Introduction

This Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the Company or CBSI) as of and for the three and nine months ended September 30, 2008 and 2007, although in some circumstances the second quarter of 2008 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 15. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, the term "this year" refers to results in calendar year 2008, "third quarter" refers to the quarter ended September 30, 2008, earnings per share (EPS) figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent (FTE) basis.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 30.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company's business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles, but also reflects on management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include:

· Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change.

· Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include, among other things, discount rate, rate of future compensation increases and expected return on plan assets.

· Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate. Should tax laws change, or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations.

· Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators.

A summary of the accounting policies used by management is disclosed in Note A, "Summary of Significant Accounting Policies" on pages 46-51 of the most recent Form 10-K (fiscal year ended December 31, 2007) filed with the Securities and Exchange Commission on March 13, 2008.

Executive Summary

The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial, and municipal customers.

The Company's core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan and deposit portfolios using both organic and acquisition strategies, (iii) increase the noninterest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and to reduce operating costs.

Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, noninterest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology enhancements, market share, peer comparisons, and the performance of acquisition and integration activities.

On July 7, 2008, Benefit Plans Administrative Services, Inc. (BPAS) completed its acquisition of the Philadelphia division of Alliance Benefit Group MidAtlantic (ABG) from BenefitStreet, Inc. ABG provides retirement plan consulting, daily valuation administration, actuarial and ancillary support services. This transaction, which is expected to add approximately $5.0 million in annual revenues, adds valuable capacity to support BPAS's growing customer base of more than 300 actuarial engagements, administration of over 200,000 defined contribution and flexible spending participant accounts.

On June 25, 2008, the Company announced an agreement to acquire 18 branch-banking centers in northern New York State from Citizens Financial Group, Inc. (Citizens) in an all-cash transaction. Under the terms of the agreement, the company will acquire approximately $115 million in loans and $590 million in deposits at a blended deposit premium of 12%. The Company has obtained all customary regulatory approvals and this acquisition is expected to close during the fourth quarter of 2008. In support of the transaction, the Company issued approximately $50 million of equity capital in October 2008. Excluding one-time expenses, the transaction is expected to be accretive to earnings per share, inclusive of the impact of the additional equity issuance, in the first year.

On June 1, 2007, the Company completed its acquisition of TLNB Financial Corporation, parent company of Tupper Lake National Bank (TLNB), in an all-cash transaction valued at approximately $17.8 million. Based in Tupper Lake, NY, TLNB operated five branches in the northeastern New York State cities of Tupper Lake, Plattsburgh and Saranac Lake, as well as an insurance subsidiary, TLNB Insurance Agency, Inc. On a consolidated basis, TLNB had approximately $100 million in assets and $87 million of deposits at the time of acquisition.

On May 18, 2007, the Company's subsidiary, BPAS, completed its acquisition of Hand Benefits & Trust, Inc. (HBT) in an all-cash transaction. HBT is a Houston, Texas based provider of employee benefit plan administration and trust services.

Third quarter and September year-to-date 2008 earnings per share were $0.39 and $1.13, respectively, an increase of $0.02 and $0.11 as compared to the respective prior year periods. The increase was driven by strong organic loan and core deposit growth, continued expansion of non-interest income sources, improved net interest margin and continued solid asset quality results. These were partially offset by a higher provision for loan losses and increased operating expenses. Cash earnings per share (which excludes the after-tax effect of the amortization of intangibles assets and acquisition-related market value adjustments) were $0.44 versus $0.41 for the prior year's third quarter and $1.27 versus $1.16 for the prior year-to-date period.

Asset quality in the third quarter of 2008 and in the first nine months of the year remain at or near the historically favorable levels achieved over the last few years. Net charge-offs and nonperforming loan and total delinquent loan ratios increased, but remained below historical average quarterly levels. The Company experienced solid year-over-year organic loan growth in all portfolios:
consumer installment, consumer mortgage and business lending. Average balances in the investment portfolio decreased as compared to the third quarter of 2007. Average deposits increased in the third quarter of 2008 as compared to the second quarter of 2008 and declined from the third quarter of 2007. These changes supported the Company's objective of lowering its overall funding costs by reducing higher cost time deposits, and focusing on expanding core account relationships. Average external borrowings increased from the second quarter of this year in anticipation of the significant additional liquidity expected to be received from the Citizens' branch acquisition in the fourth quarter. In December 2007, the Company refinanced $150 million of its fixed rate Federal Home Loan Bank (FHLB) advances, replacing them with lower cost instruments with similar remaining duration, and in the first quarter of 2008 the Company redeemed $25 million of variable-rate trust preferred securities. These restructuring strategies had a positive impact on the Company's net interest margin in the first nine months of 2008.

Net Income and Profitability

As shown in Table 1, earnings per share for the third quarter and September YTD of $0.39 and $1.13, respectively, were $0.02 and $0.11 higher than the EPS generated in the same periods of last year. Net income for the quarter of $11.8 million was up 6.9% over the third quarter of 2007 and net income of $34.0 million for the first nine months of 2008 increased 9.4% from the amount earned in the same period of 2007. As compared to the second quarter of 2008, net income increased $0.5 million or 4.4% and earnings per share increased $0.02 or 5.4%.

Third quarter net interest income of $37.1 million was up $2.8 million or 8.1% from the comparable prior year period, and net interest income for the first nine months of 2008 increased $7.1 million or 7.1% over the first nine months of 2007. The current quarter's provision for loan losses increased $1.5 million as compared to the third quarter of 2007 and increased $3.2 million for the first nine months of 2008 as compared to the same periods of 2007, primarily reflective of organic loan growth during the year. Third quarter noninterest income, excluding securities gains and losses, was $19.4 million, up $1.8 million or 10.2% from the third quarter of 2007, while YTD noninterest income of $54.4 million increased $8.3 million or 18% from the prior year level. Operating expenses of $39.3 million for the quarter and $114.6 million for the first nine months of 2008 were up $2.5 million or 6.8% and $9.8 million or 9.3% respectively, from the comparable prior year periods. Significant portions of the increases were attributable to the acquisition of ABG during the third quarter of 2008 and HBT and TLNB during the second quarter of 2007.

In addition to the earnings results presented above in accordance with generally accepted accounting principles (GAAP), the Company provides cash earnings per share (a non-GAAP measure), which excludes the after-tax effect of the amortization of intangible assets and acquisition-related market value adjustments. Management believes that this information helps investors better understand the impact of acquisition activity on reported results. Cash earnings per share for the third quarter and the first nine months of 2008 were $0.44 and $1.27, respectively, up 7.3% and 9.5% from the $0.41 and $1.16, respectively, earned in the comparable periods of 2007.

As reflected in Table 1, the primary reasons for improved earnings over the prior year were higher net interest income and noninterest income, partially offset by higher operating expenses and loan loss provision. Net interest income for the third quarter and year-to-date period increased as compared to the comparable periods of 2007 as a result of higher net interest margins as well as acquired and organic loan growth. Excluding security gains and losses, noninterest income increased due to a strong performance by the Company's employee benefits consulting and plan administration business, as a result of organic growth and the acquisitions of HBT and ABG, as well as higher banking service fees, including account fees and debit card related revenues. An increase in total loans and higher net charge-offs were the primary reasons for the increase in the loan loss provision. Operating expenses increased for the quarter and year-to-date periods, primarily due to costs associated with the three acquisitions completed in the last year, as well as higher volume-based processing costs, increased facility-based utilities and maintenance costs, and higher personnel expenses. As compared to the second quarter of 2008, operating expenses increased $2.3 million or 6.2%, primarily due to the acquisition of ABG in July 2008.

A condensed income statement and a reconciliation of GAAP-based earnings results to cash-based earnings results are as follows:

Table 1: Summary Income Statements

                                    Three Months Ended    Nine Months Ended
                                       September 30,        September 30,
         (000's omitted, except
         per share data)              2008      2007        2008      2007
         Net interest income          $37,073   $34,280    $108,111 $100,985
         Provision for loan
         losses                         1,985       510       4,335    1,124
         Noninterest income
         excluding security
         losses                        19,383    17,588      54,420   46,093
         (Loss) gain on sales of
         investment securities              0      (16)         230     (24)
         Operating expenses            39,256    36,765     114,585  104,816
         Income before taxes           15,215    14,577      43,841   41,114
         Income taxes                   3,429     3,548       9,870   10,070
         Net income                   $11,786   $11,029     $33,971  $31,044

         Diluted earnings per
         share                          $0.39     $0.37       $1.13    $1.02

Table 2: Reconciliation of GAAP Net Income to Cash Net Income (Non-GAAP measure)

                                            Three Months Ended     Nine Months Ended
                                               September 30,         September 30,
(000's omitted)                               2008      2007        2008      2007
Net income                                    $11,786   $11,029     $33,971   $31,044
After-tax cash adjustments:
 Amortization of market value adjustments
   on net assets acquired in mergers              147       172         452       526
 Amortization of intangible assets              1,338     1,233       3,799     3,568
Net income - cash                             $13,271   $12,434     $38,222   $35,138

Diluted earnings per share - cash               $0.44     $0.41       $1.27     $1.16

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash) exceed the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 3a, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the third quarter of 2008 was $40.7 million, a $2.8 million increase from the same period last year. A $21.2 million increase in interest-earning assets and a 26 basis point increase in the net interest margin versus the prior year offset a $5.8 million increase in average interest-bearing liabilities. As reflected in Table 4, the rate decreases on interest bearing liabilities and the volume increases in interest earning assets had a $7.0 million favorable impact on net interest income, while the decrease in rate on interest bearing assets and higher interest bearing liability balances had a $4.2 million unfavorable impact on net interest income. September 2008 YTD net interest income of $119.4 million increased $7.2 million or 6.5% from the year earlier period. An $84.5 million increase in interest bearing assets and a 15 basis point increase in the net interest margin more than offset a $75.0 million increase in interest bearing liabilities. The increase in interest earning asset balances and a lower rate on interest bearing liabilities had a $17.5 million favorable impact that was partially offset by a $10.2 million unfavorable impact from the decrease in the rate on interest bearing assets and the increase in interest bearing liability balances.

Higher third quarter and September YTD average loan balances were attributable to $188.2 million of quarterly average organic loan growth since the third quarter of 2007, driven by growth in all portfolios: consumer installment, consumer mortgage and business lending. Average investments and cash equivalents for the third quarter and YTD periods were $167.0 million and $76.5 million lower than the respective periods of 2007, primarily due to cash flows from maturing investments being used to fund loan growth. In comparison to the prior year, total average deposits declined $70.5 million or 2.1% and $25.6 million or 0.8% for the quarter and YTD periods, respectively. Consistent with the Company's funding mix objectives, average core deposit balances increased $99 million or 5.4% since the third quarter of 2007, while time deposits were allowed to decline $169 million during the same timeframe. Quarterly average borrowings increased $82.5 million as compared to the third quarter of 2007 primarily due to the short-term funding added that will be replaced by the significant additional liquidity expected to be received from the Citizens' branch acquisition. YTD average borrowings increased $105.9 million as compared to the first nine months of 2007 primarily due to the all-cash acquisitions of TLNB, HBT, and ABG, partially offset by the redemption of $25 million of fixed rate trust preferred securities in the first quarter of 2008.

The net interest margin of 3.82% for the third quarter and 3.80% for the year to date period increased 26 basis points and 15 basis points, respectively, versus the same periods in the prior year. The improvement was primarily attributable to a 63 basis point and a 44 basis point decrease in the cost of funds for the quarter and year-to-date periods, respectively, as compared to the prior year periods. The decrease in the cost of funds was due to a 73 basis point and 48 basis point decrease in the rate paid on interest bearing deposits for the third quarter and YTD periods, respectively, and a 90 basis point and 85 basis point decrease in the rate paid on external borrowings for the third quarter and YTD periods, respectively. Partially offsetting these improvements was a 37 basis point and 27 basis point decline in earning assets yields for the quarter and YTD periods, respectively, as compared to the comparable periods of 2007. The change in earning-asset yields was driven by a 57 basis point and 39 basis point decrease in loan yields for the quarter and YTD periods, respectively, and a five basis point and nine basis point decline in the investment yields for the quarter and YTD periods, respectively, mostly as a result of higher rate investments maturing and variable and adjustable-rate assets repricing downward due to the decline in fed funds and other short and medium-term rates.

The third quarter cost of funds decreased 63 basis points versus the prior year's quarter due to an 90 basis point decrease in the average interest rate paid on external borrowings and a 73 basis point decrease in interest-bearing deposits rates and an increased proportion of non-interest bearing demand deposits. The decrease in the external borrowing rate is due to the restructuring of $150 million of FHLB advances in December 2007 and the redemption of $25 million of variable rate, trust-preferred securities in January 2008. Additionally, the long-term rate was impacted by the 256 basis point decrease in the three month LIBOR (London Interbank Offered Rates) over the last twelve months, from which the interest rate on $25 million of the mandatorily redeemable preferred securities is based. Interest rates on selected categories of deposit accounts were lowered throughout the fourth quarter of 2007 and the first nine months of 2008 in response to market conditions. In addition, the proportion of customer deposits in higher cost time deposits has declined 4.3 percentage points over the last twelve months, while the percentage of deposits in lower cost checking and savings accounts increased.

Tables 3a and 3b below set forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis using marginal income tax rates of 38.49% in 2008 and 38.75% in 2007. Average balances are computed by accumulating the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include nonaccrual loans and loans held for sale.

Table 3a: Quarterly Average Balance Sheet

                               Three Months Ended               Three Months Ended
(000's omitted except
yields and rates)              September 30, 2008               September 30, 2007
                                                Avg.                             Avg.
                          Average            Yield/Rate    Average            Yield/Rate
                          Balance   Interest    Paid       Balance   Interest    Paid
Interest-earning assets:
 Cash equivalents            $4,320      $24      2.18%      $90,628   $1,181      5.17%
 Taxable investment
securities (1)              766,582    9,811      5.09%      881,200   11,891      5.35%
 Nontaxable investment
securities (1)              511,299    8,758      6.81%      477,369    8,184      6.80%
 Loans (net of unearned
discount)                 2,963,504   46,866      6.29%    2,775,337   47,995      6.86%
   Total
interest-earning assets   4,245,705   65,459      6.13%    4,224,534   69,251      6.50%
Noninterest-earning
assets                      466,718                          454,784
   Total assets          $4,712,423                       $4,679,318

Interest-bearing
liabilities:
 Interest checking,
savings and money market
deposits                 $1,348,288    2,691      0.79%   $1,255,656    3,640      1.15%
 Time deposits            1,310,393   12,070      3.66%    1,479,693   16,651      4.46%
 Short-term borrowings      477,139    4,644      3.87%      307,090    3,147      4.07%
 Long-term borrowings       449,292    5,336      4.72%      536,859    7,888      5.83%
   Total
interest-bearing
liabilities               3,585,112   24,741      2.75%    3,579,298   31,326      3.47%
Noninterest-bearing
liabilities:
 Demand deposits            590,098                          583,946
 Other liabilities           49,964                           53,902
Shareholders' equity        487,249                          462,172
   Total liabilities and
shareholders' equity     $4,712,423                       $4,679,318

Net interest earnings                $40,718                          $37,925
Net interest spread                               3.38%                            3.03%
Net interest margin on
interest-earnings assets                          3.82%                            3.56%

Fully tax-equivalent
adjustment                            $3,645                           $3,645

(1) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes.

Table 3b: Year-to-Date Average Balance Sheet

                                   Nine Months Ended                Nine Months Ended
(000's omitted except yields
and rates)                         September 30, 2008               September 30, 2007
                                                    Avg.                             Avg.
                              Average            Yield/Rate    Average            Yield/Rate
                              Balance   Interest    Paid       Balance   Interest    Paid
Interest-earning assets:
 Cash equivalents               $25,983     $482      2.48%      $93,535   $3,658      5.23%
 Taxable investment
securities (1)                  760,567   30,303      5.32%      807,283   33,384      5.53%
 Nontaxable investment
securities (1)                  525,530   27,154      6.90%      487,771   25,178      6.90%
 Loans (net of unearned
discount)                     2,885,267  139,375      6.45%    2,724,307  139,364      6.84%
   Total interest-earning
assets                        4,197,347  197,314      6.28%    4,112,896  201,584      6.55%
Noninterest-earning assets      467,623                          449,510
   Total assets              $4,664,970                       $4,562,406

Interest-bearing
liabilities:
 Interest checking, savings
and money market deposits    $1,304,616    7,926      0.81%   $1,222,630   10,415      1.14%
 Time deposits                1,356,937   40,569      3.99%    1,469,769   48,088      4.37%
 Short-term borrowings          441,347   13,321      4.03%      207,652    6,406      4.12%
 Long-term borrowings           451,971   16,108      4.76%      579,775   24,526      5.66%
   Total interest-bearing
liabilities                   3,554,871   77,924      2.93%    3,479,826   89,435      3.44%
Noninterest-bearing
liabilities:
 Demand deposits                569,764                          564,526
 Other liabilities               53,851                           53,914
Shareholders' equity            486,484                          464,140
   Total liabilities and
shareholders' equity         $4,664,970                       $4,562,406

Net interest earnings                   $119,390                         $112,149
Net interest spread                                   3.35%                            3.11%
Net interest margin on
interest-earnings assets                              3.80%                            3.65%

. . .