BANK OF KENTUCKY FINANCIAL CORP - FORM 10-Q

Attached files

file	filename
EXCEL - IDEA: XBRL DOCUMENT - BANK OF KENTUCKY FINANCIAL CORP	Financial_Report.xls
EX-31.1 - EXHIBIT 31.1 - BANK OF KENTUCKY FINANCIAL CORP	v392213_ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - BANK OF KENTUCKY FINANCIAL CORP	v392213_ex32-1.htm
EX-32.2 - EXHIBIT 32.2 - BANK OF KENTUCKY FINANCIAL CORP	v392213_ex32-2.htm
EX-31.2 - EXHIBIT 31.2 - BANK OF KENTUCKY FINANCIAL CORP	v392213_ex31-2.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

	x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For quarterly period ended September 30, 2014

	¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from______________to________________

Commission File Number: 001-34214

THE BANK OF KENTUCKY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Kentucky		61-1256535
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)

111 Lookout Farm Drive, Crestview Hills, Kentucky 41017

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number: (859) 371-2340

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

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

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

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

(do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of November 3, 2014, 7,691,852 shares of the registrant's Common Stock, no par value, were issued and outstanding.

The Bank of Kentucky Financial Corporation

INDEX

		PAGE
Part I	FINANCIAL INFORMATION

	Item 1 – Financial Statements	3

	Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations	40

	Item 3 – Quantitative and Qualitative Disclosures About Market Risk	58

	Item 4 – Controls and Procedures	58

Part II	OTHER INFORMATION

	Item 1 – Legal Proceedings	59

	Item 1A – Risk Factors	59

	Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds	59

	Item 3 – Defaults upon Senior Securities	59

	Item 4 – Mine Safety Disclosures	59

	Item 5 – Other Information	59

	Item 6 – Exhibits	59

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except per share data - unaudited)

	September 30,		December 31,
	2014		2013
Assets
Cash and cash equivalents	$	48,172	$	78,621
Interest-bearing deposits with banks		252		252
Available-for-sale securities		311,560		341,123
Held-to-maturity securities		76,405		77,010
Loans held for sale		3,736		3,214
Total loans		1,278,078		1,249,645
Less: Allowance for loan losses		15,941		16,306
Net loans		1,262,137		1,233,339
Premises and equipment, net		22,632		22,444
FHLB stock, at cost		4,850		5,099
Goodwill		22,023		22,023
Acquisition intangibles, net		1,477		1,848
Cash surrender value of life insurance		40,647		39,806
Accrued interest receivable and other assets		32,839		32,713
Total assets	$	1,826,730	$	1,857,492
Liabilities & Shareholders’ Equity
Liabilities
Deposits	$	1,506,996	$	1,587,585
Short-term borrowings		50,725		27,643
Notes payable		55,389		45,577
Accrued interest payable and other liabilities		18,022		15,548
Total liabilities		1,631,132		1,676,353
Shareholders’ Equity
Common stock, no par value, 15,000,000 shares authorized, 7,687,172 (2014) and 7,619,999 (2013) shares issued		3,098		3,098
Additional paid-in capital		40,039		38,100
Retained earnings		151,819		141,718
Accumulated other comprehensive income (loss)		642		(1,777	)
Total shareholders’ equity		195,598		181,139
Total liabilities and shareholders’ equity	$	1,826,730	$	1,857,492

See accompanying notes.

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013

(Dollars in thousands, except per share data - unaudited)

	Three Months Ended September 30				Nine Months Ended September 30
	2014		2013		2014		2013
INTEREST INCOME
Loans, including related fees	$	13,451	$	13,325	$	39,640	$	39,883
Securities and other		1,751		1,709		5,591		4,897
Total interest income		15,202		15,034		45,231		44,780
INTEREST EXPENSE
Deposits		898		846		2,591		2,824
Borrowings		276		266		762		743
Total interest expense		1,174		1,112		3,353		3,567

Net interest income		14,028		13,922		41,878		41,213
Provision for loan losses		300		600		2,200		4,200
Net interest income after provision for loan losses		13,728		13,322		39,678		37,013

NON-INTEREST INCOME
Service charges and fees		2,435		2,829		7,365		7,541
Mortgage banking income		219		282		632		1,493
Net securities gains		-		-		305		274
Company owned life insurance earnings		274		301		841		873
Bankcard transaction revenue		1,065		1,010		3,169		3,011
Trust fee income		993		846		2,918		2,548
Other		667		788		2,299		2,018
Total non-interest income		5,653		6,056		17,529		17,758

NON-INTEREST EXPENSE
Salaries and benefits		6,289		5,969		18,188		17,870
Occupancy and equipment		1,408		1,366		4,247		3,987
Data processing		507		533		1,562		1,620
Advertising		299		335		1,000		1,002
Electronic banking processing fees		397		398		1,185		1,235
Outside service fees		307		225		805		777
State bank taxes		642		615		1,926		1,805
Amortization of intangible assets		120		151		370		467
FDIC insurance		586		317		1,735		947
Merger related expenses		736		-		736		-
Other		1,738		1,810		5,541		5,443
Total non-interest expense		13,029		11,719		37,295		35,153

INCOME BEFORE INCOME TAXES		6,352		7,659		19,912		19,618
Less: income taxes		1,791		2,244		5,668		5,628
NET INCOME	$	4,561	$	5,415	$	14,244	$	13,990
Net income per common share:
Earnings per share, basic	$	0.59	$	0.72	$	1.86	$	1.87
Earnings per share, diluted	$	0.59	$	0.72	$	1.85	$	1.85

See accompanying notes.

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30 2014 AND 2013

(Dollars in thousands - unaudited)

	Three Months Ended September 30						Nine Months Ended September 30
	2014			2013			2014			2013
Net income	$	4,561		$	5,415		$	14,244		$	13,990
Other comprehensive income:
Unrealized gains/(loss) on securities
Unrealized holding gain/ (loss) arising during the period		(553	)		70			3,986			(6,937	)
Reclassification adjustment for losses (gains)
included in net income		-			-			(305	)		(274	)
Tax effect		194			(25	)		(1,262	)		2,451
Total other comprehensive income (loss)		(359	)		45			2,419			(4,760	)
Comprehensive income	$	4,202		$	5,460		$	16,663		$	9,230

See accompanying notes.

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30

(Dollars in thousands, except share and per share data -unaudited)

	Three Months Ended September 30						Nine Months Ended September 30
	2014			2013			2014			2013

Beginning balance	$	192,263		$	170,229		$	181,139		$	170,440

Net income		4,561			5,415			14,244			13,990
Change in net unrealized gain(loss), net of tax		(359	)		45			2,419			(4,760	)

Cash dividends paid on common stock		(1,384	)		(1,281	)		(4,144	)		(3,828	)
Stock activity under stock based compensation plans (shares for three months ended 2014 and 2013, 16,127 and 30,604 and for the nine months ended 2014 and 2013, 67,173 and 58,382), including tax benefit		388			735			1,550			1,231
Warrants repurchased		-			-			-			(2,151	)
Stock-based compensation expense		129			108			390			329
Balance as of September 30	$	195,598		$	175,251		$	195,598		$	175,251
Dividends per share	$	0.18		$	0.17		$	0.54		$	0.51

See accompanying notes.

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013

(Dollars in thousands - unaudited)

	2014			2013

Cash Flows from Operating Activities

Net income	$	14,244		$	13,990

Adjustments to reconcile net income to net cash From operating activities		7,900			22,715
Net cash from operating activities		22,144			36,705

Cash Flows from Investing Activities

Proceeds from paydowns and maturities of held-to-maturity securities		7,022			4,363
Proceeds from paydowns and maturities of available-for-sale securities		58,997			73,070
Proceeds from retirement of FHLB stock		249			-
Purchases of held-to-maturity securities		(6,460	)		(15,940	)
Purchases of available-for-sale securities		(32,823	)		(84,244	)
Purchases of company owned life insurance		-			(5,000	)
Net change in loans		(37,281	)		(14,223	)
Proceeds from the sale of other real estate		4,533			4,409
Proceeds from the sale of available-for-sale securities		5,028			5,230
Property and equipment expenditures		(1,569	)		(1,243	)
Net cash from investing activities		(2,304	)		(33,578	)

Cash Flows from Financing Activities

Net change in deposits		(80,589	)		(40,502	)
Net change in short-term borrowings		23,082			(9,241	)
Proceeds from exercise of stock options		1,550			1,231
Cash dividends paid		(4,144	)		(3,828	)
Repurchase of warrants		-			(2,151	)
Proceeds from note payable		10,000			2,000
Payments on note payable		(188	)		(20	)
Net cash from financing activities		(50,289	)		(52,511	)

Net change in cash and cash equivalents		(30,449	)		(49,384	)
Cash and cash equivalents at beginning of period		78,621			151,832
Cash and cash equivalents at end of period	$	48,172		$	102,448

See accompanying notes.

THE BANK OF KENTUCKY FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 31, 2014

(unaudited)

Note 1 - Basis of Presentation:

The condensed consolidated financial statements include the accounts of The Bank of Kentucky Financial Corporation (“BKFC” or the “Company”) and its wholly owned subsidiary, The Bank of Kentucky, Inc. (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

Note 2 - General:

On September 5, 2014, the Company entered into an agreement and plan of merger with BB&T, pursuant to which the Company will merge into BB&T, with BB&T as the surviving entity. Pending regulatory approval, the transaction is expected to close during the first half of 2015.

These financial statements were prepared in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X and, therefore, do not include all of the disclosures necessary for a complete presentation of financial position, results of operations and cash flows in conformity with U.S. generally accepted accounting principles. Except for required accounting changes, these financial statements have been prepared on a basis consistent with the annual financial statements and include, in the opinion of management, all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the results of operations and financial position at the end of and for the periods presented. These financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto as set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses and the fair values of financial instruments, in particular, are subject to change.

Note 3 - Earnings per Share:

Earnings per share are computed based upon the weighted average number of shares of common stock outstanding during the three and nine month periods. Diluted earnings per share show the potential dilutive effect of additional common shares issuable under the Company’s stock compensation plan and warrants. For the three months and nine months ended September 30, 2014 and 2013, 0 and 44,404 options were not considered, as they were not dilutive, and for the nine months ended September 30, 2014 and 2013, 0 and 46,778 options were not considered, as they were not dilutive. The following table presents the numbers of shares used to compute basic and diluted earnings per share for the indicated periods:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2014		2013		2014		2013

Weighted average shares outstanding		7,675,428		7,516,770		7,659,743		7,495,763
Dilutive effects of assumed exercises of stock options and warrant		46,646		32,760		42,268		73,500
Shares used to compute diluted earnings per share		7,722,074		7,549,530		7,702,011		7,569,263

Note 4 – Stock-Based Compensation:

Stock-based compensation in the form of options to buy stock and restricted stock units (“RSUs”) are granted to directors, officers and employees under the Company’s incentive stock plan (the “Plan”), which provides for the issuance of up to 1,000,000 shares.

Stock Options

The specific terms of each option agreement are determined by the Compensation Committee at the date of the grant. For current options outstanding, options granted to directors vest immediately and options granted to employees generally vest evenly over a five-year period.

The Company recorded stock option expense of $5,000 (net of taxes) and $15,000 (net of taxes) in the three and nine months ended September 30, 2014 respectively, and $12,000 (net of taxes) and $38,000 (net of taxes) in the three and nine months ended September 30, 2013 respectively.

Restricted Stock Units (RSUs)

The specific terms of each RSU award are determined by the Compensation Committee at the date of the grant. Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at issue date. The fair value of the stock was determined using the total number of RSUs granted multiplied by the grant date fair market value of a share of company stock. Certain service based RSUs vest after one year and performance based RSUs vest after three years based on achievement of certain targets.

A summary of changes in the Company’s non-vested shares for the three and nine months ended September 30, 2014 is as follows:

Three months ended September 30, 2014 Nonvested Shares	Shares		Weighted-Average Grant-Date Fair Value

Non-vested at July 1, 2014		18,981	$	35.58
Granted		-		-
Vested		-		-
Forfeited		-		-

Non-vested at September 30, 2014		18,981	$	35.58

Nine months ended September 30, 2014 Nonvested Shares	Shares		Weighted-Average Grant-Date Fair Value

Non-vested at January 1, 2014		4,494	$	26.25
Granted		19,094		35.58
Vested		4,494		26.25
Forfeited		113		35.16

Non-vested at September 30, 2014		18,981	$	35.58

The Company recorded RSU expense of $124,000 and $374,000 for the three and nine months ended September 30, 2014 respectively. As of September 30, 2014, there was $351,000 of total unrecognized compensation cost related to non-vested shares granted under the Plan. The cost is expected to be recognized over a period of seven months.

Note 5 – Cash and Cash Equivalents:

Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and investments in money market mutual funds. The Company reports net cash flows for customer loan and deposit transactions, interest-bearing balances with banks and short-term borrowings with maturities of 90 days or less.

Note 6 – Reclassification:

Certain prior period amounts have been reclassified to conform to the current period presentation. Such reclassifications have no effect on previously reported net income or shareholders’ equity.

Note 7 – New Accounting Pronouncements:

In May 2014, the FASB issued new accounting guidance related to revenue recognition. This new standard will replace all current U.S. GAAP guidance on this topic and eliminate all industry-specific guidance. The new revenue recognition standard provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration for which the entity expects to be entitled in exchange for those goods or services. This guidance will be effective for the Company beginning January 1, 2017 and can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. Management is evaluating the impact of adopting this new accounting standard on our financial statements.

Note 8–Securities:

The fair value of available-for-sale securities and the related gains and losses recognized in accumulated other comprehensive income (loss) was as follows (in thousands):

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
Available-for-Sale	Cost		Gains		Losses			Value
September 30, 2014
U.S. government, federal agencies and government sponsored enterprises	$	92,814	$	194	$	(1,325	)	$	91,683
U.S. government residential mortgage-backed		216,833		3,004		(885	)		218,952
Corporate		925		-		-			925
	$	310,572	$	3,198	$	(2,210	)	$	311,560
December 31, 2013
U.S. Government, federal agencies and Government sponsored enterprises	$	122,905	$	142	$	(2,908	)	$	120,139
U.S. Government mortgage-backed		219,986		2,408		(2,335	)		220,059
Corporate		925		-		-			925
	$	343,816	$	2,550	$	(5,243	)	$	341,123

The carrying amount, unrecognized gains and losses, and fair value of securities held-to-maturity were as follows (in thousands):

			Gross		Gross
	Amortized		Unrecognized		Unrecognized			Fair
Held-to-Maturity	Cost		Gains		Losses			Value
September 30, 2014
Municipal and other obligations	$	76,405	$	1,260	$	(751	)	$	76,914

December 31, 2013
Municipal and other obligations	$	77,010	$	1,085	$	(1,638	)	$	76,457

The amortized cost and fair value of debt securities at September 30, 2014 by contractual maturity were as follows (in thousands), with securities not due at a single maturity date, primarily mortgage-backed securities, shown separately.

	Available-for-Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value

Due in one year or less	$	6,187	$	6,206	$	6,427	$	6,473
Due after one year through five years		55,056		54,325		33,446		34,090
Due after five years through ten years		28,220		27,696		31,317		31,136
Due after ten years		4,276		4,381		5,215		5,215
U.S. government agency mortgage-backed		216,833		218,952		-		-
	$	310,572	$	311,560	$	76,405	$	76,914

Proceeds on the sale of $5,028,000 and $5,230,000 of available-for-sale securities resulted in gains of $305,000 and $274,000 for the first nine months of 2014 and 2013, respectively. There were no gains in the third quarter for 2014 and 2013, respectively. No securities were sold with losses in 2014 and 2013.

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available-for-sale or held-to-maturity are evaluated for OTTI under ASC 320, Accounting for Certain Investments in Debt and Equity Securities.

In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

As of September 30, 2014 and December 31, 2013, the Bank’s security portfolio consisted of 224 securities, 57 of which were in an unrealized loss position of $2,961,000 and 250 securities, 91 of which were in an unrealized loss position; totaling $6,881,000 respectively. There was no OTTI of securities at September 30, 2014. Unrealized losses have not been recognized into income because the issuers’ bonds are of high credit quality (U.S. government agencies and government sponsored enterprises and “A” rated or better Kentucky municipalities), management does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. At September 30, 2014, 100% of the mortgage-backed securities held by the Bank were issued by U.S. government sponsored entities and agencies, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to support.

At September 30, 2014 and December 31, 2013, securities with a carrying value of $375,511 and $402,999 were pledged to secure public deposits and repurchase agreements.

Securities with unrealized losses at September 30, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

Available for Sale:	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
September 30, 2014
U.S. government, federal agencies and government sponsored enterprises	$	-	$	-		$	59,917	$	(1,325	)	$	59,917	$	(1,325	)
U.S government residential mortgage-backed		30,649		(232	)		39,799		(653	)		70,448		(885	)
Total temporarily impaired	$	30,649	$	(232	)	$	99,716	$	(1,978	)	$	130,365	$	(2,210	)

Held to Maturity:	Less than 12 Months					12 Months or More					Total
	Fair		Unrecognized			Fair		Unrecognized			Fair		Unrecognized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
September 30, 2014
Municipal & other obligations	$	2,619	$	(96	)	$	22,487	$	(655	)	$	25,106	$	(751	)
Total temporarily impaired	$	2,619	$	(96	)	$	22,487	$	(655	)	$	25,106	$	(751	)

Available for Sale:	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
December 31, 2013
U.S. government, federal agencies and government sponsored enterprises	$	94,641	$	(2,522	)	$	5,996	$	(386	)	$	100,637	$	(2,908	)
U.S Gov’t. mortgage-backed		116,709		(2,241	)		7,530		(94	)		124,239		(2,335	)
Total temporarily impaired	$	211,350	$	(4,763	)	$	13,526	$	(480	)	$	224,876	$	(5,243	)

Held to Maturity:	Less than 12 Months					12 Months or More					Total
	Fair		Unrecognized			Fair		Unrecognized			Fair		Unrecognized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
December 31, 2013
Municipal & other obligations	$	26,936	$	(1,262	)	$	6,570	$	(376	)	$	33,506	$	(1,638	)
Total temporarily impaired	$	26,936	$	(1,262	)	$	6,570	$	(376	)	$	33,506	$	(1,638	)

Note 9 - Loans

Loan balances were as follows (in thousands):	September 30,			December 31,
	2014			2013

Commercial	$	254,492		$	241,794
Residential real estate		286,246			283,356
Nonresidential real estate		582,935			571,221
Construction		99,828			103,019
Consumer		15,218			15,806
Municipal obligations		40,857			36,058
Gross loans		1,279,576			1,251,254

Less: Deferred loan origination fees and discount		(1,498	)		(1,609	)
Allowance for loan losses		(15,941	)		(16,306	)

Net loans	$	1,262,137		$	1,233,339

The following tables present the activity in the allowance for loan losses for the three months ending September 30, 2014 and 2013, and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of September 30, 2014 (in thousands):

							Non
				Residential			Residential									Municipal
September 30, 2014	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
Allowance for loan losses
Beginning balance	$	3,469		$	4,087		$	6,319		$	1,970		$	366		$	123	$	16,334
Provision for loan losses		(9	)		(312	)		610			(92	)		102			1		300
Loans charged off		(326	)		(274	)		(112	)		(105	)		(133	)		-		(950	)
Recoveries		96			96			11			-			54			-		257

Total ending allowance balance	$	3,230		$	3,597		$	6,828		$	1,773		$	389		$	124	$	15,941

Ending allowance balance attributable to loans
Individually evaluated for impairment	$	1,807		$	291		$	1,470		$	791		$	-		$	-	$	4,359
Collectively evaluated for impairment		1,423			3,306			5,358			982			389			124		11,582

Total ending allowance balance	$	3,230		$	3,597		$	6,828		$	1,773		$	389		$	124	$	15,941

Loans
Loans individually evaluated for impairment	$	5,760		$	5,331		$	8,273		$	2,469		$	-		$	-	$	21,833
Loans collectively evaluated for impairment		248,732			280,915			574,662			97,359			15,218			40,857		1,257,743

Total ending loans balance	$	254,492		$	286,246		$	582,935		$	99,828		$	15,218		$	40,857	$	1,279,576

							Non
				Residential			Residential									Municipal
September 30, 2013	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
Allowance for loan losses
Beginning balance	$	2,583		$	4,214		$	7,280		$	2,061		$	450		$	62	$	16,650
Provision for loan losses		467			486			(180	)		(221	)		42			6		600
Loans charged off		(5	)		(451	)		(380	)		-			(189	)		-		(1,025	)
Recoveries		31			155			10			142			69			-		407
Total ending allowance balance	$	3,076		$	4,404		$	6,730		$	1,982		$	372		$	68	$	16,632

The following tables present the activity in the allowance for loan losses for the nine months ending September 30, 2014 and 2013, and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2013 (in thousands):

							Non
				Residential			Residential									Municipal
September 30, 2014	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
Allowance for loan losses
Beginning balance	$	3,247		$	4,554		$	6,502		$	1,538		$	373		$	92	$	16,306
Provision for loan losses		738			284			619			339			188			32		2,200
Loans charged off		(874	)		(1,413	)		(311	)		(105	)		(352	)		-		(3,055	)
Recoveries		119			172			18			1			180			-		490

Total ending allowance balance	$	3,230		$	3,597		$	6,828		$	1,773		$	389		$	124	$	15,941

							Non
				Residential			Residential									Municipal
September 30, 2013	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
Allowance for loan losses
Beginning balance	$	2,716		$	4,272		$	6,991		$	1,964		$	584		$	41	$	16,568
Provision for loan losses		874			1,931			1,305			(139	)		202			27		4,200
Loans charged off		(582	)		(1,998	)		(1,639	)		(234	)		(630	)		-		(5,083	)
Recoveries		68			199			73			391			216			-		947
Total ending allowance balance	$	3,076		$	4,404		$	6,730		$	1,982		$	372		$	68	$	16,632

					Non
			Residential		Residential						Municipal
December 31, 2013	Commercial		Real estate		Real estate		Construction		Consumer		Obligations		Total
Ending allowance balance attributable to loans
Individually evaluated for impairment	$	709	$	1,085	$	951	$	674	$	-	$	-	$	3,419
Collectively evaluated for impairment		2,538		3,469		5,551		864		373		92		12,887

	$	3,247	$	4,554	$	6,502	$	1,538	$	373	$	92	$	16,306
Loans
Loans individually evaluated for impairment	$	4,116	$	8,179	$	14,220	$	2,549	$	-	$	-	$	29,064
Loans collectively evaluated for impairment		237,678		275,177		557,001		100,470		15,806		36,058		1,222,190

Total ending loans balance	$	241,794	$	283,356	$	571,221	$	103,019	$	15,806	$	36,058	$	1,251,254

The following table presents individually impaired loans by class of loans as of and for the three months ended September 30, 2014 (in thousands):

	Unpaid				Allowance for		Average		Interest
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
	Balance		Investment		Allocated		Investment		Recognized		Received

With no related allowance recorded
Commercial	$	31	$	31	$	-	$	33	$	-	$	-

Residential real estate
Home equity lines of credit		-		-		-		-		-		-
Multifamily properties		1,264		914		-		922		-		-
Other		1,821		1,757		-		1,762		-		-

Nonresidential real estate
Owner occupied properties		655		655		-		720		-		-
Non owner occupied properties		2,097		1,969		-		2,361		-		-

Construction		788		507		-		507		-		-
Consumer		-		-		-		-		-		-

With an allowance recorded
Commercial		6,256		5,729		1,807		6,694		62		59

Residential real estate
Home equity lines of credit		-		-		-		339		-		-
Multifamily properties		318		2,146		76		901		17		17
Other		2,442		514		215		2,071		9		4

Nonresidential real estate
Owner occupied properties		5,479		3,851		1,403		5,135		10		10
Non owner occupied properties		2,318		1,798		67		1,827		24		16
Construction		1,961		1,962		791		2,029		25		25
Consumer		-		-		-		-		-		-

Total	$	25,430	$	21,833	$	4,359	$	25,301	$	147	$	131

The following table presents individually impaired loans by class of loans as of and for the three months ended September 30, 2013 (in thousands):

	Unpaid				Allowance for		Average		Interest
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
	Balance		Investment		Allocated		Investment		Recognized		Received

With no related allowance recorded
Commercial	$	111	$	111	$	-	$	141	$	-	$	-

Residential real estate
Home equity lines of credit		-		-		-		17		-		-
Multifamily properties		1,319		969		-		485		-		-
Other		1,163		1,051		-		1,642		-		-

Nonresidential real estate
Owner occupied properties		1,293		1,165		-		772		-		-
Non owner occupied properties		4,534		4,297		-		4,428		-		-

Construction		-		-		-		-		-		-
Consumer		-		-		-		-		-		-

With an allowance recorded
Commercial		5,041		5,041		1,545		3,784		57		52

Residential real estate
Home equity lines of credit		388		373		155		356		3		3
Multifamily properties		-		-		-		485		-		-
Other		5,188		4,712		648		4,671		20		19

Nonresidential real estate
Owner occupied properties		7,479		6,350		1,014		7,749		2		2
Non owner occupied properties		3,264		2,711		210		2,652		34		34
Construction		3,004		2,801		1,001		2,879		28		28
Consumer		-		-		-		-		-		-

Total	$	32,784	$	29,581	$	4,573	$	30,061	$	144	$	138

The following table presents individually impaired loans by class of loans for the nine months ended September 30, 2014 (in thousands):

	Average		Interest
	Recorded		Income		Interest
	Investment		Recognized		Received

With no related allowance recorded
Commercial	$	568	$	-	$	-

Residential real estate
Home equity lines of credit		-		-		-
Multifamily properties		936		-		-
Other		1,780		-		-
Nonresidential real estate
Owner occupied properties		1,056		-		-
Non owner occupied properties		3,086		-		-

Construction		254		-		-
Consumer		-		-		-

With an allowance recorded
Commercial		6,341		197		183

Residential real estate
Home equity lines of credit		401		3		3
Multifamily properties		1,595		58		58
Other		2,252		28		21
Nonresidential real estate
Owner occupied properties		6,302		16		16
Non owner occupied properties		2,043		81		69
Construction		2,295		77		72
Consumer		-		-		-

Total	$	28,909	$	460	$	422

The following table presents individually impaired loans by class of loans for the nine months ended September 30, 2013 (in thousands):

	Average Recorded Investment		Interest Income Recognized		Interest Received
With no related allowance recorded
Commercial	$	138	$	-	$	-
Residential real estate
Home equity lines of credit		20		-		-
Multifamily properties		485		-		-
Other		1,902		-		-
Nonresidential real estate
Owner occupied properties		2,450		-		-
Non owner occupied properties		4,359		-		-
Construction		514		-		-
With an allowance recorded
Commercial		2,623		91		80
Residential real estate
Home equity lines of credit		475		9		9
Multifamily properties		543		8		8
Other		5,177		61		58
Nonresidential real estate
Owner occupied properties		6,204		13		10
Non owner occupied properties		3,734		109		102
Construction		3,421		93		76
Consumer		20		-		-
Total	$	32,065	$	384	$	343

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2013 (in thousands):

	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
	Balance		Investment		Allocated

With no related allowance recorded Commercial	$	1,104	$	1,104	$	-

Residential real estate
Home equity lines of credit		-		-		-
Multifamily properties		1,308		958		-
Other		1,949		1,694		-

Nonresidential real estate
Owner occupied properties		1,032		1,032		-
Non owner occupied properties		3,873		3,823		-

Construction		-		-		-
Consumer		-		-		-

With an allowance recorded Commercial		3,012		3,012		709

Residential real estate
Home equity lines of credit		388		373		155
Multifamily properties		1,484		1,484		239
Other		3,776		3,670		691

Nonresidential real estate
Owner occupied properties		8,288		6,532		685
Non owner occupied properties		3,439		2,833		266
Construction		2,830		2,549		674
Consumer		-		-		-

Total	$	32,483	$	29,064	$	3,419

The following table presents the aging of the recorded investment in past due loans by class of loans as of September 30, 2014 and December 31, 2013 (in thousands):

	Loans		Loans over
	30-90 days		90 days				Loans not
	past due		past due		Nonaccrual		past due		Total
September 30, 2014
Commercial	$	272	$	-	$	821	$	253,399	$	254,492
Residential real estate
Home equity lines of credit		534		-		417		98,711		99,662
Multifamily properties		220		-		-		81,782		82,002
Other residential real estate		736		-		3,252		100,594		104,582

Nonresidential real estate
Owner occupied properties		497		-		3,775		298,032		302,304
Non owner occupied properties		237		-		2,159		278,235		280,631
Construction		79		-		507		99,242		99,828

Consumer
Credit card balances		102		26		-		6,908		7,036
Other consumer		3		-		9		8,170		8,182

Municipal obligations		-		-		-		40,857		40,857

Total	$	2,680	$	26	$	10,940	$	1,265,930	$	1,279,576

	Loans		Loans over
	30-90 days		90 days				Loans not
	past due		past due		Nonaccrual		past due		Total
December 31, 2013
Commercial	$	100	$	-	$	385	$	241,309	$	241,794
Residential real estate
Home equity lines of credit		550		-		622		97,786		98,958
Multifamily properties		-		-		-		67,964		67,964
Other residential real estate		3,693		-		4,738		108,003		116,434

Nonresidential real estate
Owner occupied properties		838		-		6,583		294,389		301,810
Non owner occupied properties		608		-		2,573		266,230		269,411
Construction		-		-		510		102,509		103,019

Consumer
Credit card balances		16		20		-		7,103		7,139
Other consumer		9		1		6		8,651		8,667

Municipal obligations		-		-		-		36,058		36,058

Total	$	5,814	$	21	$	15,417	$	1,230,002	$	1,251,254

Troubled Debt Restructurings (dollars in thousands):

The Company allocated $1,422 and $1,737 of specific reserves to customers whose loan terms had been modified in troubled debt restructurings as of September 30, 2014 and September 30, 2013, respectively. Troubled debt restructurings totaled $11,772 and $15,963 as of September 30, 2014 and September 30, 2013, respectively. The Company had not committed to lend additional amounts as of September 30, 2014 and September 30, 2013 to customers with outstanding loans that were classified as troubled debt restructurings.

Modifications involving a reduction of the stated interest rate of the loan were for periods up to three years. Modifications involving an extension of the maturity date were for periods ranging from eight to twelve months.

The following table presents loans by class modified as troubled debt restructurings that occurred during the three months ended September 30, 2014 and 2013 (dollars in thousands):

	2014						2013
	Number Of Loans		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Number Of Loans		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
Troubled Debt Restructurings:

Commercial		3	$	180	$	179		1	$	19	$	19

Residential real estate
Home equity lines of credit		-		-		-		-		-		-
Multifamily properties		1		1,485		1,485		-		-		-
Other residential real estate		-		-		-		1		21		20
Nonresidential real estate						-
Owner occupied properties		-		-		-		-		-		-
Non owner occupied properties		1		84		83		-		-		-
Construction		-		-		-		-		-		-
Consumer
Credit card balances		-		-		-		-		-		-
Other consumer		-		-		-		-		-		-
Municipal obligations		-		-		-		-		-		-
Total		5	$	1,749	$	1,747		2	$	40	$	39

The five restructured notes added in the third quarter 2014 for a total of $1,747 were added as performing troubled debt restructured loans. The two restructured notes added in the third quarter 2013 for a total of $39 were added as performing troubled debt restructured loans.

The troubled debt restructurings described above increase the allowance for loan losses totaling $134 and $0 in the third quarter ending September 30, 2014 and September 30, 2013 respectively. The troubled debt restructured described above resulted in no charge-offs during the third quarter ending September 30, 2014 and 2013.

The following table presents loans by class modified as troubled debt restructurings that occurred during nine months ended September 30, 2014 and 2013 (dollars in thousands):

	2014						2013
	Number Of Loans		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Number Of Loans		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
Troubled Debt Restructurings:

Commercial		8	$	3,624	$	2,463		3	$	190	$	128
Residential real estate
Home equity lines of credit		-		-		-		-		-		-
Multifamily properties		1		1,485		1,485		1		970		969
Other residential real estate		-		-		-		2		512		511
Nonresidential real estate
Owner occupied properties		3		433		420		-		-		-
Non owner occupied properties		1		137		137		2		970		938
Construction		-		-		-		-		-		-
Consumer
Credit card balances		-		-		-		-		-		-
Other consumer		-		-		-		-		-		-
Municipal obligations		-		-		-		-		-		-
Total		13	$	5,679	$	4,505		8	$	2,642	$	2,546

The thirteen restructured notes added during the first nine months of 2014 for $4,505 were added as performing troubled debt restructured loans. The eight restructured notes added in the first nine months of 2013 for a total of $2,546 were added as performing troubled debt restructured loans.

The troubled debt restructurings described above increased the allowance for loan losses by $927 and resulted in charge-offs of $526 during the nine months ending September 30, 2014 and increased the allowance for loan losses by $0 and resulted in charge-offs of $350 for the nine months ending September 30, 2013.

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the third quarter ending September 30, 2014 (dollars in thousands):

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

Troubled Debt Restructurings
That Subsequently Defaulted:	Number of Loans		Recorded Investment

Commercial		3	$	1,266
Residential real estate
Home equity lines of credit		-		-
Multifamily properties		-		-
Other residential real estate		-		-
Nonresidential real estate
Owner occupied properties		-		-
Non owner occupied properties		-		-
Construction		-		-
Consumer
Credit card balances		-		-
Other consumer		-		-
Municipal obligations		-		-

Total		3	$	1,266

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the nine months ending September 30, 2014 (dollars in thousands):

Troubled Debt Restructurings
That Subsequently Defaulted:	Number of Loans		Recorded Investment

Commercial		6	$	3,064
Residential real estate
Home equity lines of credit		-
Multifamily properties		-		-
Other residential real estate		-		-
Nonresidential real estate
Owner occupied properties		-		-
Non owner occupied properties		-		-
Construction		-		-
Consumer
Credit card balances		-		-
Other consumer		-		-
Municipal obligations		-		-

Total		6	$	3,064

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $127 and resulted in charge-offs of $26 during the third quarter ending September 30, 2014 and $526 for the nine months ending September 30, 2014.

(dollars in thousands)

Troubled Debt Restructurings
That Subsequently Defaulted:	Number of Loans		Recorded Investment

Commercial		1	$	15
Residential real estate
Home equity lines of credit
Multifamily properties		-		-
Other residential real estate		-		-
Nonresidential real estate
Owner occupied properties		-		-
Non owner occupied properties		-		-
Construction		-		-
Consumer
Credit card balances
Other consumer
Municipal obligations		-		-

Total		1	$	15

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification for the nine months ending September 30, 2013.

(dollars in thousands)

Troubled Debt Restructurings
That Subsequently Defaulted:	Number of Loans		Recorded Investment

Commercial		3	$	180
Residential real estate
Home equity lines of credit
Multifamily properties		1		970
Other residential real estate		-		-
Nonresidential real estate
Owner occupied properties		1		150
Non owner occupied properties		3		3,136
Construction		4		1,542
Consumer
Credit card balances
Other consumer
Municipal obligations		-		-

Total		12	$	5,978

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $31 and resulted in charge-offs of $0 during the third quarter ending September 30, 2013 and $553 for the nine months ending September 30, 2013.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, including: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $100,000 and non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. Loans with balances below $100,000 and homogenous loans, such as residential real estate and consumer loans, are analyzed for credit quality based on aging status, which was previously presented. The Company uses the following definitions for risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

Based on the most recent analysis performed, the risk category of loans by class of loans is as follows (in thousands):

			Special
	Pass		Mention		Substandard		Doubtful		Not Rated(1)		Total
September 30, 2014
Commercial	$	234,281	$	12,765	$	7,446	$	-	$	-	$	254,492
Residential real estate
Home equity lines of credit		12,495		143		2,143		-		84,881		99,662
Multifamily properties		80,550		220		1,232		-		-		82,002
Other residential real estate		19,094		2,441		7,290		-		75,757		104,582

Nonresidential real estate
Owner occupied properties		273,927		9,172		19,205		-		-		302,304
Non owner occupied properties		270,101		5,054		5,476		-		-		280,631
Construction		94,828		-		5,000		-		-		99,828

Consumer
Credit card balances		-		-		-		-		7,036		7,036
Other consumer		-		-		10		-		8,172		8,182
Municipal obligations		40,857		-		-		-		-		40,857

Total	$	1,026,133	$	29,795	$	47,802	$	-	$	175,846	$	1,279,576

(1)

Not rated loans represent the homogenous pools risk category.

			Special
	Pass		Mention		Substandard		Doubtful		Not Rated(1)		Total
December 31, 2013
Commercial	$	226,021	$	4,736	$	11,037	$	-	$	-	$	241,794
Residential real estate
Home equity lines of credit		11,775		1,721		1,582		-		83,880		98,958
Multifamily properties		65,521		-		2,443		-		-		67,964
Other residential real estate		24,697		4,594		8,606		-		78,537		116,434

Nonresidential real estate
Owner occupied properties		271,281		9,058		21,471		-		-		301,810
Non owner occupied properties		256,328		5,216		7,867		-		-		269,411
Construction		97,738		2,264		3,017		-		-		103,019

Consumer
Credit card balances		-		-		-		-		7,139		7,139
Other consumer		-		-		4		-		8,663		8,667
Municipal obligations		36,058		-		-		-		-		36,058

Total	$	989,419	$	27,589	$	56,027	$	-	$	178,219	$	1,251,254

(1)

Not rated loans represent the homogenous pools risk category.

Note 10 –Fair Value:

Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Investment Securities: The fair values of securities available-for-sale are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). One corporate security is valued using Level 3 inputs as there is no readily observable market activity. Management determines the value of this security based on expected cash flows, the credit quality of the security and current market interest rates.

Derivatives: The Bank’s derivative instruments consist of over-the-counter interest-rate swaps that trade in liquid markets. The fair value of the derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Bank. This valuation method is classified as Level 2 in the fair value hierarchy.

Impaired Loans: At the time a loan is considered impaired, it is recorded at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Loans Held For Sale: Loans held for sale are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

			Fair Value Measurements at
			September 30, 2014 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	September 30,		Identical Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	91,683	$	-	$	91,683	$	-
U.S. government agency mortgage backed		218,952		-		218,952		-
Corporate		925		-		-		925
Derivatives		1,912		-		1,912		-
Total	$	313,472	$	-	$	312,547	$	925

Liabilities
Derivatives	$	1,912	$	-	$	1,912	$	-
Total	$	1,912	$	-	$	1,912	$	-

			Fair Value Measurements at
			December 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	120,139	$	-	$	120,139	$	-
U.S. government agency mortgage backed		220,059		-		220,059		-
Corporate		925		-		-		925
Derivatives		1,915		-		1,915		-

Total	$	343,038	$		$	342,113	$	925

Liabilities
Derivatives	$	1,915	$	-	$	1,915	$	-

Total	$	1,915	$	-	$	1,915	$	-

There were no transfers between Level 1 and Level 2 during 2014 or 2013.

There were no gains or losses for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarter ended September 30, 2014.

There were no changes in unrealized gains and losses recorded in earnings for the quarter ended September 30, 2014 for Level 3 assets and liabilities that are still held at September 30, 2014.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended September 30 (in thousands):

Corporate Securities
	Nine months ended		Nine months ended
	September 30, 2014		September 30, 2013

Balance of recurring Level 3 assets at January 1	$	925	$	1,060
Total gains or losses for the period:
Included in earnings		-		-
Included in other comprehensive income		-		-
Purchases		-		-
Sales		-		-
Issuances		-		-
Settlements		-		65
Transfers into Level 3		-		-
Transfers out of Level 3		-		-

Balance of recurring Level 3 assets at September 30	$	925	$	995

The following table presents quantitative information about recurring Level 3 fair value measurements at September 30, 2014 (in thousands):

Valuation

Fair value

Technique(s)

Unobservable Input(s)

Value

Corporate

925

Discounted cash flow

Probability of default

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2013 (in thousands):

Valuation

Fair value

Technique(s)

Unobservable Input(s)

Value

Corporate

925

Discounted cash flow

Probability of default

The interest rate on this security is based on interest rates paid for securities with similar credit characteristics, but the probability of default is determined through a credit quality review rather than formal ratings or other observable inputs. The interest rate adjusts to reflect current market conditions of highly rated investments, if probability of default changed significantly, the interest rate would adjust accordingly and the fair value would be updated. Management reviews this interest rate and the security’s credit quality quarterly and a market value adjustment is made if necessary pursuant to this review.

Assets and Liabilities Measured on a Non-Recurring Basis

(Dollars in thousands)

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

			Fair Value Measurements at
			September 30, 2014 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	September 30,		Identical Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	125	$	-	$	-	$	125
Nonresidential real estate
Owner occupied properties		1,845		-		-		1,845
Non owner occupied properties		96		-		-		96
Residential real estate
Home equity lines of credit		-		-		-		-
Multifamily properties		-		-		-		-
Other		310		-		-		310
Construction		-		-		-		-
Other real estate owned
Residential		70		-		-		70
Non-Residential		1,438		-		-		1,438

Total	$	3,884	$	-	$	-	$	3,884

			Fair Value Measurements at
			December 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	2,215	$	-	$	-	$	2,215
Nonresidential real estate
Owner occupied properties		5,673		-		-		5,673
Non owner occupied properties		942		-		-		942
Residential real estate
Home equity lines of credit		218		-		-		218
Multifamily properties		1,245		-		-		1,245
Other		2,013		-		-		2,013
Construction		1,875		-		-		1,875
Other real estate owned
Residential		-		-		-		-
Non-Residential		2,772		-		-		2,772

Total	$	16,953	$	-	$	-	$	16,953

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $4,065 with a valuation allowance of $1,689, resulting in a decrease in the provision for loan losses of $1,730 in the first nine of 2014 and a $2 increase in provision for loan losses in the third quarter of 2014. As of December 31, 2013, impaired loans had a gross carrying amount of $17,600, with a valuation allowance of $3,419, resulting in a decrease in the provision for loan losses of $2,846.

Other real estate owned, measured at fair value less costs to sell, had a net carrying amount of $1,508, which is made up of the outstanding balance of $1,701, net of a valuation allowance of $193 at September 30, 2014, resulting in a write-down of $180, for the quarter ended September 30, 2014. At December 31, 2013, other real estate owned measured at fair value less costs to sell, had a net carrying amount of $2,772, which is made up of the outstanding balance of $3,287, net of a valuation allowance of $515, resulting in a write-down of $263 for the year ended December 31, 2013.

Values for collateral dependent loans and other real estate owned are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure or other factors management deems relevant to arrive at a representative fair value. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the cost to replace the current property. The market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investor’s required return. The final fair value is based on a reconciliation of these three approaches.

The following table presents quantitative information about recurring Level 3 fair value measurements at September 30, 2014 (in thousands):

					Discount Range
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	(Avg discount)
Assets
Impaired Loans:
Commercial	$	125	Cost, sales, income approach	Adjustment for comparable
				properties or equipment,	80%
				market conditions	(80%)

Nonresidential real estate
Owner occupied properties		1,845	Cost, sales, income approach	Adjustment for comparable	11-80%
				properties, market conditions	(50%)
Non owner occupied		96	Cost, sales, income approach	Adjustment for comparable	21%
properties				properties, market conditions	(21%)

Residential real estate
Home equity lines of credit		-	Cost, sales, income approach	Adjustment for comparable	-
				properties, market conditions	-

Multifamily properties		-	Cost, sales, income approach	Adjustment for comparable	-
				properties, market conditions	-

Other			Cost, sales, income approach	Adjustment for comparable	16%
		310		properties, market conditions	(16%)
Construction			Cost, sales, income approach	Adjustment for comparable	-
		-		properties, market conditions	-
Other real estate owned		70	Cost, sales, income approach	Adjustment for comparable	0-0%
Residential				properties, market conditions	(0%)
Non-residential		1,438	Cost, sales, income approach	Adjustment for comparable	0-0%
				properties, market conditions	(0%)
Total	$	3,884

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2013 (in thousands):

					Discount Range
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	(Avg discount)
Assets
Impaired Loans:					%
Commercial	$	2,215	Cost, sales, income	Adjustment for comparable	6-25%
			approach	properties, market conditions	(11%)
Nonresidential real estate
Owner occupied properties		5,673	Cost, sales, income	Adjustment for comparable	6-76%
			approach	properties, market conditions	(17%)
Non owner occupied		942	Cost, sales, income	Adjustment for comparable	3-66%
properties			approach	properties, market conditions	(15%)
Residential real estate
Home equity lines of credit		218	Cost, sales, income	Adjustment for comparable	6-26%
			approach	properties, market conditions	(8%)
Multifamily properties		1,245	Cost, sales, income	Adjustment for comparable	6%
			approach	properties, market conditions	(6%)

Other		2,013	Cost, sales, income	Adjustment for comparable	0-100%
			approach	properties, market conditions	(36%)
Construction		1,875	Cost, sales, income	Adjustment for comparable	6-16%
			approach	properties, market conditions	(14%)

Other real estate owned			Cost, sales, income	Adjustment for comparable	0-0%
Residential		-	approach	properties, market conditions	(0%)
Non-residential		2,772	Cost, sales, income	Adjustment for comparable	0-0%
			approach	properties, market conditions	(0%)

Total	$	16,953

The carrying amounts and estimated fair values of financial instruments at September 30, 2014 and December 31, 2013 are as follows (in thousands):

				Fair Value Measurements at
				September 30, 2014 Using:
	Carrying Value			Level 1			Level 2			Level 3			Total
(Dollars in thousands)
Financial assets
Cash and cash equivalents	$	48,172		$	48,172		$	-		$	-		$	48,172
Interest-bearing deposits with banks		252			252			-			-			252
Securities available-for-sale		311,560			-			310,635			925			311,560
Securities held-to-maturity		76,405			-			76,914			-			76,914
Federal Home Loan Bank stock		4,850			N/A			N/A			N/A			N/A
Loans held for sale		3,736			-			3,736			-			3,736
Loans, net		1,262,137			-			-			1,266,794			1,266,794
Accrued interest receivable		3,992			-			1,244			2,748			3,992
Derivative assets		1,912			-			1,912			-			1,912
Financial liabilities
Deposits	$	(1,506,996	)	$	(1,207,544	)	$	(300,361	)	$	-		$	(1,507,905	)
Short-term borrowings		(50,725	)		-			(50,725	)		-			(50,725	)
Notes payable		(55,389	)		-			(30,970	)		(17,891	)		(48,861	)
Accrued interest payable		(720	)		-			(707	)		(13	)		(720	)
Standby letters of credit		(271	)		-			-			(271	)		(271	)
Derivative liabilities		(1,912	)		-			(1,912	)		-			(1,912	)

				Fair Value Measurements at
				December 31, 2013 Using:
	Carrying Value			Level 1			Level 2			Level 3			Total
(Dollars in thousands)
Financial assets
Cash and cash equivalents	$	78,621		$	78,621		$	-		$	-		$	78,621
Interest-bearing deposits with banks		252			252			-			-			252
Securities available-for-sale		341,123			-			340,198			925			341,123
Securities held-to-maturity		77,010			-			76,457			-			76,457
Federal Home Loan Bank stock		5,099			N/A			N/A			N/A			N/A
Loans held for sale		3,214			-			3,214			-			3,214
Loans, net		1,233,339			-			-			1,236,112			1,236,112
Accrued interest receivable		4,123			-			1,420			2,703			4,123
Derivative assets		1,915			-			1,915			-			1,915
Financial liabilities
Deposits	$	(1,587,585	)	$	(1,286,733	)	$	(302,701	)	$	-		$	(1,589,434	)
Short-term borrowings		(27,643	)		-			(27,643	)		-			(27,643	)
Notes payable		(45,577	)		-			(20,083	)		(17,414	)		(37,497	)
Accrued interest payable		(693	)		-			(680	)		(13	)		(693	)
Standby letters of credit		(415	)		-			-			(415	)		(415	)
Derivative liabilities		(1,915	)		-			(1,915	)		-			(1,915	)

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

Cash and cash equivalents: The carrying amounts of cash and cash equivalents approximate fair values and are classified as Level 1.

Interest-bearing deposits with banks: The carrying amount of interest-bearing deposits equivalents approximate fair value and are classified as Level 1.

Federal Home Loan Bank stock: It is not practicable to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability.

Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Loans, net: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Accrued interest receivable/payable: The carrying amounts of accrued interest approximate fair value resulting in a Level 1, Level 2 or Level 3 classification consistent with the classification of the asset/liability with which they are associated.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Short-term borrowings: The carrying amounts of short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification. The carrying amounts of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification.

Notes payable: The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification. The fair values of the Company’s

subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Standby letters of credit and off-balance sheet instruments: Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing, which results in a level 3 classification. The fair value of commitments is not material. Estimated fair value of standby letters of credit are based on their current unearned fee balance. Estimated fair value for commitments to make loans and unused lines of credit are considered nominal.

Note 11- Accumulated Other Comprehensive Income

The following table summarizes the changes within each classification of accumulated other comprehensive income for the nine months ended September 30, 2014:

Reclassifications Out Of Accumulated Other Comprehensive Income

Details about Accumulated other Comprehensive Income Components	Amount Reclassified From Accumulated Other Comprehensive Income			Affected Line Item In the Statement Where Net Income is Presented
	(in thousands)
Unrealized gains and losses on available-for-sale securities	$	305		Net securities gains
		(107	)	Income tax expense
	$	198		Net of tax

The following table summarizes the changes within each classification of accumulated other comprehensive income for the nine months ended September 30, 2013:

Details about Accumulated other Comprehensive Income Components	Amount Reclassified From Accumulated Other Comprehensive Income			Affected Line Item In the Statement Where Net Income is Presented
	(in thousands)
Unrealized gains and losses on available-for-sale securities	$	274		Net securities gains
		(96	)	Income tax expense
	$	178		Net of tax

There were no reclassifications from accumulated other comprehensive income for the three months ended September 30, 2014 and September 30, 2013.

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

The objective of this section is to help shareholders and potential investors understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this quarterly report on form 10-Q (this “Quarterly Report”). References to the “Company,” “BKFC,” “we,” “us,” and “our” in this section refer to the Bank of Kentucky Financial Corporation and its subsidiaries, including The Bank of Kentucky, Inc. (the “Bank”), unless otherwise specified or unless the context otherwise requires.

FORWARD-LOOKING STATEMENTS

Certain statements contained in this quarterly report which are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Examples of forward-looking statements include, but are not limited to, projections of revenues, income or loss, earnings or loss per share, the payment or non-payment of dividends, capital structure and other financial items; statements of plans and objectives of us or our management or Board of Directors; and statements of future economic performance and statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “intends” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, the following:

indications of an improving economy may prove to be premature;

general economic or industry conditions could be less favorable than expected, resulting in a deterioration in credit quality, a change in the allowance for credit losses, or a reduced demand for credit or fee-based products and services;

changes or volatility in interest rates may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet as well as our liquidity;

our ability to determine accurate values of certain assets and liabilities;

the impact of turmoil in the financial markets and the effectiveness of governmental actions taken in response, and the effect of such governmental actions on us, our competitors and counterparties, financial markets generally and availability of credit specifically;

changes in the extensive laws, regulations and policies governing financial services companies, including the Dodd-Frank Act and any regulations promulgated thereunder;

the potential need to adapt to industry changes in information technology systems, on which the Bank is highly dependent, could present operational issues or require significant capital spending;

competitive pressures could intensify and affect the Bank’s profitability, including as a result of continued industry consolidation, the increased availability of financial services from non-banks, technological developments or bank regulatory reform;

the effect of the announcement of our merger with BB&T Corporation (“BB&T”) on our relationships with customers, vendors or employees;

the possibility that the merger does not close when expected or at all; and

the merger may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated, or may result in unforeseen integration difficulties.

Any forward-looking statements made by us or on our behalf speak only as of the date they are made, and we do not undertake any obligation to update any forward-looking statement to reflect the impact of subsequent events or circumstances. Before making an investment decision, you should carefully consider all risks and uncertainties disclosed in our other public documents on file with the Securities and Exchange Commission (“SEC”), including those described in Item 1A of our Annual Report on Form 10-K, for the year ended December 31, 2013.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

BKFC has prepared all of the consolidated financial information in this quarterly report in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). In preparing the consolidated financial statements in accordance with GAAP, BKFC makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of BKFC’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in reporting materially different amounts if conditions or underlying circumstances were to change.

The Bank maintains an allowance to absorb probable, incurred loan losses inherent in the loan portfolio. The Bank’s policy is to maintain an allowance for loan losses at an adequate level based upon ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans. Loan losses are charged and recoveries are credited to the allowance for loan losses. Provisions for loan losses are based on the Bank’s review of its historical loan loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable loan losses. The Bank’s strategy for credit risk management includes a combination of well-defined credit policies, uniform underwriting criteria, and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The credit risk management strategy also includes assessments of compliance with commercial and consumer policies, risk ratings and other important credit information. The strategy also emphasizes regular credit examinations and management reviews of loans exhibiting deterioration in credit quality. The Bank strives to identify potential problem loans early and promptly undertake the appropriate actions necessary to mitigate or eliminate the increasing risk identified in these loans.

The allowance for loan losses consists of two components, the specific reserve, pursuant to ASC 310, Accounting by Creditors for Impairment of a Loan, and the general reserve, pursuant to ASC 450-10, Accounting for Contingencies. A loan is considered impaired when, based upon current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan. The specific reserve component is an estimate of loss based upon an impairment review of loans which meet certain criteria that are considered impaired. An insignificant delay or insignificant shortfall in amount of payments is not considered an impairment. In addition, a loan is not impaired during a period of delay in payment if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay. Thus, a demand loan or loan that has been extended beyond its original maturity date is not impaired if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate during the period the loan is outstanding.

The general reserve includes an estimate of commercial and consumer loans with similar characteristics. Depending on the set of facts with respect to a particular loan, the Bank utilizes one of the following methods for determining the proper impairment of a loan:

the present value of expected future cash flows of a loan;

the market price of the loan based upon readily available information for that type of loan; and

the fair value of collateral.

The allowance established for impaired loans is generally based, for all collateral-dependent loans, on the fair value of the collateral, less the estimated cost to liquidate. For non-collateral dependent loans (such as accruing troubled debt restructurings), the allowance is based on the present value of expected future cash flows discounted by the loan’s effective interest rate. A small portion of the Bank’s loans which are impaired under the ASC 310 process carry no specific reserve allocation. These loans were reviewed for impairment and are considered adequately collateralized with respect to their respective outstanding principal loan balances. The majority of these loans are loans which have had their respective impairment (or specific reserve) amounts charged off, or are loans related to other impaired loans which continue to have a specific reserve allocation. It is the Bank’s practice to maintain these impaired loans, as analyzed and provided for in the ASC 310 component of the allowance for loan losses, to avoid double counting of any estimated losses that may have been included in the ASC 450-10 component of the allowance for loan losses.

Generally, the Bank orders a new or updated appraisal on real estate properties which are subject to an impairment review. Upon completion of the impairment review, loan reserves are increased as warranted. Charge-offs, if necessary, are generally recognized in a period after the reserves were established. Adjustments to new or updated appraisal values are not typically done, but in those cases when an adjustment is necessary, it is documented with supporting information and typically results in an adjustment to decrease the property’s value because of additional information obtained concerning the property after the appraisal or an update has been received by the Bank. If a new or updated appraisal is not available at the time of a loan’s impairment review, the Bank typically applies a discount to the value of an old appraisal to reflect the property’s current estimated value if there is believed to be deterioration in either (i) the physical or economic aspects of the subject property or (ii) any market conditions. Updated valuations on one to four family residential properties with small to moderate values are generally accomplished by obtaining an evaluation or appraisal. Generally, an “as is” value is utilized in most of the Bank’s real estate based impairment analyses. However, under certain limited circumstances, an “as stabilized” valuation may be utilized, provided that the “as stabilized” value is tied to a well-justified action plan to bring the real estate project to a stabilized occupancy under a reasonable period of time.

If a partially charged-off loan has been restructured in a manner that is reasonably assured of repayment and performance according to prudently modified terms, and has sustained historical payment performance for a reasonable period of time prior to and/or after the restructuring, it may be returned to accrual status and is classified as a TDR loan. However, if the above conditions cannot be reasonably met, the loan remains on non-accrual status.

In addition, the Bank evaluates the collectability of both principal and interest when assessing the need for loans to be placed on non-accrual status. Non-accrual status denotes loans in which, in the opinion of management, the collection of additional interest is unlikely. A loan is generally placed on non-accrual status if: (i) it becomes 90 days or more past due or (ii) for which payment in full of both principal and interest cannot be reasonably expected.

The general component of the allowance covers non-impaired loans and is based on historical loss experience adjusted for current factors. For loans that are risk rated, the historical loss experience is determined based on the actual loss history experienced by the Company over the most recent four years. These loss ratios are calculated from a migration analysis of the charge offs over this period, but excludes the ratios from the most recent twelve months period as they are not appropriately seasoned. The loss ratios for loans designated as belonging to homogeneous pools, including smaller balance consumer loans, are calculated for a five year period and a one year period, with the higher of the two loss ratio’s currently used in the allowance calculation. These actual loss experiences are supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; trends in volume and terms of loans; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These factors are consistent within each of the portfolio segments, which have been identified as: commercial, residential real estate, nonresidential real estate, construction, consumer and municipal obligations.

Management utilizes a detailed approach to setting the environmental adjustments to the historical loss. Factors that management considers as part of this approach in setting the environmental adjustments include economic trends, loan policies, lender experience, loan growth, delinquency trend, non-performing asset trends, classified loan trends and credit concentrations.

Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions, as well as actual collection and charge-off experience.

Charge-offs are recognized when it becomes evident that a loan or a portion of a loan is deemed uncollectible regardless of its delinquent status. The Bank generally charges off that portion of a loan that is determined to be unsupported by an obligor’s continued ability to repay the loan from income and/or assets, both pledged and unpledged as collateral.

OVERVIEW

Economic Overview

The third quarter ended September 30, 2014 saw the pace of growth slow slightly from the robust second quarter both nationally and in the geographic markets where we operate. The economy still experienced expansion during the quarter but reverted back closer to the historical average growth rate. The United States’ gross domestic product (GDP) was impacted by a drop in consumer spending which was partially off-set by an increase in corporate expenditures.

Overall economic growth continued to expand as the labor market improved, represented by the 671,000 non-farm jobs produced in the third quarter. The decline in the unemployment rate continued during the quarter. However, the percent of eligible workforce employed remains well below historical averages.

2014 Third Quarter and Nine Month Performance Overview

The results of the third quarter included $736,000 in merger related expenses as a result of the previously disclosed agreement and plan of merger entered into on September 5, 2014 by the Company and BB&T, pursuant to which the Company will merge into BB&T, with BB&T as the surviving entity.

The results of the third quarter and first nine months of 2014 also reflect the effects of overall improving credit metrics and net interest income growth, which were offset by lower levels of non-interest income. The Company completed the third quarter and first nine months of 2014 with an 18% decrease in diluted earnings per share from the prior year’s third quarter for the quarter, while the diluted earnings per share were flat for the first nine months. The 18% decrease in diluted earnings per share for the third quarter of 2014 compared with the same period in 2013 was the result of a $1,310,000 (11%) increase in non-interest expense and a $403,000 (7%) decrease in non-interest income, which was partially offset with $300,000 (50%) reduction in the provision for loan losses compared with the same period in 2013. The reduction in the provision for loan losses was accompanied by lower levels of non-performing loans from the previous year. The decrease in non-interest income included a $394,000 (14%) decrease in service charges on deposits.

The following sections provide more detail on subjects presented in the overview.

FINANCIAL CONDITION

Total assets at September 30, 2014 were $1,826,730,000 compared with $1,857,492,000 at December 31, 2013, a decrease of $30,762,000. Loans outstanding increased $28,433,000 from $1,249,645,000 at December 31, 2013 to $1,278,078,000 at September 30, 2014. Available-for-sale securities decreased $29,563,000 (9%) from $341,123,000 at December 31, 2013 to $311,560,000 at September 30, 2014. Cash and cash equivalents, which included fed funds sold, decreased $30,449,000 from $78,621,000 at December 31, 2013 to $48,172,000 at September 30, 2014.

As Table 1 illustrates, the increase in the loan portfolio in 2014 was the result of an increase in commercial real estate loans of $11,714,000 (2%) and commercial loans of $12,698,000 (5%). Management expects a steady increase in loan demand in 2014, mirroring the current economic conditions as discussed above. The Bank intends to continue to make loans that meet its longstanding prudent lending standards.

Deposits decreased $80,589,000 to $1,506,996,000 at September 30, 2014, compared to $1,587,585,000 at December 31, 2013. The largest decreases in deposits came from interest bearing transaction deposits which decreased $44,423,000 (8%) and money market deposits which decreased $24,434,000 (11%). The Bank’s interest bearing transaction accounts include public fund accounts which decreased $59,609,000, or 14%, from the end of 2013. Public funds are deposits of local municipalities, schools and other public entities, and tend to be cyclical in nature with higher balances in the fourth quarter of the year as a result of property tax receipts. Other changes to liabilities included a $23,082,000 (84%) increase in short-term borrowings.

Table 1 Composition of the Bank’s loans and deposits at the dates indicated:

	September 30, 2014					December 31, 2013
	Amount		%			Amount		%
			(Dollars in thousands)
Type of Loan:
Commercial real estate loans	$	582,935		45.5	%	$	571,221		45.7	%

One- to four-family residential real estate loans		286,246		22.3			283,356		22.6
Commercial loans		254,492		19.9			241,794		19.3
Consumer loans		15,218		1.2			15,806		1.3

Construction and land development loans		99,828		7.9			103,019		8.2
Municipal obligations		40,857		3.2			36,058		2.9
Total loans	$	1,279,576		100.0	%	$	1,251,254		100.0	%
Less:
Deferred loan fees		1,498					1,609
Allowance for loan losses		15,941					16,306
Net loans	$	1,262,137				$	1,233,339

Type of Deposit:
Non-interest bearing deposits		346,188		22.9	%		359,201		22.6	%
Interest bearing transaction deposits		515,942		34.2			560,365		35.3
Money market deposits		190,811		12.7			215,245		13.6
Savings deposits		154,601		10.3			151,920		9.6
Certificates of deposits		245,740		16.3			245,350		15.5
Individual retirement accounts		53,714		3.6			55,504		3.4
Total deposits	$	1,506,996		100.0	%	$	1,587,585		100.0	%

RESULTS OF OPERATIONS

GENERAL

Net income for the nine months ended September 30 increased from $13,990,000 ($1.85 diluted earnings per share) for the nine months ended September 30, 2013 to $14,244,000 ($1.85 diluted earnings per share) in 2014, an increase of $254,000 (2%). Net income for the third quarter was $4,561,000 ($.59 diluted earnings per share) as compared to $5,415,000 ($.72 diluted earnings per share) during the same period of 2013, a decrease of $854,000 (16%). As discussed in the overview section , the primary reasons for the decrease in net income from the third quarter of 2013 compared with the third quarter of 2014 was $736,000 (100%) in merger related expenses. Also contributing to this decrease was a $403,000 (7%) decrease in non-interest income which was partially offset by a $300,000 (50%) decrease in provision for loan losses. Contributing to the decrease in non-interest income was a $394,000 (14%) decrease in service charges on deposits, while the lower provision was reflective of lower levels of non-performing loans compared with the third quarter of 2013.

NET INTEREST INCOME

Net interest income increased $106,000 (1%) in the third quarter of 2014 as compared to the same period in 2013, while the year to date total increased $665,000 (2%) from $41,213,000 in 2013 to $41,878,000 in 2014. As illustrated in Table 2 below, the net interest margin of 3.38% for the third quarter of 2014 was 12 basis points less than the 3.50% net interest margin for the third quarter of 2013. The cost of interest-bearing liabilities increased one basis point from .35% for the third quarter of 2013 to .36% in the third quarter of 2014, while the yield on earning assets decreased 11 basis points from 3.77% for the third quarter of 2013 to 3.66% for the third quarter of 2014.

The increase in net interest income was the result of higher levels of earning assets and a higher yielding mix of earning assets in the third quarter of 2014 as compared to the third quarter of 2013. As illustrated in Table 2, average interest earning assets increased $70,262,000 or 4% from the third quarter of 2013 to the third quarter of 2014. The mix of earning assets also improved as average loan balances increased $74,226,000 or 6% which had a yield of 4.24%, while other interest-earning assets with a yield of 1.32% decreased $12,807,000 or 44% from the third quarter of 2013. Table 4 shows that the net interest income on a fully tax equivalent basis was positively impacted by the volume additions to the balance sheet by $756,000, which was offset with a negative rate variance of $627,000. As further illustrated in Table 4, the favorable volume variance was driven by the increase in interest income attributable to loans of $803,000. As the negative rate variance in the third quarter of 2014 indicates, if rates were to continue to fall in 2014, the effect on the Company is expected to be negative, as shown and explained below.

The Company uses an earnings simulation model to estimate and evaluate the impact of changing interest rates on earnings. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. By simulating the effects of movements in interest rates, the model can estimate the Company’s interest rate exposure. The results of the model are used by management to approximate the results of rate changes and do not indicate actual expected results. As shown below, the September 30, 2014 simulation analysis indicates that the Company is in a slightly asset interest rate sensitive position, with the net interest income positively impacted by rising rates. As a result of the current historically low rate environment, the effects of a 100 basis point decrease in rates would also be negative to the net interest income. This is the result of a significant portion of the interest-bearing liabilities already having a cost below 1.00%.

Net interest income estimates are summarized below.

	Net Interest Income Change
Increase 200 bp		1.23	%
Increase 100 bp		0.51
Decrease 100 bp		(3.44	)

Tables 2 and 3 set forth certain information relating to the Bank’s average balance sheet information and reflects the average yield on interest-earning assets, on a tax equivalent basis, and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average daily balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are daily averages for the Bank and include non-accruing loans in the loan portfolio, net of the allowance for loan losses.

Table 2- Average Balance Sheet Rates for Three Months Ended September 30, 2014 and 2013 (presented on a tax equivalent basis in thousands)

	Three Months ended September 30, 2014								Three Months ended September 30, 2013
	Average outstanding balance			Interest earned/ paid		Yield/ rate			Average outstanding balance			Interest earned/ paid		Yield/ rate

Interest-earning assets:
Loans receivable (1)(2)	$	1,274,050		$	13,612		4.24	%	$	1,199,824		$	13,442		4.44	%
Securities (2)		395,487			1,874		1.88			386,644			1,835		1.88
Other interest-earning assets		16,232			54		1.32			29,039			73		1.00

Total interest-earning assets		1,685,769			15,540		3.66			1,615,507			15,350		3.77
Non-interest-earning assets		152,913								155,984

Total assets	$	1,838,682								1,771,491
Interest-bearing liabilities:
Transaction accounts		885,792			368		0.16			848,512			327		0.15
Time deposits		299,690			530		0.70			316,435			519		0.65
Borrowings		102,684			276		1.07			80,733			266		1.31

Total interest-bearing liabilities		1,288,166			1,174		0.36			1,245,680			1,112		0.35
Non-interest-bearing liabilities		356,487								353,071
Total liabilities		1,644,653								1,598,751

Shareholders’ equity		194,029								172,740

Total liabilities and shareholders’ equity	$	1,838,682							$	1,771,491
Net interest income				$	14,366							$	14,238
Interest rate spread							3.30	%							3.42	%
Net interest margin (net interest income as a percent of average interest-earning assets)							3.38	%							3.50	%
Effect of net free funds (earning assets funded by non-interest bearing liabilities)							0.08	%							0.08	%
Average interest-earning assets to interest-bearing liabilities		130.87	%							129.69	%

(1)

Includes non-accrual loans.

(2)

Income presented on a tax equivalent basis using a 35.00% tax rate in 2014 and 2013, respectively. The tax equivalent adjustment was $338,000 and $316,000 in 2014 and 2013, respectively.

Table 3- Average Balance Sheet Rates for Nine Months Ended September 30, 2014 and 2013 (presented on a tax equivalent basis in thousands)

	Nine Months ended September 30, 2014								Nine Months ended September 30, 2013
	Average outstanding balance			Interest earned/ paid		Yield/ rate			Average outstanding balance			Interest earned/ paid		Yield/ rate

Interest-earning assets:
Loans receivable (1)(2)	$	1,266,058		$	40,090		4.22	%		1,195,042		$	40,226		4.48	%
Securities (2)		403,519			5,969		1.97			383,551			5,240		1.82
Other interest-earning assets		23,985			183		1.02			53,803			247		0.61

Total interest-earning assets		1,693,562			46,242		3.65			1,632,396			45,713		3.74
Non-interest-earning assets		151,353								158,527

Total assets	$	1,844,915							$	1,790,923
Interest-bearing liabilities:
Transaction accounts		922,140			1,141		0.17			874,240			1,081		0.17
Time deposits		299,496			1,450		0.65			333,857			1,743		0.70
Borrowings		85,274			762		1.19			77,024			743		1.29

Total interest-bearing liabilities		1,306,910			3,353		0.34			1,285,121			3,567		0.37
Non-interest-bearing liabilities		348,718								333,792

Total liabilities		1,655,628								1,618,913
Shareholders’ equity		189,287								172,010
Total liabilities and shareholders’ equity		1,844,915								1,790,923
Net interest income				$	42,889							$	42,146
Interest rate spread							3.31	%							3.37	%
Net interest margin (net interest income as a percent of average interest-earning assets)							3.39	%							3.45	%
Effect of net free funds (earning assets funded by non-interest bearing liabilities)							0.08	%							0.08	%
Average interest-earning assets to interest-bearing liabilities		129,59	%							127.02	%

___________________________

(1)

Includes non-accrual loans.

(2)

Income presented on a tax equivalent basis using a 35.00% tax rate in 2014 and 2013, respectively. The tax equivalent adjustment was $1,011,000 and $933,000 in 2014 and 2013, respectively.

Table 4 below illustrates the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Bank’s interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) changes in rate (change in rate multiplied by prior year volume) and (iii) total changes in rate and volume. The combined effects of changes in both volume and rate, which cannot be separately identified, have been allocated proportionately to the change due to volume and the change due to rate.

Table 4-Volume/Rate Analysis (in thousands)

	Three months ended September30, 2014 Compared to Three months ended September 30, 2013									Nine months ended September 30, 2014 Compared to Nine months ended September 30, 2013
	Increase (Decrease) Due to									Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
Interest income attributable to:
Loans receivable	$	803		$	(632	)	$	171		$	2,318		$	(2,454	)		(136	)
Securities		42			(3	)		39			281			448			729
Other interest-earning assets(1)		(38	)		19			(19	)		(178	)		114			(64	)

Total interest-earning assets		807			(616	)		191			2,421			(1,892	)		529


Interest expense attributable to:
Transactions accounts		15			26			41			59			1			60
Time deposits		(28	)		39			11			(173	)		(121	)		(294	)
Borrowings		64			(54	)		10			77			(58	)		19

Total interest-bearing liabilities		51			11			62			(37	)		(178	)		(215	)

Increase (decrease) in net interest income	$	756		$	(627	)	$	129		$	2,458		$	(1,714	)	$	744

(1)

Includes federal funds sold and interest-bearing deposits in other financial institutions.

PROVISION FOR LOAN LOSSES

While the economic conditions continue to be challenging, the provision for loan losses reflected the improving economy. While still above historical levels, the credit metrics showed significant improvement in 2014 compared with 2013. Management believes that loan growth experienced in 2014 is consistent with the improving economic conditions, and management anticipates growing demand for loans in the coming quarters.

Provision for loan losses decreased $300,000 in the third quarter of 2014 as compared to the same period in 2013 while the year to date total decreased $2,000,000 (48%) from $4,200,000 in 2013 to $2,200,000 in 2013. The decrease in the provision for loan losses in the third quarter of 2014 reflected significantly lower levels of non-performing loans in the third quarter of 2014 versus the third quarter of 2013. For the third quarter of 2014, non-performing loans decreased $5,438,000 or 33% from the levels at the end of the third quarter of 2013. As illustrated in Table 6 below, total non-accrual loans plus loans past due 90 days or more were $10,966,000 (.86% of loans outstanding) at September 30, 2014, compared to $15,438,000 (1.24% of loans outstanding) at December 31, 2013. Impacting the third quarter’s non-performing totals was a $2,600,000 commercial relationship that moved from non-accrual status to other real estate owned during the quarter. Management’s evaluation of the inherent risk in the loan portfolio considers both historical losses and information regarding specific borrowers. Management continues to monitor the non-performing relationships and has established appropriate reserves.

On a sequential quarterly basis, the provision for loan losses of $300,000 in the third quarter of 2014 was $700,000 lower than the provision in the second quarter of 2014. Net charge-offs on a sequential basis decreased from $1,015,000 (.32% of loans) in the second quarter of 2014 to $692,000 (.22% of loans) in the third quarter of 2014, while the non-performing loans decreased $6,442,000 or 37% from the levels at the end of the second quarter of 2014.

The provision for loan losses by portfolio segment for the third quarter of 2014, included in Note 8 of the financial statements, included the effects of lower non-specific reserves in the commercial, residential real estate and construction portfolios, compared with the second quarter of 2014 which were offset by the effects of higher levels of specific reserves in the non-residential real estate portfolio compared to the same period. Contributing to the increase in specific reserves in the non-residential real estate portfolio was the risk downgrade of one relationship.

The aggregate amounts of the Bank’s classified assets at September 30, 2014 and December 31, 2013 were as follows:

	September 30, 2014		December 31, 2013
	(Dollars in thousands)
Special mention (risk rating 6)	$	29,795	$	27,589
Substandard (risk rating 7 & 8)		47,802		56,027
Doubtful (risk rating 9)		-		-

Total classified assets	$	77,597	$	83,616

Non-performing assets, which include non-performing loans, other real estate owned (“OREO”) and repossessed assets, totaled $17,626,000 at September 30, 2014 versus $20,743,000 at December 31, 2013. This represents .96% of total assets at September 30, 2014 compared to 1.12% at December 31, 2013. While non-performing loans decreased, as discussed above, OREO balances increased from December 31, 2013 to the third quarter of 2014. OREO balances increased $1,355,000 (26%) from $5,305,000 at December 31, 2013 to $6,660,000 at September 30, 2014. These properties are initially recorded at their fair value less estimated costs to sell with the difference between this value and the loan balance being recorded as a charge-off.

Troubled Debt Restructurings (TDRs). In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In cases where the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, concessionary modification is granted to minimize or eliminate the economic loss and to avoid foreclosure or repossession of the collateral. Modifications may include interest rate reductions, extension of the maturity date or a reduction in the principal balance. Restructured loans accrue interest as long as the borrower complies with the modified terms. Performing TDRs are loans that are paying pursuant to the agreed upon modified terms and are not more than 30 days past due. Non-performing TDRs are the remainder. Total performing TDRs, which are not considered non-performing loans by management, were $6,962,000 at September 30, 2014 as compared to $8,816,000 at December 31, 2013. Total nonperforming TDRs were $4,810,000 at September 30, 2014 as compared to $8,246,000 at December 31, 2013. In order to proactively manage and resolve problem loans, the Bank expects higher than normal levels of TDRs as it continues to work with relationships that show signs of stress. All TDRs are considered impaired loans and any specific reserves related to the TDRs are included in the allowance for loan losses on the balance sheet. Any additional specific reserves related to TDRs added or reduced in a period would be reflected in the provision for loan losses on the income statement for that period. Ordinarily, loans are identified as potential problem loans, through a higher risk weighting, before actually being restructured.

Allowance for Loan Losses (“ALL”). The ALL has decreased as a result the impact of lower levels of adversely classified loans and lower historic loss ratios which were partially offset with higher levels of specific loan reserves. Management believes this is directionally consistent in the first nine months of 2014 with the overall improvement in the credit metrics of the loan portfolio. The ALL decreased $365,000 from $16,306,000 at December 31, 2013 to $15,941,000 at September 30, 2014. The decrease in the ALL accompanied with the increase in loans outstanding in the first nine months of 2014 lowered the allowance for loan losses as a percentage of total loans from 1.30% at December 31, 2013 to 1.25% at September 30, 2014. The amount of the allowance allocated to impaired loans at the end of the third quarter of 2014 was $4,359,000, which was up $940,000 from $3,419,000 at December 31, 2013. The impairment process is described in the “Critical Accounting Policies and Estimates” section of this Quarterly Report. Management believes the current level of the ALL is sufficient to absorb probable incurred losses in the loan portfolio. Management continues to monitor the loan portfolio closely and believes the provision for loan losses is directionally consistent with the changes in the probable losses inherent in the loan portfolio from the year end of 2013 to September 30, 2014. The Bank does not originate or purchase sub-prime loans for its portfolio. Management will continue to monitor and evaluate the effects of the current housing market conditions and any signs of further deterioration in credit quality on the Bank’s loan portfolio.

Monitoring loan quality and maintaining an adequate allowance is an ongoing process overseen by senior management and the loan review function. On at least a quarterly basis, a formal analysis of the adequacy of the ALL is prepared and reviewed by management and the Board of Directors. This analysis serves as a point in time assessment of the level of the ALL and serves as a basis for provisions for loan losses. The loan quality monitoring process includes assigning loan grades and the use of a watch list to identify loans of concern.

The following tables set forth an analysis of certain credit risk information for the periods indicated:

Table 5-Summary of Loan Loss Experience and Allowance for Loan Loss Analysis (in thousands)

	Three Months ended September 30,						Nine Months ended September 30,
	2014			2013			2014			2013
Balance of allowance at beginning of period	$	16,334		$	16,650		$	16,306		$	16,568
Recoveries of loans previously charged off:
Commercial loans		170			226			243			587
Consumer loans		84			75			240			251
Mortgage loans		3			106			7			109
Total recoveries		257			407			490			947
Loans charged off:
Commercial loans		438			123			1,087			2,283
Consumer loans		405			265			401			946
Mortgage loans		107			637			1,173			1,854
Total charge-offs		950			1,025			3,055			5,083
Net charge-offs		(693	)		(618	)		(2,565	)		(4,136	)
Provision for loan losses		300			600			2,200			4,200
Balance of allowance at end of period	$	15,941		$	16,632		$	15,941		$	16,632

Net charge-offs to average loans outstanding for period		0.22	%		0.21	%		0.27	%		0.46	%

Allowance at end of period to loans at end of period		1.25	%		1.38	%		1.25	%		1.38	%

Allowance to non-performing loans at end of period		145	%		101	%		145	%		101	%

Table 6 - Analysis of non-performing loans for the periods indicated (in thousands)

	September 30, 2014			December 31, 2013

Loans accounted for on a non-accrual basis:
Nonresidential real estate	$	5,934		$	9,156
Residential real estate		3,669			5,360
Construction		507			510
Commercial		821			385
Consumer and other		9			6
Total	$	10,940		$	15,417
Accruing loans which are contractually past due 90 days or more:
Nonresidential real estate	$	-			-
Residential real estate		-			-
Construction		-			-
Commercial		-			-
Consumer and other loans		26			21
Total		26			21
Total non-performing loans	$	10,966		$	15,438
Non-performing loans as a percentage of total loans		0.86	%		1.24	%

Other real estate owned	$	6,660		$	5,305

Trouble debt restructured (TDR) loans:
Performing troubled debt restructured (TDR) loans	$	6,962			8,816
Nonperforming trouble debt restructured (TDR) loans (included in nonaccrual loans)		4,810			8,246
Total troubled debt restructured loans	$	11,772		$	17,062

The amount of gross interest income that would have been recorded for nonaccrual loans in the third quarter of 2014 if loans had been current in accordance with their original terms was $130,000 and $154,000 in the third quarter of 2013.

Loans detailed on the credit quality table and the non-performing loan table are the indicators of potential problem loans and there are no other known problems beyond what is disclosed in these tables.

NON-INTEREST INCOME

Table 7-Major components of non-interest income (in thousands)

	Three Months ended September 30,						Nine Months ended September 30,
Non-interest income:	2014			2013			2014			2013

Service charges and fees	$	2,435		$	2,829		$	7,365		$	7,541
Net securities gains		-			-			305			274
Mortgage banking income		219			282			632			1,493
Trust fee income		993			846			2,918			2,548
Bankcard transaction revenue		1,065			1,010			3,169			3,011
Company owned life insurance earnings		274			301			841			873
Gain/(loss) on other real estate owned		(167	)		(201	)		(354	)		(513	)
Other		834			989			2,653			2,531

Total non-interest income	$	5,653		$	6,056		$	17,529		$	17,758

As illustrated in Table 7, total non-interest income decreased $229,000 (1%) from $17,758,000 for the first nine months of 2013 to $17,529,000 for the first nine months of 2014. For the third quarter of 2014, non-interest income decreased $403,000 (7%) to $5,653,000 from $6,056,000 for the same period in 2013. Contributing to the decrease for the first nine months ended September 30, 2014 was a $861,000 (58%) decrease in mortgage banking income which was partially offset by a $370,000 (15%) increase in trust fee income and $159,000 lower losses on the sale of real estate owned. The decrease in mortgage banking income was the result of lower demand for home mortgage loan refinancing. Contributing to the decrease in non-interest income in the third quarter was a $394,000 (14%) decrease in service charges and fees which was partially offset by a $147,000 (17%) increase in trust fee income. The decrease in service charges and fees included a decrease of $191,000 in fees charged for overdrawn accounts from the third quarter of 2013 to the same period in 2014.

NON-INTEREST EXPENSE

Table 8-Major components of non-interest expense (in thousands)

	Three Months ended September 30,				Nine Months ended September 30,
Non-interest expense:	2014		2013		2014		2013

Salaries and benefits	$	6,289	$	5,969	$	18,188	$	17,870
Occupancy and equipment		1,408		1,366		4,247		3,987
Data processing		507		533		1,562		1,620
Advertising		299		335		1,000		1,002
Electronic banking		397		398		1,185		1,235
Outside servicing fees		307		225		805		777
State bank taxes		642		615		1,926		1,805
Other real estate owned and loan collection		247		455		935		1,143
Amortization of intangible assets		120		151		370		467
FDIC insurance		586		316		1,735		947
Merger related expenses		736		-		736		-
Other		1,491		1,356		4,606		4,300

Total non-interest expense	$	13,029	$	11,719	$	37,295	$	35,153

As illustrated in Table 8 above, non-interest expense increased to $37,295,000 in the first nine months of 2014, from $35,153,000 in the same period of 2013, an increase of $2,142,000 (6%). For the third quarter of 2014, non-interest expense increased $1,310,000 (11%) to $13,029,000 compared to $11,719,000 for the same period in 2013. Contributing to the increase in non-interest expense in the first nine months of 2014 were merger related expenses (up $736,000 or 100% from September 30, 2013) and FDIC insurance expense (up $788,000 or 83% from September 30, 2013). The increase in merger related expenses were expenses incurred in connection with the previously disclosed agreement and plan of merger entered into on September 5, 2014 by the Company and BB&T, pursuant to which the Company will merge into BB&T, with BB&T as the surviving entity. FDIC insurance was the result of an insurance rate increase for the Bank.

INCOME TAX EXPENSE

During the first nine months of 2014, income tax expense increased $40,000 (1%) from $5,628,000 in the first nine months of 2013 to $5,668,000 in the same period of 2014. During the third quarter of 2014, income tax expense decreased $453,000 (20%) from $2,244,000 in the third quarter of 2013 to $1,791,000 in the same period of 2014 as a result of lower earnings. For the third quarter of 2014, the effective tax rate decreased to 28.20% compared to 29.30% for the same period of 2013. The effective tax rate decreased to 28.47% for the first nine months of 2014 compared to 28.69% for the same period in 2013.

LIQUIDITY AND CAPITAL RESOURCES

The Bank achieves liquidity by maintaining an appropriate balance between its sources and uses of funds to assure that sufficient funds are available to meet loan demands and deposit fluctuations. As indicated on the statement of cash flows, cash and cash equivalents have decreased $30,449,000, from $78,621,000 at December 31, 2013 to $48,172,000 at September 30, 2014.

The Company’s total shareholders’ equity increased $14,459,000 from $181,139,000 at December 31, 2013 to $195,598,000 at September 30, 2014. In the first nine months of 2014, the Company paid a cash dividend of $.54 per share totaling $4,144,000 to common shareholders. The change in the shareholders’ equity in 2014 included a $2,419,000 increase in accumulated other comprehensive income, which was the result of the increase in the market value of the available-for-sale securities. The market value of these securities increased as a result of the decrease in long term interest rates since December 31, 2013. The after tax market value of these securities changed from an unrealized loss at December 31, 2013 of $1,777,000 to an unrealized gain of $642,000 at September 30, 2014.

The Company’s liquidity depends primarily on the dividends paid to it as the sole shareholder of the Bank and the Company’s cash on hand. The Company needs liquidity to meet its financial obligations under certain subordinated debentures issued by the Company in connection with the issuance of trust preferred securities issued by the Company’s unconsolidated subsidiary, for the other notes payable and for the payment of dividends to common shareholders and for general operating expenses. The Board of Governors of the Federal Reserve System and the FDIC have legal requirements, which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. The FDIC prohibits the payment of any dividend by a bank that would constitute an unsafe or unsound practice. Compliance with the minimum capital requirements limits the amounts that the Company and the Bank can pay as dividends. At September 30, 2014, the Bank had capital in excess of the FDIC’s most restrictive minimum capital requirements in an amount over $59,071,000 from which dividends could be paid, subject to the FDIC’s general safety and soundness review and state banking regulations.

For purposes of determining a bank’s deposit insurance assessment, the FDIC has issued regulations that define a "well capitalized" bank as one with a leverage ratio of 5% or more and a total risk-based capital ratio of 10% or more. At September 30, 2014, the Bank's leverage and total risk-based capital ratios were 10.38% and 13.78%, respectively, which exceed the well-capitalized thresholds.

As described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2013, in July 2013, U.S. federal banking authorities approved final capital rules that revise risk-based and leverage capital requirements that will apply to BKFC and the Bank once fully implemented.

Based on our current capital composition and levels, we believe that we would be in compliance with the requirements as set forth in the Final Capital Rules if they were presently in effect.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

There have been no significant changes to the Bank’s contractual obligations or off-balance sheet arrangements since December 31, 2013. For additional information regarding the Bank’s contractual obligations and off-balance sheet arrangements, refer to the Company’s Form 10-K for the year ending December 31, 2013.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

There has been no material change in market risk since December 31, 2013. For information regarding the Company’s market risk, refer to the Company’s Form 10-K for the year ending December 31, 2013. Market risk is discussed further under the heading “Net Interest Income” above.

Item 4. Controls and Procedures.

Disclosure Controls and Procedures

Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be included in the reports filed or submitted under the Exchange Act is accumulated and communicated to Management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Under the supervision, and with the participation of Management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of the disclosure controls and procedures as of September 30, 2014, and, based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures were effective to ensure that information requiring disclosure is communicated to Management in a timely manner and reported within the timeframe specified by the SEC’s rules and forms.

Changes in Internal Control over Financial Reporting

There was no change in the Company’s internal control over financial reporting that occurred in the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

The Bank of Kentucky Financial Corporation

PART II OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, the Company and the Bank are involved in litigation incidental to the conduct of business, but neither the Company nor the Bank is presently involved in any lawsuit or proceeding which, in the opinion of management, is likely to have a material adverse effect on the Company.

Item 1A. Risk Factors

There have been no material changes in the Company’s risk factors from those previously disclosed in the Company’s Form 10-K for the year ended December 31, 2013, other than the addition of the following:

The pendency of our merger with BB&T could have a negative impact on our business.

On September 5, 2014, the Company entered into an agreement and plan of merger with BB&T, pursuant to which the Company will merge into BB&T, with BB&T as the surviving entity. The announcement and pendency of the merger may have a negative impact on our business, financial results and operations or disrupt our business by:

•

legal claims from purported shareholders challenging the merger;

•

intensifying competition as our competitors may seek opportunities related to our pending merger;

•

affecting our relationships with our customers, vendors and employees;

•

limiting certain of our business operations prior to completion of the merger which may prevent us from pursuing certain opportunities without BB&T’s approval;

•

causing us to forego certain opportunities we might otherwise pursue absent the pending merger;

•

impairing our ability to attract, recruit, retain, and motivate current and prospective employees who may be uncertain about their future roles and relationships with BB&T following the completion of the merger; and

•

creating distractions from our strategy and day-to-day operations for our employees and management and a strain on resources.

The failure to complete the merger could negatively impact our business.

We anticipate our merger will conclude in the first half of 2015, pending regulatory approval. However, there is no assurance that our merger with BB&T will occur or that the conditions to the merger will be satisfied in a timely manner or at all. Further, there is no assurance that any event, change or other circumstances that could give rise to the termination of the agreement and plan of merger will not occur. If the proposed merger or a similar transaction is not completed, the price of our common shares may drop to the extent that the current market price of our common shares reflects an assumption that a transaction will be completed. Certain costs associated with the merger are already incurred or may be payable even if the merger is not completed. Further, a failed transaction may result in negative publicity and a negative impression of us in the investment community. Finally, any disruptions to our business resulting from the announcement and pendency of the merger and from intensifying competition from our competitors, including any adverse changes in our relationships with our customers, vendors and employees or recruiting and retention efforts, could continue or accelerate in the event of a failed transaction. There can be no assurance that our business, these relationships or our financial condition will not be negatively impacted, as compared to the condition prior to the announcement of the merger, if the merger is not consummated.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

Exhibit Number		Description
2.1		Agreement and Plan of Merger, dated September 5, 2014, between BB&T Corporation and The Bank of Kentucky Financial Corporation (Incorporated by reference to Exhibit 2.1 to the Form 8-K filed on September 11, 2014)
10.1		Voting and Support Agreement, dated September 5, 2014 among BB&T Corporation, The Bank of Kentucky Financial Corporation and the individual signatories thereto (Incorporated by reference to Exhibit 10.1 to the Form 8-K filed on September 11, 2014)
10.2		Amendment #3 to The Bank of Kentucky, Inc. Private Pension Plan (Incorporated by reference to Exhibit 10.1 to the Form 8-K filed on October 31, 2014)
31.1		Rule 13a – 14(a) Certification of Robert W. Zapp
31.2		Rule 13a – 14(a) Certification of Martin J. Gerrety
32.1		Section 1350 Certification of Robert W. Zapp
32.2		Section 1350 Certification of Martin J. Gerrety
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema Document*
101.CAL		XBRL Taxonomy Extension Calculation Linkbase*
101.LAB		XBRL Taxonomy Extension Label Linkbase*
101.PRE		XBRL Taxonomy Extension Presentation Linkbase*
101.DEF		XBRL Taxonomy Extension Definition Linkbase*

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		The Bank of Kentucky Financial Corporation

Date:	November 7, 2014		/s/ Robert W. Zapp
			Robert W. Zapp
			President and Chief Executive Officer
			(principal executive officer)

Date:	November 7, 2014		/s/ Martin J.Gerrety
			Martin J. Gerrety
			Treasurer and Assistant Secretary (principal financial officer)

Attached files

Stock widget

Investing forum

BANK OF KENTUCKY FINANCIAL CORP Reports