014, a decrease of $18,685,000, or 1.9%, from $1,000,390,000 at December 31, 2013. Despite the decrease in total deposits, there was a shift to non-interest bearing deposits, which grew by $5,533,000, or 4.81%. Growth was experienced in deposit products, with the exception of time deposits, which are interest rate sensitive, and municipal deposits, given the seasonality of them.



Capital Adequacy and Regulatory Matters

Capital Resources. The management of capital in a regulated financial services industry must properly balance return on equity to its stockholders while maintaining sufficient levels of capital and related risk-based regulatory capital ratios to satisfy statutory regulatory requirements. The Company's capital management strategies have historically been developed to provide attractive rates of returns to its shareholders, while maintaining a "well capitalized" position of regulatory strength.

Total shareholders' equity increased $11,013,000 from $91,439,000 at December 31, 2013 to $102,452,000 at June 30, 2014. The primary reason for the increase in shareholders' equity was the $4,851,000 net income retained for the six months ended, combined with a $6,098,000 increase in accumulated other comprehensive income, net of taxes. The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Although applicable to the Bank, prompt corrective action provisions are not applicable to bank holding companies, including financial holding companies. Capital Adequacy. In the determination of Tier 1 and Total risk based capital, generally accumulated other comprehensive income (loss) is excluded from capital, as are intangible assets, a portion of mortgage servicing rights and deferred tax assets that is dependent on future taxable income greater than one year from the reporting date. As of June 30, 2014 and December 31, 2013, the Company provided a full valuation allowance on its deferred tax asset, which reduced the deferred tax asset, excluding other comprehensive income items, to zero. The allowance for credit losses, including the allowance for loan losses and reserve for off-balance sheet credit commitments, is included as Tier 2 capital to the extent it does not exceeds 1.25% of risk weighted assets. The amount that exceeds 1.25% of risk weighted assets, is disallowed as Tier 2 capital, but also reduces the Company's risk weighted assets. As of June 30, 2014 and December 31, 2013, $12,085,000 and $12,598,000 of the allowance for credit losses was excluded from Tier 2 capital. In March 2012, the Company and the Bank entered into a Written Agreement with the Federal Reserve Bank and the Bank entered into a Consent Order with the PDB. The Consent Order with the PBD has subsequently been terminated and replaced with an MOU, which contains similar provisions pertaining to capital. In accordance therewith, the Bank has filed a confidential Capital Plan with each of those banking regulators. 52



--------------------------------------------------------------------------------

Table of Contents

Regulatory Capital. As of June 30, 2014 and December 31, 2013, the Bank was considered well capitalized under applicable banking regulations. The Company's and the Bank's capital ratios as of June 30, 2014 and December 31, 2013 were as follows: Minimum to Be Well Capitalized Under Minimum Capital Prompt Corrective Actual Requirement Action Provisions (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio June 30, 2014 Total capital to risk weighted assets Orrstown Financial Services, Inc. $ 109,588 15.6 % $ 56,185 8.0 % n/a n/a Orrstown Bank 108,102 15.4 % 56,153 8.0 % $ 70,191 10.0 % Tier 1 capital to risk weighted assets Orrstown Financial Services, Inc. 100,658 14.3 % 28,092 4.0 % n/a n/a Orrstown Bank 99,177 14.1 % 28,076 4.0 % 42,114 6.0 % Tier 1 capital to average assets Orrstown Financial Services, Inc. 100,658 8.5 % 47,335 4.0 % n/a n/a Orrstown Bank 99,177 8.4 % 47,358 4.0 % 59,198 5.0 % December 31, 2013 Total capital to risk weighted assets Orrstown Financial Services, Inc. $ 104,637 15.0 % $ 55,926 8.0 % n/a n/a Orrstown Bank 102,806 14.7 % 55,893 8.0 % $ 69,866 10.0 % Tier 1 capital to risk weighted assets Orrstown Financial Services, Inc. 95,741 13.7 % 27,963 4.0 % n/a n/a Orrstown Bank 93,915 13.4 % 27,947 4.0 % 41,920 6.0 % Tier 1 capital to average assets Orrstown Financial Services, Inc. 95,741 8.1 % 47,058 4.0 % n/a n/a Orrstown Bank 93,915 8.0 % 47,077 4.0 % 58,846 5.0 % As noted above, the Bank's capital ratios exceed the regulatory minimums to be considered well capitalized under applicable banking regulations. The Company routinely evaluates its capital levels in light of its risk profile to assess its capital needs. On January 8, 2013, the Company filed a shelf registration statement on Form S-3 with the Commission, covering up to an aggregate of $80,000,000 worth of common stock, preferred stock, and warrants. To date, the Company has not issued any of the securities registered under this shelf registration statement. In October 2011, the Company announced it had discontinued its quarterly dividend, which was the result of regulatory guidance from the Federal Reserve Bank. Due to the regulatory restrictions included in the Written Agreement and the MOU with the respective regulators, the Company is restricted from paying any dividends or repurchasing any stock without prior regulatory approval. Accordingly, there can be no assurance that we will be permitted to pay a cash dividend or conduct any stock repurchases in the near future. Basel III Capital Rules. In July 2013, the Company and Bank's primary federal regulator, the FRB, approved final rules (the "Basel III Capital Rules") establishing a new comprehensive capital framework for U.S. banking organizations, including community banks, which also incorporate provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Company and Bank, compared to existing U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions' regulatory capital ratios, addresses risk weights and other issues affecting the denominator in banking institutions' regulatory capital ratios and replace the current risk-weighting approach. The Basel III Capital Rules are effective for the Company and Bank on January 1, 2015 (subject to a phase-in period). The Basel III Capital Rules, among other things, (i) introduce a new capital measure called "Common Equity Tier 1" ("CET1"), (ii) specify that Tier 1 capital consist of CET1 and "Additional Tier 1 capital" instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions/adjustments from capital as compared to existing regulations. When fully phased in on January 1, 2019, the Basel III Capital Rules will require the Company and Bank to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer 53



--------------------------------------------------------------------------------

Table of Contents

(which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets. The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) may face constraints on dividends, equity repurchases and discretionary bonuses to executive officers based on the amount of the shortfall.



Under the Basel III Capital Rules, the initial minimum capital ratios as of January 1, 2015 will be as follows:

4.5% CET1 to risk-weighted assets; 6.0% Tier 1 capital to risk-weighted assets; and 8.0% Total capital to risk-weighted assets. The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however the Company and Bank, may make a one-time permanent election to continue to exclude these items. The Company and Bank are still evaluating the benefits and limitations of making this election, and have not yet concluded if they will take advantage of the election. Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2015 and will be phased-in over a 4-year period (beginning at 40% on January 1, 2015 and an additional 20% per year thereafter until fully phased-in at January 1, 2018). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). With respect to the Bank, the Basel III Capital Rules also revise the "prompt corrective action" regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%), and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category. The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Significant changes to current rules that will impact the Company's determination of risk-weighted assets include, among other things:



Applying a 150% risk weight for certain high volatility commercial real

estate acquisition, development and construction loans, compared to 100%

risk weight currently in place;



Assigning a 150% risk weight to exposures (other than residential mortgage

exposures) that are 90 days past due or in nonaccrual status, compared to

100% risk weight currently in place; and



Providing for a 20% credit conversion factor for the unused portion of a

commitment with an original maturity of one year or less that is not unconditionally cancellable, compared to 0% currently in place.



Management is currently evaluating the impact that the Basel III Capital Rules, on a fully phased-in basis, will have on our capital levels. Management anticipates that it will be in compliance with the phased in rules.

54



--------------------------------------------------------------------------------

Table of Contents

Liquidity

The primary function of asset/liability management is to ensure adequate liquidity and manage the Company's sensitivity to changing interest rates. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities, the sale of mortgage loans and borrowings from the Federal Home Loan Bank of Pittsburgh. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. We regularly adjust our investments in liquid assets based upon our assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities and (4) the objectives of our asset/liability management policy.


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters