The following discussion focuses on the consolidated financial condition of Northern States Financial Corporation (the "Company") at September 30, 2008 and the consolidated results of operations for the three and nine month periods ended September 30, 2008, compared with the same periods of 2007. The purpose of this discussion is to provide a better understanding of the condensed consolidated financial statements of Northern States Financial Corporation and the operations of its wholly owned subsidiary, NorStates Bank (the "Bank") and the Bank's wholly owned subsidiary, Northern States Community Development Corporation ("NSCDC"). This discussion should be read in conjunction with the interim condensed consolidated unaudited financial statements and notes thereto included herein.

Statements contained in this report that are not historical facts may constitute forward-looking statements (within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended), which involve significant risks and uncertainties. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of invoking these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by the use of the words "believe," "expect," "intend," "anticipate," "estimate," "project," "plan," or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain and actual results may differ from those predicted. The Company undertakes no obligation to update these forward-looking statements in the future. The Company cautions readers of this report that a number of important factors could cause the Company's actual results subsequent to September 30, 2008 to differ materially from those expressed in forward-looking statements. Factors that could cause actual results to differ from those predicted and could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, the potential for further deterioration in the credit quality of the Company's loan and lease portfolios, a continued increase in nonperforming assets, uncertainty regarding the Company's ability to ultimately recover on loans currently on nonaccrual status, unanticipated changes in interest rates, general economic conditions, increasing regulatory compliance burdens or potential legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the Company's loan or investment portfolios, deposit flows, competition, demand for loan products and financial services in the Company's market area, and changes in accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements.

OVERVIEW

Total assets at September 30, 2008 were $694.7 million, increasing by $56.5 million or 8.9 percent, from total assets of $638.2 million at December 31, 2007. Loans totaled $489.8 million at September 30, 2008, the highest quarter-end level in the Company's history, increasing $54.1 million, or 12.4 percent, from loans of $435.7 million at December 31, 2007. The increase in loans was primarily due to meeting the borrowing needs of the Company's customers. Deposits at September 30, 2008 increased $12.2 million, or 2.5 percent, compared to December 31, 2007 as the Company increased its brokered time deposits by $34.3 million to $78.1 million at September 30, 2008 while most other types of deposits declined as the Company, in order to increase its net interest income, lowered deposit rates. Securities sold under repurchase agreements at September 30, 2008 declined $14.8 million from December 31, 2007. The Company increased its borrowings of federal funds purchased and Federal Home Loan Bank term advances by $30.0 million and $35.0 million, respectively.

The Company reported a loss for the three months ended September 30, 2008 of $2,781,000, or $.68 per share, compared with earnings of $581,000, or $.14 per share, for the same period of 2007. The loss resulted from a $5.1 million provision for loan losses and a $2.2 million write-down of its other than temporarily impaired securities during the quarter. During the third quarter of 2007, the Company had a $967,000 provision for loan losses and had no write-downs to its securities.

The 2008 third quarter provision for loan losses of $5.1 million was attributable to worsening economic conditions in the real estate market that have increased the volume of the Company's nonperforming loans by $15.8 million or 132 percent from year-end. The provision also increased as the real estate used as collateral for these loans decline in value due to the economy. The Company believes that the allowance for loan and lease losses of $9.9 million, or 2.03 percent of total loans at September 30, 2008, is adequate to cover probable credit losses.

The Company's net interest income increased $1.0 million or 21.2 percent during the third quarter of 2008 as compared to the like quarter of 2007. The growth in net interest income was attributable to the Company's loan growth while the Company decreased interest expense by lowering rates paid on deposits and borrowings. The net interest spread increased to 3.39 percent during the third quarter of 2008 as compared with 2.50 percent during the same quarter of 2007.

CRITICAL ACCOUNTING POLICIES

Certain critical accounting policies involve estimates and assumptions made by management. To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes 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 Company's accounting policies for the allowance for loan and lease losses, securities other than temporarily impaired and other real estate owned are critical as the Company's management must make estimates of valuations and these estimates are subject to change.

Management estimates impairment to its securities portfolio based on whether full payments of a security's principal and interest will be collected under the terms of the security. If a security is considered other than temporarily impaired, the Company must write-down the affected security to its market value. Where a market value is not readily available, FSP 157-3 allows the Company to write-down the affected security by using a cash flow analysis using assumptions as to expected payment streams.

The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required using past loan and lease loss experience, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values, economic conditions and other factors. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, based on management's judgment, should be charged-off.

Management analyzes the adequacy of the allowance for loan and lease losses at least quarterly. Loans and leases judged to be impaired, with probable incurred loss exposure, that are no longer accruing interest, and historical net loss percentages are reviewed in the analysis of the allowance for loan and lease losses. Factors consid­ered in assessing the adequacy of the allowance include:
changes in the type and volume of the loan and lease portfolio; review of the larger credits within the Bank; historical loss experi­ence; current economic trends and conditions; review of the present value of expected cash flows or fair value of collateral on impaired loans and leases; portfolio growth; and other factors management deems appropriate. Based on management's analysis, the allowance for loan and lease losses at September 30, 2008 is adequate to cover probable incurred credit losses.

One of the components of the allowance for loan losses is historical loss experience. Different loan classifications within the portfolio have different loss experience ratios. For example, loans secured by real estate generally have a better loss experience than loans secured by other assets. Changes in the classification between periods can impact the allocation for historical losses. At September 30, 2008, approximately 88 percent of the Bank's loans were secured by real estate compared with approximately 85 percent at December 31, 2007.

Management specifically analyzes its impaired loans for probable losses. The change in the volume of impaired loans may significantly impact the amount of estimated losses specifically allocated to these loans depending on the adequacy of the loan collateral and the borrowers' ability to repay the loans. As specific allocations are done on a loan-by-loan basis, the amount of the specific allocation is more likely subject to fluctuation than an allocation for a pool of loans based on historical loss trends. The amount of the allocations on impaired loans may fluctuate in future periods due to changes in conditions of underlying collateral and changes in the borrowers' ability to repay.

Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed for impairment annually during the fourth quarter of each year. Any such impairment of goodwill would be recognized in that period.

Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank and branch acquisitions, which is periodically evaluated for impairment. They are initially measured at fair value and then are amortized on the straight-line method over their estimated useful life of seven years.

FINANCIAL CONDITION

The Company's cash and cash equivalents at September 30, 2008 were $57.0 million and increased $33.4 million from December 31, 2007. The Company had $42.9 million of federal funds sold at September 30, 2008 as compared with $9.2 million at December 31, 2007. The Company's growth in federal funds sold resulted from efforts by the Company to increase its liquidity at quarter-end. Federal funds sold are excess funds above what is necessary to maintain at the Federal Reserve that the Company lends/sells to other financial institutions on an overnight basis. Rather than lend/sell these excess funds, the Company may use the funds for its liquidity needs.

The Company's securities available for sale declined $31.5 million to $121.8 million at September 30, 2008 from $153.3 million at year-end 2007. The liquidity provided by the maturities and calls to the Company's securities available for sale during the nine months ended September 30, 2008 was used to fund loan growth. The Company had proceeds from the sales of securities available for sale of $8.2 million during the third quarter of 2008 and recognized a gain of $40,000 from these sales.

During the third quarter of 2008 the Company incurred losses of $2.2 million due to the write-down of securities available for sale that were considered to be other than temporarily impaired. The Company earlier in 2008 had purchased Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) preferred stock totaling $2.1 million. This preferred stock became other than temporarily impaired when the U.S. Treasury took over FNMA and FHLMC during the quarter, suspended dividend payments and began to restructure these entities. The Company recognized a $1.9 million loss in writing this preferred stock down to its fair value. The Company also took a $275,000 loss on bonds with a book value of $10.8 million consisting of collateralized debt obligations due to the other than temporarily impairment caused by defaults and deferral of payments by the financial institutions and insurance companies issuing the underlying debt.

Loans and leases, the largest earning asset of the Company, totaled $489.8 million at September 30, 2008, increasing $54.1 million from $435.7 million at December 31, 2007. The increase mainly came from increases in loans to the hotel industry secured by commercial real estate. The Company's loans to the hotel industry were $61.1 million at September 30, 2008, an increase of $41.6 million from $19.5 million at December 31, 2007.

The Company's loans are made primarily to small and midsize businesses and are primarily secured by real estate. Approximately 88 percent of the Bank's loan portfolio at September 30, 2008 was secured by real estate. There have been some declines in the real estate values in our market area that have affected the collateral values of the Company's loans secured by real estate. It should be noted that the Bank's underwriting standards require that borrowers have adequate cash flows in order to support loan repayment. As such, the Company carries no subprime mortgages in its loan portfolio. At September 30, 2008, approximately $40.5 million of the Bank's 1 - 4 family loans and home equity loans were pledged under a blanket agreement to the Federal Home Loan Bank to secure our borrowings and line of credit there.

Loan commitments have decreased $20.9 million to $115.8 million at September 30, 2008 compared with $136.7 million at December 31, 2007 as loans were drawn on and the Bank tightened its credit requirements. Letters of credit also decreased at quarter-end to $9.1 million from $10.7 million at year-end. At September 30, 2008, loans to related parties totaled $1.0 million and loan commitments and letters of credit issued to related parties were $1.9 million. Loans, loan commitments and letters of credit to related parties are made on the same terms and conditions that are available to the public.

Deposits at September 30, 2008 increased $12.2 million, or 2.5 percent, from year-end 2007. The growth in deposits came mainly from increases in brokered time deposits, which increased $34.3 million from December 31, 2007. Other deposit types, other than brokered time deposits and time deposits of $100,000 and greater, declined from year-end 2007 as the Bank had lowered interest rates to increase its net interest income. Subsequent to September 30, 2008, the Bank increased its time deposit rates and has a higher promotional money market rate in order to bring in more deposits of these types.

Securities sold under repurchase agreements decreased by $14.8 million to $52.0 million at September 30, 2008 from $66.8 million at December 31, 2007. The decline during 2008 was due to one customer who closed their $20.0 million repurchase agreement relationship. As the repurchase agreements decreased and the Company increased its liquidity, the Company drew on its Federal Home Loan Bank and federal funds purchased lines that totaled $35.0 million and $30.0 million, respectively, at September 30, 2008.

As previously disclosed, the Company has estimated environmental clean-up expenses pertaining to a parcel of other real estate sold in previous years carried as an other liability. At September 30, 2008, this environmental liability was carried in the amount of $298,000. The Company intends to seek reimbursement of these expenses from the State of Illinois that has a fund for this type of cleanup. However, there can be no assurance that the Company will be successful in obtaining any such reimbursement.

FAIR VALUE MEASUREMENTS

The following tables present information about the Company's securities that were measured at fair value on a recurring basis at September 30, 2008, and the valuation techniques used by the Company to determine the fair values.

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical securities that the Company has the ability to access.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar securities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related securities.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each security.

On an annual basis the Company validates the measurement of the fair values of its securities by sending a listing of its securities to an independent securities valuation firm. This independent securities valuation firm determines the fair values of the Company's securities portfolio that is then compared to the fair value using the methods outlined. When this validation was last done at September 30, 2007, the difference between the fair value reported and the fair value determined by the independent securities valuation firm was considered insignificant.

Disclosures concerning securities measured at fair value are as follows:

                                    TABLE 1

                     NORTHERN STATES FINANCIAL CORPORATION

               ASSETS MEASURED AT FAIR VALUE ON A RECURRING BASIS

                            As of September 30, 2008

                                    ($ 000s)

                                                              Fair Value Measurements at Reporting Date Using
                                                         Quoted Prices
                                                           in Active            Significant
                                                          Markets for              Other              Significant
                                                           Identical            Observable            Unobservable
                                                         Assets (Level         Inputs (Level         Inputs (Level
              Description                   9/30/08           1)                    2)                     3)
Securities available for sale              $ 121,822     $           -         $     111,297         $       10,525

During the third quarter of 2008, the Company used the Financial Accounting Standards Board Staff Position No. 157-3 ("FSP 157-3") to determine the fair value of its investment in collateralized debt obligations that are backed by financial institutions and insurance companies that had issued the debt. The methodology for determining fair value on these securities using FSP 157-3 changed the fair value measurement to a Level 3. The Company used FSP 157-3 on these securities, as there were very few trades for these securities and little relevant market data to determine a market value.

The Company used discounted cash flow analysis to determine the fair value of these collateralized debt obligations that had an amortized cost of $10.8 million at September 30, 2008. These securities were transferred to a Level 3 and the Company realized a write-down of $275,000 as it was determined that a portion of these collateralized debt obligations was other than temporarily impaired as shown in Table 2. Reasonable judgement was used that carefully analyzed the defaults and deferral of payments by the financial institutions and insurance companies that had issued the underlying debt.

                     NORTHERN STATES FINANCIAL CORPORATION


                                    TABLE 2

                     NORTHERN STATES FINANCIAL CORPORATION

                   CHANGES IN LEVEL 3 ASSETS AND LIABILITIES

                  MEASURED AT FAIR VALUE ON A RECURRING BASIS

                            As of September 30, 2008

                                    ($ 000s)

                                                                          Investment Securities
                                                                           Available-For-Sale
Balance at December 31, 2007                                             $                     0
Total realized and unrealized gains (losses) included in income                             (275 )
Total unrealized gains (losses) included in other comprehensive income                         0
Net purchase, sales, calls and maturities                                                      0
Net transfer into Level 3                                                                 10,800
Balance at September 30, 2008                                            $                10,525

The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets are held to maturity loans that are considered impaired per Financial Accounting Standard Board Statement No. 114 ("FAS 114"). The Company has estimated the fair values of the impaired loans using Level 3 inputs, specifically discounted cash flow projections. For the quarter ended September 30, 2008, the Company's net change to its specific allocation to these impaired loans in order to adjust these assets to their estimated fair values was $1,261,000.

                                    TABLE 3

                     NORTHERN STATES FINANCIAL CORPORATION

             ASSETS MEASURED AT FAIR VALUE ON A NON-RECURRING BASIS

                            As of September 30, 2008

                                    ($ 000s)

                                                          Fair Value Measurements at Report Date Using
                                                 Quoted Prices                                                        Total
                                                   in Active            Significant                                 Change for
                                                  Markets for              Other                 Significant           the
                                                   Identical             Observable             Unobservable         quarter
                                                    Assets                 Inputs                  Inputs             ended
          Description              09/30/08        (Level 1)             (Level 2)                (Level 3)          09/30/08
Impaired loans accounted For
under FAS 114                     $   19,651     $           -         $            -         $          19,651     $    1,261

Impaired loans that are accounted for under FAS 114 are categorized as Level 3 for fair value measurement. The Company estimates the fair value of these loans are based on the present value of expected future cash flows using management's best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated net realizable values of available collateral (typically based on outside appraisals).

Other assets, including goodwill, intangible assets and other assets acquired in business combinations, are also subject to periodic impairment assessments under other accounting principles generally accepted in the United States of America. These assets are not considered financial instruments. Effective February 12, 2008, the FASB issued a staff position, FSP FAS 157-2, which delayed the applicability of FAS 157 to non-financial instruments. Accordingly, these assets are not included for purposes of the above disclosures.

CAPITAL

Total stockholders' equity decreased $5.4 million to $68.0 million during the nine months ended September 30, 2008. Items causing a reduction to stockholders' equity were a net loss of $1,730,000 for the nine months ended September 30, 2008, purchases of 105,850 shares of treasury stock for $2,078,000 and a payment of a $.40 per share cash dividend to stockholders on June 1, 2008 that totaled $1,628,000. Stockholders' equity was increased by $5,000 from the change in the accumulated other comprehensive income due to unrealized gains on securities available for sale, net of deferred tax during the first nine months of 2008. The book value of the Company's common stock at September 30, 2008 was $16.70 per share.

On a consolidated basis, the Company's Tier 1 to total assets ratio and total capital to assets ratio, on a risk adjusted basis, were 11.69 percent and 12.95 percent, respectively, at September 30, 2008 and exceed the regulatory minimum for capital adequacy purposes for bank holding companies of 4.00 percent an 8.00 percent. The Bank's total capital to assets ratio, at September 30, 2008, on a risk adjusted basis, were 11.62 percent and 12.87 percent, respectively, and exceed the regulatory minimum to be considered "well-capitalized" of 6.00 percent an 10.00 percent. Management believes that the capital position of the Company is appropriate for current projected needs.

LIQUIDITY

The Company's liquidity is measured by the ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment or maturities of loans and securities and net profits. Liquidity is primarily managed through the growth of deposits and by liquid assets such as cash and due from banks less any reserve requirements, securities available for sale less any pledged securities and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities in such a way that achieves an interest rate risk profile acceptable to management and assists in achieving a desired level of profitability. An important part of the overall asset and liability management process is providing adequate liquidity. Liquid assets at the Bank consist of cash and equivalents less any Federal Reserve Bank deposit requirements plus unpledged securities available for sale. The Bank's liquid assets totaled $81.6 million at September 30, 2008 as compared with $46.5 million at December 31, 2007.

Management reviews the liquidity ratio as well as its sources and uses of funds periodically. The liquidity ratio is the net liquid assets divided by net deposits and short-term liabilities. At September 30, 2008, this ratio at the Bank was 15.70 percent, and was within management's internal policy guidelines.

. . .