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EX-99.2 - EXHIBIT 99.2 - Porter Bancorp, Inc.a6664114ex99-2.htm
EX-21.1 - EXHIBIT 21.1 - Porter Bancorp, Inc.a6664114ex21-1.htm
EX-23.1 - EXHIBIT 23.1 - Porter Bancorp, Inc.a6664114ex23-1.htm
EX-31.1 - EXHIBIT 31.1 - Porter Bancorp, Inc.a6664114ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - Porter Bancorp, Inc.a6664114ex32-1.htm
EX-99.1 - EXHIBIT 99.1 - Porter Bancorp, Inc.a6664114ex99-1.htm
EX-31.2 - EXHIBIT 31.2 - Porter Bancorp, Inc.a6664114ex31-2.htm
EX-32.2 - EXHIBIT 32.2 - Porter Bancorp, Inc.a6664114ex32-2.htm
EX-10.14 - EXHIBIT 10.14 - Porter Bancorp, Inc.a6664114ex10-14.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
 
(Mark One)
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 For the Fiscal Year Ended December 31, 2010

OR

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from              to             
 
Commission file number: 001-33033
 
PORTER BANCORP, INC.
(Exact name of registrant as specified in its charter)
   
Kentucky
61-1142247
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer Identification No.)
 
2500 Eastpoint Parkway, Louisville, Kentucky
40223
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number, including area code: (502) 499-4800
Securities registered pursuant to Section 12(b) of the Act:
 
   
Title of each class
Name of each exchange on which registered
Common Stock, no par value
NASDAQ Global Market

Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Act).    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
 
The aggregate market value of the voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the close of business on June 30, 2010, was $61,478,225 based upon the last sales price reported for such date on the NASDAQ Global Market.
 
The number of shares outstanding of the registrant’s Common Stock, no par value, as of February 28, 2011, was 11,281,625.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held May 18, 2011 are incorporated by reference into Part III of this Form 10-K.



 
 
 
 
 
TABLE OF CONTENTS
 
   
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Preliminary Note Concerning Forward-Looking Statements
 
This report contains statements about the future expectations, activities and events that constitute forward-looking statements. Forward-looking statements express our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.
 
Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we expressed or implied in any forward-looking statements. These risks and uncertainties can be difficult to predict and may be out of our control. Factors that could contribute to differences in our results include, but are not limited to deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; changes in the interest rate environment, which may reduce our margins or impact the value of securities, loans, deposits and other financial instruments; changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments; general economic or business conditions, either nationally, regionally or locally in the communities we serve, may be worse than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit; the results of regulatory examinations; any matter that would cause us to conclude that there was impairment of any asset, including intangible assets; the continued service of key management personnel; our ability to attract, motivate and retain qualified employees; factors that increase the competitive pressure among depository and other financial institutions, including product and pricing pressures; the ability of our competitors with greater financial resources to develop and introduce products and services that enable them to compete more successfully than us; the impact of governmental restrictions on entities participating in the Capital Purchase Program of the U.S. Department of the Treasury; inability to comply with regulatory capital requirements and to secure any required regulatory approvals for capital actions; legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry; and fiscal and governmental policies of the United States federal government.
 
Other risks are detailed in Item 1A. “Risk Factors” of this Form 10-K all of which are difficult to predict and many of which are beyond our control.
 
Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include the assumptions or bases underlying the forward-looking statement. We have made our assumptions and bases in good faith and believe they are reasonable. We caution you however, that estimates based on such assumptions or bases frequently differ from actual results, and the differences can be material. The forward-looking statements included in this report speak only as of the date of the report. We do not intend to update these statements unless applicable laws require us to do so.
 
 
Overview
 
We are a bank holding company headquartered in Louisville, Kentucky. We are the seventh largest independent banking organization domiciled in the state of Kentucky based on total assets. Through our wholly-owned subsidiary PBI Bank, we operate 18 full-service banking offices in twelve counties in Kentucky.  Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt, and extend south along the Interstate 65 corridor to Tennessee. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties.  We also have an office in Lexington, Kentucky, the second largest city in Kentucky. PBI Bank is both a traditional community bank with a wide range of commercial and personal banking products, including wealth management and trust services, and an innovative on-line bank which delivers competitive deposit products and services through an on-line banking division operating under the name of Ascencia.  As of December 31, 2010, we had total assets of $1.7 billion, total net loans of $1.3 billion, total deposits of $1.5 billion and stockholders’ equity of $189 million.

History
 
We were organized in 1988, and historically conducted our banking business through separate community banks under the common control of J. Chester Porter, our chairman, and Maria L. Bouvette, our president and chief executive officer. In 2005, we completed a reorganization in which we consolidated our subsidiary banks into a single bank. On December 31, 2005, we renamed our consolidated subsidiary PBI Bank to create a single brand name for our banking operations throughout our market area.
 
 
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We completed the acquisition of Paramount Bank in Lexington, Kentucky, effective February 1, 2008. Paramount had approximately $75 million in assets and $76 million in deposits.  The total acquisition price paid was approximately $5 million in cash.
 
On June 30, 2010, we completed a $27.0 million stock offering to a group of accredited investors in a private placement transaction.  On July 23, 2010 we completed a supplemental private placement to one additional accredited investor on comparable terms as the June 30, 2010 private placement.  The Company received aggregate gross proceeds of $4,255,000 from the new investor.  See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation – Capital.
 
Our Markets
 
We operate in markets that include the four largest cities in Kentucky – Louisville, Lexington, Owensboro and Bowling Green – and in other communities along the I-65 corridor.
 
 
§
Louisville/Jefferson, Bullitt and Henry Counties: Our headquarters are in Louisville, the largest city in Kentucky and the twenty-ninth largest city in the United States. The Louisville metropolitan area includes the consolidated Louisville/Jefferson County and 12 surrounding Kentucky and Southern Indiana counties with an estimated 1.3 million residents in 2009. We also have banking offices in Bullitt County, south of Louisville, and Henry County, east of Louisville. Our six banking offices in these counties also serve the contiguous counties of Spencer, Shelby and Oldham to the east and northeast of Louisville. The area’s employers are diversified across many industries and include the air hub for United Parcel Service (“UPS”), two Ford assembly plants, General Electric’s Consumer and Industrial division, Humana, Norton Healthcare, Brown-Forman and YUM! Brands.
 
 
§
Lexington/Fayette County: Lexington, located in Fayette County, is the second largest city in Kentucky with an estimated countywide population of over 296,000 in 2009. Lexington is the financial, educational, retail, healthcare and cultural hub for Central and Eastern Kentucky. It is known worldwide for its Bluegrass horse farms and Keeneland Race Track, and proudly boasts of itself as “The Horse Capital of the World.”  It is also the home of the University of Kentucky and Transylvania University. The area’s employers include Toyota, Lexmark, IBM Global Services and Valvoline.
 
 
§
Owensboro/Daviess County: Owensboro, located on the banks of the Ohio River, is Kentucky’s third largest city. Daviess County had an estimated countywide population of approximately 95,000 in 2009. The city is called a festival city, with over 20 annual community celebrations that attract visitors from around the world, including its world famous Bar-B-Q Festival which attracts over 80,000 visitors giving Owensboro recognition as “The Bar-B-Q Capital of the World”. It is an industrial, medical, retail and cultural hub for Western Kentucky and the area employers include Owensboro Medical System, Texas Gas, US Bank Home Mortgage and Toyotetsu.
 
 
§
Southern Kentucky: This market includes Bowling Green, the fourth largest city in Kentucky, located about 60 miles north of Nashville, Tennessee.  Bowling Green, located in Warren County, is the home of Western Kentucky University and is the economic hub of an estimated countywide population of approximately 109,000 in 2009. This market also includes thriving communities in the contiguous Barren County, including the city of Glasgow.  Major employers in Barren and Warren Counties include GM’s Corvette plant and several other automotive facilities and R.R. Donnelley’s regional printing facility.
 
 
§
South Central Kentucky: South of the Louisville metropolitan area, we have banking offices in Butler, Edmonson, Green, Hart, and Ohio Counties, which had a combined population of approximately 79,000 in 2009. This region includes stable community markets comprised primarily of agricultural and service-based businesses. Each of our banking offices in these markets has a stable customer base and core deposits that are less sensitive to market competition, which provide us a lower cost source of funds for our lending operations.

Our Products and Services
 
We meet our customers’ banking needs with a broad range of financial products and services. Our lending services include real estate, commercial, mortgage and consumer loans to small to medium-sized businesses located in our markets, the owners and employees of those businesses, as well as other executives and professionals. We complement our lending operations with an array of retail and commercial deposit products. In addition, we offer our customers drive-through banking facilities, automatic teller machines, night depository, personalized checks, credit cards, debit cards, internet banking, electronic funds transfers through ACH services, domestic and foreign wire transfers, travelers’ checks, cash management, vault services, loan and deposit sweep accounts and lock box services.  Through our trust division, we offer personal trust services, employer retirement plan services and personal financial and retirement planning services.
 
 
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Employees
 
At December 31, 2010, the Company had 286 full-time equivalent employees. Our employees are not subject to a collective bargaining agreement, and management considers the Company’s relationship with employees to be good.
 
Competition
 
The banking business is highly competitive, and we experience competition in our market from many other financial institutions. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services offered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices within our market area and beyond.
 
There are a number of banks that offer services exclusively over the internet and other banks market their internet services to their customers nationwide. We believe that only the very largest of the commercial banks with which we compete offer the comprehensiveness of internet banking services that we are able to offer. However, many of the larger banks do have greater market presence and greater financial resources to market their internet banking services. Additionally, new competitors and competitive factors are likely to emerge, particularly in view of the rapid development of internet commerce. On the other hand, we believe that many customers still prefer to be able to conduct at least some of their banking transactions at local banking offices. We believe that these findings support our strategic decision to complement our traditional community bank with our uniquely branded online bank to offer customers the benefits of both traditional and internet banking services. We believe that this strategy will contribute to our growth in the future.
 
Supervision and Regulation
 
The following is a summary description of the relevant laws, rules and regulations governing banks and bank holding companies. The descriptions of, and references to, the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.
 
The Dodd-Frank Act. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was signed into law. The Dodd-Frank Act imposes new restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions. Because the Dodd-Frank Act requires various federal agencies to adopt a broad range of regulations with significant discretion, many of the details of the new law and the effects it will have on the Company are not known at this time.
 
The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States. There are a number of reform provisions that are likely to significantly impact the ways in which banks and bank holding companies, including the Company, do business. For example, the Dodd-Frank Act changes the assessment base for federal deposit insurance premiums by modifying the deposit insurance assessment base calculation to be based on a depository institution’s consolidated assets less tangible capital instead of deposits, permanently increases the standard maximum amount of deposit insurance per customer to $250,000 and extends the unlimited deposit insurance on non-interest bearing transaction accounts through January 1, 2013. The Dodd-Frank Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred issuances from counting as Tier I capital. The Dodd-Frank Act also repeals the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. The Act codifies and expands the Federal Reserve’s source of strength doctrine, which requires that all bank holding companies serve as a source of financial strength for its subsidiary banks. Other provisions of the Dodd-Frank Act include, but are not limited to: (i) the creation of a new financial consumer protection agency that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer protection; (ii) enhanced regulation of financial markets, including derivatives and securitization markets; (iii) reform related to the regulation of credit rating agencies; (iv) the elimination of certain trading activities by banks; and (v) new disclosure and other requirements relating to executive compensation and corporate governance.
 
 
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Many provisions of the Dodd-Frank Act will not be implemented immediately and will require interpretation and rule making by federal regulators. The Company is monitoring all relevant sections of the Dodd-Frank Act to ensure continued compliance with laws and regulations. While the ultimate effect of the Dodd-Frank Act on the Company cannot currently be determined, the law is likely to result in increased compliance costs and fees paid to regulators, along with possible restrictions on the Company’s operations.
 
Porter Bancorp.  Porter Bancorp is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System. As such, we must file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to operational guidelines established by the Federal Reserve Board. We are subject to the Bank Holding Company Act and other federal laws on the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.
 
Acquisitions. A bank holding company must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock or all or substantially all of the assets of a bank, merging or consolidating with any other bank holding company and before engaging, or acquiring a company that is not a bank but is engaged in certain non-banking activities.  Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance, and then only if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company with a class of securities registered under the Securities Exchange Act of 1934 would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.
 
Permissible Activities. A bank holding company is generally permitted under the Bank Holding Company Act to engage in or acquire direct or indirect control of more than 5% of the voting shares of any bank, bank holding company or company engaged in any activity that the Federal Reserve Board determines to be so closely related to banking as to be a proper incident to the business of banking.
 
Under current federal law, a bank holding company may elect to become a financial holding company, which enables the holding company to conduct activities that are “financial in nature.”  Activities that are “financial in nature” include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. We have not filed an election to become a financial holding company.
 
U.S. Treasury Capital Purchase Program.  On November 21, 2008, pursuant to the U.S. Department of the Treasury’s (the “U.S. Treasury”) Capital Purchase Program (the “CPP”), established under the Emergency Economic Stabilization Act of 2008 (“EESA”), Porter Bancorp issued and sold to the U.S. Treasury in an offering exempt from registration under the Securities Act of 1933, (i) 35,000 shares of Porter Bancorp’ Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value and liquidation preference $1,000 per share ($35 million aggregate liquidation preference) (the “Series A Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 330,561 shares (adjusted for stock dividend) of Porter Bancorp’s common stock, at an exercise price of $15.88 per share (adjusted for stock dividend), subject to certain anti-dilution and other adjustments for an aggregate purchase price of $35 million in cash. The securities purchase agreement, dated November 21, 2008, pursuant to which the securities issued to the U.S. Treasury under the CPP were sold, limits the payment of dividends on Porter Bancorp’s common stock to the quarterly dividend level at the time of the transaction without prior approval of the U.S. Treasury, limits Porter Bancorp’s ability to repurchase shares of its common stock (with certain exceptions, including the repurchase of our common stock to offset share dilution from equity-based compensation awards) and grants registration rights to the holders of the Series A Preferred Stock, the Warrant and the common stock of Porter Bancorp to be issued upon any exercise of the Warrant.
 
 
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The American Recovery and Reinvestment Act (“ARRA”) was enacted on February 17, 2009.  ARRA imposes certain executive compensation and corporate governance obligations on all current and future CPP recipients, including Porter Bancorp, until the institution has redeemed the preferred stock. On June 15, 2009, under the authority granted to it under EESA and ARRA, the U. S. Treasury issued an interim final rule under Section 111 of EESA, as amended by ARRA, regarding compensation and corporate governance restrictions that would be imposed on CPP recipients, effective June 15, 2009. As a CPP recipient with currently outstanding CPP obligations, we are subject to the compensation and corporate governance restrictions and requirements set forth in the interim final rule.  The restrictions and requirements provided for in the implementing regulations are generally as follows: (1) required us to establish an independent compensation committee, (2) required us to adopt a corporate policy on luxury or excessive expenditures; (3) requires our compensation committee to conduct semi-annual risk assessments to assure that our compensation arrangements do not encourage “unnecessary and excessive risks” or the manipulation of earnings to increase compensation; (4) requires us to recoup or “clawback” any bonus, retention award or incentive compensation paid by us to a senior executive officer or any of our next 20 most highly compensated employees, if the payment was based on financial statements or other performance criteria that are later found to be materially inaccurate; (5) prohibits us from making severance payments or “golden parachutes” to any of our senior executive officers or next five most highly compensated employees; (6) prohibits us from paying or accruing bonuses, retention awards or incentive compensation, except for certain long-term stock awards, to our five most highly compensated employees; (7) prohibits us from providing tax gross-ups to any of our senior executive officers or next 20 most highly compensated employees; (8) requires us to provide enhanced disclosure of perquisites to the FDIC and the U.S. Treasury; (9) requires us to disclose to the FDIC and the U.S. Treasury the use and role of compensation consultants; (10) requires our chief executive officer and chief financial officer to provide period certifications about our compensation practices and compliance with the interim final rule; and (11) requires us to provide an annual non-binding shareholder vote, or “say-on-pay” proposal, to approve the compensation of our named executives, consistent with regulations promulgated by the Securities and Exchange Commission. On January 12, 2010, the SEC adopted final regulations setting forth the parameters for such say-on pay proposals for public company CPP participants.
 
Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. The guidelines require a minimum total risk-based capital ratio of 8.0%. At least half of the total capital must be composed of common equity, retained earnings, senior perpetual preferred stock issued to the U. S. Treasury under the CPP and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangible assets (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the allowance for loan losses (“Tier 2 capital”). Total capital is the sum of Tier 1 and Tier 2 capital. To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total capital to total risk-weighted assets ratio of at least 10% and a Tier 1 capital to total risk-weighted assets ratio of 6% or greater. As of December 31, 2010, our ratio of total capital to total risk-weighted assets was 16.3% and our ratio of Tier 1 capital to total risk-weighted assets was 14.4%, both ratios significantly above the required amounts. PBI Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a ratio of Tier I capital to total risk-weighted asset of 9.0%.
 
In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company’s Tier 1 capital divided by its average total consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies may be required to maintain a leverage ratio of 4.0%. As of December 31, 2010, our leverage ratio of 11.1% was significantly above the required amount.
 
The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.
 
Dividends. Under Federal Reserve policy, bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not declare a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.
 
 
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Porter Bancorp is a legal entity separate and distinct from PBI Bank. The majority of our revenue is from dividends paid to us by PBI Bank. PBI Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and hearing, that the institution cease such practice. The federal banking agencies have indicated that paying dividends that deplete an institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act (FDICIA), an insured institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings. A bank holding company may still declare and pay a dividend if it does not have current operating earnings if the bank holding company expects profits for the entire year and the bank holding company obtains the prior consent of the Federal Reserve. Porter Bancorp and PBI Bank must obtain the prior written consent of each of their primary regulators prior to declaring or paying any future dividends.
 
Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank’s capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the Kentucky Department of Financial Institutions must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank’s total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or in the corporation becoming unable to pay debts as they come due. PBI Bank did not pay any dividends in 2010.
 
Prior to November 21, 2011, unless Porter Bancorp has redeemed all of the Series A Preferred Stock issued to the U.S. Treasury on November 21, 2008 or unless the U.S. Treasury has transferred all the preferred securities to a third party, the consent of the U.S. Treasury will be required for Porter Bancorp to declare or pay any dividend or make any distribution on common stock other than (i) regular quarterly cash dividends of not more than the per share dividend amount at the time of the issuance of the Series A Preferred Stock, as adjusted for any stock split, stock dividend, reverse stock split, reclassification or similar transaction, (ii) dividends payable solely in shares of common stock and (iii) dividends or distributions of rights or junior stock in connection with a shareholders’ rights plan.
 
Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take “prompt corrective action” to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes “undercapitalized,” it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.
 
The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.
 
Source of Financial Strength. Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to, and to commit resources to support, its bank subsidiaries. This support may be required at times when, absent such a policy, the bank holding company may not be inclined to provide it. In addition, any capital loans by the bank holding company to its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of the bank subsidiary. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Federal Reserve’s “Source of Financial Strength” policy was codified in the Dodd-Frank Act.
 
 
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PBI Bank.  PBI Bank, a Kentucky chartered commercial bank, is subject to regular bank examinations and other supervision and regulation by both the FDIC and the Kentucky Department of Financial Institutions (“KDFI”). Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky banking corporation to engage in any banking activity which could be engaged in by a national bank operating in any state; a state bank, a thrift or savings bank operating in any other state; or a federal chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.
 
Capital Requirements. Similar to the Federal Reserve Board’s requirements for bank holding companies, the FDIC has adopted risk-based capital requirements for assessing state non-member banks’ capital adequacy. The FDIC’s risk-based capital guidelines require that all banks maintain a minimum ratio of total capital to total risk-weighted assets of 8.0% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0%.  To be well-capitalized, a bank must have a ratio of total capital to total risk-weighted assets of at least 10.0% and a ratio of Tier 1 capital to total risk-weighted assets of 6.0%. PBI Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a ratio of Tier 1 capital to total risk-weighted assets of 9%. As of December 31, 2010, PBI Bank’s ratio of total capital to total risk-weighted assets was 14.7% and its ratio of Tier 1 capital to total risk-weighted assets was 12.8%. PBI Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a ratio of Tier I capital to total risk-weighted asset of 9.0%.
 
The FDIC also requires a minimum leverage ratio of 3.0% of Tier 1 capital to total assets for the highest rated banks and an additional cushion of approximately 100-200 basis points for all other banks. As of December 31, 2010, PBI Bank’s leverage ratio was 9.9%. The leverage ratio operates in tandem with the FDIC’s risk-based capital guidelines and places a limit on the amount of leverage a bank can undertake by requiring a minimum level of capital to total assets.
 
Prompt Corrective Action. Pursuant to the Federal Deposit Insurance Act (“FDIA”), the FDIC must take prompt corrective action to resolve the problems of undercapitalized institutions. FDIC regulations define the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A “well-capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk- based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well-capitalized bank. A bank is “undercapitalized” if it fails to meet any one of the ratios required to be adequately capitalized. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The degree of regulatory scrutiny increases and the permissible activities of a bank decreases, as the bank moves downward through the capital categories. Depending on a bank’s level of capital, the FDIC’s corrective powers include:
 
 
requiring a capital restoration plan;
 
 
placing limits on asset growth and restriction on activities;
 
 
requiring the bank to issue additional voting or other capital stock or to be acquired;
 
 
placing restrictions on transactions with affiliates;
 
 
restricting the interest rate the bank may pay on deposits;
 
 
ordering a new election of the bank’s board of directors;
 
 
requiring that certain senior executive officers or directors be dismissed;
 
 
prohibiting the bank from accepting deposits from correspondent banks;
 
 
requiring the bank to divest certain subsidiaries;
 
 
prohibiting the payment of principal or interest on subordinated debt; and
 
 
ultimately, appointing a receiver for the bank.

 
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In the event an institution is required to submit a capital restoration plan, the institution’s holding company must guaranty the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.  The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.
 
Deposit Insurance Assessments. The deposits of PBI Bank are insured by the Depositors Insurance Fund (DIF) of the FDIC up to the limits set forth under applicable law and are subject to the deposit insurance premium assessments of the DIF. The FDIC imposes a risk-based deposit premium assessment system, which was amended pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits.
 
On November 12, 2009, the FDIC amended the final rule adopted on May 22, 2009 to restore losses to the DIF. The new rule required insured institutions to prepay on December 30, 2009, an estimated quarterly risk-based assessment for the fourth quarter of 2009 and for all 2010, 2011, and 2012. An institution’s assessment is calculated by taking the institution’s actual September 30, 2009 assessment and adjusting it quarterly by an estimated 5% annual growth rate through the end of 2012. Further, the FDIC incorporated a uniform 3 basis point increase effective January 1, 2011. On December 30, 2009, PBI Bank prepaid $7.9 million of FDIC insurance premiums for the next three years. The entire amount of the prepaid assessment was recorded as a prepaid expense. As of December 31, 2009, and each quarter thereafter, each institution is to record an expense, or a charge to earnings, for its quarterly assessment invoiced on its quarterly statement and an offsetting credit to the prepaid assessment until the asset is exhausted. At December 31, 2010, our unexhausted prepaid assessment was $5.4 million.
 
The Dodd-Frank Act imposes additional assessments and costs with respect to deposits. Under the Dodd-Frank Act, the FDIC is directed to impose deposit insurance assessments based on total assets rather than total deposits, as well as making permanent the increase of deposit insurance to $250,000 and providing for full insurance of non-interest bearing transaction accounts beginning December 31, 2010, for two years. In February 2011, the FDIC adopted a final rule on the deposit insurance assessment system. The rule is effective as of April 1, 2011 and revises the assessment system to comply with Dodd-Frank and also includes a revised assessment rate process with the goal of differentiating insured depository institutions who pose greater risk to the DIF. The first assessments under the new rule will be payable in the third quarter of 2011.
 
Safety and Soundness Standards.    The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. See “Prompt Corrective Actions” above.  If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

 
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Branching. Kentucky law permits Kentucky chartered banks to establish a banking office in any county in Kentucky. A Kentucky bank may also establish a banking office outside of Kentucky. Well capitalized Kentucky banks that have been in operation at least three years and that satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a banking office in Kentucky without the approval of the KDFI upon notice to the KDFI and any other state bank with its main office located in the county where the new banking office will be located. Branching by all other banks requires the approval of the KDFI, who must ascertain and determine that the public convenience and advantage will be served and promoted and that there is reasonable probability of the successful operation of the banking office.
 
The transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.
 
An out-of-state bank is permitted to establish banking offices in Kentucky only by merging with a Kentucky bank. De novo branching into Kentucky by an out-of-state bank is not permitted. This difficulty for out-of-state banks to branch in Kentucky may limit the ability of a Kentucky bank to branch into many states, as several states have reciprocity requirements for interstate branching.  The Dodd-Frank Act permits de novo interstate branching by national banks and insured state banks by amending the state “opt-in” election.  Applications for out-of-state de novo branches would be approved if, under the law of the state in which the branch is to be located, a state bank chartered by such state would have been permitted to establish the branch.
 
Insider Credit Transactions. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured depository institutions and their subsidiaries. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution’s total unimpaired capital and surplus.
 
Automated Overdraft Payment Regulation. The Federal Reserve and FDIC have recently enacted consumer protection regulations related to automated overdraft payment programs offered by financial institutions. In November 2009, the Federal Reserve amended its Regulation E to prohibit financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. The Regulation E amendments also require financial institutions to provide consumers with a notice that explains the financial institution’s overdraft services, including the fees associated with the service and the consumer’s choices.
 
In November 2010, the FDIC supplemented the Regulation E amendments by requiring FDIC-supervised institutions to implement additional changes relating to automated overdraft payment programs by July 1, 2011. The most significant of these changes require financial institutions to monitor overdraft payment programs for “excessive or chronic” customer use and undertake “meaningful and effective” follow-up action with customers that overdraw their accounts more than six times during a rolling 12-month period. The additional guidance also imposes daily limits on overdraft charges, requires institutions to review and modify check-clearing procedures, prominently distinguish account balances from available overdraft coverage amounts and requires increased board and management oversight regarding overdraft payment programs.
 
Consumer Protection Laws. PBI Bank is subject to consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Real Estate Settlement and Procedures Act, the Fair Credit Reporting Act, and the Federal Trade Commission Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers.
 
Privacy. Federal law currently contains extensive customer privacy protections provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.
 
 
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Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC’s assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new banking office or to relocate an office.
 
Bank Secrecy Act. The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of PBI Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities. In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.
 
USA Patriot Act. The USA PATRIOT Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering, and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.
 
Temporary Liquidity Guarantee Program. Under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), the FDIC guaranteed U.S. depository institutions’ transaction accounts and certain qualifying senior unsecured debt. We participated in the TLGP’s Transaction Account Guarantee Program (TAGP), which provided that all non-interest bearing transaction accounts maintained at PBI Bank were insured in full by the FDIC, regardless of the standard maximum deposit insurance amounts.  Although the guarantee of non-interest bearing transaction account deposits under the TLGP ended on June 30, 2010, the Dodd-Frank Act provides for unlimited FDIC deposit insurance coverage on non-interest bearing transaction accounts at all insured institutions, regardless of participation in the TLGP, until January 1, 2013.

Effect on Economic Environment.  The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits.
 
Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on our business and earnings and those of our subsidiaries cannot be predicted.

Recently Enacted and Future Legislation.  Various laws, regulations and governmental programs affecting financial institutions and the financial industry are from time to time introduced in Congress or otherwise promulgated by regulatory agencies. Such measures may change the operating environment of Porter Bancorp and its subsidiaries in substantial and unpredictable ways. The nature and extent of future legislative, regulatory or other changes affecting financial institutions is very unpredictable at this time.  

We cannot predict what other legislation or economic policies of the various regulatory authorities might be enacted or adopted or what other regulations might be adopted or the effects thereof. Future legislation and policies and the effects thereof might have a significant influence on overall growth and distribution of loans, investments and deposits and affect interest rates charged on loans or paid on time and savings deposits. Such legislation and policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.
 
 
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Available Information
 
We file reports with the SEC including our annual report on Form 10-K, quarterly reports on Form 10-Q, current event reports on Form 8-K and proxy statements, as well as any amendments to those reports. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are accessible at no cost on our web site at http://www.pbibank.com, under the Investors Relations section, once they are electronically filed with or furnished to the SEC. A shareholder may also request a copy of our Annual Report on Form 10-K free of charge upon written request to: Corporate General Counsel, Porter Bancorp, Inc., 2500 Eastpoint Parkway, Louisville, Kentucky 40223.
 
 
An investment in our common stock involves a number of risks. Realization of any of the risks described below could have a material adverse effect on our business, financial condition, results of operations, cash flow and/or future prospects.

Our business has been and may continue to be adversely affected by current conditions in the financial markets and by economic conditions generally.

The capital and credit markets have been experiencing unprecedented levels of volatility and disruption since 2008 In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. Reduced consumer spending and the absence of liquidity in the global credit markets during the current recession have depressed business activity across a wide range of industries. Unemployment has also increased significantly. Ongoing weakness in business and economic conditions generally or specifically in our markets has had, and could continue to have one or more of the following adverse effects on our business:

 
·
A decrease in the demand for loans and other products and services offered by us;
 
·
A decrease in the value of collateral securing our loans;
 
·
An impairment of certain intangible assets, such as goodwill; and
 
·
An increase in the number of customers who become delinquent, file for protection under bankruptcy laws or default on their loans.

The general business environment has had an adverse effect on our business for the past three years, and it is not certain that the environment will improve in the near term. Until conditions improve, we expect our businesses, financial condition and results of operations to be adversely affected.

Current market developments could continue to adversely affect our industry, businesses and results of operations.

Over the past three years, the financial services industry as a whole, as well as the securities markets generally, have been materially and adversely affected by very significant declines in the values of nearly all asset classes and by a very serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence. The loss of confidence in the financial sector, increased volatility in the financial markets and reduced business activity could continue to adversely affect our business, financial condition and results of operations. Further negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provisions for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial services industry.

 
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A large percentage of our loans are collateralized by real estate, and further disruptions in the real estate market may result in losses and adversely affect our profitability.

Approximately 88.7% of our loan portfolio, as of December 31, 2010, was comprised of loans collateralized by real estate. The declining economic conditions have caused a decrease in demand for real estate which has resulted in declining real estate values in our markets. Further disruptions in the real estate market could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values decline further, it will become more likely that we would be required to increase our allowance for loan losses. If during a period of reduced real estate values, we are required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

We have a significant percentage of real estate construction and development loans, which carry a higher degree of risk. The poor condition of the residential construction and commercial development real estate markets may lead to increased non-performing assets in our loan portfolio and increased provision expense for losses on loans, which could have a material adverse effect on our capital, financial condition and results of operations.

Approximately 15.3% of our loan portfolio as of December 31, 2010, consisted of real estate construction and development loans. These loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the sale of the property. If we are forced to foreclose on a project prior to its completion, we may not be able to recover the entire unpaid portion of the loan or we may be required to fund additional money to complete the project or hold the property for an indeterminate period of time. Any of these outcomes may result in losses and adversely affect our profitability.

The residential construction and commercial development real estate markets continue to experience challenging economic conditions. Further disruptions in these markets may lead to additional valuation adjustments on our loan portfolios and real estate owned as we continue to reassess the fair value of our non-performing assets, the loss severities of loans in default and the fair value of real estate owned. We also may realize additional losses in connection with our disposition of non-performing assets. A weak real estate market could further reduce demand for residential housing, which, in turn, could adversely affect the development and construction activities of residential real estate developers. Consequently, the longer the current economic conditions persist, the more likely they are to adversely affect the ability of residential real estate developer borrowers to repay these loans and the value of property used as collateral for such loans. These economic conditions and market factors have negatively affected some of our larger loans, causing our total net-charge offs to increase and requiring us to significantly increase our allowance for loan losses. If adverse economic conditions persist, these trends could continue to worsen. Any further increase in our non-performing assets and related increases in our provision expense for losses on loans could negatively affect our business and could have a material adverse effect on our capital, financial condition and results of operations.

Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.

We maintain an allowance for loan losses at a level we believe is adequate to absorb probable incurred losses in our loan portfolio based on historical loan loss experience, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual future loan losses, which would adversely affect our operating results. Our estimates are subjective and their accuracy depends on the outcome of future events. Changes in economic, operating and other conditions that are generally beyond our control could cause actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have from time to time required us to increase our provision for loan losses or to recognize further loan charge-offs when their judgment has differed from ours, which could have a material negative impact on our operating results.

We may experience additional classified loans and non-performing assets in the foreseeable future if the real estate markets remain weak and cause more borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, likely will be negatively affected if the real estate market remains weak, making us less likely to realize a full recovery if a borrower defaults on a loan. Any additional non-performing assets, loan charge-offs, increases in the provision for loan losses or any inability by us to realize the full value of underlying collateral in the event of a loan default, could negatively affect our business, financial condition, and results of operations and the price of our securities.

 
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We continue to hold and acquire a significant amount of OREO properties, which could increase operating expenses and result in future losses to the Company.
 
During 2010, we have acquired a significant amount of real estate as a result of foreclosure or by deed in lieu of foreclosure that is listed on our balance sheet as other real estate owned (OREO). Large OREO balances have led to increased expenses as we have incurred costs to manage and dispose of these properties and, in certain cases, complete construction of structures prior to sale. We expect that our operating results in 2011 will continue to be adversely affected by expenses associated with OREO, including insurance and taxes, completion and repair costs, and valuation adjustments, as well as by the funding costs associated with assets that are tied up in OREO. In addition, any further decreases in market prices of real estate in our market areas may lead to additional OREO write downs, with a corresponding expense in our income statement. We evaluate OREO property values periodically and write down the carrying value of the properties if and when the results of our evaluations require it.

Our profitability depends significantly on local economic conditions.

Because most of our business activities are conducted in central Kentucky and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business and employment activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy remains weak, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio will likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by the economic downturn or a localized natural disaster. The economic downturn has had a negative impact on our financial results and may continue to have a negative impact on our business, financial condition, results of operations and future prospects.

If we experience greater credit losses than anticipated, our earnings may be adversely affected.

As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse effect on our operating results. Our credit risk with respect to our real estate and construction loan portfolio will relate principally to the creditworthiness of borrowers and the value of the real estate serving as security for the repayment of loans. Our credit risk with respect to our commercial and consumer loan portfolio will relate principally to the general creditworthiness of businesses and individuals within our local markets.

We make various assumptions and judgments about the collectability of our loan portfolio and provide an allowance for estimated credit losses based on a number of factors. We believe that our allowance for credit losses is adequate. However, if our assumptions or judgments are wrong, our allowance for credit losses may not be sufficient to cover our actual credit losses. We may have to increase our allowance in the future in response to the request of one of our primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of our loan portfolio. The actual amount of future provisions for credit losses cannot be determined at this time and may vary from the amounts of past provisions.

Our profitability is vulnerable to fluctuations in interest rates.

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Factors beyond our control, such as inflation, recession, unemployment and money supply may also affect interest rates. If our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period as a result of decreasing interest rates, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period as a result of increasing interest rates.

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

 
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If we cannot obtain adequate funding, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Company to fund corporate expansion or other activities.

Our liquidity policies and limits are established by the Board of Directors of PBI Bank, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits and the percentage of assets funded with non-core or wholesale funding. The ALCO regularly monitors the overall liquidity position of PBI Bank and the Company to ensure that various alternative strategies exist to cover unanticipated events that could affect liquidity. Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. The ALCO follows established board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and Federal Home Loan Bank (“FHLB”) advances that are collateralized with mortgage-related assets.

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows and our level of regulatory-qualifying capital.

Our small to medium-sized business portfolio may have fewer resources to weather the downturn in the
economy.

Our portfolio includes loans to small and medium-sized businesses and other commercial enterprises.  Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small or medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn could have a more pronounced negative impact on our target market, which could cause us to incur substantial credit losses that could materially harm our operating results.

We may need to raise additional capital in the future, but that capital may not be available when needed or at all.

We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. Capital may not be available to us on acceptable terms or at all. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on our businesses, financial condition and results of operations.

There may be future sales or other dilution of our equity, which may adversely affect the market price of our common stock.

We are not restricted from issuing additional common stock, including securities that are convertible into or exchangeable for, or that represent the right to receive, common stock. The issuance of additional shares of common stock or the issuance of convertible securities would dilute the ownership interest of our existing common shareholders. The market price of our common stock could decline as a result of such an offering as well as other sales of a large block of shares of our common stock or similar securities in the market after such an offering, or the perception that such sales could occur.

Our issuance of securities to the U.S. Department of the Treasury may limit our ability to return capital to our shareholders and is dilutive to our common shares. In addition, the dividend rate increases substantially after five years if we do not redeem the shares by that time.

On November 21, 2008, as part of the Capital Purchase Program established under the Emergency Economic Stabilization Act of 2008 (“EESA”), we sold $35 million of senior preferred stock to the U.S. Treasury. We also issued to the U.S. Treasury a warrant to purchase 299,829 shares of our common stock at $17.51 per share, subject to certain anti-dilution and other adjustments. The warrant is currently exercisable for 330,561 shares at an exercise price of $15.88, based on our 2009 and 2010 5% stock dividends. The terms of the transaction with the U.S. Treasury limit our ability to pay dividends and repurchase our shares. For three years after issuance or until the U.S. Treasury no longer holds any preferred shares, we will not be able to increase our dividends above the current quarterly amount nor repurchase any of our shares without the U.S. Treasury’s approval with limited exceptions, most significantly the repurchase of our common stock to offset share dilution from equity-based compensation awards. Also, we will not be able to pay any dividends at all unless we are current on our dividend payments on the preferred shares. These restrictions, as well as the dilutive impact of the warrant, may have an adverse effect on the market price of our common stock.

 
14

 
 
Unless we are able to redeem the preferred stock during the first five years, the dividends on this capital will increase substantially at that point, from 5% (approximately $1.75 million annually) to 9% (approximately $3.15 million annually). Depending on market conditions and our financial performance at the time, this increase in dividends could significantly impact our capital, liquidity and earnings available to common shareholders.

The U.S. Treasury has the unilateral ability to change some of the restrictions imposed on us by virtue of our sale of securities to it.

Our agreement with the U.S. Treasury under which it purchased our senior preferred stock imposes restrictions on the conduct of our business, including restrictions related to our payment of dividends, repurchases of our stock and our executive compensation and corporate governance. The U.S. Treasury has the right under this agreement to unilaterally amend it to the extent required to comply with any future changes in federal statutes. These amendments could have an adverse impact on the conduct of our business, as could additional amendments in the future that impose further requirements or amend existing requirements.

Our chairman and our president and chief executive officer together have sufficient voting power to elect or remove our directors, to determine the vote on any matter that requires shareholder approval, and otherwise control our company. In exercising their voting power, they may act according to their own interests, which may be adverse to your interests.

As of December 31, 2010, J. Chester Porter and Maria L. Bouvette beneficially owned approximately 6,057,606 shares, or 51.1% of our outstanding common stock. Mr. Porter and Ms. Bouvette each have made testamentary arrangements that provide for the other to retain voting control of his or her common stock in the event of death. Accordingly, they will be able to exercise control over our business and affairs and will be able to determine the outcome of any matter submitted to a vote of our shareholders, including the election and removal of our entire board of directors, any amendment of our articles of incorporation (including any amendment that changes the rights of our common stock) and any merger, consolidation or sale of all or substantially all of our assets. Mr. Porter and Ms. Bouvette could take actions or make decisions in their self-interest that are opposed to your best interests. They could remove directors who take actions or make decisions they oppose but are favored by our other shareholders. They may be less receptive to the desires communicated by shareholders. Neither our articles of incorporation, our bylaws, nor Kentucky law requires the vote of more than a simple majority of our outstanding shares of common stock to approve a matter submitted for shareholder approval, subject to the general statutory requirement that any transaction in which one or more directors have a direct or indirect interest (other than as a shareholder) must be “fair” to the corporation. Mr. Porter and Ms. Bouvette have a level of concentrated control that could discourage others from initiating any potential merger, takeover or other change of control transaction that may otherwise give you the opportunity to realize a premium over the then-prevailing market price of our common stock. As a result, the market price of our common stock could be adversely affected.

 
15

 
 
We are a “controlled company” within the meaning of the NASDAQ corporate governance rules because J. Chester Porter and Maria L. Bouvette together own more than 50% of our sole class of voting stock. As a controlled company, our controlling shareholders have greater power to make decisions in their own self-interest and against the interests of other shareholders, and investors and other shareholders will have fewer procedural and substantive protections against the exercise of this power.

A “controlled company” may elect not to comply with the following NASDAQ corporate governance rules, which require that:

 
·
a majority of its board of directors consists of “independent directors,” which the NASDAQ rules define as persons who are not either officers or employees of the company and have no relationships that, in the opinion of the board of directors, would interfere with the exercise of independent judgment in carrying out their responsibilities as directors;
 
·
decisions regarding the compensation paid to executive officers are made either by a compensation committee composed entirely of independent directors or by a majority of the independent directors; and
 
·
nominations for election to the board of directors are made either by a nominating committee composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities or by a majority of the independent directors.

Although a majority of our directors are independent directors, they have all been selected by Mr. Porter and Ms. Bouvette, who together have the voting power to remove directors who oppose actions or decisions they favor. Mr. Porter and Ms. Bouvette also have the power to elect a majority of directors who are not independent directors. Our board may elect to dispense with the nominating and governance committee at any time without shareholder consent. Accordingly, our shareholders have fewer procedural and substantive protections than shareholders of companies subject to all of the NASDAQ corporate governance requirements.

If we are unable to manage our growth effectively, our operations could be negatively affected.

Financial institutions like us that have experience rapid growth face various risks and difficulties, including:

 
·
attracting funding to support additional growth;
 
·
maintaining asset quality;
 
·
attracting and retaining qualified management; and
 
·
maintaining adequate regulatory capital.

In addition, in order to manage our growth and maintain adequate information and reporting systems within our organization, we must identify, hire and retain additional qualified employees, particularly in the accounting and operational areas of our business.

If we do not manage our growth effectively, our business, financial condition, results of operations and future prospects could be negatively affected, and we may not be able to continue to implement our business strategy and successfully conduct our operations.

We may not be able to maintain our historical earnings trends if we are not able to continue to grow.

We have expanded our business through both organic growth and a number of strategic acquisitions. Our ability to continue our organic growth depends, in part, upon our ability to expand our market presence, successfully attract core deposits and identify attractive commercial lending opportunities. If we are not able to do this successfully, we may not be able to maintain our historical earnings trends.

Our ability to implement our strategy for continued growth also depends on our ability to continue to identify and integrate acquisition targets profitably. We may not be able to continue this trend, nor may future acquisitions always be profitable. In addition, increased regulatory scrutiny may limit the ability to make future acquisitions.  We also expect that competition for suitable acquisition candidates will be significant. We compete with other banks or financial service companies with similar acquisition strategies, many of which are larger and have greater financial and other resources than we do. We may not be able to successfully identify and acquire suitable acquisition targets on acceptable terms and conditions.

 
16

 
 
Higher FDIC deposit insurance premiums and assessments could significantly increase our non-interest expense.
 
Our deposits are insured by the FDIC up to legal limits and, accordingly, we are subject to FDIC deposit insurance assessments. High levels of bank failures over the past three years and increases in the statutory deposit insurance limits have increased resolution costs to the FDIC and put pressure on the DIF. In order to maintain a strong funding position and restore the reserve ratios of the DIF, the FDIC increased assessment rates on insured institutions, charged a special assessment to all insured institutions as of June 30, 2009 and required banks to prepay three years’ worth of premiums on December 30, 2009. If there are additional financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels, or the FDIC may charge additional special assessments. Further, the FDIC recently increased the DIF’s target reserve ratio to 2.0 percent of insured deposits following the Dodd-Frank Act’s elimination of the 1.5 percent cap on the DIF’s reserve ratio. Additional increases in our assessment rate may be required in the future to achieve this targeted reserve ratio. These recent increases in deposit assessments and any future increases, required prepayments or special assessments of FDIC insurance premiums may adversely affect our business, financial condition or results of operations.
 
Additionally, pursuant to the Dodd-Frank Act, the FDIC must amend its regulations regarding assessment for federal deposit insurance to base such assessments on the average total consolidated assets of the insured institution during the assessment period, less the average tangible equity of the institution during the assessment period. Currently, we are assessed only on deposit balances. The FDIC adopted a rule implementing this change, as well as adopting a revised risk-based assessment calculation in February 2011. The FDIC has also proposed a rule tying assessment rates of FDIC-insured institutions to the institution’s employee compensation programs. The exact nature and cumulative effect of these recent changes are not yet known, but they are expected to increase the amount of premiums we must pay for FDIC insurance. Any such increase may adversely affect our business, financial condition or results of operations.
 
We are a holding company and depend on our subsidiaries for dividends and distributions.
 
We are a legal entity separate and distinct from our banking and other subsidiaries. Our principal source of cash flow, from which we fund any dividends paid to our shareholders, is dividends from PBI Bank. There are statutory and regulatory limitations on the payment of dividends by PBI Bank to us, as well as by us to our shareholders. Regulations of the Federal Reserve affect our ability to pay dividends and other distributions to our shareholders.  Regulations of the FDIC and the KDFI affect the ability of PBI Bank to pay dividends and other distributions to us, and PBI Bank has agreed to obtain the prior consent of those regulators before it can pay dividends to us. See the “Supervision-Porter Bancorp-Dividends” section of Item 1. “Business” and the “Dividends” section of Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” of this Annual Report on Form 10-K.
 
We may not pay dividends on your common stock and we have agreed with the Federal Reserve to obtain its written consent before declaring or paying any future dividends.
 
Holders of shares of our common stock are only entitled to receive such dividends as our board of directors may declare from funds legally available for such payments. Although we have historically declared cash dividends on our common stock, we are not required to do so and may reduce or eliminate our common stock dividend in the future. This could adversely affect the market price of our common stock.  Also, participation in the CPP limits our ability to increase our dividend or to repurchase our common stock for so long as any securities issued under such program remain outstanding, as discussed in greater detail in the “Dividends” section of Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” of this Annual Report on Form 10-K. We have reduced our quarterly dividend to $0.01 per share. There can be no assurance that we will pay dividends to our shareholders in the future, or if dividends are paid, that we will increase our dividend to historical levels or otherwise. Our ability to pay dividends to our shareholders is not only subject to limitations imposed by the terms of the CPP, but also by limitations and guidance issued by the Federal Reserve.  For example, under Federal Reserve guidance, bank holding companies generally are advised to consult in advance with the Federal Reserve before declaring dividends, and to strongly consider reducing, deferring or eliminating dividends, in certain situations, such as when declaring or paying a dividend that would exceed earnings for the fiscal quarter for which the dividend is being paid, or when declaring or paying a dividend that could result in a material adverse change to the organization's capital structure. In addition, Porter Bancorp has agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends.

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.
 
We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from other commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds and other mutual funds. Our competition in making loans comes principally from other commercial banks, credit unions, savings and loan associations, mortgage banking firms and consumer finance companies. In addition, competition for business in the Louisville metropolitan area has grown in recent years as changes in banking law have allowed several banks to enter the market by establishing new branches. Likewise, competition is increasing in the other growing markets we have targeted, which may adversely affect our ability to execute our plans for expansion. Moreover, our advantage from having operated a nationally recognized online banking division since 1999 may diminish, as nearly all of our competitors now offer online banking and may become more successful in attracting online business over time as they become more experienced.

 
17

 
 
Competition in the banking industry may also limit our ability to attract and retain banking clients. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:

 
·
offer higher interest rates on deposits and lower interest rates on loans than we can;
 
·
offer a broader range of services than we do;
 
·
maintain more branch locations than we do; and
 
·
mount extensive promotional and advertising campaigns.

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

We depend on our senior management team, and the unexpected loss of one or more of our senior executives could impair our relationship with customers and adversely affect our business and financial results.
 
Our future success significantly depends on the continued services and performance of our key management personnel, particularly J. Chester Porter, chairman of the board, Maria L. Bouvette, president and chief executive officer, and David B. Pierce, chief financial officer. We do not have employment agreements with any of our senior executives. Our future performance will depend on our ability to motivate and retain these and other key officers. The loss of the services of members of our senior management or other key officers or the inability to attract additional qualified personnel as needed could materially harm our business.
 
Our reported financial results depend on management’s selection of accounting methods and certain assumptions and estimates.
 
Our accounting policies and assumptions are fundamental to our reported financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in our reporting materially different results than would have been reported under a different alternative.
 
Certain accounting policies are critical to presenting our reported financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include: the allowance for credit losses; intangible assets; mortgage servicing rights; and income taxes. Because of the uncertainty of estimates involved in these matters, we may be required to do one or more of the following: significantly increase the allowance for credit losses and/or sustain credit losses that are significantly higher than the reserve provided; recognize significant impairment on our goodwill, other intangible assets and deferred tax asset balances; or significantly increase our accrued income taxes.
 
The value of our goodwill and other intangible assets may decline in the future.
 
A significant decline in our expected future cash flows, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of our common stock, any or all of which could be materially impacted by many of the risk factors discussed herein, may necessitate our taking charges in the future related to the impairment of our goodwill. Future regulatory actions could also have a material impact on assessments of goodwill for impairment. We test goodwill and intangible assets that have indefinite useful lives for impairment at least annually and more frequently if circumstances indicate their value may not be recoverable. If we were to conclude that a future write-down of our goodwill and other intangible assets is necessary, we would record the appropriate charge, which could have a material adverse effect on our results of operations.
 
 
18

 
 
While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, we may suffer losses from operational risk in the future.
 
Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions. However, we may not be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operational risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies.
 
We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, which is described under “Item 1 - Business—Supervision and Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably.

Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations and policies or to maintain our capital requirements could affect our ability to pay dividends on common stock, our ability to grow through the development of new offices and our ability to make acquisitions. These limitations may prevent us from successfully implementing our growth and operating strategies.

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

Changes in banking laws could have a material adverse effect on us.
 
We are subject to changes in federal and state laws as well as changes in banking and credit regulations, and governmental economic and monetary policies. We cannot predict whether any of these changes may adversely and materially affect us. The current regulatory environment for financial institutions entails significant potential increases in compliance requirements and associated costs. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on our activities that could have a material adverse effect on our business and profitability.
 
 
19

 
 
Recent legislation regarding the financial services industry may have a significant adverse effect on our operations.
 
The Dodd-Frank Act was signed into law on July 21, 2010. The Dodd-Frank Act will implement significant changes to the U.S. financial system, including among others:

 
·
new requirements on banking, derivative and investment activities, including the repeal of the prohibition on the payment of interest on business demand accounts, debit card interchange fee requirements, and the “Volcker Rule,” which restricts the sponsorship, or the acquisition or retention of ownership interests, in private equity funds;

 
·
the creation of a new Consumer Financial Protection Bureau with supervisory authority, including the power to conduct examinations and take enforcement actions with respect to financial institutions with assets of $10 billion or more;
 
 
·
the creation of a Financial Stability Oversight Council with authority to identify institutions and practices that might pose a systemic risk;

 
·
provisions affecting corporate governance and executive compensation of all companies subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended;
 
 
·
a provision that would broaden the base for FDIC insurance assessments; and
 
 
·
a provision that would require bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for holding companies with less than $15 billion in assets as of December 31, 2009.
 
Many provisions in the Dodd-Frank Act remain subject to regulatory rule-making and implementation, the effects of which are not yet known. As a result, it is difficult to gauge the ultimate impact of certain provisions of the Dodd-Frank Act because the implementation of many concepts is left to regulatory agencies. For example, the CFPB is given the power to adopt new regulations to protect consumers and is given control over existing consumer protection regulations adopted by federal banking regulators.
 
The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions as well as any additional legislative or regulatory changes may impact the profitability of our business activities and costs of operations, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional regulatory capital, including additional Tier 1 capital, and could expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition.

As a result of our participation in the Capital Purchase Program, we are subject to significant restrictions on compensation payable to our executive officers and other key employees.

Our ability to attract and retain key officers and employees may be further impacted by legislation and regulation affecting the financial services industry. As noted above, in early 2009, the ARRA was signed into law. The ARRA, through the implementing regulations of the U.S. Treasury, significantly expanded the executive compensation restrictions originally imposed on CPP participants. Among other things, these restrictions impose limits on our ability to pay bonuses and other incentive compensation and to make severance payments. These restrictions will continue to apply to us for as long as the preferred stock we issued pursuant to the Capital Purchase Program remains outstanding. These restrictions may negatively affect our ability to compete with financial institutions that are not subject to the same limitations.
 
 
Not applicable.
 
 
20

 
 
Item 2.
 
PBI Bank has 18 full-service banking offices. The following table shows the location, square footage and ownership of each property. We believe that each of these locations is adequately insured.  Data processing and support operations are located in the Main office in Louisville and the Glasgow office building on Columbia Avenue.  Trust services and operations are located in the Campbell Lane office in Bowling Green.
 
         
Markets
 
Square Footage
 
Owned/Leased
Louisville/Jefferson, Bullitt and Henry Counties
       
Main Office: 2500 Eastpoint Parkway, Louisville
    30,000  
         Owned
Eminence Office: 645 Elm Street, Eminence
    1,500  
         Owned
Hillview Office: 11998 Preston Highway, Hillview
    3,500  
         Owned
Pleasureville Office: 5440 Castle Highway, Pleasureville
    10,000  
         Owned
Shepherdsville Office: 340 South Buckman Street, Shepherdsville
    10,000  
         Owned
Conestoga Office: 155 Conestoga Parkway, Shepherdsville
    3,900  
         Owned
           
Lexington/Fayette County
         
Lexington Office: 2424 Harrodsburg Road, Suite 100, Lexington
    8,500  
         Leased
           
South Central Kentucky
         
Brownsville Office: 113 East Main, Brownsville
    8,500  
         Owned
Greensburg Office: 202-04 North Main Street, Greensburg
    11,000  
         Owned
Horse Cave Office: 210 East Main Street, Horse Cave
    5,000  
         Owned
Morgantown Office: 112 West Logan Street, Morgantown
    7,500  
         Owned
Munfordville Office: 949 South Dixie Highway, Munfordville
    9,000  
         Owned
Northside Office: 1300 North Main Street, Beaver Dam
    3,200  
         Owned
Wal-Mart Office: 1701 North Main Street, Beaver Dam
    500  
         Leased
           
Owensboro/Davies County
         
Owensboro Office: 1819 Frederica Street, Owensboro
    3,000  
         Owned
           
Southern Kentucky
         
Fairview Office: 1042 Fairview Avenue, Bowling Green
    3,300  
         Leased
Campbell Lane Office: 751 Campbell Lane, Bowling Green
    7,500  
         Owned
Glasgow Office: 1006 West Main Street, Glasgow
    12,000  
         Owned
           
Other Properties
         
Office Building: 701 Columbia Avenue, Glasgow
    19,000  
         Owned
Canmer Office: 2708 North Jackson Highway, Canmer
    5,000  
         Owned
 
 
In the normal course of operations, we are defendants in various legal proceedings. In the opinion of management, there is no proceeding pending or, to the knowledge of our management, threatened in which an adverse decision could result in a material adverse change in our business or consolidated financial position.
 
 
 
21

 
 
 
 
Market Information
 
Our common stock is traded on the NASDAQ Global Market under the ticker symbol “PBIB”.  The following table presents the high and low sales prices for our common stock reported on the NASDAQ Global Market for the periods indicated.  Market prices and dividends paid have been restated to reflect stock dividends.

   
2010
 
   
Market Value
       
Quarter Ended
 
High
   
Low
   
Dividend
 
Fourth Quarter
  $ 10.89     $ 9.94     $ 0.01  
Third Quarter
    11.63       9.05       0.10  
Second Quarter
    14.02       12.02       0.19  
First Quarter
    14.30       10.21       0.19  

   
2009
 
   
Market Value
       
Quarter Ended
 
High
   
Low
   
Dividend
 
Fourth Quarter
  $ 15.86     $ 12.96     $ 0.19  
Third Quarter
    16.42       13.26       0.19  
Second Quarter
    14.20       10.65       0.19  
First Quarter
    14.39       8.85       0.19  
 
As of December 31, 2010, we had approximately 1,171 shareholders, including 361 shareholders of record and approximately 810 beneficial owners whose shares are held in “street” name by securities broker-dealers or other nominees.
 
GRAPHIC 
  *   
$100 invested on 9/22/06 in stock or 8/31/06 in index, including reinvestment of dividends.  Fiscal year ending December 31.

 
22

 

Dividends
 
Shareholders of a Kentucky corporation are entitled to receive such dividends and other distributions when, as and if declared from time to time by the board of directors out of funds legally available for distributions to shareholders. Any future determination relating to the payment of dividends will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects and other factors that our board of directors may deem relevant. Also, Porter Bancorp is a bank holding company, and its ability to declare and pay dividends depends on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends. Porter Bancorp has agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends.
 
As a bank holding company, our principal source of revenue is the dividends that may be declared from time to time by PBI Bank out of funds legally available for payment of dividends. PBI Bank must obtain the prior written consent of its primary regulators prior to declaring or paying any future dividends.  In addition to this current restriction, various banking laws applicable to PBI Bank limit its payment of dividends to us. A Kentucky chartered bank may declare a dividend of an amount of the bank’s net profits as the board deems appropriate. The approval of the KDFI is required if the total of all dividends declared by the bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. On July 1, 2008, PBI Bank sold a $9 million subordinated capital note to Silverton Bank, N.A., which has been assumed by the FDIC as receiver for Silverton Bank, N.A.  The capital note provides that if PBI Bank is in default under the terms of the capital note, PBI Bank would be prohibited from paying dividends on its common stock.
 
On November 21, 2008, we sold $35 million of senior preferred stock to the U.S. Treasury pursuant to the CPP.  The terms of the transaction with the U.S. Treasury limit our ability to pay dividends. For three years after issuance or until the U.S. Treasury no longer holds any preferred shares, we will not be able to increase our dividends above the quarterly dividend level at the time of the transaction without the U.S. Treasury’s approval with limited exceptions, most significantly the repurchase of our common stock to offset share dilution from equity-based compensation awards. Also, we will not be able to pay any dividends at all unless we are current on our dividend payments on the preferred shares.
 
In addition, we have issued an aggregate of approximately $25.0 million in our junior subordinated debentures to our subsidiary trusts. We pay interest on the debentures, which is used by the trusts to pay distributions on the trust preferred securities issued by them. The indenture governing the issuance of each of these debentures provides that if we fail to make an interest payment on the debentures, we would be prohibited from paying dividends on our common stock until all debenture interest payments are current. Accordingly, if we are unable to pay interest on these debentures, we will be contractually restricted from paying dividends on our common stock.
 
Purchase of Equity Securities by Issuer
 
The Company did not repurchase any shares in the fourth quarter of 2010.
 
 
23

 
 
 
The following table summarizes our selected historical consolidated financial data from 2006 to 2010. You should read this information in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data.”
 
Selected Consolidated Financial Data
 
   
As of and for the Years Ended December 31,
 
(Dollars in thousands except per share data)
 
2010
   
2009
   
2008
   
2007
   
2006
 
Income Statement Data:
                             
Interest income
  $ 86,407     $ 94,466     $ 100,107     $ 91,800     $ 72,863  
Interest expense
    28,841       40,412       52,881       49,404       35,622  
Net interest income
    57,566       54,054       47,226       42,396       37,241  
Provision for loan losses
    30,100       14,200       5,400       4,025       1,405  
Non-interest income
    11,582       7,094       6,868       5,556       5,196  
Non-interest expense
    46,478       30,456       27,757       22,474       19,785  
Income (loss) before income taxes
    (7,430 )     16,492       20,937       21,453       21,247  
Income tax expense (benefit)
    (3,046 )     5,424       6,927       7,224       6,908  
Net income (loss)
    (4,384 )     11,068       14,010       14,229       14,339  
Less:
                                       
  Dividends on preferred stock
    1,810       1,750       194              
  Accretion on Series A preferred stock
    177       176       20              
  Earnings allocated to participating securities
    (184 )     97       94              
Net income (loss) available to common
  $ (6,187 )   $ 9,045     $ 13,702     $ 14,229     $ 14,339  
                                         
Common Share Data (1):
                                       
Basic earnings (loss) per common share
  $ (0.60 )   $ 1.00     $ 1.51     $ 1.60     $ 1.85  
Diluted earnings (loss) per common share
  $ (0.60 )     1.00       1.51       1.60       1.85  
Cash dividends declared per common share
    0.49       0.76       0.73       0.70       0.70  
Book value per common share
    12.76       14.61       14.14       13.40       12.28  
Tangible book value per common share
    10.33       11.44       11.18       11.06       10.75  
                                         
Balance Sheet Data (at period end):
                                       
Total assets
  $ 1,723,952     $ 1,835,090     $ 1,647,857     $ 1,456,020     $ 1,051,006  
Debt obligations:
                                       
FHLB advances
    15,022       82,980       142,776       121,767       47,562  
Junior subordinated debentures
    25,000       25,000       25,000       25,000       25,000  
Subordinated capital note
    8,550       9,000       9,000              
                                         
Average Balance Data:
                                       
Average assets
  $ 1,747,648     $ 1,714,131     $ 1,572,599     $ 1,221,649     $ 995,018  
Average loans
    1,353,295       1,371,034       1,324,658       1,019,628       814,202  
Average deposits
    1,459,041       1,385,572       1,250,614       997,287       810,419  
Average FHLB advances
    47,800       106,259       138,954       69,276       57,847  
Average junior subordinated debentures
    25,000       25,000       25,000       25,000       25,000  
Average subordinated capital note
    8,941       9,000       4,525              
Average notes payable
                      14       7,329  
Average stockholders’ equity
    188,015       168,752       131,706       114,797       83,428  
 
(1)
Common share data has been adjusted to reflect a 5% stock dividend effective December 14, 2010, November 19, 2009 and November 10, 2008.
 
 
24

 
 
 
Management’s discussion and analysis of financial condition and results of operations analyzes the consolidated financial condition and results of operations of Porter Bancorp Inc. and its wholly owned subsidiary, PBI Bank. Porter Bancorp, Inc. is a Louisville, Kentucky-based bank holding company which operates 18 full-service banking offices in twelve counties through its wholly-owned subsidiary, PBI Bank. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt, and extend south along the Interstate 65 corridor to Tennessee. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, Kentucky, the second largest city in Kentucky.  Our markets have experienced annual positive deposit growth rates in recent years with the trend expected to continue for the next few years. The Bank is both a traditional community bank with a wide range of commercial and personal banking products and an innovative online bank which delivers competitive deposit products and services through an on-line banking division operating under the name of Ascencia.
 
Historically, we have focused on commercial and commercial real estate lending, both in markets where we have banking offices and other growing markets in our region. Commercial, commercial real estate and real estate construction loans accounted for 62.7% of our total loan portfolio as of December 31, 2010, and 65.8% as of December 31, 2009. Commercial lending generally produces higher yields than residential lending, but involves greater risk and requires more rigorous underwriting standards and credit quality monitoring.
 
Overview
 
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes and other schedules presented elsewhere in the report.

For the year ended December 31, 2010, we reported a net loss of $4.4 million compared to net income of $11.1 million for the year ended December 31, 2009.  After deductions for dividends on preferred stock, accretion on preferred stock, and earnings allocated to participating securities, the net loss available to common shareholders was $6.2 million for the year ended December 31, 2010, compared to net income available to common shareholders of $9.1 million for the year ended December 31, 2009. Basic and diluted loss per common share were $(0.60) for the year ended December 31, 2010, compared to earnings per common share of $1.00 for 2009. The decline in our financial performance in 2010 was due to the continued weakness in the real estate market and its effects on values of collateral securing our loans and other real estate owned, as well as on some customers’ ability to repay their loans.  As a result of these trends we charged off a high level of construction and land development loans and wrote down other real estate owned (OREO) to reflect lower appraisal values.  Non-performing loans were 4.63% of total loans and nonperforming assets stand at 7.43% of total assets at December 31, 2010.  We remain diligent in the management of our portfolio and are striving to improve credit quality by working throughout our markets with our clients to balance selective new customer acquisition, customer service for our existing clients and prudent risk management.
 
 
25

 
 
Significant developments for the year ended December 31, 2010 were:
 
 
§
Loans decreased 7.8% to $1.30 billion compared to $1.41 billion at December 31, 2009.
 
 
§
Total assets decreased 6.1% to $1.7 billion since the 2009 year-end.
 
 
§
Deposits declined 4.1% to $1.47 billion compared with $1.53 billion at December 31, 2009.
 
 
§
Our capital ratios were strengthened during 2010 with capital raises of approximately $32 million. At December 31, 2010, our total risk-based capital ratio rose to 16.3% from 13.8% at December 31, 2009, well above the 10.0% requirement for a well-capitalized institution.
 
 
§
Our efficiency ratio was 72.0% for 2010 compared with 50.1% for 2009.
 
 
§
Net interest margin increased to 3.59% for 2010 compared to 3.33% for 2009 as a result of lower average cost of funds.
 
 
§
Non-performing assets increased from $99.5 million at December 31, 2009, to $128 million at December 31, 2010. The bulk of our non-performing assets are the result of weakness in our construction and land development portfolio. We have made solid progress in reducing our exposure to higher risk construction and land development loans. Since year-end 2008, our construction and land development loans have been reduced by 46.3% and represented only 15.3% of our loan portfolio at year-end 2010. We also continue to be diligent in moving non-performing loans through the system of collection or foreclosure.
 
 
§
Provision for loan losses increased $15.9 million in 2010 compared to 2009 as the result of an increase in non-performing loans, and an increase in net loan charge-offs of $22.2 million, or 1.64% of average loans for 2010, compared with $7.5 million, or 0.54% of average loans for 2009.
 
 
§
Other real estate owned (OREO) expenses increased to $16.3 million for the year ended December 31, 2010, from $1.2 million for the year ended December 31, 2009.  This increase was primarily attributable to $14.1 million in fair value write-downs tied to declining real estate values reflected in new appraisals, as well as the ongoing carrying and maintenance costs for the OREO portfolio.
 
These items are discussed in further detail throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” Section.
 
Application of Critical Accounting Policies
 
Our accounting and reporting policies comply with GAAP and conform to general practices within the banking industry. We believe that of our significant accounting policies, the following may involve a higher degree of management assumptions and judgments that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.
 
Allowance for Loan Losses – PBI Bank maintains an allowance for loan losses believed to be sufficient to absorb probable incurred credit losses existing in the loan portfolio, and the board of directors evaluates the adequacy of the allowance for loan losses on a quarterly basis. We evaluate the adequacy of the allowance using, among other things, historical loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral and current economic conditions and trends.  The allowance may be allocated for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.  The general component is based on historical loss experience adjusted for environmental factors.  We develop allowance estimates based on actual loss experience adjusted for current economic conditions and trends. Allowance estimates are a prudent measurement of the risk in the loan portfolio which we apply to individual loans based on loan type. If the mix and amount of future charge-off percentages differ significantly from those assumptions used by management in making its determination, we may be required to materially increase our allowance for loan losses and provision for loan losses, which could adversely affect our results.
 
 
26

 
 
Other Real Estate Owned – Other real estate owned (OREO) is real estate acquired as a result of foreclosure or by deed in lieu of foreclosure.  It is classified as real estate owned until such time as it is sold.  When property is acquired as a result of foreclosure or by deed in lieu of foreclosure, it is recorded at its fair market value less cost to sell.  Any write-down of the property at the time of acquisition is charged to the allowance for loan losses.  Subsequent reductions in fair value are recorded as non-interest expense.  To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers.  If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are recorded.  For larger dollar commercial real estate properties, we obtain a new appraisal of the subject property in connection with the transfer to other real estate owned.  In some of these circumstances, an appraisal is in process at quarter end and we must make our best estimate of the fair value of the underlying collateral based on our internal evaluation of the property, review of the most recent appraisal, and discussions with the currently engaged appraiser.  We do not obtain updated appraisals on a quarterly basis after the receipt of the initial appraisal.  Rather, we internally review the fair value of the other real estate owned in our portfolio on a quarterly basis to determine if a new appraisal is warranted based on the specific circumstances of each property.
 
Goodwill and Intangible Assets – We test goodwill and intangible assets that have indefinite useful lives for impairment at least annually and more frequently if circumstances indicate their value may not be recoverable. We test goodwill for impairment by comparing the fair value of the reporting unit to the book value of the reporting unit. If the fair value, net of goodwill, exceeds book value, then goodwill is not considered to be impaired. We assessed goodwill for impairment during the fourth quarter of 2010 with the assistance of an independent valuation professional by applying a series of fair-value-based tests.  While step 1 of the evaluation indicated potential impairment, the detailed step 2 test concluded that our goodwill was not impaired.  Under prevailing accounting standards, different conditions, assumptions, or changes in expected cash flows and profitability could have a material adverse effect on the outcome of the impairment evaluation.

Intangible assets that are not amortized are tested for impairment at least annually by comparing the fair values of those assets to their carrying values. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which we believe is 10 years. We review these amortizable intangible assets for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on our annual review, management does not believe our intangible assets are impaired at December 31, 2010.
 
Stock-based Compensation – Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model, which requires the input of highly subjective assumptions, such as volatility, risk-free interest rates and dividend pay-out rates, is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards.  Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
 
Valuation of Deferred Tax Asset –We evaluate deferred tax assets quarterly. We will realize this asset to the extent it is profitable or carry back tax losses to periods in which we paid income taxes. Our determination of the realization of the deferred tax asset will be based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income we will earn and the implementation of various tax plans to maximize realization of the deferred tax assets. Management believes we will generate sufficient operating earnings to realize the deferred tax benefits and does have sufficient taxable income in carry back years to realize the deferred tax asset. While there is a financial statement loss for 2010, the Company had net taxable income in each of the three previous years, 2008 through 2010. Examinations of our income tax returns or changes in tax law may impact the tax liabilities and resulting provisions for income taxes.

 
27

 
 
Results of Operations
 
The following table summarizes components of income and expense and the change in those components for 2010 compared with 2009:
 
   
For the
Years Ended December 31,
   
Change from Prior Period
 
   
2010
   
2009
   
Amount
   
Percent
 
   
(dollars in thousands)
 
Gross interest income
  $ 86,407     $ 94,466     $ (8,059 )     (8.5 )%
Gross interest expense
    28,841       40,412       (11,571 )     (28.6 )
Net interest income
    57,566       54,054       3,512       6.5  
Provision for credit losses
    30,100       14,200       15,900       112.0  
Non-interest income
    7,027       6,779       248       3.7  
Gains on sale of securities, net
    5,152       315       4,837       1535.6  
Other than temporary impairment on securities
    (597 )           (597 )     (100.0 )
Non-interest expense
    46,478       30,456       16,022       52.6  
Net income (loss) before taxes
    (7,430 )     16,492       (23,922 )     (145.1 )
Income tax expense (benefit)
    (3,046 )     5,424       (8,470 )     (156.2 )
Net income (loss)
    (4,384 )     11,068       (15,452 )     (139.6 )
Dividends on preferred stock
    1,810       1,750       60       3.4  
Accretion on Series A preferred stock
    177       176       1       0.6  
Earnings allocated to participating securities
    (184 )     97       (281 )     (289.7 )
Net income (loss) available to common
    (6,187 )     9,045       (15,232 )     (168.4 )
 
Net loss of $4.4 million for the year ended December 31, 2010 decreased $15.5 million, or 139.6%, from net income of $11.1 million for 2009.  Net loss available to common of $6.2 million for the year ended December 31, 2010 decreased $15.3 million, or 167.7%, from net income available to common of $9.1 million for 2009. This decrease in earnings was primarily attributable to increased provision for loan losses expense and non-interest expense.  Provision for loan losses expense increased $15.9 million, or 112.0%, in comparison with 2009 as a result of an increase in non-performing loans, and an increase in net loan charge-offs to $22.2 million, or 1.64% of average loans for 2010, compared with $7.5 million, or 0.54% of average loans for 2009.  Non-interest income increased $248,000, or 3.7%, in comparison with 2009 primarily as a result of increased income from fiduciary activities, and increased gains on sales of loans originated for sale.  Gains on sales of investment securities increased $4.8 million, or 1535.6% in comparison with 2009 due to a strategic decision to liquidate our portfolio of private label mortgage-backed securities and certain other mortgage-backed securities and corporate bonds. These gains were partially offset by other than temporary impairment write downs on investment securities of $597,000 during 2010. No similar write-downs were recorded during 2009.  Non-interest expense increased $16.0 million, or 52.6%, in comparison with 2009 as a result of increased state franchise tax expense and increased expense related to other real estate owned.  Earnings allocated to participating securities for 2010 resulted from the issuance of participating Series C preferred shares during 2010.
 
 
28

 
 
The following table summarizes components of income and expense and the change in those components for 2009 compared with 2008:
 
   
For the
Years Ended December 31,
   
Change from Prior Period
 
   
2009
   
2008
   
Amount
   
Percent
 
   
(dollars in thousands)
 
Gross interest income
  $ 94,466     $ 100,107     $ (5,641 )     (5.6 )%
Gross interest expense
    40,412       52,881       (12,469 )     (23.6 )
Net interest income
    54,054       47,226       6,828       14.5  
Provision for credit losses
    14,200       5,400       8,800       163.0  
Non-interest income
    6,779       7,475       (696 )     (9.3 )
Gains (losses) on sale of securities, net
    315       (136 )     451       331.6  
Other than temporary impairment on securities
    -       (471 )     471       100.0  
Non-interest expense
    30,456       27,757       2,699       9.7  
Net income before taxes
    16,492       20,937       (4,445 )     (21.2 )
Income tax expense
    5,424       6,927       (1,503 )     (21.7 )
Net income
    11,068       14,010       (2,942 )     (21.0 )
Dividends on preferred stock
    1,750       194       1,556       802.1  
Accretion on Series A preferred stock
    176       20       156       780.0  
Earnings allocated to participating securities
    97       94       3       3.2  
Net income available to common
    9,045       13,702       (4,657 )     (34.0 )
 
Net income of $11.1 million for the year ended December 31, 2009 decreased $2.9 million, or 21.0%, from $14.0 million for 2008.  Net income available to common of $9.1 million for the year ended December 31, 2009 decreased $4.7 million, or 33.7%, from $13.8 million for 2008. This decrease in earnings was primarily attributable to increased provision for loan losses expense.  Provision for loan losses expense increased $8.8 million, or 163.0%, in comparison to 2008 as a result of an increase in non-performing loans, increased net loan charge-offs of $7.5 million, or 0.54% of average loans for 2009, compared with $3.5 million, or 0.27% of average loans for 2008, and modest loan growth.  Non-interest income decreased $696,000, or 9.3%, in comparison to 2008 primarily as a result of decreased service charges on deposit accounts, and decreased income from fiduciary activities.  These decreases were partially offset by increased gains on sales of investment securities and no recurrence of other than temporary impairment write-downs on investment securities during 2009.  Non-interest expense increased $2.7 million, or 9.7%, in comparison to 2008 as a result of increased salary and benefits expense, increased occupancy and equipment expense, and increased expense related to other real estate owned.  Professional fees increased due to costs associated with our abandoned tender offer to acquire Citizens First Corporation of Bowling Green, Kentucky, that was terminated in December 2009.  In addition, FDIC insurance premiums rose significantly due to amendments made by the FDIC in 2007 to its risk-based deposit premium assessment systems and increases in premium rates and a special assessment in 2009.  The increased dividends and accretion on preferred stock of $1.6 million and $156,000, respectively, from 2008 was the result of preferred stock being outstanding for 12 months during 2009 versus 41 days during 2008.
 
Net Interest Income – Our net interest income was $57.6 million for the year ended December 31, 2010, an increase of $3.5 million, or 6.5%, compared with $54.1 million for the same period in 2009. Net interest spread and margin were 3.38% and 3.59%, respectively, for 2010, compared with 2.99% and 3.33%, respectively, for 2009. The increase in net interest income was primarily the result of lower cost of funds.  Our cost of interest bearing liabilities decreased 82 basis points for 2010 while our yield on average earning assets decreased 43 basis points.
 
Our average interest-earning assets were $1.62 billion for 2010, compared with $1.64 billion for 2009, a 1.1% decrease, primarily attributable to lower average loans and investment securities.  Average loans were $1.35 billion for 2010, compared with $1.37 billion for 2009, a 1.3% decrease. Average investment securities were $158 million for 2010, compared with $171 million for 2009, a 7.9% decrease.  Our total interest income decreased 8.5% to $86.4 million for 2010, compared with $94.5 million for 2009. The change was due primarily to lower interest rates on loan volume.
 
 
29

 
 
Our average interest-bearing liabilities increased by 0.9% to $1.45 billion for 2010, compared with $1.44 billion for 2009. Our total interest expense decreased by 28.6% to $28.8 million for 2010, compared with $40.4 million during 2009, due primarily to lower interest rates paid on certificates of deposit, and a lower volume of FHLB advances. Our average volume of certificates of deposit increased 6.1% to $1.16 billion for 2010, compared with $1.09 billion for 2009. The average interest rate paid on certificates of deposits decreased to 2.02% for 2010, compared with 3.01% for 2009.   Our average volume of FHLB advances decreased 55.0% to $47.8 million for 2010, compared with $106.3 million for 2009.  The average interest rate paid on FHLB advances increased to 4.22% for 2010, compared with 3.47% for 2009.  The decrease in cost of funds was the result of the continued re-pricing of certificates of deposit at maturity at lower interest rates.
 
Our net interest income was $54.1 million for the year ended December 31, 2009, an increase of $6.8 million, or 14.5%, compared with $47.2 million for the same period in 2008. Net interest spread and margin were 2.99% and 3.33%, respectively, for 2009, compared with 2.79% and 3.20%, respectively, for 2008. The increase in net interest income was primarily the result of higher loan and investment securities volume, but was partially offset by higher volume of certificates of deposit.  In addition, our cost of interest bearing liabilities decreased 114 basis points for 2009 while our yield on average earning assets decreased 94 basis points.
 
Our average interest-earning assets were $1.6 billion for 2009, compared with $1.5 billion for 2008, a 9.8% increase, primarily attributable to loan growth and growth in our investment securities portfolio.  Average loans were $1.4 billion for 2009, compared with $1.3 billion for 2008, a 3.5% increase. Average investment securities were $172 million for 2009, compared with $117 million for 2008, a 46.7% increase.  Our total interest income decreased 5.6% to $94.5 million for 2009, compared with $100.1 million for 2008. The change was due primarily to lower interest rates on loan volume.
 
Our average interest-bearing liabilities also increased by 7.3% to $1.4 billion for 2009, compared with $1.3 billion for 2008. Our total interest expense decreased by 23.6% to $40.4 million for 2009, compared with $52.9 million during 2008, due primarily to lower interest rates paid on certificates of deposit, interest-bearing transaction accounts, and FHLB advances. Our average volume of certificates of deposit increased 15.1% to $1.1 billion for 2009, compared with $946.5 million for 2008. The average interest rate paid on certificates of deposits decreased to 3.01% for 2009, compared with 4.31% for 2008.
 
Our average volume of NOW and money market deposit accounts decreased 8.3% to $162 million for 2009, compared with $177 million for 2008.  The average interest paid on these deposits decreased to 1.21% for 2009, compared with 2.16% for 2008.  Our average volume of FHLB advances decreased 23.5% to $106.3 million for 2009, compared with $139.0 million for 2008.  The average interest rate paid on FHLB advances decreased to 3.47% for 2009, compared with 4.02% for 2008.  The decrease in cost of funds was the result of the continued re-pricing of certificates of deposit at maturity at lower interest rates, and decreased rates on interest-bearing transaction accounts and FHLB advances. 
 
 
30

 

Average Balance Sheets
 
The following table sets forth the average daily balances, the interest earned or paid on such amounts, and the weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities for the periods indicated. Dividing income or expense by the average daily balance of assets or liabilities, respectively, derives such yields and costs for the periods presented.
 
   
For the Years Ended December 31,
 
   
2010
   
2009
 
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
 
   
(dollars in thousands)
 
ASSETS
                                   
Interest-earning assets:
                                   
Loans receivables (1)(2)
                                   
Real estate
  $ 1,209,125     $ 67,960       5.62 %   $ 1,226,403     $ 73,843       6.02
Commercial
    84,847       5,131       6.05       89,010       5,705       6.41  
Consumer
    34,346       2,944       8.57       36,848       3,209       8.71  
Agriculture
    23,877       1,483       6.21       16,559       1,117       6.75  
Other
    1,100       41       3.73       2,214       96       4.34  
U.S. Treasury and agencies
    9,674       362       3.74       1,279       57       4.46  
Mortgage-backed securities
    110,718       5,846       5.28       134,779       7,978       5.92  
State and political subdivision securities (3)
    21,331       854       6.16       21,813       878       6.19  
State and political subdivision securities
    2,947       161       5.46       2,826       154       5.45  
Corporate bonds
    12,906       875       6.78       10,423       681       6.53  
FHLB stock
    10,072       441       4.38       10,072       466       4.63  
Other debt securities
    694       46       6.63       704       46       6.53  
Other equity securities
    1,623       48       2.96       1,901       55       2.89  
Federal funds sold
    12,633       16       0.13       21,591       18       0.08  
Interest-bearing deposits in other financial institutions
    82,648       199       0.24       60,681       163       0.27  
Total interest-earning assets
    1,618,541       86,407       5.37 %     1,637,103       94,466       5.80
Less: Allowance for loan losses
    (27,836                     (21,130 )                
Non-interest-earning assets
    156,943                       98,158                  
Total assets
  $ 1,747,648                     $ 1,714,131                  
                                                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                               
Interest-bearing liabilities
                                               
Certificates of deposit and other time deposits
  $ 1,156,724     $ 23,415       2.02 %   $ 1,089,798     $ 32,816       3.01
NOW and money market deposits
    164,541       1,716       1.04       162,221       1,962       1.21  
Savings accounts
    35,393       261       0.74       34,386       310       0.90  
Federal funds purchased and repurchase agreements
    11,734       484       4.12       11,042       476       4.31  
FHLB advances
    47,800       2,015       4.22       106,259       3,691       3.47  
Junior subordinated debentures
    33,941       950       2.80       34,000       1,157       3.40  
Total interest-bearing liabilities
    1,450,133       28,841       1.99 %     1,437,706       40,412       2.81
Non-interest-bearing liabilities
                                               
Non-interest-bearing deposits
    102,383                       99,167                  
Other liabilities
    7,117                       8,506                  
Total liabilities
    1,559,633                       1,545,379                  
Stockholders’ equity
    188,015                       168,752                  
Total liabilities and stockholders’ equity
  $ 1,747,648                     $ 1,714,131                  
Net interest income
          $ 57,566                     $ 54,054          
Net interest spread
                    3.38 %                     2.99
Net interest margin
                    3.59 %                     3.33
Ratio of average interest-earning assets to average interest-bearing liabilities
                    111.61 %                     113.87

(1)
Includes loan fees in both interest income and the calculation of yield on loans.
(2)
Calculations include non-accruing loans in average loan amounts outstanding.
(3)
Taxable equivalent yields are calculated assuming a 35% federal income tax rate.
 
 
31

 
 
   
For the Years Ended December 31,
 
   
2009
   
2008
 
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
 
   
(dollars in thousands)
 
ASSETS
                                   
Interest-earning assets:
                                   
Loans receivables (1)(2)
                                   
Real estate
  $ 1,226,403     $ 73,843       6.02 %   $ 1,164,892     $ 81,125       6.96 %
Commercial
    89,010       5,705       6.41       102,726       7,238       7.05  
Consumer
    36,848       3,209       8.71       38,786       3,637       9.38  
Agriculture
    16,559       1,117       6.75       15,555       1,181       7.59  
Other
    2,214       96       4.34       2,699       36       1.33  
U.S. Treasury and agencies
    1,279       57       4.46       11,000       482       4.38  
Mortgage-backed securities
    134,779       7,978       5.92       76,227       3,828       5.02  
State and political subdivision securities (3)
    21,813       878       6.19       20,272       818       6.21  
State and political subdivision securities
    2,826       154       5.45       2,455       133       5.42  
Corporate bonds
    10,423       681       6.53       6,499       382       5.88  
FHLB stock
    10,072       466       4.63       9,876       518       5.25  
Other debt securities
    704       46       6.53       704       46       6.53  
Other equity securities
    1,901       55       2.89       3,474       112       3.22  
Federal funds sold
    21,591       18       0.08       21,138       405       1.92  
Interest-bearing deposits in other financial institutions
    60,681       163       0.27       14,853       166       1.12  
                   Total interest-earning assets
    1,637,103       94,466       5.80 %     1,491,156       100,107       6.74 %
Less: Allowance for loan losses
    (21,130 )                     (18,087 )                
Non-interest-earning assets
    98,158                       99,530                  
Total assets
  $ 1,714,131                     $ 1,572,599                  
                                                 
                                                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                               
Interest-bearing liabilities
                                               
Certificates of deposit and other time deposits
  $ 1,089,798     $ 32,816       3.01 %   $ 946,477     $ 40,811       4.31 %
NOW and money market deposits
    162,221       1,962       1.21       176,812       3,822       2.16  
Savings accounts
    34,386       310       0.90       33,969       440       1.30  
Federal funds purchased and repurchase agreements
    11,042       476       4.31       14,045       555       3.95  
FHLB advances
    106,259       3,691       3.47       138,954       5,589       4.02  
Junior subordinated debentures
    34,000       1,157       3.40       29,525       1,664       5.64  
Total interest-bearing liabilities
    1,437,706       40,412       2.81 %     1,339,782       52,881       3.95 %
Non-interest-bearing liabilities
                                               
Non-interest-bearing deposits
    99,167                       93,356                  
Other liabilities
    8,506                       7,755                  
Total liabilities
    1,545,379                       1,440,893                  
Stockholders’ equity
    168,752                       131,706                  
Total liabilities and stockholders’ equity
  $ 1,714,131                     $ 1,572,599                  
Net interest income
          $ 54,054                     $ 47,226          
Net interest spread
                    2.99 %                     2.79 %
Net interest margin
                    3.33 %                     3.20 %
Ratio of average interest-earning assets to average interest-bearing liabilities
                    113.87 %                     111.30 %
 

(1)
Includes loan fees in both interest income and the calculation of yield on loans.
(2)
Calculations include non-accruing loans in average loan amounts outstanding.
(3)
Taxable equivalent yields are calculated assuming a 35% federal income tax rate.
 
 
32

 
 
Rate/Volume Analysis
 
The table below sets forth information regarding changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (changes in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.
 
   
Year Ended December 31, 2010 vs. 2009
   
Year Ended December 31, 2009 vs. 2008
 
   
Increase (decrease)
due to change in
   
Increase (decrease)
due to change in
 
     
Rate
     
Volume
   
Net
Change
     
Rate
     
Volume
   
Net
Change
 
 
(in thousands)
Interest-earning assets:
                                   
Loan receivables
  $ (5,337 )        $ (1,074 )   $ (6,411 )   $ (12,421 )   $ 3,174     $ (9,247 )
U.S. Treasury and agencies
    (10 )     315       305       8       (433     (425 )
Mortgage-backed securities
    (804 )     (1,328 )     (2,132 )     525       3,625       4,150  
State and political subdivision securities
    (2 )     (15 )     (17 )     1       80       81  
Corporate bonds
    27       167       194       37       262       299  
FHLB stock
    (25 )           (25 )     (62 )     10       (52 )
Other debt securities
    1       (1 )                        
Other equity securities
    1