CANANDAIGUA NATIONAL CORPORATION

72 South Main Street

Canandaigua, New York 14424

Phone: 585-394-4260 or

1-800-724-2621

Fax: 585-394-4001

Internet: www.cnbank.com

2012 Annual Report

Table of Contents

Page

Financial Highlights

1

Management's Discussion and Analysis of Financial Condition and Results of Operations

2

Our Common Stock

24

Management's Report on the Effectiveness of Internal Controls over Financial Reporting

26

Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting

27

Consolidated Financial Statement

     Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements

28

     Consolidated Balance Sheets

29

     Consolidated Statements of Income

30

     Consolidated Statements of Comprehensive Income

31

     Consolidated Statements of Stockholders' Equity

32

     Consolidated Statements of Cash Flows

33

     Notes to Consolidated Financial Statements

34

Annual Meeting:

The Annual Meeting of Shareholders of Canandaigua National Corporation (the Company) will be held at the Main Office of The Canandaigua National Bank and Trust Company, 72 South Main Street, Canandaigua, NY, 14424; April 24, 2013, at 1:00 p.m.    

Form 10-K:

Copies of the Company’s Form 10-K Annual Report and the Company’s Code of Conduct are available without charge to shareholders upon written request to: Steven H. Swartout, Secretary, 72 South Main Street, Canandaigua, New York 14424. Copies are also available at the website of the Securities and Exchange Commission (www.sec.gov) and by link from the website of the Company’s subsidiary The Canandaigua National Bank and Trust Company (www.cnbank.com/your_bank/cnc_financials).    

Forward-Looking Statements

This report, including information incorporated by reference, contains, and future filings by Canandaigua National Corporation on Forms 10-K, 10-Q and 8-K and future oral and written statements, press releases, and letters to shareholders by Canandaigua National Corporation and its management may contain, certain "forward-looking statements" intended to qualify for the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. When used or incorporated by reference in the Company's disclosures and documents, the words "anticipate," "believe," "contemplate," "estimate," "expect," "foresee," "project," "target," "goal," "budget" and similar expressions are intended to identify forward-looking statements within the meaning of Section 27A of the Securities Act. Such forward-looking statements are subject to certain risks discussed within this document and the Company’s most recent Annual Report on Form 10-K, including under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K. These forward-looking statements are based on currently available financial, economic, and competitive data and management's views and assumptions regarding future events. These forward-looking statements are inherently uncertain, so should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, expected, projected, targeted, or budgeted. Certain matters which management has identified, which may cause material variations are noted elsewhere herein and in the Company’s other publicly filed reports. These forward-looking statements speak only as of the date of the document. We expressly disclaim any obligation or undertaking to publicly release any updates or revisions to any forward-looking statement contained herein.  We caution readers not to place undue reliance on any of these forward-looking statements.

Some examples of forward-looking statements include statements related to our expectations on the direction of interest rates, demand for our loans, changes in customer transactions types, and the payment performance of our loan portfolio.  Our experience and assumptions we believe are reasonable to form the basis of our stated expectations, but results can also be impacted by other factors.

As described in our public filings, factors which may cause our results to vary materiality from our expectations include, among many others,  adverse changes in the global economy which may affect interest rates and as well as the stability of our local service areas, which may affect loan demand and credit quality; changes in fees related to servicing electronic transactions which may affect consumer usage, and continued focus of regulatory authorities at the state, federal and international level on bank regulation.

We present below a summary of selected financial highlights to help you see a snapshot of our performance for the past five years. Balance sheet information is as of the year end, while income statement and average balance information is for the full-year period.  (All share and per-share information has been adjusted to reflect the 4-for-1 stock split in 2011). This and all information concerning our financial performance should be read in conjunction with the following Management's Discussion and Analysis of Financial Condition and Results of Operations, as well as the Consolidated Financial Statements and Notes thereto.  These sections help to provide context for the information you see here.

Financial Highlights
(Dollars in thousands except per share data)
		2012			% Change			2011			2010			2009			2008
Income Statement Information:
	Net interest income	$	65,603			6.72	%		61,473			61,141			54,374			47,485
	Provision for loan losses		4,300			13.91	%		3,775			6,150			4,345			3,805
	Non-interest income		35,123			21.92	%		28,808			26,721			24,770			22,454
	Operating expenses		69,375			7.72	%		64,403			57,851			54,204			47,243
	Income taxes		8,434			36.52	%		6,178			6,205			5,401			4,958
	Net income attributable to CNC		18,837			15.48	%		16,312			17,656			15,194			13,933
Balance Sheet Data:
	Total investments(1)	$	281,357			(0.98)	%		284,139			272,336			280,797			261,149
	Total loans, net		1,441,455			12.93	%		1,276,426			1,189,221			1,145,707			1,076,620
	Total assets		1,887,028			7.17	%		1,760,764			1,661,504			1,566,000			1,419,037
	Total deposits		1,662,863			7.52	%		1,546,610			1,473,330			1,377,697			1,228,907
	Total borrowings(2)		55,843			(4.35)	%		58,383			51,877			61,388			77,406
	Total equity		144,363			6.75	%		135,238			123,794			111,735			100,438
	Average assets		1,822,867			7.52	%		1,695,327			1,627,113			1,535,224			1,329,056
	Average equity		138,171			7.62	%		128,393			116,696			104,196			95,004
Asset Under Administration:(3)
	Book value (cost basis)	$	1,879,397			8.88	%		1,726,172			1,658,111			1,591,943			1,573,960
	Market value		2,115,346			13.84	%		1,858,130			1,830,549			1,651,777			1,450,021
Per Share Data:
	Net income, basic	$	9.98			15.51	%		8.64			9.35			8.06			7.36
	Net income, diluted	$	9.76			15.09	%		8.48			9.20			7.93			7.24
	Cash dividends(4)	$	4.74			65.16	%		2.87			2.72			2.47			2.25
	Book Value	$	74.64			6.01	%		70.41			65.54			59.33			53.21
	Closing stock price(5)	$	141.03			9.14	%		129.22			95.85			81.78			78.98
	Weighted average share - diluted		1,929,360			0.29	%		1,923,777			1,919,192			1,917,512			1,926,044
Other ratios:
	Return on average assets		1.03	%		7.29	%		0.96	%		1.09	%		0.99	%		1.05	%
	Return on average equity		13.63	%		7.32	%		12.70	%		15.13	%		14.58	%		14.67	%
	Return on beginning equity		13.93	%		5.69	%		13.18	%		15.80	%		15.13	%		15.11	%
	Dividend payout(4)		48.57	%		43.53	%		33.84	%		29.48	%		31.23	%		31.10	%
	Average equity to average assets		7.58	%		0.13	%		7.57	%		7.17	%		6.90	%		7.15	%
	Net interest margin		4.02	%		(0.74)	%		4.05	%		4.26	%		4.10	%		4.10	%
	Efficiency(6)		67.38	%		(3.77)	%		70.02	%		64.71	%		67.14	%		66.04	%
Employees (year end)
	Total		537			3.47	%		519			481			459			430
	FTE's		480			4.58	%		459			407			379			363

(1)   Includes the Company's investment in Federal Reserve Bank stock and Federal Home Loan Bank stock.

(2)   Includes junior subordinated debentures.

(3)   These assets are held in a fiduciary or agency capacity for clients and are not included in our balance sheet. Beginning in 2008, the figures include our subsidiary Genesee Valley Trust’s assets under administration.

(4)   Includes $1.63 per share accelerated to December 2012 from February 2013.

(5)   For the respective year, price is based upon last sealed-bid auction administered by the Bank’s Trust Department. Due to the limited number of transactions, the prices may not be indicative of the actual market value of the Company's stock or disclosed prices on OTC.BB.

(6)   Operating expenses, exclusive of intangible amortization, divided by total revenues.

1

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

The Management Discussion and Analysis (MD&A) is intended to provide, in one section, historical and prospective material disclosure enabling investors and other users to assess the financial condition and results of operations of the Company, with particular emphasis on our prospects for the future.  It is intended to give you an opportunity to look through the eyes of your Company's management (we/us) by providing both a short-term and long-term analysis of our business.  On the following pages, we will discuss the dynamics of our business and analyze our financial information through text and tables. (Dollar and percentage changes are calculated before rounding.)

Throughout this and other documents we prepare from time to time, we include our predictions (or "forward-looking information"). Of course, any discussion of the future is subject to many risks and uncertainties, and, while we seek ways to manage these risks and develop programs to control those we can, we ultimately cannot predict the future. Our actual results may differ materially from those indicated by our forward-looking statements. Significant risks and uncertainties affecting our business are enumerated below:

·

The strength of the United States economy in general and the strength of the local economy in particular; general economic conditions, either nationally or locally could be less favorable than expected, resulting in, for example, a deterioration in credit quality of assets;

·

The effects of and changes in United States trade, monetary, and fiscal policies and laws, including and most importantly, the interest rate policy of the Federal Open Market Committee (FOMC) of the Federal Reserve Board, which can have an immediate and significant impact on earnings;

·

The impact of changes in laws and regulations governing financial services and public companies, including laws, regulations, and rules concerning taxes, accounting, auditing and reporting standards;

·

The impact of the imposition of legislative or regulatory price controls on financial transactions;

·

The cost of compliance with governmental regulations, particularly as a result of passage of The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Financial Reform Act”)

·

The impact of technological changes;

·

The development of new products, their competitiveness, and their acceptance by customers;

·

Changes in commercial and consumer spending and saving habits;

·

Changes in demographics within the Company's market area;

·

The commission of fraud by customers and non-customers against the Company; and

·

Our success in managing these risks.

RESULT OF OPERATIONS

Messrs. Hamlin messages to shareholders in this Annual Report provide a further overview of the Company's 2012 results.  They include a discussion of the economy, the banking industry, the regulatory environment, and their impact on the Company, as well as activities internal to the Company.

For the year ended December 31, 2012, we reported a 15.5% improvement in net income to $18.8 million compared to $16.3 million for the year ended December 31, 2011, and $17.7 million for the year ended December 31, 2010.  Diluted earnings per share for each of these years were $9.76, $8.48, and $9.20, respectively.  The major components of these results, which include net interest income, provision for loan losses, non-interest income, operating expenses, and income taxes, are discussed below.

Net interest income

Net interest income is the difference between the interest and dividend income earned on loans and investments and the interest expense paid on deposits and borrowings.  Net interest income is the Company's principal source of earnings, comprising approximately 65% of total revenues.  Net interest income is affected by a number of factors, including the level, pricing and maturity of interest-earning assets and interest-bearing liabilities, interest rate fluctuations and asset quality, as well as general economic conditions and regulatory policies.

As we entered 2012, we saw our local economy continue the slow recovery from the 2009 recession. The national economy was showing signs of improved performance, but the expectation was a slow-down from the fourth quarter of 2011.  With slow growth, high unemployment, and little prospect for significant inflation, as previously noted, the FOMC signaled its willingness to maintain short-term interest rates at historically low levels into 2014.  The impact to our balance sheet would be continued downward pressure on asset yields combined with some reduction in liability costs.  This would erode both margin and spread.  Thus, net interest revenue growth would have to come from higher volumes of loans, a strategy we pursued in 2012.

 

Our predictions of an improving economy were generally accurate.  GDP growth was less than 2% in the first and second quarters of 2012, jumping to 3.1% for the third quarter, but the fourth quarter data showed a decline from the growth rate of the third quarter.  Unemployment remains above 7%, and inflation below 2%.  Given the continued relatively weak growth prospects, high unemployment, and low price inflation, the FOMC announced during the fourth quarter of 2012 that it expected to keep the target range for the federal funds rate at 0 to 1/4 percent through 2015, and possibly longer depending upon the unemployment rate.

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As was seen in 2011, with rates remaining low for all of 2012, our asset yields declined significantly due to refinancing of existing loans and originations of new loans at lower rates than those maturing.  Funding costs also decreased, despite being already at historical lows.  During 2012 we continued our strategy begun in the second half of 2011 to implement a multi-loan portfolio effort to increase originations of short- to medium-term duration, higher yielding loans to replace low yielding investments in federal funds (“fed funds”).  These efforts resulted in strong year-over-year growth in net interest income, despite a narrowing margin.

For 2012, tax-equivalent net interest income grew $3.8 million or 5.8%.  Impacting these results was a $102.1 million (6.4%) increase in average earning assets, all in higher-yielding loans, and a $52.4 million (3.9%) increase in average interest-bearing liabilities. During the year, the tax-equivalent yield on earning assets fell 26 basis points to 4.52%, while the cost of interest-bearing liabilities also fell by 26 basis points to 0.61%. The combination of these reductions led to stability of the net interest spread (the difference between rates earned and rates paid) at 3.91%, while net interest margin (net interest income divided by average earning assets, or balance sheet profit margin) fell to 4.02% from 4.05%.  

In 2011, tax-equivalent net interest income grew less than $0.1 million.  Impacting these results was a $76.3 million (5.0%) increase in average earning assets, mostly in low-yielding fed funds sold, and a $37.6 million (2.9%) increase in average interest-bearing liabilities. During the year, the tax-equivalent yield on earning assets fell 47 basis points to 4.79%, while the cost of interest-bearing liabilities fell only 30 basis points to 0.87%. The combination of these reductions led to a 17 basis point decline in net interest spread and a 21 basis point decline in margin from 2010.  

The following table provides additional details of net interest income and shows average balances, tax-equivalent interest earned or paid, and average rates for the years ended December 31, 2012, 2011, and 2010.  Taxable securities include the Company's required investments in Federal Reserve Bank Stock and Federal Home Loan Bank Stock. The mark-to-market adjustments on securities available for sale are included in non-interest-earning assets. Nonaccrual loans are included in the average balances of loans.   Non-interest-bearing demand deposit accounts are included in non-interest-bearing liabilities. Borrowings include junior subordinated debentures. Tax-exempt interest includes a tax equivalency adjustment of $2,989,000 in 2012, $3,342,000 in 2011, and $3,646,000 in 2010.  A marginal federal income tax rate of 35% was applied in each year. Interest on loans includes a deduction for net deferred loan costs of $3,312,000 in 2012, $2,067,000 in 2011, and $2,043,000 in 2010.  The substantial increase in deferred costs in 2012 is related to loan costs incurred to originate indirect automobile loans, which tend to have relatively short average life, leading to faster cost amortization than the entire loan portfolio in general.

				Average Balances and Interest for the Years Ended December 31,
				(dollars in thousands)
					2012										2011										2010
					Average						Average				Average						Average				Average						Average
					Balance			Interest			Rate				Balance			Interest			Rate				Balance			Interest			Rate
Assets
Interest-earning assets:
	Interest-bearing deposits
		with  others		$	6,953		$	13			0.19	%		$	3,132		$	24			0.77	%		$	1,729		$	36			2.06	%
	Federal funds sold				56,693			132			0.23				145,509			354			0.24				87,203			207			0.24
	Securities:
		Taxable			59,421			1,327			2.23				58,541			1,505			2.57				48,373			1,547			3.20
		Tax-exempt			217,240			8,677			3.99				214,985			9,773			4.55				224,272			10,750			4.79
	Loans, net				1,365,953			66,963			4.90				1,178,132			64,907			5.51				1,161,172			67,571			5.82
		Total interest-earning
			assets		1,706,260			77,112			4.52				1,600,299			76,563			4.78				1,522,749			80,111			5.26
Non-interest-earning
	assets				116,607										96,859										104,989
		Total assets		$	1,822,867									$	1,697,158									$	1,627,738
Liabilities and
Stockholders' Equity
Interest-bearing liabilities:
	Interest-bearing demand			$	179,974			115			0.06	%		$	155,688			146			0.09	%		$	139,158			255			0.18	%
	Savings and money
		market			786,196			1,631			0.21				692,271			1,831			0.26				637,215			2,319			0.36
	Time deposits				386,115			3,908			1.01				449,404			6,866			1.53				476,486			9,539			2.00
	Borrowings				52,878			2,865			5.42				51,575			2,905			5.63				57,256			3,212			5.61
		Total interest-bearing
			liabilities		1,405,163			8,519			0.61				1,348,938			11,748			0.87				1,310,115			15,325			1.17
Non-interest-bearing
	deposits				252,751										207,551										187,957
Other non-interest-bearing
	liabilities				26,782										12,276										12,970
Stockholders' equity					138,171										128,393										116,696
		Total liabilities and
			stockholders' equity	$	1,822,867									$	1,697,158									$	1,627,738
Interest rate spread											3.91	%									3.91	%									4.09	%
Net interest margin							$	68,593			4.02	%					$	64,815			4.05	%					$	64,786			4.25	%

The following rate/volume analysis is meant to show separately the relative contribution that changes in rates and in volume (balances) have on total tax-equivalent net interest income year over year.  By looking at these components separately, we can identify the sources from which net interest income growth arises - changes in balances or changes in rates.  Because each component requires different management techniques, for example: customer demand in the case of balances, and market interest rate changes in the case of rates, separating them gives us a clearer view for analyzing our results.  In deriving the information, volume changes are

3

 

computed by multiplying the balance difference by the prior year's rate.  Rate changes are computed by multiplying the rate difference by the prior year's balance.  The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the dollar amounts of the change in each.

We see from the analysis that substantially all of the interest income growth came from growth in loans.  Changes in rates reduced the overall increase in income.  As discussed previously, we had anticipated the potential impact of rate decreases, thus the reason why we set out in late 2011 to significantly increase total loans by reinvesting fed funds sold and new deposits. Deposit cost reductions provided an even greater benefit to net interest income.  Parsing the data, we see it was principally due to, as anticipated, rate and volume reductions in time deposits, a product generally less attractive to savers during low interest rate periods.

			2012 compared to 2011									2011 compared to 2010
			Increase/(decrease)									Increase/(decrease)
			Due to change in									Due to change in
				Volume			Rate			Total			Volume			Rate			Total
Interest-earning assets:
	Interest-bearing deposits with others		$	16			(27)			(11)		$	19			(31)			(12)
	Federal funds sold			(207)			(15)			(222)			142			5			147
	Securities, taxable			22			(200)			(178)			292			(334)			(42)
	Securities, tax-exempt			102			(1,198)			(1,096)			(435)			(542)			(977)
	Loans, net			9,673			(7,617)			2,056			976			(3,640)			(2,664)
		Total		9,606			(9,057)			549			994			(4,542)			(3,548)
Interest-bearing liabilities:
	Interest-bearing demand			20			(51)			(31)			27			(136)			(109)
	Savings and money market			228			(428)			(200)			187			(675)			(488)
	Time deposits			(871)			(2,087)			(2,958)			(517)			(2,156)			(2,673)
	Borrowings			72			(112)			(40)			(320)			13			(307)
		Total		(551)			(2,678)			(3,229)			(623)			(2,954)			(3,577)
		Net Change	$	10,157			(6,379)			3,778		$	1,617			(1,588)			29

Taking into account the results of 2012, and considering our expectation of continued low interest rates into 2015, we anticipate 2013 will be another year of narrowing net interest margin and spread as asset yields will continue to decline, and liability costs will have less and less opportunity for reduction. We remain encouraged that our local economy will grow, leading to opportunities for us to provide credit to growing business and households, resulting in loan and deposit growth.   However, overall net interest income growth will be in the low single digits due to the impact of asset yield declines.  Thus the contribution of net interest income to total revenues will fall below 65%.  We will see our greatest revenue growth in non-interest income sources, which is discussed hereafter.

Provision for Loan Losses

The provision for loan losses (a charge to earnings) in each period is a result of our judgment about the credit quality of the Company's assets.  We present a detailed discussion and analysis in a following section entitled "Loan Loss Experience and Allowance for Loan Losses" and Note 4 of the Consolidated Financial Statements.

Non-Interest Income

Non-interest income accounts for approximately 35% of total revenue, and growing, consistent with our strategy to broaden our revenue sources through providing comprehensive financial services.  It is composed mainly of revenues from: (a) service charges on deposit accounts, (b) fees for trust and investment services (asset management), (c) income from brokerage and investment subadvisory services, and (d) net revenues from mortgage banking.  For the year ended December 31, 2012, non-interest income increased $6.3 million or 22.0% from 2011, and for the year ended December 31, 2011, it increased $2.1 million or 7.8% from 2010.

     Service charges on deposit accounts increased 6.8% in 2012 from 2011, attributable to both increased revenues from our Courtesy Limit service and electronic transaction services associated with our debit card.  Service charges on deposit accounts increased 2.3% in 2011 from 2010 with growth only seen in electronic banking services.  Account maintenance service charges (included in service charges) have been relatively flat the last three years due to higher customer balances offsetting their periodic fees. Courtesy limit-related service fees and electronic banking revenues continued to increase with consumers shifting from cash and checks (paper-based) to electronic transactions. We expect a similar trend in 2013, and will be exploring opportunities for targeted price changes to enhance this revenue source.

     Trust and investment services income is earned based upon the fair value of assets under our administration.  Income is further dependent upon the services we provide (managed or custodial) and the mix of assets underlying the accounts - stock, bonds, and money market funds.  This income increased in 2012 by $0.5 million or 3.8% from 2011, and increased in 2011 by $1.5 million or 13.3% from 2010. For both 2012 and 2011, the increases in revenue were a result of an increase in the underlying fair value of assets under

4

 

administration (see table below), sales to new customers, and improved conditions in the stock market in general.  We expect similar positive results in 2013 from a growing customer base and rising stock market, which should contribute to a high single-digit increase in both revenues and fair value of assets under administration. The table below presents information about recent period-end actual and average balances of assets under administration and the related income for the respective years (dollars in thousands).

		2012			2011			2010
Book value of assets under administration (period end)	$	1,879,397			1,726,172			1,658,111
Fair value of assets under administration (period end)	$	2,115,346			1,858,130			1,830,549
Fair value of assets under administration (average)	$	1,988,061			1,869,900			1,685,694
Trust and investment income	$	12,916			12,445			10,984

Brokerage and investment subadvisory services income increased by $2.5 million in 2012 from 2011. This increase as well as the increase from 2010 to 2011, were solely associated with our acquisition of OBS in late 2011. OBS’s growing customer base and the related underlying assets are expected to contribute to revenue growth in excess of $1.0 million in 2013.

Mortgage banking income is another important source of non-interest income and is comprised of the net gain on sale of mortgage loans and loan servicing income.  Our residential mortgage originations are handled through our wholly owned subsidiary, CNB Mortgage Company (CNB Mortgage), with results primarily reflected in the net gain on sale of mortgage loans.  Due mostly to changes in the volume of loans closed each year the line item grew over 85% in 2012 after having fallen 10.1% in 2011.

We typically sell long-term, non-callable, fixed-rate residential mortgages with loan-to-value ratios less than 85% to the Federal Home Loan Mortgage Corporation (Freddie Mac) to: (1) provide mortgage financing to homeowners we could not otherwise accommodate, primarily due to our inability to fund the high demand for these loans with local deposits; and (2) to reduce our long-term interest rate risk.  However, we continue to service these loans locally with our staff.  Generally, residential mortgage loans with an original loan-to-value ratio greater than 85%, and loans requiring escrow services, are sold with servicing released to third parties.  

The revenue generated by CNB Mortgage is dependent upon the volume of loans originated.  This volume is composed of purchase money loans (loans to purchase a property) and refinance loans (new loans that change the terms of an already existing loan).  CNB Mortgage generally must originate approximately $150 million annually to break even based on its current operating expense structure. This breakeven volume has increased significantly from less than $100 million in prior years due to the impact of increasing costs expended as a result of regulatory changes, particularly enhanced disclosure requirements, appraisal requirements, and underwriting costs.  During years without significant refinance activity, the Company is more dependent upon purchase money mortgages.  Refinance activity in 2011 and 2010, while very strong, was much lower than in 2012 when mortgage interest rates kept falling. For the coming year we anticipate mortgage originations of about $300 to $330 million, somewhat lower than 2012’s due to lower anticipated refinance activity. During each year, some of our originations are retained in the Bank’s portfolio.  The amount of loans retained is dependent upon the rates and terms of the mortgages.  Generally, the Bank retains loans with interest rates of 4.00% or above and with maturities or call dates of ten years or less.  Because of the low interest rate environment, a smaller percentage of total originations (20%-25%) have been retained in portfolio than in years past. For the years ended December 31, 2012, 2011 and 2010, CNB Mortgage originated and sold the following types of loans (dollars in thousands):

			2012			2011			2010
Purchase money mortgages		$	199,004			115,529			140,764
Refinance mortgages			151,531			105,554			114,012
	Total mortgage originations	$	350,535			221,083			254,776
Of which:
	Sold to third parties	$	271,815			166,240			203,582
	Sold to (retained by) the Bank	$	78,720			54,843			51,194
	Percentage of total sold to Bank		22.5	%		24.8	%		20.1	%

Net loan servicing income fell by 5.6% in 2012, after having increased 5.8% in 2011. This income source is composed primarily of service fees earned on loans sold to Freddie Mac but serviced by us, and service fees we earn on commercial loan participations, and reduced by amortization of loan servicing rights.  (We discuss loan servicing rights in greater detail in Note 6 to the Consolidated Financial Statements. Residential loans sold to Freddie Mac and commercial loan participations are not included in the consolidated balance sheet, since the interest income earned is not ours.) Net loan servicing income grew in 2011 due to higher underlying serviced loan balances and relatively lower amortization expense for loan servicing assets. Despite overall growth in serviced loans, the higher volume of refinancing in 2012 led to higher loan payoffs of previously-originated serviced loans, resulting in comparatively higher amortization of servicing rights.  Amortization expense was about $0.1 million higher in 2012 than either 2011 or 2010. With continuing

5

 

low interest rates, we expect loans serviced for Freddie Mac to increase further in 2013 as long as 30-year fixed-rate mortgages stay at or below 4%.  Given our positive outlook for commercial loan demand we also expect participation loans to increase in the coming year, reversing a multi-year decline.  As a result of both of these factors net loan servicing income should increase.   At each of the three years ended December 31, 2012, 2011, and 2010, we were servicing the following types of loans (dollars in thousands):

			2012			2011			2010
Residential mortgages (sold to Freddie Mac)		$	528,316			461,950			435,220
Commercial loans and mortgages (participations sold)			109,365			114,969			116,111
	Total loans serviced for others	$	637,681			576,919			551,331

The Company’s contract to sell loans to Freddie Mac and to the Federal Housing Administration (FHA) via third-parties contain certain representations and warranties that if not met by the Company would require the repurchase of such loans.  The Company has not historically nor currently been subject to a material volume of repurchases.

Included in non-interest income are losses on security transactions.  In each of the years 2011 and 2010, we recorded modest write-downs on a collateralized debt obligation (CDO), which accounted for a portion of the net losses on securities in these years. The remainder was mostly due to losses on called securities resulting from recognition of unamortized premiums. No such write-downs occurred in 2012. In the fourth quarter of 2011 we sold approximately 60% of our holdings in this CDO for a modest loss and expect to sell the remainder in the coming years as tax-loss planning opportunities arise. Net of these write-downs and sale, we hold approximately $0.1 million in carrying value of these types of securities with an original remaining cost basis of $0.5 million, representing an immaterial portion of our total securities portfolio.  While future writedowns or a loss on the sale of the CDO could occur, the maximum amount would not exceed its carrying value of less than $0.1 million.

All remaining sources of non-interest income rose $0.8 million in 2012 and $0.5 million in 2011.  Income grew in both years due to higher income from our investment in Cephas Capital Partners, a Small Business Investment Company. We expect these sources of non-interest income to be similar in 2013 as in 2012.  We expect continued earnings from Cephas, as it liquidates it positions, and we expect all other revenue sources to rise consistent with our underlying growth.

Operating Expenses

Operating expenses grew $5.0 million or 7.7% in 2012 from 2011.  Included in this growth figure is $3.9 million associated with the full-year impact of OBS, which compares to $1.3 million in operating expenses for OBS in 2011. In 2011, operating expenses increased $6.6 million, with half ($3.3 million) due to acquisition costs related to OBS (included in Professional and Other Services), and a higher accrual for the Stock Appreciation Rights Plan (“SAR Plan”) liability (included in Salaries and Employee Benefits). With the exception of these unusually large expenses, most year-over-year increases were reflective of continued growth in our operations and expansion in Monroe County, New York and Sarasota, Florida.  As a highly service-oriented financial company we continue to see the largest dollar increase in any category was in salaries and employee benefits and was attributable to increased staffing and raises for incumbent employees.  For 2013, we expect further increases in total operating expenses due to our franchise growth.

Substantially all of the increase in salaries in the past two years has been due to wage increases and new staff, including OBS at a cost of $1.8 million in 2012.  Benefit costs declined in 2012 due to a lower accrual for the SAR Plan than in 2011.  The increase in 2011 was principally driven by significant SAR Plan accrual ($3.1 million in 2011 compared to $0.6 million in 2010) [See Note 14 to the Consolidated Financial Statements], which was a result of a combination of a higher stock price and lower long-term interest rates.  For 2013, salaries and benefit costs should increase about 2-4% from 2012.

Occupancy expenses increased $0.6 million (8.1%) in 2012 over 2011 and $0.7 million (10.7%) in 2011 over 2010. OBS accounted for $0.4 million of the increase in 2012. For all years, rent expense associated with our new offices – Greece-Latta, Jackson Ridge, and Alex-Park– along with rent increases and additional rent expense resulting from our branch sale-leaseback transaction in June 2008, were the largest contributor to the increases.  (Please also see Notes 5 and 15 to the Consolidated Financial Statements.) Occupancy expenses can also fluctuate depending upon growth in the Company and the timing and nature of capital expenditures and cosmetic renovations.  General growth in the Company’s operations will result in higher occupancy expenses due to greater purchases, year-over-year cost increases due to inflation and more rentable square footage.  However, the timing of purchases and the age of equipment will impact depreciation expense, which will diminish after the depreciation period expires, even if the equipment is still being used.  In 2013, we expect to see higher occupancy expenses due to increases in rent and depreciation, as well as renovation costs associated with physical improvement investments in our facilities and related equipment.

Technology and data processing expenses increased $0.8 million or 18.5% in 2012 over 2011 and increased $0.6 million or 15.4% in 2011 over 2010 with OBS accounting for $0.2 million of the 2012 increase.  The 2012 and 2011 increases were mostly due to higher software maintenance costs and software amortization, which have increased due to the impact of recent systems upgrades associated with franchise growth and technology improvements. We are also incurring growing expenses for debit card processing services, but these costs are growing at a slower rate than their related income. In 2013 and forward we expect these same expenses to increase reflecting the Company’s growth.  

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The largest components of professional services are contract costs, with the largest recurring contract costs being subadvisor investment fees.  Because these fees are tied to the underlying market value of applicable assets under administration, they will fluctuate from year to year. In 2012 compared to 2011, these fees fell, because those paid to OBS since its acquisition are eliminated in consolidation.  The drop in these fees was offset by an increase in credit reporting fees associated with the increased volume of loans originated.  However, the largest component of the decrease was due to fees incurred in 2011, not recurring in 2012.  In 2011 $1.1 million of professional fees were incurred related to the acquisition of OBS. For 2013 we expect this category to continue to rise with increases associated with growth in the market value of managed assets, and fees to consultants and professionals.

Marketing (advertising and promotion) and public relations (contributions and entertainment) expenses increased $0.2 million in 2012 from 2011 and $0.3 million in 2011 from 2010.  Increases in 2012 were associated with promotional activities associated with the Bank’s 125^th anniversary celebration, as well as increased charitable contributions, and costs for on-boarding new deposit customers.  The increase in 2011 was mostly due to advertising and promoting our new offices and media spending for brand management.  In general, though, as with occupancy expenses, some underlying expenses continue to grow with overall Company growth and inflation, while others fall due to the timing of expenditures. Included in public relations expenses is our monetary commitment to our communities as measured by our contributions to community organizations which amounted to $390,000, $339,000, and $303,000 for 2012, 2011 and 2010, respectively. We expect marketing and public relations expenses will show a nearly 10% increase in 2013 for promotional activities surrounding the PGA Championship in Rochester, NY, and costs associated with re-branding at GVT and OBS.

Office-related expenses increased $0.1 million in 2012 due to check printing costs associated with new business deposit accounts, while in 2011 and 2010 they were relatively flat at $1.5 million.  Despite growth in customers, staff and physical locations, we have been able to manage the overall growth in these costs through continuing investment in cost-saving technology, including electronic communications. Notwithstanding these process improvements, for 2013 it is expected that these expenses will increase due to branding efforts at subsidiary companies combined with higher postage rates.

Intangible amortization expense was $1.5 million in 2012 and increased from $1.2 million in 2011 due to the addition of OBS intangible assets.  In the fourth quarter of 2011, as a result of the Company’s annual fair value estimation, an additional $0.3 million amortization expense over scheduled amortization was recorded to reflect customer account attrition in excess of original estimates at GVT.  We believe this higher attrition rate was associated with customers transferring their accounts to a firm started by employees who left the Company. Similar attrition did not recur in 2012. Details of future amortization expense are found in Note 2 to the Annual Report.

   

Expenses associated with operating other real estate were $0.8 million in 2012, $1.0 million in 2011, and $1.3 million in 2010.  These comparatively high levels of historical expenses are mostly associated with our acquisition of nearly 60 rental properties from a commercial borrower through foreclosure in the first quarter of 2009.  We have been successful during the years in selling some of these properties, and expect to sell more in 2013.  Operating expenses for managing these and the handful of other properties approximated $0.7 million in 2012 and $0.8 million in both 2011 and 2010 with the balance of the expense associated with valuation writedowns.  We regularly review the carrying value of foreclosed properties to determine if their fair value has fallen based upon then current market conditions.  We continue to market these properties with a goal to liquidate them.  Associated operating expenses will be directly impacted by the timing and number of properties sold, and new properties which might be acquired through future foreclosures.

Despite growth in deposits, FDIC insurance expenses in recent years have fallen due to changes in assessment methodologies.  In 2012, insurance costs fell $0.2 million, while they fell $0.7 million in 2011 and $0.4 million in 2010 after having tripled in 2009 when it included a special $0.7 million assessment paid in the second quarter of that year.  At the end of 2009, we, and all banks, prepaid an estimated thirteen quarters of insurance premiums with approximately $2.8 million remaining at December 31, 2012.  Over the past several years the FDIC had raised insurance premiums to cover substantial losses incurred by its insurance fund due to actual and anticipated bank failures.  In October 2010, the FDIC announced that it will extend the period to reach its maximum reserve levels, and combined with lower loss projections, eliminated the three (3) basis point premium increase scheduled for 2011.  In the first quarter of 2011, the FDIC finalized its new assessment system in accordance with the Financial Reform Act.  The changes became effective beginning mid 2011 and were assessed against our prepayments to the FDIC. The FDIC Board approved a final rule that changed the assessment base for deposit insurance, adopted a new large-bank pricing assessment scheme, and set a target size for the Deposit Insurance Fund.  The rule -- as mandated by the Dodd-Frank Act -- finalized a target size for the Deposit Insurance Fund at 2 percent of insured deposits. It also implemented a lower assessment rate schedule when the fund reaches 1.15 percent and, in lieu of dividends, provided for a lower rate schedule when the reserve ratio reaches 2 percent and 2.5 percent. As mandated by the Financial Reform Act, the rule changed the assessment base from adjusted domestic deposits to a bank’s average consolidated total assets minus average tangible equity. The rule defined tangible equity as Tier 1 capital. The rule lowered overall assessment rates in order to generate the same approximate amount of insurance premiums under the new larger base as was raised under the old base. The largest banks (over $10 billion in assets) pay higher insurance premiums than under the previous formula, while smaller banks, ours included, pay lower relative premiums. When fully implemented, assuming no change in deposit base, we estimated our annualized premiums would fall as much as $1.0 million. In 2013, with our continued growth, premium expenses are expected to rise over 2012, but not to the extent seen prior to the rule change.

All other operating expenses grew $0.8 million in 2012 with about one-third due to OBS, and the remainder due to a variety of costs associated with our growth.  Expenses fell about $0.3 million in 2011 and grew about $0.4 million in 2010 with no particular material item.  For 2013, we expect to see some modest expense growth in this category consistent with the Company’s growth.

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Income Taxes

Our effective income tax rate was approximately 31%, 28%, and 26% in each of the past three years, respectively.  These effective rates differ substantially from our marginal rate of about 40%, mainly due to our significant non-taxable interest income from state and municipal obligations. A detail of their impact can be found in Note 10 to the Consolidated Financial Statements. The rise in rate in 2012 and 2011 is directly attributable to lower tax-exempt income, which was caused by lower market interest rates. We anticipate our 2013 effective tax rate will be in the 30% to 33% range and is mostly dependent upon the amount of non-taxable interest income we earn in proportion to taxable income, as well as the fiscal policy of New York State and the U.S. Government.  

FINANCIAL CONDITION

As of December 31, 2012, total assets of the Company were $1,887.0 million up $126.2 million or 7.2% from $1,760.8 million at year-end 2011. Substantially all of the asset increase occurred in the loan portfolio. Asset increases were principally funded by deposit inflows, continuing a multi-year trend as customers sought the safety and convenience of community banks, and to a lesser extent, redeployment of fed funds sold.

Cash and due from banks, including interest-bearing accounts, fell $2.7 million to $56.5 million, due to lower balances in the course of collection through the Federal Reserve Bank of New York.  While this balance can fluctuate from day to day, depending upon customer transactions, we expect it to range between $30 million and $50 million on average.  While endeavoring to maintain a sufficient supply of cash for our customers' needs, we also strive to minimize the amount of physical cash on hand, since this is a non-interest earning asset.

Federal funds sold were $34.6 million at year end 2012, down from $67.5 million at year end 2011. These balances generally reflect liquidity (cash) not invested in securities or loans.  These balances are managed on a daily basis by representatives of our Asset/Liability Management Committee (ALCO).  This liquidity is used to manage daily cash inflows and outflows from deposits and loans.  Our floor target for federal funds sold balances is $20 million to $40 million, but day-to-day balances will fluctuate.  During 2012, we averaged about $56.7 million down from $145.5 million in 2011.  In 2011 the balance far exceeded our target as local demand for loans was lower than the amount at which deposits were growing, and a reasonable supply of liquid securities providing sufficient yields were not available for purchase.  Foreseeing market rate stability for several years, and improvements in the local economy, during the second half of 2011 we aggressively grew our loan portfolio with high quality automobile loans, which reduced the fed funds balance by year’s end, and in 2012 we continued the loan growth with residential and commercial loans. For 2013, we expect federal funds sold balances to remain near their current level, which exceeds our target, due to a continuation of the general trend of deposit growth exceeding net loan originations.

Net premises and equipment fell $1.0 million in 2012 as depreciation expense exceeded new assets capitalized, while in 2011 it increased $1.7 million due to costs of our new banking branch, renovations to existing offices, and purchases of new equipment.  During each of the past few years, we have annually invested approximately $3.0 million to $4.0 million in premises and equipment, mostly for office improvements and technology upgrades. For 2013 we expect to begin construction of a new office at CollegeTown at the University of Rochester, and an associated stand-alone drive-up ATM facility.  In total we anticipate investing about $3.0 million to $4.0 million for these and for existing facility renovations and equipment replacements with the remainder for computer hardware purchases. These investments have been, and will be, funded from current operating cash flow.

Goodwill and intangible assets fell due to amortization of the intangibles.  During 2012 we finalized our estimate of the fair value of assets acquired and liabilities assumed in connection with the acquisition of OBS.  Compared to our original estimates, the value of the technology and customer list intangibles increased, while the value of the non-controlling interest declined, and the net change impacted goodwill and deferred taxes.  However, in accordance with current accounting guidance, these changes were applied retrospectively to 2011.  More detail is presented in Note 2 to the Consolidated Financial Statements.  

Prepaid FDIC assessment declined $1.1 million due to credits posted for the past four quarters’ assessments. At December 31, 2012, this balance was $2.8 million compared to $3.9 million at December 31, 2011. In the fall of 2009, the FDIC proposed and approved a requirement that insured institutions prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012 (thirteen quarterly periods). The prepaid assessment for these periods was collected on December 30, 2009. The prepaid assessment rate was based on the Bank’s total base assessment rate for the third quarter of 2009. The prepaid assessment rate for 2011 and 2012 was equal to the Bank’s modified third quarter 2009 total base assessment rate plus three (3) basis points. Each institution’s prepaid assessment base, including ours, was calculated using our third quarter 2009 assessment base, adjusted quarterly for an estimated five (5) percent annual growth rate in the assessment base through the end of 2012. We recorded the entire amount of this prepaid assessment as a prepaid expense (asset) as of December 31, 2009. As of year-end 2009, and each quarter thereafter, we record an expense (charge to earnings) for our regular quarterly assessment for the quarter and an offsetting credit to the prepaid assessment until the asset is exhausted. If the prepaid assessment is not exhausted by December 30, 2014, any remaining amount will be refunded to the Bank. Given the change in assessment methodology discussed in the Operating Expenses section above, we believe it is possible there will be a refund to our Bank.

Other assets increased $3.2 million by year-end 2012 to $26.7 million. The increase was associated with mortgage servicing rights, which are more fully described in Note 6 of the 2012 Consolidated Financial Statements, and deferred taxes, which are more fully described in Note 10.

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A more detailed discussion of the Company's principal interest-earning assets (securities and loans), and interest-bearing liabilities (deposits and borrowings), follows.

Securities Portfolio

We maintain our portfolio of (investment) securities mostly in U.S. Treasury, U.S. government sponsored enterprise obligations (“U.S. GSE’s” or “GSE’s”), and municipal obligations. We invest in securities with short to intermediate average maturities in order to better match the interest rate sensitivities of our other earning assets and liabilities. You can find more information about the carrying value of our securities in Note 3 to the Consolidated Financial Statements.

Investment decisions are made within policy guidelines established by our Board of Directors.  The investment policy is based on and supplements the Company’s Interest Rate Risk and Funds Management Policy (ALCO Policy), also established by our Board.  Together these policies set financial and investment goals, which direct investment in all assets, including securities.  The investment policy states that "... the Company shall invest funds not needed for local loans and mortgages in United States Government Bonds, GSE’s, Municipal Bonds, Corporate Obligations, and Money Market Instruments.  The goal of the investment portfolio shall be to provide sufficient safety and liquidity in order to help meet the Company's needs and to produce income for the Company consistent with the safety features of quality, maturity, marketability, and risk diversification." The investment policy further limits total investments to no more than 40% of total Company assets.  There are additional limits on asset classes (U.S. Treasury, GSE’s, etc.), issuers, credit quality and maturities. Allowed within our policy are securities hedging activities, interest rate risk swaps, and other programs involving the use of off-balance-sheet derivatives.

We classify securities as either "available for sale" or "held to maturity." These classifications result in differing management and accounting treatments.  Securities "available for sale" are used to absorb our available liquidity not used for lending purposes or not sold in the federal funds market.  These securities may or may not be held to their stated maturity, as demand for loan and deposit in- and out-flows change.  Securities which we have both the ability and intent to hold to maturity are classified as "held-to-maturity." Substantially all of these securities are pledged to collateralize municipal deposits.  Municipalities in New York State are generally required to secure deposits in excess of FDIC insurance limits so these deposits are collateralized by eligible securities.

During 2012, total investment securities fell $2.9 million by year end. Throughout most of the year, as with 2011, we experienced a high volume of security calls (i.e., issuers repaid debt obligations before their stated maturities).   The continued low interest rate environment made it beneficial for issuers to call outstanding higher cost debt and replace with lower cost debt.   Because market rates have been low for some time, and most of the portfolios’ higher yielding callable securities have already been called, we expect calls of current portfolio securities to slow, allowing us to continue to modestly increase the portfolio balance, but at interest rates lower than those maturing or called.

Substantially all of the held-to-maturity portfolio is used to support the collateralization of the communities’ funds in the form of municipal deposits.   At December 31, 2012, about 75% of our total investment portfolio (available-for-sale and held-to-maturity) was used to collateralize these deposits.  These deposits, in turn, are used to purchase tax-exempt securities of local municipalities, thereby recycling local deposits within our communities.  Other securities consist mainly of triple-A rated taxable GSE’s – Federal Home Loan Bank, Fannie Mae, Freddie Mac, and Federal Farm Credit Bank.  We will vary the mix of taxable and tax-exempt securities from time to time depending upon the amount of our taxable income, the securities' tax-equivalent yield, and the supply of high-grade, tax-exempt securities.  

Because changes in the interest rate environment impact the market value (price or fair value) of securities and because market interest rates often differ from the rates at which securities were purchased, the underlying price of securities will vary from time to time.  The price of a security will move inversely to interest rates.  So, generally, if market rates are higher than that of the security, the fair value of the security will be lower than our cost.  On the other hand, if market rates are lower than those of the security, the fair value of the security will be higher than our cost.  Since 2008, market rates have declined regularly resulting in relatively higher market values for our securities than their cost, particularly for state and municipal obligations.  At December 31, 2012 the fair value of our securities exceeded their amortized cost basis by $5.9 million or 2.1%. We expect market rates to remain low in 2013, generally not impacting current fair values.  However, with the maturities and calls of securities, new purchases will carry then-current market rates, so the fair value of our securities is likely to fall closer to their amortized cost over time. Additionally, yields available on securities remain at market cycle lows, so as we purchase lower-rate securities, and if market rates subsequently rise, the fair value of these securities may fall below their cost.  Notwithstanding the lower rate environment, even at December 31, 2012, the fair value of some individual securities remained below cost, as more fully discussed in Note 3 to the Consolidated Financial Statements.  None of these securities was considered to be other than temporarily impaired as of December 31, 2012, therefore no write-down of carrying value in the income statement was required.

Securities available for sale are carried at estimated fair value. In addition, all securities are evaluated for “other-than-temporary-impairment,” which can result, as in the past several years, in the write-down of securities to fair value with a resulting charge to earnings and to capital.  The valuation of securities can involve a significant amount of judgment, particularly when liquid markets do not exist for the security being valued.  We use quoted market prices to estimate fair value when an active market for the securities exist.  However, when an observable liquid market does not exist, we utilize significant estimates and assumptions to estimate fair value. These assumptions, include among others, discount rates, expected cash flows, and default rates. The use of different

9

 

assumptions from ours could produce significantly different results, which could have a material effect on out other comprehensive income.  Because of the level of judgment involved, we consider the valuation of securities a critical accounting estimate. Note 3 to the Consolidated Financial Statements provides additional information about the fair value of securities.         

The following table summarizes the maturities and weighted average yields of debt securities available for sale and held to maturity at their carrying value at December 31, 2012. In this table, we do not reflect yields on a tax-equivalent basis.  Our small balance in mortgage backed securities is reported at its final stated maturity, notwithstanding that principal is prepaid regularly, reducing its effective maturity. Some securities in the table below can be called by the issuer prior to their stated maturity.

Maturities and Yields of Debt Securities at December 31, 2012
(dollars in thousands)
										After						After
										One						Five
				One						through						through						After
				Year or						Five						Ten						Ten
				Less						Years						Years						Years
				Amount			Yield			Amount			Yield			Amount			Yield			Amount			Yield
Available for Sale
	U.S. Treasury		$	400			0.25	%		100			0.21	%		-			-	%		-			-	%
	U.S. GSE's			2,022			0.76			4,000			1.36			51,422			1.44			2,714			3.77
	State and municipal			12,395			3.26			25,002			2.94			115			1.47			-			-
	Corporate			-			-			-			-			-			-			1,073			1.66
		Total	$	14,817			2.84	%		29,102			2.71	%		51,537			1.44	%		3,787			3.17	%
Held to Maturity
	U.S. GSE's		$	-			-	%		5			3.13	%		-			-	%		-			-	%
	State and municipal			31,638			3.26			133,951			2.08			9,476			1.30			-			-
	Corporate			-			-			-			-			-			-			780			5.51
		Total	$	31,638			3.26	%		133,956			2.08	%		9,476			1.30	%		780			5.51	%

Loans

Presented in Note 4 to the Consolidated Financial Statements is a description of the types of loans we make. What follows is a historical table of their balances.  The Bank's loan policies establish the general parameters of the types of loans that are desirable, emphasizing cash flow and collateral coverage. Credit decisions are made at the Bank by officers who have extensive experience with commercial and consumer lending, helping to ensure thorough underwriting and sound credit decisions. Our Board of Directors has approved policies for commercial, consumer, and residential mortgage loans. These policies establish the lending authority of individual loan officers as well as the loan authority of the Bank's Officers Loan Committee (OLC). Certain of the Bank's executives each have loan authority up to $1,000,000 while other officers' lending authorities are $250,000 or less. A combination of officers and credit analysts can jointly approve certain loans up to $500,000 and OLC up to $4,000,000.  Loans over that amount generally must be approved by the Board or a designated committee of the Board.

Loans are generally originated in our primary market area (Rochester Metropolitan Statistical Area [MSA]), but as a national bank, we can make loans to customers anywhere in the country.  We use the same credit principles and guidelines for small, medium, and large credits.  A borrower's cash flow, overall financial condition/capacity, character, and the collateral securing a loan are considered during the credit decision process.  Specific emphasis is placed on the borrower's ability to generate cash sufficient to cover operations and financing costs when assessing the overall quality of a borrower's financial condition.  The commercial loan policy imposes limits on loans to one borrower and any borrowing relationship, as well as concentrations of credit to particular industries.  Federal banking regulations limit loans to one borrower (as defined) to 15% of the lending institution's regulatory capital.  At December 31, 2012, this limit for the Bank was approximately $26.0 million, and the Bank's largest committed borrowing relationship under these regulations was $15.7 million.

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For all years, the loan portfolio was composed solely of domestic loans with their concentrations set forth in the schedule of loan classifications below. We are not aware of any material concentrations of credit risk to any industry or individual borrower.  The following summary shows the classifications of loans by category as of the year end for the past five years.

Summary of Loans by Category
As of December 31,
(dollars in thousands)
			2012			2011			2010			2009			2008
Commercial and industrial		$	213,467		$	198,744		$	212,707		$	214,841		$	205,818
Mortgages:
	Commercial		525,413			467,413			434,787			429,955			389,907
	Residential  - first lien		286,972			256,173			232,953			218,731			213,411
	Residential  - second lien		100,099			101,877			96,416			83,236			75,971
Consumer:
	Automobile - indirect		283,836			227,541			181,481			171,902			168,830
	Other		18,323			25,583			26,437			28,919			25,999
Other, including loans held for sale			21,113			7,556			14,113			6,657			2,900
	Total loans		1,449,223			1,284,887			1,198,894			1,154,241			1,082,836
Plus - Net deferred loan costs			9,549			7,634			5,962			5,698			5,776
Less - Allowance for loan losses			(17,317)			(16,095)			(15,635)			(14,232)			(11,992)
	Loans - net	$	1,441,455		$	1,276,426		$	1,189,221		$	1,145,707		$	1,076,620

As planned, gross loans increased significantly in 2012, rising $166.3 million (12.9%) with growth occurring in all major loan categories-commercial, mortgage, and indirect automobile. The largest dollar increases occurred in commercial mortgages and automobile loans, which were the focus of our origination efforts.  We also targeted significant residential loan growth for 2012, but with continued low interest rates, we sold most originations to the secondary market to reduce long-term interest rate risk in our balance sheet. Notwithstanding, we did grow that portfolio over $30 million through our 5-year and 10-year callable mortgages.

Excluded from the balances in the table are loans serviced for others, the balances of which are discussed in the Non-interest Income section. We sell many originated residential mortgage loans and sell participation interests in some large balance commercial loans to manage liquidity, interest rate, and credit risk, but retain the servicing to continue to accommodate the needs of our customers and retain their relationship.  

Overall, we are projecting the net balance of loans across all categories to increase approximately 4.0% in 2013, a slower pace than in 2012, but we will adjust this rate depending upon corresponding growth in deposits, market interest rates for loans, and our level of capital formation. We expect to continue to manage the overall mix of loans -- commercial and individual (mortgage and consumer) -- near a 50% / 50% mix. Since our expansion beginning in the late 1990s, the loan portfolio mix had moved from 50% commercial, 50% individual to a high of 64% / 36%, and stood at 51% / 49% at year-end 2012.  We believe a balanced mix of these assets provides an optimal level of credit, interest rate, and liquidity risk.  To accomplish these goals over time, we will increase consumer loans as well as first- and second-lien residential real estate loans, except when low interest rates lead us to sell residential mortgages rather than retain in portfolio.  Additionally, we will continue to utilize commercial loan participations.

In January 2013, the Consumer Financial Protection Bureau (CFPB) issued its final rule regarding Qualified Residential Mortgages (QRM). The CFPB’s final rule, which takes effect Jan. 10, 2014, implements laws requiring mortgage lenders to consider consumers’ ability to repay home loans before extending them credit, a consideration we have always made prior to extending credit. Included in the rule is a definition of “qualified mortgage” loans, which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. Among its provisions, the rule provides a safe harbor for loans that satisfy the definition of a qualified mortgage and are not deemed to be “higher-priced” loans, which will help avoid unnecessary litigation. Further, the rule treats balloon-payment loans as qualified mortgages if they are originated and held in portfolio by small creditors operating predominantly in rural or underserved areas.  Unfortunately, this definition excludes our Company. We are evaluating these rules and their potential impact on our current products and our future balance sheet. We are particularly concerned about the potential for the proposed rule to impact our callable mortgage product (a $282 million portfolio at year-end 2012), which is not a balloon mortgage. The CFPB is also seeking comment on modifications to the final rule that would extend the safe harbor, qualified mortgage designation to additional loans originated and held in portfolio by community banks with less than $2 billion in assets, but we will quickly outgrow this measure.

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Loan Quality

Poor credit quality can be devastating to a bank, as the world experienced during the end of the last decade. Therefore, we are diligent in initial underwriting and subsequent asset management to measure, monitor and manage credit risk.  The quality of the loan portfolio, as measured by the ratio of non-performing loans to total loans, has mirrored the economy, with the measure worsening in the early years of the decade and improving since then, and declining once again during the most recent recession.  Total non-performing loans increased $0.2 million from December 31, 2011 to December 2012, but declined to 1.28% of the loan portfolio from $1.42%, respectively.  At December 31, 2011, non-performing loans fell by $4.6 million  from 2010 when they stood at $22.8 million and were 1.90% of the loan portfolio. The highest balances of non-performing loans are concentrated within commercial relationships with about half of the balance primarily in the recreation sector – an industry impacted by the recession.  We are actively working with the borrowers with credit difficulties.  Our focus is to direct them towards resolving their cash flow issues by addressing the root-causes of their business troubles, rather than forcing business bankruptcy or liquidation.  We believe this strategy provides longer term value to the Company, the community, and to our customers and their employees, but at times it can result in a higher ratio of non-performing assets relative to our peers, because of our conservative non-accrual policy.  During the past three years we have also seen an increase in non-performing residential loans.  This increase is also tied to the effects of the recession, as a number of borrowers continue to struggle making monthly payments.  We work with each individually for a positive result, including short-term interest deferrals, financing in government-sponsored programs, and refinancing portfolio loans. Even with these community-focused strategies for troubled-loan resolution, borrowers’ circumstances can deteriorate rapidly and we could suffer significant losses.  As of December 31, 2012 we believe we have adequately reserved for this risk within the allowance for loan losses.  More information about the reserves established for these impaired loans is included in Note 4 to the Consolidated Financial Statements.

To ensure that we only report income we have or expect to receive, the accrual of interest on commercial and real estate loans is generally discontinued, and previously accrued interest is reversed, when the loans become 90 days delinquent or when, in our judgment, the collection of principal and interest is uncertain. Loans are returned to accrual status when the doubt no longer exists about the loan's collectability and the borrower has demonstrated a sustained period of timely payment history. Specifically, the borrower will have resumed paying the full amount of scheduled interest and principal payments; all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within a reasonable period (six months); and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms involving payments of cash or cash equivalents.  Interest on consumer loans is accrued until the loan becomes 120 days past due at which time principal and interest are generally charged off.

Interest can be earned on a cash basis for these loans in non-accrual status, and it was: $433,000 in 2012, $127,000 in 2011, and $35,000 in 2010.  The substantial increase in 2012 is related to the successful resolution of a long-standing non-accrual loan for which we recovered all past due interest owed.  Had non-accrual loans been current in accordance with their original terms, we would have recognized additional interest income approximating $596,000, $743,000 and $429,000 during 2012, 2011, and 2010, respectively. Instead these cash payments received were applied to reduce our carrying amount of the loans.

Occasionally we must foreclose on mortgaged properties.  These foreclosed properties are initially recorded at the lower of their fair value, including estimated costs to sell, or carrying value and are included in other real estate owned in the Other Assets section of the balance sheet.  At December 31, 2012, we had four commercial properties and 36 residential properties in other real estate owned. In the first half of 2009 we took possession of 60 one-to-four-family residential rental properties associated with the foreclosure of a commercial loan relationship that was in non-accrual status at December 31, 2008.  At the time, the estimated fair value of the properties was significantly higher than their carrying value, their combined cash flow was positive, exclusive of non-recurring expenses, such as major repairs, and nearly all properties were occupied by tenants. At year end 2012, 15 of these properties remained in other real estate.  Since our foreclosure we have experienced higher than anticipated repair costs, lower revenues, higher vacancies, and lower proceeds from sales.  As a result, and in consideration of current market conditions we wrote down the value of these properties by $0.3 million in the fourth quarter of 2010. No subsequent writedowns have been taken on these properties.  As indicated by our current inventory, we have successfully liquidated most of these properties, as well as other properties formerly foreclosed. As with non-performing loans, we can anticipate additions and dispositions of other real estate in the future.  

In the process of resolving nonperforming loans, we may choose to restructure the contractual terms of certain loans and attempt to work out alternative payment schedules with the borrower in order to avoid foreclosure of collateral. Any loans that are modified are evaluated to determine if they are "troubled debt restructurings (TDR)" and if so, are evaluated for impairment.  A TDR is defined as a loan restructure where for legal or economic reasons related to a borrower’s financial difficulties, the creditor grants one or more concessions to the borrower that it would not otherwise consider. Terms of loan agreements may be modified to fit the ability of the borrower to repay in respect of its current financial status and restructuring of loans may include the transfer of assets from the borrower to satisfy debt, a modification of loan terms, or a combination of the two. If a satisfactory restructure and payment arrangement cannot be reached, the loan may be referred to legal counsel for foreclosure.

As of December 31, 2012, there was one commercial relationship with a carrying value $4.3 million that was considered a TDR due to the nature of the concessions granted to the borrower. We have established no impairment reserve for the relationship in light of the value of underlying collateral and management’s recovery expectations. The balances of the underlying loans are included in non-performing loans. For this relationship, we renegotiated certain terms of their loans in 2010.  The significant term modified was the monthly principal and interest payment amount.  We agreed to forbear our rights under default provisions in the loan agreements on the condition that the borrower made monthly payments which were significantly less than those required under the terms of the original loan agreements. The customer was in compliance with the terms of the forbearance agreement which expired in March 2011. At that

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time, we renewed the forbearance agreement for an additional 24 months with higher monthly payments than under the previous agreement.  The borrower has paid as agreed. A loan totaling $0.3 million, previously classified as a TDR was liquidated in the second quarter of 2012. Additional information is set forth in Note 4 to the Consolidated Financial Statements.

Summary of Non-performing Assets
As of December 31,
(dollars in thousands)
				2012			2011			2010			2009			2008
Loans past due 90 days or more and accruing:
	Commercial, financial, and agricultural		$	46			75			225			422			106
	Real estate-commercial			-			-			413			-			121
	Real estate-residential			250			660			658			290			326
	Consumer and other			426			234			293			375			243
	Total past due 90 days or more and accruing			722			969			1,589			1,087			796
Loans in non-accrual status:
	Commercial, financial, and agricultural			2,429			3,917			4,070			10,282			3,134
	Real estate-commercial			10,116			9,078			11,032			5,656			2,617
	Real estate-residential			5,225			4,212			6,141			2,609			3,018
	Consumer and other			-			100			-			-			-
		Total non-accrual loans		17,770			17,307			21,243			18,547			8,769
		Total non-performing loans		18,492			18,276			22,832			19,634			9,565
Other real estate owned:
	Commercial			1,373			2,580			1,400			2,607			639
	Residential			2,183			1,655			2,340			162			90
		Total other real estate owned		3,556			4,235			3,740			2,769			729
		Total non-performing assets	$	22,048			22,511			26,572			22,403			10,294
Restructured real-estate
	debt (included in non-accrual loans)		$	4,324			4,826			4,885			-			-
Non-performing loans to total period-end loans				1.28	%		1.42	%		1.90	%		1.70	%		0.88	%
Non-performing assets to total
	period-end loans and other real estate			1.52	%		1.75	%		2.21	%		1.94	%		0.95	%
Allowance to non-performing loans				93.65	%		88.07	%		68.48	%		72.49	%		125.37	%

Loan Loss Experience and Allowance for Loan Losses

Our policy for, and the determination of the appropriate balance of, the allowance for loan losses is our most difficult, subjective, and complex accounting estimate.  It is also highly uncertain, since it is merely an estimate of the inherent risk of loss in the current loan portfolio.  Therefore, we consider this a critical accounting estimate.  Our policy and methodology for its calculation are set forth in Note 1 to the Consolidated Financial Statements.

Changes in the allowance for loan losses may arise as a result of factors both within and outside of our direct control.  For example, we may change the concentration of the loan portfolio to a particular industry, a particular loan type -- commercial, residential, consumer -- or a particular geography in our market area. These changes may increase or decrease the level of allowance necessary to reflect probable incurred losses within the portfolio. The effect of the economy, including resulting changes in the value of collateral securing loans, are outside of our control, but can have significant impact on the allowance for loan losses.  Generally, a declining economy will negatively impact the ability of borrowers to repay loans in a timely manner and can also negatively impact collateral values. These factors cause probable losses within the portfolio to increase, resulting in the need for a higher allowance for loan losses.

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The following table summarizes the changes in the allowance for loan losses for each of the last five years.

Summary of Changes in the Allowance for Loan Losses
As of and for the years ended December 31,
(dollars in thousands)
				2012			2011			2010			2009			2008
Balance at beginning of year			$	16,095			15,635			14,232			11,992			9,679
Provision charged to operations				4,300			3,775			6,150			4,345			3,805
Charge-offs:
	Commercial, financial and  agricultural			(907)			(2,082)			(2,957)			(1,063)			(1,008)
	Real estate-commercial			(746)			(263)			(678)			(327)			(28)
	Real estate-residential			(721)			(355)			(286)			(10)			-
	Consumer and other			(1,829)			(1,863)			(2,077)			(1,564)			(1,094)
				(4,203)			(4,563)			(5,998)			(2,964)			(2,130)
Recoveries:
	Commercial, financial and agricultural			168			153			243			216			54
	Real estate-commercial			3			-			47			5			90
	Real estate-residential			65			151			50			21			28
	Consumer and other			889			944			911			617			466
				1,125			1,248			1,251			859			638
		Net charge-offs:		(3,078)			(3,315)			(4,747)			(2,105)			(1,492)
Balance at end of year			$	17,317			16,095			15,635			14,232			11,992
Net charge-offs to average loans				0.23	%		0.28	%		0.41	%		0.19	%		0.15	%
Allowance to total loans				1.19	%		1.25	%		1.30	%		1.23	%		1.11	%

The allowance for loan losses was $17.3 million at December 31, 2012, up from $16.1 million at December 31, 2011. We consider the allowance for loan losses at December 31, 2012 to be at a level adequate to cover probable and inherent losses in the loan portfolio. Growth in the allowance for loans losses has been driven by a combination of general growth in the overall loan portfolio and the provision for loan losses associated with impaired loans, which were not already included in the pool-based allowance calculation. Net charge-offs to average loans decreased in 2012, continuing the downward trend from last year.  The largest dollar amounts of net charge-offs had been from commercial-related loans, but these have decreased due to improvements in the economy.  Consumer net charge-offs are generally stable in dollar terms, despite the increased portfolio.  On the other hand we are experiencing higher net charge-offs on residential-related loans.  The losses are occurring in loans to borrowers with sub-660 credit scores, and which were generally originated prior to 2008. Looking to 2013, we expect net charge-offs to stabilize around the 25 basis point level.  

At December 31, 2012 we identified a total of 94 loans totaling $17.8 million that were considered impaired.  Of these, 5, with a balance of $1.2 million outstanding, had specific reserves associated with them amounting to $0.6 million. These reserves are included in the total allowance for loan losses.  One loan relationship accounted for about half of the balance of impaired loans and two-thirds of the related allowance associated with impaired loans.  The decrease in both the amount of impaired loans and the related reserve is due to improvements in and payoffs of formerly impaired loans.

The specific reserve associated with impaired and other loans was partially funded by the existing pool-based reserves. As more fully described in the Notes to the 2012 Consolidated Financial Statements, the allowance is a combination of both specific and general reserve pool-based components.  Internally classified loans not considered impaired are included in a pool calculation.  If a loan become impaired and a specific impairment reserve is deemed necessary, a portion of the allowance becomes allocated for the specific reserve, and the total allowance is then adjusted upward or downward as necessary through the provision for loan losses. The pool-based reserve is then recalculated to determine whether additional provision is necessary on the remaining portfolio as part of the regular allowance estimation process.

As noted, we are seeing improvements in the economy.  Our local employment picture is generally faring better than the rest of the state, but is still relatively weak, just returning to a pre-recession state.  According to the New York State Department of Labor as of December 31, 2012, the Rochester MSA had an unemployment rate of 8.0%, compared to New York State’s of 8.2%, and the United States at 7.6%. While the nation’s unemployment rate declined, both New York’s and the Rochester MSA’s increased, which is likely a result of more laborers seeking to re-enter the workforce.

Noting the above improved economic conditions, and the changing mix in our portfolios, we have increased the dollar amount of allowance provided for the consumer portfolio and the residential portfolio, while decreasing the allowance for the commercial portfolio.  

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The dollar amount in the mortgage portfolio has increased due mostly to the portfolios’ balance increases, but also due to higher year-over-year nonaccrual balances. The dollar amount in the commercial portfolio has fallen recognizing its declining percentage of the entire loan portfolio, overall improvement in credit quality, and an improved business climate.

The following table presents an allocation of the allowance for loan losses and the percentage of loans in each category to total gross loans at year end for each of the last five years.  In addition to an allocation for specific problem loans, each category includes a portion of the general allowance for loan losses based upon loans outstanding, credit risk and historical charge-offs.  The unallocated portion of the allowance is not specifically associated with a loan category, but represents the portion of the allowance for which we have less precise loan data; it represents our estimate, based on our judgment, decades of lending experience, and total portfolio considerations.  Notwithstanding the following allocation, the entire allowance for loan losses is available to absorb charge-offs in any category of loans.

	Allocation of Allowance for Loan Loss and Categorical Percentage of Loan Types
	As of December 31,
		2012						2011						2010						2009						2008
		$ (1)		% (2)				$ (1)		% (2)				$ (1)		% (2)				$ (1)		% (2)				$ (1)		% (2)
Commercial (3)		5,098		51.0				7,387		51.8				7,735		54.0				7,536		55.9			$	5,689		55.0
Residential		3,108		26.7				2,307		27.9				1,867		27.5				1,402		26.2				1,383		26.7
Consumer		7,670		22.3				5,755		20.3				5,351		18.5				4,499		17.9				3,749		18.3
Unallocated		1,441		-				646		-				682		-				795		-				1,171		-
		17,317		100.0				16,095		100.0				15,635		100.0				14,232		100.0			$	11,992		100.0

⁽¹⁾   Amount of allowance for loan losses

⁽²⁾   Percent of loans in each category to total loans

⁽³⁾   Includes commercial, financial, agricultural, and commercial real estate

In December 2012, the Financial Accounting Standard Board (FASB) issued a proposed Accounting Standards Update (ASU) to Credit Losses Subtopic 825-15.  According to the FASB, the main objective in developing this proposal is to provide financial statement users with more decision-useful information about the expected credit losses on financial assets and other commitments to extend credit held by a reporting entity at each reporting date. This objective would be achieved by replacing the current impairment model, which reflects incurred credit events, with a model that recognizes expected credit risks and by requiring consideration of a broader range of reasonable and supportable information to inform credit loss estimates. These proposed amendments also would reduce complexity by replacing the numerous existing impairment models in current U.S. GAAP with a consistent measurement approach.

The proposed amendments would require an entity to impair its existing financial assets on the basis of the current estimate of contractual cash flows not expected to be collected on financial assets held at the reporting date. This impairment would be reflected as an allowance for expected credit losses. The proposed amendments would remove the existing ―”probable” threshold in U.S. GAAP for recognizing credit losses and broaden the range of information that must be considered in measuring the allowance for expected credit losses. More specifically, the estimate of expected credit losses would be based on relevant information about past events, including historical loss experience with similar assets, current conditions, and reasonable and supportable forecasts that affect the expected collectibility of the assets’ remaining contractual cash flows. An estimate of expected credit losses would always reflect both the possibility that a credit loss results and the possibility that no credit loss results. Accordingly, the proposed amendments would prohibit an entity from estimating expected credit losses solely on the basis of the most likely outcome (that is, the statistical mode).

As a result of the proposed amendments, financial assets carried at amortized cost less an allowance would reflect the current estimate of the cash flows expected to be collected at the reporting date, and the income statement would reflect credit deterioration (or improvement) that has taken place during the period. For financial assets measured at fair value with changes in fair value recognized through other comprehensive income, the balance sheet would reflect the fair value, but the income statement would reflect credit deterioration (or improvement) that has taken place during the period. An entity, however, may choose to not recognize expected credit losses on financial assets measured at fair value, with changes in fair value recognized through other comprehensive income, if both (1) the fair value of the financial asset is greater than (or equal to) the amortized cost basis; and (2) expected credit losses on the financial asset are insignificant.

We have not yet begun to evaluate the potential impact of this proposal.  However, if implemented as proposed, it might be possible that a higher allowance for loan losses would result, since losses would be recognized on an “expected” model, which takes into account the future in contrast to the current “incurred” model, which anticipates losses already incurred. Additionally we would need to consider the changes to and accounting for expected losses on investment securities.

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Funding sources - Deposits and Borrowings

Our principal sources for funding assets are deposits and borrowings.  Set forth below, and in Notes 7, 8 and 9 of the Consolidated Financial Statements is more detailed information about deposits and borrowings at period ends and during the year.

The following tables summarize the average deposits and average rates paid during each of the three years presented.

Average Deposits and Rates Paid
For the Years Ended December 31,
(dollars in thousands)
		2012						2011						2010
		Amount		Rate				Amount		Rate				Amount		Rate
Non-interest-bearing demand	$	252,751		-	%		$	207,551		-	%		$	187,957		-	%
Interest-bearing demand		179,974		0.06				155,688		0.09				139,158		0.18
Savings and money market		786,196		0.21				692,271		0.26				637,215		0.36
Time		386,115		1.01				449,404		1.53				476,486		2.00
	$	1,605,036		0.35	%		$	1,504,914		0.59	%		$	1,440,816		0.84	%

The following table sets forth time deposits of $100,000 or greater classified by the time remaining until maturity which were on deposit as of December 31, 2012 (dollars in thousands).

3 months or less	$	34,499
4 through 6 months		22,696
7 through 12 months		45,662
Over 12 months		54,732
	$	157,589

Total deposits at December 31, 2012, were $1,663.0 million and were up $116.4 million from December 31, 2011.   Retail and commercial account deposits grew $117.8 million or 8.8%, due mainly to the continued success of our products, services, and brand, as well as a continued flight-to-safety of depositors toward strong community banks. Municipal deposits fell a modest $1.4 million.  Time deposits were the only category that showed a year-over-year decline.  In this low rate environment, depositors are reluctant to invest in CD’s for long periods.  As a result they reduce both the amount they place in time deposits and the maturity terms.  

Substantially all of the retail and commercial deposit growth occurred in Monroe County, while substantially all of the municipal deposit reduction came in Ontario County, where we have a relatively larger long-term municipal deposit base of customers.  For 2013, we anticipate retail and commercial deposits to grow about 5% and municipal deposits to climb 3% from 2012. As in 2012, we expect the bulk of the deposit growth to come from Monroe County where we have opened new banking offices and our current market penetration is lower.

With our high level of federal funds sold in 2012 and 2011, we found no need to borrow short-term funds during these years.  At December 31, 2012 we had no overnight borrowings.  Depending upon our liquidity needs, we might use short-term borrowings in 2013 from time to time, as we have in the past. Short-term borrowings from the Federal Home Loan Bank of New York and the Federal Reserve Bank of New York, collateralized by loans, are used to fund near-term liquidity needs. More information about our borrowings and borrowing capacity can be found in Notes 8 and 9 to the Consolidated Financial Statements.

As of December 31, 2012, we had no short-term or medium-term borrowings beyond the payments due for the acquisition of OBS. These amount to $3.5 million due in November 2013, and a remaining contingent amount of $0.8 million with no stated maturity date.

Our long-term borrowings are in the form of junior subordinated debentures.  In 2007, we issued $20.6 million of fixed-to-floating-rate junior subordinated debentures and paid off a similar amount of floating rate debentures.  In 2006, we issued $30.9 million of floating rate junior subordinated debentures.  The terms of these borrowings are more fully described in Note 9 to the Consolidated Financial Statements.  Also in Note 9, you will find a discussion and details of interest rate swap agreements used to modify the interest rate of these debentures from floating rate to fixed rate.

Liquidity

Liquidity can be considered the lifeblood of banking.  Our Board of Directors has set general liquidity guidelines for management to meet, which can be summarized as: the ability to generate adequate amounts of cash to meet the demand from depositors who wish to withdraw funds, borrowers who require funds, and capital expansion.  Liquidity is produced by cash flows from our operating, investing, and financing activities.

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Liquidity needs generally arise from asset originations and deposit outflows. Liquidity needs can increase when asset origination (of loans and investments) exceeds net deposit inflows.  Conversely, liquidity needs are reduced when the opposite occurs.  In these instances, the needs are funded through short-term borrowings, while excess liquidity is sold into the Federal Funds market.

Our principal source of day-to-day liquidity is through wholesale, secured borrowing lines from the Federal Home Loan Bank of New York (FHLB) and the Federal Reserve Bank of New York (FRB), details of which are set out in Note 8 to the Consolidated Financial Statements.  During 2012, credit available to us under these lines increased by $135.9 million to $695.1 million at December 31, 2012, due partially to growth in the loan portfolios we pledge as collateral, and the addition of pledging commercial mortgages to the FHLB during the year. Since February 2009, we have not accessed either of these lines as deposit inflows were sufficient to provide funds for asset growth.

Secondarily, we occasionally use the liquidity source of time deposit sales in the national brokered market.  We will use this source from time to time to manage both liquidity and interest rate risk as conditions may require.  At December 31, 2012 we had none outstanding.  It is possible we will increase the balance of brokered deposits from time to time if our internal models dictate the need for additional long-term funds at relatively attractive rates.

We measure our liquidity on a daily basis with reference to our Fed Funds and Federal Reserve Bank of New York clearing account balances.  This is supplemented by a monthly Liquidity Report, which projects expected liquidity sources and uses over a twelve-month period.  The results of this model provide ALCO with a near-term view of liquidity and allow us to make appropriate plans and adjustments in a comprehensive manner, consistent with short- and long-term financial goals.  Our use of the model reduces the risk of short-term, unplanned liquidity crises, which can be costly to net interest income, or ultimately, impact a bank’s survival.

As measured using the Consolidated Statement of Cash Flows, for the year ended December 31, 2012, we used $35.6 million in net cash equivalents versus $11.5 million in net cash and equivalents in 2011.

Net cash provided by operating activities was $16.2 million in 2012 and $35.3 million in 2011.  Both the largest source and use of operating cash in each year were mortgage banking-related activities.  These activities were about 65% higher in 2012 than in 2011.  We expect 2013 operating activities to approximate levels experienced in 2012.

Cash used by investing activities in 2012 increased from 2011 to $157.2 million from $116.6 million 2011. Net portfolio loan originations were the largest user of cash.   Net purchases of securities used little cash in 2012 as purchases nearly equaled maturities and calls, while in 2011 net purchases used $12.3 million in cash. In 2011 we increased our portfolio to reinvest the high level of fed funds sold. Net portfolio loan originations were $158.3 million in 2012 and $99.4 million in 2011. The increases in both 2012 and 2011 were due to our efforts to reinvest liquid assets into higher yielding loans from fed funds sold.  In 2013, we expect net loan originations to be somewhat lower than 2011’s as we slow our rate of loan growth from recent years.

Cash provided by financing activities was $105.4 million in 2012 compared to $69.7 million in 2011.  The largest source of financing funds in 2012 and 2011 was customer deposits.  Repayments of term borrowings used cash in both years.  For 2013, we expect financing to be provided by deposits, though we may use long-term borrowings if rates are attractive. We expect deposit growth to come from consumer and business deposits, which, are expected to come mainly from Monroe County sources.

Less material, but a part of our ongoing operations, and expected to be funded by normal operations, are liquidity uses such as lease obligations and long-term debt repayments. A summary of these required commitments is included in the table below and details can be found in Notes 8, 9, 15 and 16 to the Consolidated Financial Statements.  Contingent funding commitments associated with extensions of credit to customers are set out in Note 16 to the Consolidated Financial Statements and are not included in the table below, because we are unable to determine the amount that would be drawn or its timing.

Payment due by period
As of December 31, 2012
(dollars in  thousands)
												After
									One			Three
									Year			Years			More
						Less			Through			Through			Than
						Than one			Three			Five			Five
			Total			Year			Years			Years			Years
Borrowings		$	51,547			-			-			-			51,547
Operating leases			21,316			2,465			4,737			4,598			9,516
WBI's acquisition payments			4,367			3,500			867			-			-
Cephas Capital Partners II			1,500			-			-			-			1,500
Trillium Lakefront Partners			40			40			-			-			-
	Total	$	78,770			6,005			5,604			4,598			62,563

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Total obligations are $78.8 million at year-end 2012 compared to $82.7 million at year-end 2011.  The only significant change is WBI’s commitment associated with the acquisition of OBS due to the scheduled May 2012 payment.  Except for the payments set forth in the table above, we are not aware of any material commitments in 2013.

Interest Rate Risk Management

Because our largest single source of revenue is net interest income, interest rate risk management is an important function at our Company.  We consider interest rate risk to be our most significant market-based risk.  We realize net interest income principally from the differential or spread between the interest earned on loans, investments and other interest-earning assets and the interest paid on deposits and borrowings. Loan volumes and yields, as well as the volume of and rates on investments, deposits and borrowings, are affected by market interest rates. Additionally, because of the terms and conditions of many of our loans and deposit accounts, a change in interest rates could also affect the projected maturities of the loan portfolio and/or the deposit base, which could alter our sensitivity to future changes in interest rates.

Interest rate risk management focuses on maintaining consistent growth in net interest income within Board-approved policy limits. Considered in the evaluation, among other factors are: overall credit risk, operating income, operating costs, and available capital. Our Asset/Liability Committee (ALCO) includes the Bank's CEO, President and senior officers in various disciplines including Treasury, Finance, Commercial Lending, Retail Lending, and Sales.  The Committee reports to the Board on its activities to monitor and manage interest rate risk.

Management of interest rate risk leads us to select certain techniques and instruments to utilize after considering the benefits, costs and risks associated with available alternatives.  Since we do not utilize derivative financial instruments, other than interest rate swap agreements, we usually consider one or more of the following: (1) interest rates offered on products, (2) maturity terms offered on products, (3) types of products offered, and (4) products available to us in the wholesale market such as advances from the FHLB and brokered time deposits.

ALCO's principal focus is net interest income at risk. We use a net interest margin shock simulation model as one method to identify and manage our interest rate risk profile.  The model measures projected net interest income "at-risk" and anticipated resulting changes in net income and economic value of equity.  The model is based on expected cash flows and repricing characteristics for all financial instruments at a point in time and incorporates our market-based assumptions regarding the impact of changing interest rates on these financial instruments over a twelve-month period. We also incorporate assumptions based on the historical behavior of deposit rates and balances in relation to changes in interest rates. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure net interest income or precisely predict the impact of fluctuations in interest rates on net interest income. While actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies, this model has proven to be an important guidance tool for ALCO.  The following table sets forth the results of this model for the Bank, the principal entity exposed to market risk, at December 31, 2012.

	Changes in Interest		Estimated
	Rates		Percentage Change in
	(basis points)		Future Net Interest Income
	200		-	%
	100		(2)
	No change		-
	-100		-
	-200		-

We measure net interest income at risk by estimating the changes in future net interest income resulting from instantaneous and sustained parallel shifts in interest rates of plus or minus 200 basis points over a twelve-month period.  This provides a basis or benchmark for ALCO to manage the Company's interest rate risk profile.  At December 31, 2012, a relatively small upward shock (100 basis points) would cause an estimated 2% reduction in net interest income due to our gap position (discussed below), and a larger shock would have no measurable impact as asset yields would rise considerably more than liability costs.  Downward shocks would have little impact on net interest income, because rates paid are near zero, although they could be lowered somewhat, and asset yields are near our floor rates.   We recognize the model only provides a benchmark, because it makes the simplifying assumptions that: (1) interest rates will move in a parallel direction with no change in the yield curve; (2) the interest rate moves will be instantaneous and sustained; and (3) there will be no change in the product mix as determined by customer demand or pricing policies by management.

A second tool used by ALCO is its proprietary cost of funds model.  This model is used weekly and measures actual interest rates paid on deposits and borrowings and earned on loans and investments.  This model takes into consideration current interest rates, interest rate trends, product and portfolio spreads, and projected and historical net interest income data.  Using this model, we can adjust and determine the financial impact on net interest income on a more rapid basis than the net interest margin shock simulation model, which is prepared monthly.

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A third method used to identify and manage our interest rate risk profile is the static gap analysis. Interest sensitivity gap ("gap") analysis measures the resulting difference between interest-earning assets and interest-bearing liabilities repricing or maturing within specific time periods. An asset-sensitive position indicates that there are more rate-sensitive assets than rate-sensitive liabilities repricing or maturing within specific time horizons.  This generally implies a favorable impact on net interest income in periods of rising interest rates and a negative impact in periods of falling rates. A liability-sensitive position generally implies a negative impact on net interest income in periods of rising rates and a positive impact in periods of falling rates.

The following table presents an analysis of our interest rate sensitivity gap position at December 31, 2012. Interest-earning assets are shown based on the earlier of their contractual maturity or repricing date.  Securities include the market value of available-for-sale securities, amortized cost of held-to-maturity securities, FRB and FHLB stock.  Callable securities are shown at their stated maturity.  Loans, without deferred costs, include principal amortization adjusted for estimated prepayments (principal payments in excess of contractual amounts) and non-accrual loans. All interest-bearing liabilities are shown based on the earlier of their contractual maturity or repricing date with no adjustment for decay (withdrawal) rates. Borrowings include the junior subordinated debentures.  Because the interest rate sensitivity levels shown in the table could be changed by external factors such as loan prepayments and liability decay rates, or by factors controllable by us such as asset sales, it is not an absolute reflection of our potential interest rate risk profile.

The maturities set forth are based upon contractual maturities.  Demand loans, overdrafts and certain time loans, the principal of which may be renewed in whole or in part, are included in the " One Year or Less" classification.  Our loan policy encourages a repayment schedule to be established whenever possible for loans that do not have stated contractual maturities. The policy provides that a demand loan should mature within one year of its origination, with any renewals at the then-prevailing interest rate and with the assurance that the borrower demonstrates the ability to repay on maturity of the loan.

Interest Rate Sensitivity Gap
December 31, 2012
(dollars in thousands)
			Maturity/Repricing Period
			Within 3			4 to 12			13 to 36			37 to 48			Over 48
			Months			Months			Months			Months			Months
Interest-earning assets:
	Interest-bearing deposits	$	91,159			-			-			-			-
	Securities		35,149			11,899			78,532			40,439			115,338
	Loans		469,252			180,111			387,308			180,238			232,314
Total interest-earnings assets			595,560			192,010			465,840			220,677			347,652
Interest-bearing liabilities:
	NOW accounts		196,478			-			-			-			-
	Savings and money market		812,485			-			-			-			-
	Time deposits		65,555			169,219			97,201			38,365			13
	Borrowings		51,547			3,500			867			-			-
Total interest-bearing liabilities			1,126,065			172,719			98,068			38,365			13
Interest rate swap affecting liabilities			(51,547)			-			-			-			51,547
Interest rate sensitivity gap		$	(478,958)			19,291			367,772			182,312			296,092
Cumulative gap		$	(478,958)			(459,667)			(91,895)			90,417			386,509
Cumulative gap ratio (1)			55.4	%		63.1	%		93.2	%		106.5	%		126.9	%
Cumulative gap as percent of total assets			(25.4)	%		(24.4)	%		(4.9)	%		4.8	%		20.5	%

⁽¹⁾   Cumulative total interest-earning assets divided by cumulative total interest-bearing liabilities.

The table indicates that $479.0 million more interest-bearing liabilities (than interest-earning assets) will reprice in the 0-3 month range. For the 4-12 month period, we are asset sensitive, as $19.3 million more of interest-earning assets are repricing than interest-bearing liabilities.  For the entire one-year range, we are repricing $459.7 million more interest-bearing liabilities than assets and at 63.1% are within our gap ratio targets of 30% to 125%. We are asset sensitive at $367.8 million for the 13-36 month range, $182.3 million for the 37 to 48 month year range, and $296.1 million over 48 months. For the entire portfolio range, we are asset sensitive at $386.5 million versus asset sensitive of $324.9 million last year, mostly reflecting the growth in non-interest-bearing liabilities.

Our product mix is such that nearly all assets and liabilities reprice or mature within five years.  With such a balance sheet profile, we face interest rate risk over the short to medium term. We consider this interest rate gap manageable, as substantially all of the NOW accounts and savings balances are considered insensitive to rate changes.  

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     The following table provides additional detail of the interest sensitivity specifically of certain commercial and industrial loans as of December 31, 2012.

Maturity and Repricing of Commercial and Industrial Loans
As of December 31, 2012
(dollars in thousands)
							After
							One
				One			Through			After
				Year or			Five			Five
				Less			Years			Years			Total
Commercial and industrial loans			$	167,958		$	39,465		$	6,044		$	213,467
	Maturing or repricing after one year:
		with a fixed interest rate	$	1,278			39,465			6,044			46,787
		with a floating or adjustable rate	$	166,680			-			-			166,680

Capital and Dividends

     The Company and Bank are each subject to certain regulatory capital requirements.  As of December 31, 2012, the Company and Bank each substantially exceeded all capital requirements to which they were subject.  A full description of these requirements and applicable calculations are set out in Note 17 to the Consolidated Financial Statements.

     Our goal is to maintain the Company's and Bank's categorization as "well-capitalized," and our current operating plans project the Company and Bank to remain at well-capitalized status.  This will be accomplished mainly through balancing asset growth and net capital formation (net income less dividends and treasury stock purchases).  We can take other steps to improve capital ratios as considered necessary, such as dividend reductions, asset sales, issuing equity securities, or issuing additional debt qualifying as regulatory capital and other means.  None of these are contemplated in 2013.  

     On September 12, 2010, the Basel Committee on Banking Supervision released its proposal for revising capital requirements for internationally active financial institutions. These new standards are called Basel III.  On June 7, 2012, the US banking regulators published their Notice of Proposed Rule Making (NPRM) to implement changes in capital rules. In two different actions, both the Federal Reserve and the Federal Deposit Insurance Corporation have proposed new capital requirements for all banks that essentially accept all recommendations from the Basel III accord. While we had anticipated some changes for community banks, we were surprised that non-international banks like us would be within the scope of much of the proposal. The proposed rule will increase required capital and change risk-weightings for many assets. The proposed rule will apply across all institutions regardless of their systematic risk profile.  While the proposed rule was to be effective as of January 1, 2013, full compliance with most aspects would not be required until January 1, 2019.  In late 2012, the regulators indefinitely delayed implementation of the proposal. We have not determined the financial impact of the proposed rule on us, because of the regulatory uncertainty and the deferred implementation.

The key features that generally relate to banks like ours are:

·

New minimum regulatory capital ratio requirements

o

A newly-introduced “common equity” tier 1 ratio of 4.5%,

o

Tier 1 capital ratio of 6% (increased from the current requirement of 4%),

o

Total capital ratio of 8% of risk-weighted assets (unchanged from the current requirement), and

o

Tier 1 leverage ratio of 4%.

·

New capital conservation buffer: To avoid restrictions on capital distributions (e.g. distributing dividends) and discretionary bonus payments to executive officers, a bank will be required to hold an additional buffer of common equity Tier 1 capital in an amount above 2.5% of total risk-weighted assets in addition to the minimum common equity Tier 1, Tier 1, and total risk-based capital ratios.

·

Capital is redefined, what is included in Tier 1 capital will change:

o

Cumulative preferred and trust preferred instruments would be excluded from Tier 1 capital.

o

Regulatory capital deductions would be stricter than those currently required. Examples of the more stringent requirements for common equity Tier 1 capital are:

§

Unrealized gains and losses on all available-for-sale securities and gains and losses associated with certain cash flow hedges will now flow through to common equity Tier 1 capital. Currently, these gains and losses are neutralized when calculating regulatory capital;

§

Goodwill and net defined benefit pension plan assets will be deducted;

§

Deferred tax assets (DTAs) arising from operating losses and tax credit carry forwards will be deducted;

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§

Mortgage servicing assets, deferred tax assets arising from temporary differences that an organization could not realize through net operating loss carry backs, and the common stock of unconsolidated financial institutions each would be individually limited to 10% of common equity Tier 1 capital, and, in the aggregate, to 15% of common equity Tier 1 capital; and

§

The amount of minority interests permitted in capital would be more limited.

·

Asset risk-weighting changed: The most significant changes to the calculation of risk-weighted assets are:

o

The treatment of exposures to the U.S. government, U.S. public sector entities (such as states and municipalities), U.S. government-sponsored entities, and U.S. depository institutions would be unchanged from the current rules. However, the risk weight for an exposure to a foreign bank or public-sector entity (PSE), such as a state or municipality, would be assigned based on the rating of its home country.

o

Residential mortgage exposures would be assigned to a range of risk weight categories (between 35 and 200%) based upon the loan-to-value (LTV) ratio of the mortgage and certain mortgage product features. Currently, most residential mortgages are assigned a 50% risk weight despite the broad range of risk profiles associated with mortgage exposures.

o

Certain commercial real estate loans are assigned a 150% risk weight.

o

Nonaccrual loans and loans greater than 90 days past due are assigned a 150% risk weight.

     We expect capital to increase in 2013 by a greater amount than in 2012 due to a combination of higher net income and lower dividends.  In December 2012, with uncertainty caused by the so-called “fiscal cliff”, we accelerated a $1.63 per share dividend that would have been paid in February 2013. So, per share dividends in 2013 will reflect only the semi-annual dividend paid in the summer, while 2012 included both semi-annual dividends and the December 2012 dividend.  Total dividends thus were $4.74 per outstanding common share or $9.0 million in 2012 and $5.4 million or $2.87 per outstanding common share in 2011. Payment of dividends by the Bank to the Company is limited in certain circumstances, which are discussed in Note 11 to the Consolidated Financial Statements.  You can find historical dividend information in the Common Stock Data section below and in the Financial Highlights.  While we cannot provide assurance that the amount and timing of dividends paid in recent years will continue, we have no knowledge of current activities that would require us to reduce dividends.

     From time to time the Company purchases shares for treasury and re-issues shares from treasury.  In 2012, activity was much higher than in recent years, and generally related to stock option exercises.  This was due to employee retirements and tax planning activities of option holders in connection with the “fiscal cliff” uncertainty.  We expect common shares to be available in the open market resulting from stock option exercises and shareholders' sales.  From time to time, we may buy shares into treasury, from which we fund our ESOP and other employee awards, including the annual Arthur S. Hamlin Award.  In 2013, we expect to purchase more shares into treasury for past stock option exercises than in recent years due to 2012’s higher activity.

Off Balance Sheet Arrangements

     We offer certain financial products which are not recorded on our balance sheet because actual funds have not been extended.  These are in the form of standby letters of credit and loan commitments.  We have enumerated these in Note 16 to the Consolidated Financial Statements.  At December 31, 2012, there were no material commitments to extend credit which represent unusual risks outside of our normal course of business.

Legislative and Regulatory Matters

     On July 21, 2010, the President signed into law The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Financial Reform Act”). The Financial Reform Act significantly alters financial regulation in the United States by creating new regulators, regulating new markets, bringing new firms into the regulatory arena, and providing new rulemaking and enforcement powers to regulators. The Financial Reform Act is intended to address specific issues that contributed to the financial crisis and is heavily remedial in nature. Many of the provisions in the Act are applicable to larger institutions (greater than $10 billion in assets, which does not include us). A summary of the Financial Reform Act’s principal provisions that have impacted or may potentially impact the Company follows.

     The Financial Reform Act created the Financial Stability Oversight Council with the primary obligation to identify, monitor, and assist in the management of systemic risk that may pose a threat to the country’s financial system.  Included in its responsibilities is a requirement to review and, at its option, submit comments as appropriate to any standard-setting body (such as the Financial Accounting Standards Board [FASB]) with respect to existing or proposed accounting principles, standards or procedures.  Though this responsibility may not directly impact the Company, the Council’s review and commentary on accounting matters may result in more consideration by standard-setters of the volatility created by some of its current and proposed standards.  We hope the Council’s activities will bring restraint to standard setters and temper ineffective proposals such as mark-to-market accounting for all financial instruments.

     The Act permanently implemented FDIC insurance coverage for all deposit accounts up to $250,000. Furthermore, the insurance premium assessment base was revised from all domestic deposits to the average of total assets less tangible equity.  The minimum reserve ratio of the deposit insurance fund was increased from 1.15% to 1.35%, with the increase to be covered by assessments on

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insured institutions with assets over $10 billion until the new reserve ratio is reached. We discussed the impact of this provision under “Operating Expenses” above, but in summary, this provision has significantly reduced the Company’s deposit insurance premiums.

     The Act creates the Consumer Financial Protection Bureau (CFPB). It has an independent budget and is housed in the Federal Reserve Board, but not subject to its jurisdiction.  The CFPB has rulemaking authority to promulgate regulations regarding consumer financial products and services offered by all banks and thrifts, their affiliates and many non-bank financial services firms.  We cannot determine what the impact the CFPB’s rules and regulations might have on the Company, its product offerings, its customers’ ability to purchase products to meet their specific needs, or the Company’s general business practices, but they are likely to be significant given the CFPB’s broad powers.

     The so-called “Durbin Amendment” requires the Federal Reserve Board to adopt regulations limiting interchange fees that can be charged in an electronic debit card transaction to the “reasonable and proportionate” costs related to the incremental cost of the transaction. Banks under $10 billion in assets are exempt, which would include the Company.  Final rules were implemented in 2011.  While the rules are not designed to negatively impact smaller banks, and to date we have not experienced any detrimental effects. The Company contracts with large debit card processors with which we have relatively weak bargaining power. It is possible these processors, as a result of the Act, will earn lower revenues, leaving less revenue per transaction for the Company.

     The Act has changed oversight authority for the prudential regulation of our Company so both the Bank and its holding company will be regulated by the Office of the Comptroller of the Currency (OCC), because the Company has less than $50 billion in assets.  Formerly the Bank was regulated by the OCC and the holding company was regulated by the Federal Reserve Board.

     The Act significantly changes the regulatory structure of the mortgage lending business, but, in effect, has codified the prudent and customer-focused activities the Company has always pursued.  For example, the Act provides that a creditor must make a reasonable and good faith determination of a consumer’s ability to repay before making a residential mortgage loan. The determination must be based on verified and documented information and must take into account all applicable taxes, insurance and assessments. While not previously enforced by regulation, this has been our consistent practice.

     On the other hand, the Act does add substantial burdens to the Company by, subject to certain exemptions, requiring the establishment of an escrow account in connection with a closed-end consumer credit transaction secured by a first lien on a consumer’s principal dwelling for the payment of taxes and hazard insurance and, if applicable, flood insurance, mortgage insurance, ground rents and any other required periodic payments or premiums with respect to the property or the loan terms. The Company has not historically escrowed such payments. We provide financial advice and a savings product for customers to self-escrow, believing that customers are the best stewards and managers of their personal cash flow sources and uses, and government is ill-suited to dictate how much and when individual consumers should save to meet their financial obligations. That notwithstanding, we are able to satisfy the escrow requirements as proposed.

     The Act also modified the calculation for a loan to be subject to “high-cost-loan” status under the Home Ownership and Equity Protection Act (HOEPA) by requiring the Annual Percentage Rate (APR) to be compared to the average prime offer rate for a comparable transaction and not the rate on U.S. Treasury securities having a comparable maturity. The points and fees trigger is lowered, and a prepayment fee trigger is added.  We believe any comparison is a flawed policy, because low balance loans, those most beneficial to first-time homeowners, would carry an interest rate unprofitable to the Company. Principally the methodology ignores that originating a loan, no matter what its balance, has certain fixed costs, and these costs when spread over a smaller balance result in a higher effective interest rate.

Recent Accounting Standards to be implemented in Future Periods

          The following presents a summary of Accounting Standards Updates (ASU’s), exclusive of technical correction ASU’s that will be subject to implementation in future periods.

ASU 2011-11 Disclosures about Offsetting Assets and Liabilities, issued December 2011, and ASU 2013-01 Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, issued January 2013. The amendments in these Updates require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position.  The amendments are intended to bring closer convergence of US GAAP with International Financial Reporting Standards (IFRS). The ASU applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210-20-45 or Section 815-10-45 or subject to an enforceable master netting arrangement or similar agreement. The amendments are effective for us beginning in 2013. Because we do not currently engage in these types of transactions, we do not anticipate any material impact to our financial statements.

ASU 2012-02 Testing Indefinite-Lived Intangible Assets for Impairment, issued July 2012. The amendments in this update permit an entity first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, Intangibles—Goodwill and Other—General Intangibles Other than Goodwill. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. Previous guidance in Subtopic 350-30 required an entity to test indefinite-lived intangible assets for

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impairment, on at least an annual basis, by comparing the fair value of the asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an entity should recognize an impairment loss in the amount of that excess. In accordance with the amendments in this Update, an entity will have an option not to calculate annually the fair value of an indefinite-lived intangible asset if the entity determines that it is not more likely than not that the asset is impaired. Permitting an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance in Update 2011-08.  This update is effective for us beginning in 2013, although earlier adoption is permitted. Since we have recorded no indefinite-lived intangible assets, implementation of this update will have no impact on the financial condition or results of operations of the Company.

ASU 2013-02 Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, issued February 2013. The amendments in this Update seek to improve the reporting of reclassifications out of accumulated other comprehensive income by requiring an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (GAAP) to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account (for example, inventory) instead of directly to income or expense in the same reporting period. The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. The amendments are effective for us beginning in 2013, and will result in additional disclosures, but no change in accounting for the relevant transactions.

Summary Quarterly Financial Data

     In the tables below, we present summary quarterly financial results for each of the quarters in the years ended December 31, 2012, and 2011.  The sum of each quarter's earnings-per-share data may differ from the full year's results due to rounding (in thousands except share data).

2012 Quarters:		1st			2nd			3rd			4th
Net interest income	$	16,193		$	16,038		$	16,357		$	17,015
Provision for loan losses		(1,150)			(1,150)			(1,500)			(500)
Non-interest income		8,182			8,758			8,910			9,273
Operating expenses		(18,144)			(17,243)			(16,692)			(17,296)
Income taxes		(1,510)			(1,955)			(2,138)			(2,831)
Noncontrolling interests		(42)			108			51			103
Net income	$	3,529		$	4,556		$	4,988		$	5,764
Basic earnings per share	$	1.87		$	2.41		$	2.64		$	3.06
Diluted earnings per share	$	1.83		$	2.36		$	2.58		$	2.99
2011 Quarters:
Net interest income	$	14,823		$	15,145		$	15,310		$	16,195
Provision for loan losses		(750)			(140)			(1,500)			(1,385)
Non-interest income		7,192			6,919			7,338			7,359
Operating expenses		(15,321)			(14,835)			(13,961)			(20,286)
Income taxes		(1,605)			(2,045)			(2,162)			(366)
Noncontrolling interests		-			-			-			387
Net income	$	4,339		$	5,044		$	5,025		$	1,904
Basic earnings per share	$	2.30		$	2.67		$	2.66		$	1.01
Diluted earnings per share	$	2.26		$	2.63		$	2.61		$	0.99

      The fourth quarter of 2012’s results were positively impacted by growth in both net interest income and non-interest income, and lower provision for loan losses due to credit improvements.  This was offset by higher operating expenses associated with higher bonus accruals based upon full-year earnings and general expenses associated with growth. The fourth quarter of 2011’s results were positively impacted by higher net interest income due to loan portfolio growth, offset by significantly higher operating expenses driven by higher incentive stock plan accruals associated with the increase in the price of the Company’s stock, acquisition costs of OBS, and higher intangible amortization.

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Our Common Stock

     At December 31, 2012, we had approximately 1,500 shareholders of record. Information about beneficial ownership of the Company's stock by directors and certain officers is set forth in the Company’s Proxy Statement for the 2013 Annual Meeting of Shareholders. Market value and dividend information is set forth in table below.  The Company currently pays a semi-annual dividend in February and August (exclusive of the acceleration of February 2013’s dividend to December 2012).  We expect to continue to pay cash dividends to our stockholders for the foreseeable future.

     The following table sets forth, for the monthly period indicated in 2012, the total number of shares purchased and the price paid per share by The Canandaigua National Bank and Trust Company (Bank) for the Arthur S. Hamlin Award, the Canandaigua National Corporation Employee Stock Ownership Plan (ESOP) and the Canandaigua National Corporation for treasury.  Each of these entities is considered an affiliated purchaser of the Company under Item 703 of Regulation S-K.  Shares repurchased by Company are not part of a publicly announced plan or program.  The Bank, ESOP, and Company purchase prices per share were determined based on the most recent price established at the sealed-bid auction immediately preceding the purchase. Purchases occur on an ad-hoc basis when shares become available in the marketplace and the Company is interested in purchasing these shares for the corporate purposes discussed above. Sales occur when corporate needs require the use of shares and there are none available in the market at the time.

Purchases and Sales of Equity Securities for the Year Ended December 31, 2012
		Total			Average
		Shares			Price Per
Date		Purchased (Sold) (#)			Share ($)		Purpose
April		100		$	152.56		Treasury
June		(243)		$	153.53		Compensation
June		1,336		$	154.86		Treasury
July		222		$	149.24		Treasury
November		623		$	149.75		Treasury
December		7,434		$	147.07		Treasury
December		(21)		$	147.07		Compensation
Total  purchases		9,715
Total sales		(264)

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        While the Company's stock is not actively traded, from time to time, shareholders sell shares to interested persons in sealed-bid public auctions administered by the Bank’s Trust Department at the request of selling shareholders. Our stock is not listed with a national securities exchange. Due to the limited number of transactions, the quarterly high, low and weighted average sale prices may not be indicative of the actual market value of the Company's stock. The following table sets forth a summary of transactions by selling shareholders and bidders in the Company's common stock during each period for transactions that were administered by the Bank’s Trust Department.  Also included are the book value at quarter end, and semi-annual dividends paid per share since the first quarter of 2010. The $1.63 per share dividend paid in December 2012 was accelerated from the semi-annual dividend payment that would have been paid in February 2013.

		#			Quarterly			Quarterly			Quarterly
		Shares			Average			High			Low			Book			Dividend
		Sold			Sales Price			Sales Price			Sales Price			Value			Paid
2012
4th Quarter		5,034		$	145.51		$	170.00		$	125.00		$	74.64		$	1.63
3rd Quarter		2,748		$	148.70		$	190.00		$	138.00		$	73.42		$	1.61
2nd Quarter		10,635		$	152.17		$	185.00		$	137.51		$	72.57			-
1st Quarter		1,926		$	147.48		$	165.78		$	141.93		$	71.00		$	1.50
2011
4th Quarter		1,492		$	129.22		$	150.00		$	123.75		$	71.95			-
3rd Quarter		3,216		$	111.34		$	118.13		$	107.50		$	69.55		$	1.44
2nd Quarter		3,036		$	103.87		$	110.00		$	102.50		$	69.34			-
1st Quarter		2,948		$	99.89		$	107.21		$	98.69		$	66.71		$	1.43
2010
4th Quarter		2,528		$	95.85		$	102.90		$	93.91		$	65.54			-
3rd Quarter		3,172		$	91.89		$	100.00		$	90.03		$	63.55		$	1.43
2nd Quarter		3,200		$	88.44		$	92.50		$	87.53		$	62.99			-
1st Quarter		3,040		$	85.37		$	91.75		$	83.75		$	59.93		$	1.29

Although the Company’s common stock is not listed with a national securities exchange, it trades sporadically on the Over-the-Counter Bulletin Board System under the symbol CNND or CNND.OB. The following table sets forth a summary of information about these trades. Due to the limited number of transactions, the quarterly high, low and weighted average bid/ask prices may not be indicative of the actual market value of the Company's stock.

The OTC Bulletin Board^® (OTCBB) is a regulated quotation service that displays real-time quotes, last-sale prices, and volume information in over-the-counter (OTC) equity securities. An OTC equity security generally is any equity that is not listed or traded on NASDAQ^® or a national securities exchange. The OTCBB is a quotation medium for subscribing members, not an issuer listing service, and should not be confused with The NASDAQ Stock Market^SM.  Investors must contact a broker/dealer to trade OTCBB securities. Investors do not have direct access to the OTCBB service. The Securities and Exchange Commission's (SEC's) Order-Handling Rules which apply to NASDAQ-listed securities do not apply to OTCBB securities.  The OTCBB market quotations set forth below reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

					Quarterly			Quarterly			Quarterly
		#			Average			High			Low
		Shares			Bid/Ask Price			Bid/Ask Price			Bid/Ask Price
2012
4th Quarter		1,963		$	123.24		$	130.00		$	115.00
3rd Quarter		3,055		$	130.97		$	200.01		$	120.00
2nd Quarter		1,897		$	112.01		$	135.00		$	105.00
1st Quarter		5,603		$	93.56		$	105.00		$	87.50
2011
4th Quarter		7,375		$	97.00		$	160.00		$	79.64
3rd Quarter		2,456		$	97.70		$	105.00		$	87.50
2nd Quarter		636		$	90.12		$	93.75		$	86.50
1st Quarter		2,536		$	85.26		$	88.50		$	83.75
2010
4th Quarter		2,544		$	81.82		$	90.00		$	78.25
3rd Quarter		3,256		$	75.55		$	78.75		$	70.25
2nd Quarter		748		$	78.01		$	80.00		$	75.25
1st Quarter		1,808		$	77.42		$	82.50		$	70.00

25

 

Management Report on the Effectiveness of

Internal Controls over Financial Reporting

Management of Canandaigua National Corporation (the Company) is responsible for the preparation, integrity, and fair presentation of its published financial statements and all other information presented in its annual report. The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles and, as such, include amounts based on informed judgments, assumptions and estimates made by management.

Management is also responsible for establishing and maintaining adequate and effective internal control over financial reporting presented in conformity with both U.S. generally accepted accounting principles and the Federal Financial Institutions Examination Council instructions for Consolidated Reports of Condition and Income (call report instructions) and as defined in Exchange Act Rules 13a-15(f).  This internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.

There are inherent limitations in any internal control, including the possibility of human error and the circumvention of overriding controls.  Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation.  Further, because of changes in conditions, the effectiveness of internal control may vary over time.

Management assessed the Company's internal control over financial reporting presented in conformity with both U.S. generally accepted accounting principles and call report instructions as of December 31, 2012.  This assessment was based on criteria for effective internal control over financial reporting described in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on this assessment, management believes that, as of December 31, 2012, the Company maintained effective internal control over financial reporting presented in conformity with both U.S. generally accepted accounting principles and call report instructions.

KPMG LLP, an independent registered public accounting firm, has audited the consolidated financial statements included in the annual report and the effectiveness of the Company's internal control over financial reporting as of December 31, 2012.

Management is also responsible for complying with federal laws and regulations concerning dividend restrictions and loans to insiders, designated by the FDIC as safety and soundness laws and regulations.

Management assessed compliance with the aforementioned designated safety and soundness laws and regulations.  Based on this assessment, management believes that the Company complied, in all material respects, with such designated laws and regulations relating to safety and soundness during the year ended December 31, 2012.

February 21, 2013

/s/ George W. Hamlin, IV

/s/ Lawrence A. Heilbronner

George W. Hamlin, IV

Lawrence A. Heilbronner

Chairman and Chief Executive Officer

Executive Vice President and Chief Financial Officer

26

 

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Canandaigua National Corporation:

We have audited Canandaigua National Corporation’s (the Company) internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on the Effectiveness of Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because management’s assessment and our audit were conducted to also meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management’s assessment and our audit of the Company’s internal control over financial reporting included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Canandaigua National Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We do not express an opinion or any other form of assurance on management’s statement referring to compliance with laws and regulations.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Canandaigua National Corporation and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012, and our report dated February 21, 2013 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Rochester, New York

February 21, 2013

27

 

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Canandaigua National Corporation:

We have audited the accompanying consolidated balance sheets of Canandaigua National Corporation and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Canandaigua National Corporation and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Canandaigua National Corporation’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 21, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ KPMG LLP

Rochester, New York

February 21, 2013

28

CANANDAIGUA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2012 and December 31, 2011 (dollars in thousands, except per share data)

					2012			2011
	Assets
Cash and due from banks				$	47,748			52,715
Interest-bearing deposits with other financial institutions					8,767			6,490
Federal funds sold					34,644			67,535
Securities:
		- Available for sale, at fair value			102,774			114,258
		- Held-to-maturity (fair value of $180,015 in 2012 and $172,517 in 2011)			175,850			167,225
Loans - net					1,441,455			1,276,426
Premises and equipment – net					15,119			16,101
Accrued interest receivable					6,596			6,627
Federal Home Loan Bank stock and Federal Reserve Bank stock					2,733			2,656
Goodwill					15,570			15,570
Intangible assets – net					6,233			7,737
Prepaid FDIC assessment					2,824			3,905
Other assets					26,715			23,519
			Total Assets	$	1,887,028			1,760,764
	Liabilities and Stockholders' Equity
Deposits:
	Demand
		Non-interest bearing		$	283,547			227,284
		Interest bearing			196,478			175,409
	Savings and money market				812,485			745,713
	Time				370,353			398,204
			Total deposits		1,662,863			1,546,610
Borrowings					4,296			6,836
Junior subordinated debentures					51,547			51,547
Accrued interest payable and other liabilities					23,959			20,533
			Total Liabilities		1,742,665			1,625,526
Canandaigua National Corporation stockholders' equity:
	Preferred stock, $.01 par value; 4,000,000 shares
		authorized, no shares issued or outstanding			-			-
	Common stock, $5.00 par value; 16,000,000 shares
		authorized, 1,946,496 shares issued in 2012 and 2011			9,732			9,732
	Additional paid-in-capital				9,974			8,834
	Retained earnings				129,502			120,675
	Treasury stock, at cost (40,993 shares at December 31, 2012
		and 59,242 at December 31, 2011)			(4,046)			(4,912)
	Accumulated other comprehensive income, net				(2,937)			(1,455)
	Total Canandaigua National Corporation Stockholders' Equity				142,225			132,874
	Non-controlling interests				2,138			2,364
		Total Equity			144,363			135,238
		Total Liabilities and Equity		$	1,887,028			1,760,764

See accompanying notes to consolidated financial statements.

29

CANANDAIGUA NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2012, 2011 and 2010

(dollars in thousands, except per share data)

					2012			2011			2010
Interest income:
	Loans, including fees			$	66,963			64,907			67,571
	Securities				7,014			7,936			8,652
	Federal funds sold				132			354			207
	Other				13			24			36
			Total interest income		74,122			73,221			76,466
Interest expense:
	Deposits				5,654			8,843			12,113
	Borrowings				92			-			207
	Junior subordinated debentures				2,773			2,905			3,005
			Total interest expense		8,519			11,748			15,325
			Net interest income		65,603			61,473			61,141
Provision for loan losses					4,300			3,775			6,150
			Net interest income after provision for loan losses		61,303			57,698			54,991
Non-interest income:
	Service charges on deposit accounts				11,713			10,972			10,725
	Trust and investment services income				12,916			12,445			10,984
	Brokerage and investment subadvisory services income				2,819			280			86
	Net gain on sale of mortgage loans				3,959			2,126			2,366
	Loan servicing income, net				876			928			877
	Loan-related fees				431			267			351
	Loss on securities transactions, net				(118)			(191)			(170)
	Other non-interest income				2,527			1,981			1,502
			Total non-interest income		35,123			28,808			26,721
Operating expenses:
	Salaries and employee benefits				38,407			35,019			30,526
	Occupancy, net				8,142			7,530			6,805
	Technology and data processing				5,309			4,480			3,881
	Professional and other services				3,812			4,751			3,297
	Marketing and public relations				3,077			2,829			2,515
	Office supplies, printing and postage				1,665			1,556			1,470
	Intangible amortization				1,504			1,187			995
	Other real estate operations				854			1,049			1,297
	FDIC insurance				1,186			1,405			2,152
	Other operating expenses				5,419			4,597			4,913
			Total operating expenses		69,375			64,403			57,851
			Income before income taxes		27,051			22,103			23,861
Income taxes					8,434			6,178			6,205
			Net income attributable to noncontrolling interests and
			Canandaigua National Corporation		18,617			15,925			17,656
Less: Net loss attributable to noncontrolling interests					(220)			(387)			-
Net income attributable to Canandaigua National Corporation				$	18,837			16,312			17,656
Basic earnings per share				$	9.98			8.64			9.35
Diluted earnings per share				$	9.76			8.48			9.20

See accompanying notes to consolidated financial statements.

30

CANANDAIGUA NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

[WITH RESPECTIVE TAX INFORMATION PRESENTED PARENTHETICALLY]
Years Ended December 31, 2012, 2011 and 2010
(dollars in thousands)

						2012		2011		2010
Net income					$	18,617		15,925		17,656
	Other comprehensive income:
		Change in fair value of
			interest rate swaps,
			net of taxes of ($760), ($1,341) and $180 respectively			(987)		(2,141)		324
		Change in unrealized gain on
			on securities available for sale,
			net of taxes of ($329), $180 and ($483) respectively			(468)		346		(971)
		Plus reclassification adjustment
			for realized gains and losses included in
			net income on called securities,
			net of taxes of ($9), $69 and $44 respectively			(27)		141		86
				Other comprehensive income	$	(1,482)		(1,654)		(561)
Total comprehensive income						17,135		14,271		17,095
	Comprehensive income attributable
		to the noncontrolling interest			$	(220)		(387)		-
	Comprehensive income attributable to the Company				$	17,355		14,658		17,095

See accompanying notes to consolidated financial statements.

31

CANANDAIGUA NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years Ended December 31, 2012, 2011 and 2010

(dollars in thousands, except share data)

																			Accumulated
					Number of					Additional									Other			Non-
					Shares		Common			Paid-in			Retained			Treasury			Comprehensive			controlling
					Outstanding		Stock			Capital			Earnings			Stock			Income (Loss)			Interest				Total
Balance at December 31, 2009					1,883,344		$	9,732			8,591			97,795			(5,143)			760			-			111,735
	Comprehensive income:
		Change in fair value of
			interest rate swaps,
			net of taxes of $180					-			-			-			-			324			-			324
		Change in unrealized gain on
			on securities available for sale,
			net of taxes of ($483)					-			-			-			-			(971)			-			(971)
		Plus reclassification adjustment
			for realized losses included in
			net income on called securities,
			net of taxes of $44					-			-			-			-			86			-			86
		Net income						-			-			17,656			-			-			-			17,656
			Total comprehensive income
	Purchase of treasury stock				(5,564)			-			-			-			(511)			-			-			(511)
	Shares issued as compensation				624			-			-			-			54			-			-			54
	Exercise of stock options,
	including tax benefit of $232				10,344			-			232			(562)			872			-			-			542
	Cash dividend - $ 2.72 per share							-			-			(5,121)			-			-			-			(5,121)
Balance at December 31, 2010					1,888,748		$	9,732			8,823			109,768			(4,728)			199			-			123,794
	Comprehensive income:
		Change in fair value of
			interest rate swaps,
			net of taxes of ($1,341)					-			-			-			-			(2,141)			-			(2,141)
		Change in unrealized gain on
			on securities available for sale,
			net of taxes of $180					-			-			-			-			346			-			346
		Plus reclassification adjustment
			for realized gains and losses included in
			net income on called securities,
			net of taxes of $69					-			-			-			-			141			-			141
		Net income attributable to non-
			controlling interest and
			Canandaigua National Corporation					-			-			16,312			-			-			(387)			15,925
	Total comprehensive income							-			-			16,312			-			(1,654)			(387)			14,271
	Purchase of treasury stock				(1,912)			-			-			-			(219)			-			-			(219)
	Shares issued as compensation				418			-			11			-			35			-			-			46
	Cash dividend - $ 2.87 per share							-			-			(5,405)			-			-			-			(5,405)
	Change in non-controlling interest							-			-			-			-			-			2,757			2,757
	Dividend to non-controlling interests							-			-			-			-			-			(6)			(6)
Balance at December 31, 2011					1,887,254		$	9,732			8,834			120,675			(4,912)			(1,455)			2,364			135,238
	Comprehensive income:
		Change in fair value of
			interest rate swaps,
			net of taxes of ($760)					-			-			-			-			(987)			-			(987)
		Change in unrealized gain on
			on securities available for sale,
			net of taxes of ($329)					-			-			-			-			(468)			-			(468)
		Plus reclassification adjustment
			for realized gains and losses included in
			net income on called securities,
			net of taxes of ($9)					-			-			-			-			(27)			-			(27)
		Net income (loss) attributable to non-
			controlling interest and
			Canandaigua National Corporation					-			-			18,837			-			-			(220)			18,617
	Total comprehensive income							-			-			18,837			-			(1,482)			(220)			17,135
	Purchase of treasury stock				(9,715)			-			-			-			(1,442)			-			-			(1,442)
	Shares issued as compensation				264			-			18			-			21			-			-			39
	Exercise of stock options ($1,122 tax benefit)				27,700			-			1,122			(1,035)			2,287			-			-			2,374
	Cash dividend - $ 4.74 per share							-			-			(8,975)			-			-			-			(8,975)
	Dividend to non-controlling interests							-			-			-			-			-			(6)			(6)
Balance at December 31, 2012					1,905,503		$	9,732			9,974			129,502			(4,046)			(2,937)			2,138			144,363

See accompanying notes to consolidated financial statements.

32

CANANDAIGUA NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2012, 2011 and 2010
(dollars in thousands)

						2012			2011			2010
Cash flow from operating activities:
	Net income attributable to Canandaigua National Corporation				$	18,837			16,312			17,656
	Adjustments to reconcile net income to
		Net cash provided by operating activities:
			Depreciation, amortization and accretion			7,216			6,097			5,285
			Provision for loan losses			4,300			3,775			6,150
			Gain on sale of premises and equipment and other real estate, net			(213)			(105)			(32)
			Writedown of other real estate			200			208			493
			Deferred income tax benefit			(1,328)			(574)			(763)
			Income from equity-method investments, net			(336)			(363)			59
			Loss on calls of securities and write-down, net			118			191			170
			Gain on sale of mortgage loans, net			(3,959)			(2,126)			(2,366)
			Originations of loans held for sale			(271,815)			(166,240)			(203,582)
			Proceeds from sale of loans held for sale			262,217			174,923			198,492
			Increase in other assets			(689)			304			3,564
			Increase in all other liabilities			1,679			2,930			(2,857)
				Net cash provided by operating activities		16,227			35,332			22,269
Cash flow from investing activities:
	Securities available-for-sale:
		Proceeds from maturities and calls				103,842			80,156			65,844
		Purchases				(93,322)			(79,888)			(62,409)
	Securities held to maturity:
		Proceeds from maturities and calls				36,329			42,613			33,256
		Purchases				(46,632)			(55,228)			(31,076)
	Loan originations in excess of principal collections, net					(158,306)			(99,398)			(45,135)
	Purchase of premises and equipment, net					(1,597)			(4,044)			(4,428)
	Calls of FHLB stock, net of purchases of FHLB and FRB stock					(95)			(196)			229
	Other investments  - net					(679)			(5)			(752)
	Acquisition of WBI net of cash acquired					-			(1,725)			-
	Proceeds from sale of other real estate					3,261			1,158			1,144
				Net cash used by investing activities		(157,199)			(116,557)			(43,327)
Cash flow from financing activities:
	Net increase in demand, savings and money market deposits					144,104			163,466			96,846
	Net decrease in time deposits					(27,851)			(90,186)			(1,213)
	Principal repayments of term borrowings					(2,632)			(330)			(9,534)
	Proceeds from sale of treasury stock					39			46			54
	Payments to acquire treasury stock					(1,442)			(219)			(511)
	Proceeds from issuance of treasury stock under stock option plan					1,252			-			310
	Tax benefit from stock option exercise					1,122			-			232
	Change in noncontrolling interest, net					(226)			2,364			-
	Dividends paid					(8,975)			(5,405)			(5,121)
				Net cash provided by financing activities		105,391			69,736			81,063
				Net (decrease) increase in cash and cash equivalents		(35,581)			(11,489)			60,005
	Cash and cash equivalents - beginning of period					126,740			138,229			78,224
	Cash and cash equivalents - end of period				$	91,159			126,740			138,229
Supplemental disclosure of cash flow information:
	Interest paid				$	8,575			12,251			15,444
	Income taxes paid					8,336			7,395			8,029
Supplemental schedule of noncash investing activities
	Real estate acquired in settlement of loans				$	2,534			1,861			2,927
	Acquisitions:
		Fair value of assets acquired (noncash)				-			8,878			-
		Fair value of liabilities assumed				-			8,454			-

See accompanying notes to consolidated financial statements.

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