$ in thousands, except per share data

The following discussion and analysis provides information about the results of operations, financial condition, liquidity and capital resources of National Bankshares, Inc. and its subsidiaries. The discussion should be read in conjunction with the material presented in Item 8, "Financial Statements and Supplementary Data", of this Form 10-K.

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements.

Per share data has been adjusted to reflect a 2-for-1 stock split effective March 31, 2006.

Critical Accounting Policies

General

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our 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 when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from one previously acceptable method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, "Accounting for Contingencies", which requires that losses be accrued when they are probable of occurring and are estimable and (ii) SFAS 114, "Accounting by Creditors for Impairment of a Loan", which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The use of these values is inherently subjective, and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events and to industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized either in the formula or in the specific allowance.

Core deposit intangibles

Effective January 1, 2002, the Company adopted Financial Accounting Standards Board Statement No. 142, "Goodwill and Other Intangible Assets". Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, Statement 142 requires that acquired intangible assets (such as core deposit intangibles) be separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over its estimated useful life. Branch acquisition transactions were outside the scope of the Statement and therefore any intangible asset arising from such transactions remained subject to amortization over their estimated useful life.

In October 2002, the Financial Accounting Standards Board issued Statement No. 147, "Acquisitions of Certain Financial Institutions". The Statement amends previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement No. 141, "Business Combinations", and Statement No. 142 to branch acquisitions if such transactions meet the definition of a business combination. The provisions of the Statement do not apply to transactions between two or more mutual enterprises. In addition, the Statement amends Statement No. 144, "Accounting for the Impairment of Long-Lived Assets", to include in its scope core deposit intangibles of financial institutions. Accordingly, such intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. The Company has determined that the acquisitions that generated the intangible assets and goodwill on the consolidated balance sheets in the amount of $9,958 and $10,912 at December 31, 2003 and 2002, respectively, did not constitute the acquisition of a business, and therefore will continue to be amortized.

Overview

National Bankshares, Inc. is a financial holding company incorporated under the laws of Virginia. Located in southwest Virginia, NBI has two wholly-owned subsidiaries, the National Bank of Blacksburg and National Bankshares Financial Services, Inc. The National Bank of Blacksburg, which does business as National Bank from twenty-six office locations, is a community bank. NBB is the source of nearly all of the Company's revenue. National Bankshares Financial Services, Inc. does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future. Until May 26, 2006, NBI operated a second wholly-owned bank subsidiary, Bank of Tazewell County. On that date it was merged with and into the National Bank of Blacksburg.

Performance Summary



  The following table presents NBI's key performance ratios for the years ending December 31, 2008 and December 31, 2007:




                                                   12/31/08     12/31/07
           Return on average assets                     1.51 %       1.46 %
           Return on average equity                    12.52 %      12.60 %
           Basic net earnings per share           $     1.96   $     1.82
           Fully diluted net earnings per share   $     1.96   $     1.82
           Net interest margin (1)                      4.12 %       3.98 %
           Noninterest margin (2)                       1.46 %       1.41 %

(1) Net Interest Margin - Year-to-date tax equivalent net interest income divided by year-to-date average earning assets.

(2) Noninterest Margin - Noninterest income (excluding securities gains and losses) less noninterest expense (excluding the provision for bad debts and income taxes) divided by average year-to-date assets.

Because net earnings were higher in 2008 than in 2007, basic earnings per share grew by $0.14. Return on average assets increased 5 basis points, from 1.46% in 2007 to 1.51% in 2008. Return on average assets increased because net earnings in 2008 grew at a faster rate than internally generated asset growth. Return on average equity declined by 8 basis points, from 12.60% for 2007 to 12.52% in 2008. Return on average equity was lower in 2008 because the Company's equity, mostly from retained earnings, increased more rapidly than did the current year's net earnings. Reflecting both the effects of the 2008 drop in Federal Reserve interest rates on NBI's funding costs as deposit rates declined and the Company's own asset/liability management practices, the net interest margin increased from 3.98% for 2007 to 4.12% for 2008. The noninterest margin increased from 1.41% to 1.46% over the same period.

Management's longtime focus on profitability over growth for the sake of growth and NBB's conservative credit culture served the Company well in 2008's uncertain economic environment.

Growth



  NBI's key growth indicators are shown in the following table:




                                       12/31/08    12/31/07
                        Securities     $ 264,999   $ 273,343
                        Loans, net       569,699     518,435
                        Deposits         817,848     776,339
                        Total assets     935,374     887,647

Total assets at December 31, 2008 were $935,374, an increase of $47,727 or 5.4%. Net loans increased $51,264 or 9.9%. Total deposits at period-end were $817,848, an increase of $41,509 or 5.4%. Growth in 2008 and 2007 was internally generated.

Asset Quality



  Key indicators of NBI's asset quality are presented in the following table:




                                                     12/31/08     12/31/07
         Nonperforming loans                        $    1,333   $    1,150
         Loans past due over 90 days and accruing        1,127        1,181
         Other real estate owned                         1,984          263
         Allowance for loan losses to loans               1.02 %       1.00 %
         Net charge-off ratio                             0.09 %       0.07 %

There were two nonperforming loans at December 31, 2008, both of which were nonaccrual loans. The total of nonperforming loans at year-end was $1,333, or 0.23% of loans net of unearned income. One loan of $1,028 accounted for the majority of the nonperforming loans total. At December 31, 2007, there was $1,150, or 0.22% of loans net of unearned income, in nonperforming loans. At year-end 2008, loans past due 90 days or more were $1,127, a decrease of $95 from December 31, 2007. Other real estate owned (OREO) grew from $263 at December 31, 2007 to $1,984 at December 31, 2008. Two retail properties constitute a large percentage of the OREO balance at year-end. Additional information about nonaccrual and past due loans is provided in "Balance Sheet - Loans - Risk Elements"

The ratio of the allowance for loan losses to loans net of unearned income was 1.02% and 1.00% at December 31, 2008 and 2007, respectively. The increase in the allowance takes into account both the historical loss projections that accompany growth in the loan portfolio and the higher level of nonperforming loans at year-end 2008.

During the last quarter of 2008, there were serious disruptions in the nation's financial markets which were caused largely by the country's housing crisis. NBI's market did not participate in the rapid inflation of real estate prices that pre-dated recent problems. To date, there have not been the large number of home foreclosures in the Company's markets, particularly in its core area, as have occurred in other regions. If the economic downturn is prolonged, management anticipates that the level of future loan delinquencies will increase. The Company will continue to monitor asset quality and will regularly review the adequacy of the allowance for loan losses. For more information, see "Provision and Allowance for Loan Losses".

Net Interest Income

Net interest income for the period ended December 31, 2008 was $31,293, an increase of $2,269, or 7.8%, when compared to the prior year. Net interest income for the period ended December 31, 2007 was $29,024, a decrease of $313, or 1.1%, from 2006. The net interest margin for 2008 was 4.12%, compared to 3.98% for 2007. Total interest income for the period ended December 31, 2008 was $50,111, a decrease of $658 from the period ended December 31, 2007. Interest expense was down by $2,927 during the same time frame. The decline in interest expense came about because of rapidly falling interest rates in the money markets combined with the Company's liability sensitive balance sheet. In summary, the rates paid on the Company's deposit liabilities declined at a more rapid pace than the interest rates on its interest earning assets.

The amount of net interest income earned is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy; the level and composition of the earning assets; and the level and composition of interest-bearing liabilities. The Company has the ability to respond to interest rate movements and reduce volatility in the net interest margin. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict and may have a greater impact on net interest income than adjustments by management.

Interest rates are at historic lows, and low and stable interest rates benefit the Company. Offsetting the effect of low interest rates is the fact that some higher yielding securities in the Company's investment portfolio may be called when rates are low and are replaced with securities yielding at the lower market rate.

The primary source of funds used to support the Company's interest-earning assets is deposits. Deposits are obtained in the Company's trade area through traditional marketing techniques. Other funding sources, such as the Federal Home Loan Bank, while available, are only occasionally used. The cost of funds is dependent on interest rate levels and competitive factors. This limits the ability of the Company to react to interest rate movements.

If interest rates remain low and stable, management anticipates that there will be less pressure on the net interest margin as management is able to price loans and deposits rationally. If interest rates were to rise quickly, the net interest margin would narrow, because deposit rates would increase at a faster rate than loan rates. If interest rates rise more slowly, the negative effect on the net interest margin would be less pronounced.

Analysis of Net Interest Earnings

The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the interest earned or paid, the average yield or rate on the daily average balance outstanding, net interest income and net yield on average interest-earning assets for the years indicated.

                          December 31, 2008                   December 31, 2007                   December 31, 2006
                                           Average                             Average                             Average
                    Average                Yield/       Average                Yield/       Average                Yield/
                    Balance    Interest     Rate        Balance    Interest     Rate        Balance    Interest     Rate
Interest-earning
assets:
Loans, net
(1)(2)(3)          $ 538,868   $  37,356      6.93 %   $ 510,772   $  37,549      7.35 %   $ 494,495   $  35,134      7.11 %
Taxable
securities           137,497       6,817      4.96 %     152,422       7,476      4.90 %     152,715       7,462      4.89 %
Nontaxable
securities
(1)(4)               144,137       8,911      6.18 %     131,864       8,233      6.24 %     119,931       7,502      6.25 %
Interest bearing
deposits              21,440         449      2.09 %      14,180         726      5.12 %      13,457         684      5.08 %
Total
interest-earning
assets             $ 841,942   $  53,533      6.36 %   $ 809,238   $  53,984      6.67 %   $ 780,598   $  50,782      6.51 %
Interest-bearing
liabilities:
Interest-bearing
demand deposits    $ 243,409   $   3,486      1.43 %   $ 223,771   $   4,371      1.95 %   $ 221,927   $   4,152      1.87 %
Savings deposits      45,796         132      0.29 %      46,943         237      0.50 %      51,745         259      0.50 %
Time deposits        381,961      15,188      3.98 %     379,089      17,102      4.51 %     358,422      14,127      3.94 %
Short-term
borrowings               297          12      4.04 %         626          35      5.59 %         420          26      6.19 %
Total
interest-bearing
liabilities        $ 671,463   $  18,818      2.80 %   $ 650,429   $  21,745      3.34 %   $ 632,514   $  18,564      2.94 %
Net interest
income and
interest rate
spread                         $  34,715      3.56 %               $  32,239      3.33 %               $  32,218      3.57 %
Net yield on
average
interest-earning
assets                                        4.12 %                              3.98 %                              4.13 %

(1) Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 35% in the three years presented.

(2) Loan fees of $859 in 2008, $851 in 2007 and $798 in 2006 are included in total interest income.

(3) Nonaccrual loans are included in average balances for yield computations.

(4) Daily averages are shown at amortized cost.

Analysis of Changes in Interest Income and Interest Expense

The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).

                                                   2008 Over 2007                          2007 Over 2006
                                             Changes Due To                           Changes Due To
                                                                                                              Net
                                                                   Net Dollar                               Dollar
                                       Rates(2)     Volume(2)        Change      Rates(2)     Volume(2)     Change
Interest income:(1)
Loans                                   $ (2,200 )  $    2,008     $      (192 )  $  1,239    $    1,176     $ 2,415
Taxable securities                            80          (739 )          (659 )        28           (14 )        14
Nontaxable securities                        (82 )         759             677         (14 )         745         731
Interest-bearing deposits                   (547 )         270            (277 )         5            37          42
Increase (decrease) in income on
interest-earning assets                 $ (2,749 )  $    2,298     $      (451 )  $  1,258    $    1,944     $ 3,202
Interest expense:
Interest-bearing demand deposits        $ (1,243 )  $      358     $      (885 )  $    184    $       35     $   219
Savings deposits                             (99 )          (6 )          (105 )         2           (24 )       (22 )
Time deposits                             (2,043 )         129          (1,914 )     2,127           848       2,975
Short-term borrowings                         (8 )         (15 )           (23 )        (3 )          12           9
Increase (decrease) in expense of
interest- bearing liabilities           $ (3,393 )  $      466     $    (2,927 )  $  2,310    $      871     $ 3,181
Increase (decrease) in net interest
income                                  $    644    $    1,832     $     2,476    $ (1,052 )  $    1,073     $    21

(1) Taxable equivalent basis using a Federal income tax rate of 35% in 2008, 2007 and 2006.

(2) Variances caused by the change in rate times the change in volume have been allocated to rate and volume changes proportional to the relationship of the absolute dollar amounts of the change in each.

As shown in the chart above, interest expense declined at a faster rate than interest income in 2008. In particular, there was a significant decline in interest expense associated with time deposits. When 2008 and 2007 are compared, time deposit interest expense was $1,914 lower. Of the total decline, $2,043 was due to rates, offset by $129 from higher deposit volume. For the same period, interest-bearing demand deposits had a net decline of $885, of which $1,243 is attributable to rates, offset by $358 from volume.

Lower interest expense in 2008 was the result of the declining interest rate environment caused in part by the Federal Reserve lowering the federal funds rate seven times during the year. Management focused on deposit pricing throughout 2008 and took advantage of falling rates to lower interest expense.

From 2007 to 2008, interest on loans was down by $192. This total came about because rates were $2,200 lower, while volume increased by $2,008. An average volume increase of $28,096 offset to a large degree the decline in loan interest income caused by the effect of falling interest rates.

In 2009, management anticipates that the net interest margin will improve if interest rates remain low and stable. This is because, as the year progresses, the near term pressure on loan rates from 2008 Federal Reserve interest rate cuts may be offset by an improving ability to price loans favorably and to price deposits rationally.

Interest Rate Sensitivity

The Company considers interest rate risk to be a significant market risk and has systems in place to measure the exposure of net interest income and fair market values to movement in interest rates. Among the tools available to management is interest rate sensitivity analysis, which provides information related to repricing opportunities. Interest rate shock simulations indicate potential economic loss due to future interest rate changes. Shock analysis is a test that measures the effect of a hypothetical, immediate and parallel shift in interest rates. The following table shows the results of a rate shock and the effects on net income and return on average assets and return on average equity projected at December 31, 2008 and 2007. For purposes of this analysis, noninterest income and expenses are assumed to be flat.

$ in thousands, except percent data

      Rate Shift (bp)    Return on Average Assets      Return on Average Equity
                           2008            2007          2008            2007
            300                0.83 %          1.21 %        6.87 %         10.24 %
            200                1.08 %          1.30 %        8.81 %         11.01 %
            100                1.32 %          1.39 %       10.71 %         11.77 %
          (-)100               1.81 %          1.56 %       14.46 %         13.20 %
          (-)200               1.85 %          1.60 %       14.79 %         13.54 %
          (-)300               1.74 %          1.60 %       13.93 %         13.52 %

Simulation analysis is another tool available to the Company to test asset and liability management strategies under rising and falling rate conditions. As a part of the simulation process, certain estimates and assumptions must be made. These include, but are not limited to, asset growth, the mix of assets and liabilities, rate environment and local and national economic conditions. Asset growth and the mix of assets can, to a degree, be influenced by management. Other areas, such as the rate environment and economic factors, cannot be controlled. In addition, competitive pressures can make it difficult to price deposits and loans in a manner that optimally minimizes interest rate risk. Therefore, actual results may vary materially from any particular forecast or shock analysis. This shortcoming is offset somewhat by the periodic reforecasting of the balance sheet to reflect current trends and economic conditions. Shock analysis must also be updated periodically as a part of the asset and liability management process.

Noninterest Income



                                                             Year Ended
                                    December 31, 2008     December 31, 2007     December 31, 2006
Service charges on deposits        $             3,425   $             3,291   $             3,361
Other service charges and fees                     326                   330                   370
Credit card fees                                 2,808                 2,740                 2,396
Trust fees                                       1,231                 1,333                 1,528
Other income                                     1,122                 1,015                 1,117
Realized securities gains/losses                   175                    51                    30
Total noninterest income           $             9,087   $             8,760   $             8,802

Service charges on deposit accounts increased by $134, or 4.1%, from 2007 to 2008. For 2007, service charges on deposits were $3,291, which was a decline of $70, or 2.1%, over year-end 2006. This category of fees is impacted by the level of service charges, the number of deposit accounts and the volume of checking account overdrafts. Service charges were increased in mid-2008, and the change accounted for the growth in this income category. Of the $134 increase, approximately $120 is attributable to fees for overdrafts and return checks. The decline in 2007 resulted from a decrease in fees paid for checking account overdrafts and for checks returned because of insufficient funds.

A variety of fees are included in the other service charges and fees category. Among them are fees for official checks, income from the sale of checks to customers, safe deposit box rent, fees for letters of credit and commission earned on the sale of credit life, accident and health insurance. At December 31, 2008, the total for other service charges and fees was $326, a decrease of $4 from the year ended December 31, 2007. In 2007, other service charges and fees were $330, a decrease of $40, from 2006. The 2008 and 2007 declines were the result of small decreases in several types of fees, none of which is significant by itself.

Credit card fees for 2008 grew by $68, or 2.5%. In 2007, that category was up by $344, or 14.4%. Internal growth, resulting in a higher volume of accounts, transactions and merchant transactions, caused the increases in 2008 and 2007 credit card fee income.

For the year ended December 31, 2008, trust fees were $1,231, as compared with $1,333 in 2007 and $1,528 in 2006. This represents a decline of $102, or 7.7%, from 2007 and 2008 and a drop of $195, or 12.8% between 2006 and 2007. Trust fees are generated from a number of different types of accounts, including estates, personal trusts, employee benefit trusts, investment management accounts, attorney-in-fact accounts and guardianships. Trust income varies depending upon the types of accounts under management and with market conditions. Trust account values are affected by financial market conditions, and this leads to fluctuations in trust income. The decline in 2007 from 2006 was primarily accounted for by a $127 decline in estate management fees. The decrease in trust fees for 2008 from 2007 is attributable to both factors, the . . .