Certain statements in this Form 10-Q (excluding statements of fact or historical financial information) involve forward-looking information within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors:
competitive pressure in banking industry increases significantly; changes in the interest rate environment reduce margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions, particularly in the Northern California region; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; the California power crises; the U.S. "war on terrorism" and military action by the U.S. in the Middle East, and changes in the securities markets.

Critical Accounting Policies

General

North Valley Bancorp's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan and lease portfolio. Actual losses could differ significantly from the historical factors that we use. Another estimate that we use is related to the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

The allowance for loan and lease losses is maintained to provide for losses related to impaired loans and leases and other losses that can be reasonably expected to occur in the normal course of business. The allowance for loan and lease losses is established through a provision for loan and lease losses charged to operations. Loans and leases are charged against the allowance for loan and lease losses when management believes that the collectibility of the principal is unlikely or, with respect to consumer installment loans, according to an established delinquency schedule. Management attributes formula reserves to different types of loans using percentages which are based upon perceived risk associated with the portfolio and underlying collateral, historical loss experience, and vulnerability to existing economic conditions, which may affect the collectibility of the loans. Specific reserves are allocated for impaired loans and leases which have experienced a decline in internal grading and when management believes additional loss exposure exists. The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of inherent losses with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. Although the allowance for loan and lease losses is allocated to various portfolio segments, it is general in nature and is available for the loan and lease portfolio in its entirety. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and leases. Actual amounts could differ from those estimates.

The Company considers a loan or lease impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. The measurement of impaired loans and leases is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans and leases are measured for impairment based on the fair value of the collateral.

Share Based Compensation

At September 30, 2008, the Company had four shareholder approved stock-based compensation plans: the North Valley Bancorp 1989 Director Stock Option Plan, the 1998 Employee Stock Incentive Plan, the 1999 Director Stock Option Plan and the 2008 Stock Incentive Plan. The 1999 Director Stock Option Plan replaced the existing North Valley Bancorp 1989 Director Stock Option Plan. The North Valley Bancorp 2008 Stock Incentive Plan was adopted by the Company's Board of Directors on February 27, 2008, effective that date, and was approved by the Company's shareholders at the Annual Meeting, May 22, 2008. The terms of the 2008 Stock Incentive Plan are substantially the same as the North Valley Bancorp 1998 Employee Stock Incentive Plan. See Note C - Stock-Based Compensation to the Unaudited Condensed Consolidated Financial Statements in Item 1 - Financial Statements.

Prior to January 1, 2006, the Company accounted for the plans under the recognition and measurement provisions of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Financial Accounting Standards Board ("FASB") Statement No. 123, Accounting for Stock-Based Compensation ("Statement 123") and FASB Statement No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. Effective January 1, 2006, the Company adopted the fair value recognition provisions of FASB Statement No. 123(R), Share-Based Payment ("Statement 123 (R)"), using the modified prospective transition method. Under this transition method, compensation cost recognized in fiscal year 2007 and 2008 includes: (a) compensation cost for all share-based payments vesting during 2007 and 2008 that were granted prior to, but not yet vested as of, January 1, 2006 based on the grant-date fair value estimated in accordance with the original provisions of Statement 123; and, (b) compensation cost for all share-based payments vesting during 2007 and 2008 that were granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of Statement 123(R). The Company has elected the alternative method prescribed by FASB Staff Position No. FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, commonly referred to as the "short-cut" method, for accounting for the tax consequences of share-based awards.

Goodwill

Business combinations involving the Company's acquisition of the equity interests or net assets of another enterprise may give rise to goodwill. Goodwill represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed in transactions accounted for under the purchase method of accounting. Goodwill of $15,187,000 was recorded in the Company's acquisition of Yolo Community Bank. The value of goodwill is ultimately derived from the Company's ability to generate net earnings. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill will be assessed for impairment at a reporting unit level at least annually. Management will conduct its annual assessment of impairment during the fourth quarter of 2008.

Investment securities are evaluated for other-than-temporary impairment on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value below amortized cost is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, the financial condition of the issuer, rating agency changes related to the issuer's securities and the intent and ability of the Company to retain its investment in the issues for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term "other-than-temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. See Note B - Investment Securities to the Unaudited Condensed Consolidated Financial Statements in Item 1 - Financial Statements.

Fair Value

Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, which among other things, requires enhanced disclosures about financial instruments carried at fair value. SFAS No. 157 establishes a hierarchical disclosure framework associated with the level of observable pricing scenarios utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of the observable pricing scenario. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment utilized in measuring fair value. Observable pricing scenarios are impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.

See Note J - Fair Value Measurement to the Unaudited Condensed Consolidated Financial Statements in Item 1 - Financial Statements for additional information about the financial instruments carried at fair value.

Overview

North Valley Bancorp (the "Company") is a bank holding company headquartered in Redding, California. The Company's wholly owned subsidiary, North Valley Bank ("NVB"), a state-chartered bank, operates out of its main office located at 300 Park Marina Circle, Redding, CA 96001, with twenty-six commercial banking offices, including two in-store supermarket branches, seven Business Banking Centers and a loan production office, in Northern California. The Company's principal business consists of attracting deposits from the general public and using the funds to originate commercial, real estate and installment loans to customers, who are predominately small and middle market businesses and middle income individuals. The Company's primary source of revenues is interest income from its loan and investment securities portfolios. The Company is not dependent on any single customer for more than ten percent of its revenues.

Earnings Summary


(in thousands except         Three months ended September 30,        Nine months ended September 30,
per share amounts)              2008                 2007               2008                 2007


Net interest income        $         8,812      $        10,245    $        27,009      $        30,674
Provision for loan and
lease losses                         1,500                  850              9,100                  850
Noninterest income                     284                3,350              7,252                9,654
Noninterest expense                  9,694                9,481             29,075               30,443
(Benefit) provision for
income taxes                          (679 )              1,044             (1,266 )              2,891

Net (loss) income          $        (1,419 )    $         2,220    $        (2,648 )    $         6,144


(Loss)/Earnings Per
Share
Basic                      $         (0.19 )    $          0.30    $         (0.36 )    $          0.84
Diluted                    $         (0.19 )    $          0.29    $         (0.36 )    $          0.80

Annualized
(Loss)/Return on
Average Assets                       (0.62 %)              0.97 %            (0.38 %)              0.92 %
Annualized
(Loss)/Return on
Average Equity                       (7.13 %)             11.15 %            (4.33 %)             10.55 %

The Company had a net loss of $1,419,000, or $0.19 per diluted share, and $2,648,000, or $0.36 per diluted share, for the three and nine months ended September 30, 2008, respectively. This represents a decrease in net income of $3,639,000 and $8,792,000 when compared to the three and nine months ended September 30, 2007. The decrease in net income for the three and nine months ended September 30, 2008 compared to the same periods in 2007 was principally driven by an impairment charge of $3,284,000 on FNMA Preferred Stock that management concluded was impaired during the third quarter of 2008 and a $1,500,000 provision for loan and lease losses for the three months ended September 30, 2008 and a total provision of $9,100,000 for the nine months ended September 30, 2008 compared to an $850,000 provision for the three and nine month periods in 2007. Additionally, net interest income decreased $1,433,000 for the three months ended September 30, 2008 and decreased $3,665,000 for the nine months ended September 30, 2008 compared to the same periods in 2007. Noninterest income decreased $3,066,000 and $2,402,000 for the three and nine months ended September 30, 2008 compared to the same periods in 2007 due to the impairment charge discussed above. Noninterest expense increased $213,000 for the three months ended September 30, 2008 compared to the same period in 2007, and decreased $1,367,000 for the nine months ended September 30, 2008 compared to the same period in 2007. As a result of the net losses, the Company recorded a benefit for income taxes of $679,000 and $1,266,000 for the three and nine months ended September 30, 2008 compared to a provision for income taxes of $2,220,000 and $2,891,000 for the same periods in 2007.

Net Interest Income

Net interest income is the principal source of the Company's operating earnings and represents the difference between interest earned on loans and leases and other investments and interest paid on deposits and other borrowings. The amount of interest income and expense is affected by changes in the volume and mix of earning assets and interest-bearing deposits and borrowings, along with changes in interest rates.

Schedule of Average Daily Balance and Average Yields and Rates
(Dollars in thousands)


                                Three months ended September 30, 2008               Three months ended September 30, 2007

                               Average          Yield/          Interest           Average          Yield/          Interest
                               Balance           Rate            Amount            Balance           Rate            Amount


Assets
Earning assets:
Federal funds sold         $           604           1.97 %  $            3    $           977           4.87 %  $           12
Investment securities:
Taxable                             73,827           4.13 %             769             90,946           4.30 %             986
Non-taxable (1)                     20,019           6.74 %             340             20,748           6.73 %             352
FNMA preferred stock (1)             3,248           9.53 %              78              5,000           6.19 %              78

Total investments                   97,094           4.85 %           1,187            116,694           4.81 %           1,416
Loans and leases (2)(3)            714,546           6.49 %          11,686            696,861           7.85 %          13,790

Total earning assets               812,244           6.29 %          12,876            814,532           7.41 %          15,218

Non earning assets                 102,698                                              99,286
Allowance for loan and
lease losses                       (13,547 )                                            (8,786 )

Total non-earning assets            89,151                                              90,500

Total assets               $       901,395                                     $       905,032


Liabilities and
Shareholders' Equity
Interest bearing
liabilities:
Transaction accounts       $       154,408           0.58 %  $          227    $       156,414           0.51 %  $          200
Savings and money market           177,654           1.51 %             678            189,995           1.92 %             918
Time certificates                  261,105           3.47 %           2,282            224,154           4.68 %           2,642
Other borrowed funds                61,363           4.82 %             745             71,269           6.00 %           1,078

Total interest bearing
liabilities                        654,530           2.38 %           3,932            641,832           2.99 %           4,838

Demand deposits                    156,427                                             174,123
Other liabilities                   11,488                                              10,098

Total liabilities                  822,445                                             826,053

Shareholders' equity                78,950                                              78,979

Total liabilities and
shareholders' equity       $       901,395                                     $       905,032

Net interest income                                          $        8,944                                      $       10,380

Net interest spread                                  3.91 %                                              4.42 %

Net interest margin                                  4.37 %                                              5.06 %

(1) Tax-equivalent basis; non-taxable securities are exempt from federal taxation.

(2) Loans on nonaccrual status have been included in the computations of averages balances.

(3) Includes loan fees of $95 and $351 for the three months ended September 30, 2008 and 2007, respectively.

Schedule of Average Daily Balance and Average Yields and Rates
(Dollars in thousands)


                         Nine months ended September 30, 2008              Nine months ended September 30, 2007

                        Average          Yield/        Interest           Average          Yield/        Interest
                        Balance           Rate          Amount            Balance           Rate          Amount

Assets
Earning assets:
Federal funds
sold                $           475          2.52 %  $           9    $         9,933          5.26 %  $         391
Investment
securities:
Taxable                      79,858          4.12 %          2,469             96,972          4.38 %          3,177
Non-taxable (1)              20,248          6.72 %          1,021             21,007          6.82 %          1,072
FNMA preferred
stock (1)                     3,272          9.57 %            235              7,175          6.45 %            346

Total
investments                 103,378          4.80 %          3,725            125,154          4.91 %          4,595
Loans and leases
(2)(3)                      734,913          6.69 %         36,908            670,469          7.90 %         39,622

Total earning
assets                      838,766          6.45 %         40,642            805,556          7.40 %         44,608

Non earning
assets                       99,708                                            99,603
Allowance for
loan and lease
losses                      (12,472 )                                          (8,809 )

Total
non-earning
assets                       87,236                                            90,794
Total assets        $       926,002                                   $       896,350


Liabilities and
Shareholders'
Equity
Interest bearing
liabilities:
Transaction
accounts            $       155,624          0.63 %  $         732    $       158,883          0.48 %  $         574
Savings and
money market                181,149          1.64 %          2,231            195,453          1.88 %          2,746
Time
certificates                252,463          3.93 %          7,443            214,403          4.55 %          7,304
Other borrowed
funds                        86,150          4.39 %          2,842             63,551          6.06 %          2,881

Total interest
bearing
liabilities                 675,386          2.61 %         13,248            632,290          2.86 %         13,505

Demand deposits             159,564                                           175,200
Other
liabilities                   9,579                                            10,970

Total
liabilities                 844,529                                           818,460

Shareholders'
equity                       81,473                                            77,890


Total
liabilities and
shareholders'
equity              $       926,002                                   $       896,350

Net interest
income                                               $      27,394                                     $      31,103

Net interest
spread                                       3.84 %                                            4.54 %

Net interest
margin                                       4.35 %                                            5.16 %

(1) Tax-equivalent basis; non-taxable securities are exempt from federal taxation.

(2) Loans on nonaccrual status have been included in the computations of averages balances.

(3) Includes loan fees of $387 and $1,076 for the nine months ended September 30, 2008 and 2007, respectively.

Net interest income has been adjusted to a fully taxable equivalent basis (FTE) for tax-exempt investments included in earning assets. Net interest income, which represents the Company's largest component of revenues and is the difference between interest earned on loans and investments and interest paid on deposits and borrowings, decreased $1,436,000, or 13.8%, for the three months ended September 30, 2008 compared to the same period in 2007. Interest income decreased by $2,342,000 for the third quarter of 2008, primarily due to foregone interest income of $507,000 due to loans placed on nonaccrual status and a reduction in yield on the loan portfolio and in the interest earned on investment securities and Federal funds sold due primarily to the decreases in the average balances. Interest expense decreased $906,000 as the increase in the average balance of interest bearing liabilities of $12,698,000 was more than offset by the decrease on rates paid on deposits and borrowings for the quarter ended September 30, 2008 compared to the same period in 2007. Average loans increased $17,685,000 in the third quarter of 2008 compared to the third quarter of 2007, however the yield on the loan portfolio for the comparable periods decreased 136 basis points to 6.49%. This decrease is reflective of the declining interest rate environment and the impact of foregone interest income on the loans placed on nonaccrual. Interest rates set by the Federal Reserve Board have declined 325 basis points since September 2007. The increase in average total loans was primarily funded by a decrease in average investments and Federal funds sold of $19,973,000. Average yields on total average earning assets decreased 112 basis points from the quarter ended September 30, 2007 to 6.29% for the quarter ended September 30, 2008. Over the same period the average rate paid on interest-bearing liabilities decreased by 61 basis points to 2.38%. As a result of the above, the Company's net interest margin for the quarter ended September 30, 2008 was 4.37%, a decrease of 69 basis points from the 5.06% for the quarter ended September 30, 2007 but consistent with the 4.34% net interest margin for the linked quarter ended June 30, 2008.

Currently the Company is retaining fixed-rate 15-and 30-year conforming residential mortgages to better diversify the portfolio and also adding fixed rate mortgages with the steepening of the yield curve in this declining interest rate environment. The Company will continue to sell the fixed rate jumbo mortgage loans it originates.

Provision for Loan and Lease Losses

The Company recorded a provision for loan and lease losses of $1,500,000 for the three months ended September 30, 2008 and a total provision of $9,100,000 for the nine months ended September 30, 2008. The Company recorded an $850,000 provision for the three and nine months ended September 30, 2007. The process for determining allowance adequacy and the resultant provision for loan losses includes a comprehensive analysis of the loan portfolio. Factors in the analysis include size and mix of the loan portfolio, nonperforming loan levels, charge-off/recovery activity and other qualitative factors including economic environment and activity. The decision to record the $1,500,000 and $9,100,000 . . .